(Bloomberg) -- The International Monetary Fund warned it was too soon to sound the all-clear from the turmoil that’s shaken the world financial system and said the banking breakdowns will likely be a drag on global economic growth.
While forceful actions by policymakers to a series of bank collapses have reduced investor anxiety, the financial markets remain fragile and stressed, the IMF said in its semi-annual Global Financial Stability Report released Tuesday.
“The resilience of the global financial system has been severely tested,” the fund said. “It remains to be seen whether the measures taken so far have been sufficient to fully restore confidence in markets and institutions.”
In the US, the authorities took extraordinary action to contain contagion by guaranteeing all deposits in Silicon Valley Bank and Signature Bank (OTC:SBNY) after they failed and by opening up a new facility at the Federal Reserve to provide more liquidity to system. Swiss authorities, meanwhile, engineered and supported the takeover of crisis-racked Credit Suisse (SIX:CSGN) Group AG by UBS Group AG (SIX:UBSG).
The IMF released the report shortly after publishing an update to its World Economic Outlook in which it trimmed its global growth projections and warn of high uncertainty and risks as financial-sector stress adds to pressures emanating from tighter monetary policy and Russia’s invasion of Ukraine.
In a blog post accompanying the financial stability report, senior IMF official Tobias Adrian suggested investors may be too sanguine about the risks to the outlook, with equity valuations stretched, particularly in the US.
“Perhaps surprisingly, overall financial conditions have not tightened meaningfully” since the banking collapses, he wrote.
The bank breakdowns were symptomatic of a “perilous combination of vulnerabilities” that have been “lurking under the surface of the global financial system for years” and that have now been exposed by an aggressive tightening of credit by central banks to fight decades-high inflation, the IMF said in the report.
“The rapid pace of policy tightening is causing fundamental shifts in the financial risk landscape,” the fund said. “Asset allocations, asset prices, and market conditions are adjusting, challenging market structures, investors, and financial institutions.”
The financial strains are also complicating central banks’ efforts to rein in inflationary pressures that are proving more persistent than expected, the IMF said. If those stresses intensify, the authorities may face difficult trade-offs between fighting inflation on one hand and ensuring the stability of the financial system on the other.
Act Swiftly
“Policymakers should act swiftly to prevent any systemic event that could shake investor confidence in the global financial system” even if that means cutting interest rates, the fund said.
But they should also make clear their resolve to bring inflation down as soon as possible once the financial stress dissipates, the lending organization said.
In his blog post, Adrian said the recent turmoil was more akin to the 1980s savings and loan crunch in the US than to the global financial crisis some 15 years ago. The banking system has much more capital than it did in 2008 and post-crisis regulations have curbed credit risks, he wrote.
Nevertheless, “stress in the banking sector will likely weigh on broader lending conditions and thus economic growth,” the IMF said in its report.
Recent sharp declines in bank stocks might lead to cutbacks in credit that lop almost a half percentage point off growth in the US and euro area, according to fund estimates.
Among the many pockets of weakness cited by the IMF in the financial stability report:
- Almost 9% of US banks with assets between $10 billion and $300 billion would effectively be under-capitalized if they were forced to fully account for unrealized losses on Treasury and other securities they hold.
- Commercial real estate markets appear to be significantly overvalued across countries and are at risk of a further tightening of credit by banks and other lenders in the wake of the recent turmoil. That could “create an adverse feedback loop between credit growth and asset prices” as declines in the latter reduce the value of collateral put up for loans.
- The European Central Bank may need to provide additional liquidity to the financial system when mandatory targeted long-term refinancing operations come due in June. Banks in some southern European countries may not have enough extra cash to repay.
The IMF though did cite a comparative bright spot. “Large emerging markets have so far managed relatively smoothly the sharp tightening of monetary policy in advanced economies,” it said.
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