Pandemic will likely test resilience of the global financial system, IMF says

People walk along Wall Street in the Financial District on September 02, 2020 in New York City.

Some banking system vulnerabilities that were elevated before the coronavirus pandemic have continued to rise in recent months, setting up a major test of the resilience of the global financial system, the International Monetary Fund said Tuesday.

Swift, massive intervention by central banks and government spending helped avoid a financial catastrophe so far, but have not eliminated the risks, the IMF said, in its latest Global Financial Stability Report.

There is a now a gap between rising market valuations and the evolution of the economy. The odds of a sharp adjustment may rise if investors reassess the outlook, the report warned.

The IMF said vulnerabilities were elevated in several sectors across 29 countries with systemically important financial sectors. They contributed to the market selloff in March and have continued to rise, the IMF said.

“Some pre-existing financial vulnerabilities are now intensifying, representing potential headwinds to the recovery,” said Tobias Adrian, the IMF’s financial counsellor at a press briefing to discuss the report.

Triggers such as new virus outbreaks, policy missteps or other shocks could lead to more bankruptcies, tightening of bank lending standards and tightening of financial conditions, the report said.

Many firms had high levels of debt before the crisis and this is still increasing in some sectors, presenting solvency risks.

While the global banking system is well capitalized, IMF analysis shows that some banking systems could suffer significant capital shortfalls especially if the global economy stumbles.

In addition, the shadow bank sector remains vulnerable, the IMF said.

“The increased links between corporates, banks, and non-bank financial institutions imply that – at some point- fragilities could spread through the entire financial system,” Adrian said.

As economies reopen, policymakers should keep policy accommodative to ensure the recovery takes hold, the IMF said.

Once the crisis has eased, governments should take steps to strengthen oversight of shadow banks and step up prudential regulation to contain excessive risk-taking in a “lower for longer” interest-rate environment, he added.

For the U.S., the sell off in markets in March as a result of the pandemic exposed “a number of vulnerabilities in the non-bank market based sector, he said.

Money markets dried up and money-market funds became vulnerable and should be an area of focus, he said.

Another area for study is the surprising evaporation of liquidity in the U.S. Treasury market.

Asset managers continue to see vulnerabilities from liquidity and risk-transformations.

And in March, margins increased very rapidly in some market segments and this is another focus area.

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