How does the IMF monitor Global Financial Stability?
Two approaches to measuring the financial vulnerabilities affecting the World economy
It’s been more than a decade since the last major financial crisis hit the global economy. A lot of safety mechanisms were put in place after the crisis to plug the loopholes in the financial system in case of another financial downturn. A better understanding of these financial vulnerabilities can lead to muting the negative effects on global growth & employment.
The Central global monetary authority — International Monetary Fund (IMF) has been continuously working on devising & improving a financial stability framework via its analysis, published twice a year, called the Global Financial Stability Report.
The most recent report describes a two-part approach to assessing the vulnerabilities of the financial firms and markets, and business, household and government borrowers, and a summary financial stability risk measure in terms of forecast GDP growth depending on financial conditions.
This approach is expected to improve communication between regulators & policymakers with the aim of enhancing transparency.
The framework explains that cyclical financial stability risks go up due to the collective risk-taking of lenders & borrowers, with loose monetary conditions (low-interest rates) in place, as we have seen that existed for a long time after the financial crisis of 2008. These vulnerabilities lead to magnifying the shocks of a downturn leading to tighter monetary conditions.
The first approach is a “bottom-up” monitoring matrix of indicators (Figure 1) defined by the following vulnerabilities:
- Inflated asset valuations
- Greater leverage and funding mismatches of banks & other financial firms
- Greater indebtedness among nonfinancial borrowers, including households, businesses, and governments.
The chart above plots the degree of vulnerabilities of these risks across banks, nonbank financial firms & households in the financial sector. It illustrates the high levels of debts & vulnerabilities during the times of financial crisis showed by the red lines.
While sovereign & nonfinancial firms have crossed the red line, banks, households, Insurers & other financial institutions are in much better shape. IMF intends to evolve this risk matrix as the monitoring framework captures other emerging vulnerabilities.
The second approach measures the “top-down” summary measure of financial stability risk — “Growth at Risk” or GaR. It is basically measured by taking into account the downside risks to projected GDP growth, dependent on the existing financial conditions.
Instead of hard quoting a number for GDP growth, growth projection is looked like a set of probabilities, incorporating the risks to growth. The chart above (Figure 2) illustrates the probability distribution of forecast global GDP growth shifts for three different time periods — since the conditions before the Q1 2019 were tighter than the previous two quarters, the downside risks to the GDP forecast in the year ahead increased.
And while loose monetary conditions provide the impetus for growth & reduce volatility in the short term, vulnerabilities from loose monetary conditions build up in the medium term. Work is in progress to include this so-called ‘volatility paradox,’ in the measure of financial stability risks.
Continued work on the monitoring framework is going to lead to better indicators of the financial conditions & the risks so that a more representative estimate of GaR for the global economy, regions, or countries could be provided. The IMF has launched a new annual survey for the framework that will also incorporate the effect of macroprudential policy implementation by governments in their respective countries to improve the financial conditions.
While this framework may not tell us when the next financial crisis will hit, it will certainly lead to better monetary and regulatory policy — a more proactive approach rather than a reactive one.