The Financial System Is Stronger, But New Vulnerabilities Have Emerged in the Decade Since the Crisis


Although the global expansion has plateaued, easy monetary policies continue to
support growth. But we shouldn’t rest too easily. Chapter 1 of the latest Global
Financial Stability Report finds that short-term risks to the financial system have
increased somewhat over the past six months. Trade tensions have escalated, policy
uncertainties have increased in a number of countries, and some emerging market
economies are facing financial-market pressures.
Looking further ahead, risks remain elevated. To be sure, the financial system is
stronger today than before the global financial crisis, thanks to a decade of reform
and recovery. However, vulnerabilities continue to build, and the new financial
system remains untested. Additional steps are needed to improve its resilience.
Before we discuss specific policy measures, let’s take a closer look at the global
financial landscape. So far, robust risk appetite has continued to support rising asset
prices in major financial markets and financial conditions have remained relatively
easy, despite policy rate hikes by the US Federal Reserve. However, the stronger
dollar and higher US interest rates have made overseas borrowing more expensive
for emerging markets, especially those with larger credit needs and weaker economic
conditions or policy frameworks.

New vulnerabilities
If pressures on emerging market economies were to broaden and intensify, financial
stability risks would increase significantly. Our analysis suggests that — in the
medium term — there is a 5 percent probability that emerging market economies will
experience portfolio debt outflows of $100 billion or more. That is broadly similar in
magnitude to outflows experienced during the crisis.

There are other ways stability risks could rise sharply. These include a broader
escalation of trade tensions, a no-deal Brexit, renewed concerns about fiscal policy in
some highly indebted euro area countries, and a faster-than-expected normalization
of monetary policy in advanced economies.
Any of these concerns could expose the financial vulnerabilities that have grown over
years of accommodative monetary policy. In economies with globally systemically
important financial sectors, debt owed by governments, companies, and households
has risen from around 200 percent of GDP a decade ago to almost 250 percent
today. Emerging market economies are borrowing more in international markets
and face the risk that they will be unable to refinance a substantial portion of their
foreign currency debt. Banks are exposed to these highly indebted borrowers, and
some global banks have large holdings of more illiquid and opaque assets. Asset
valuations remain stretched across several sectors and regions, and underwriting
standards are deteriorating.

This accumulation of vulnerabilities raises the urgency for policymakers to step up
efforts to bolster the financial system:
• Micro-prudential, or firm level, policies should aim to strengthen bank
balance sheets against solvency and liquidity risks.
• Broad-based macroprudential tools, such as the countercyclical capital buffer
(which aims to increase bank capital when borrowing is rising in the
economy), should be used more actively in countries where financial
conditions remain accommodative and vulnerabilities high. Financial stability
also requires new macroprudential tools to address vulnerabilities outside the
banking sector, for example, to ensure sound underwriting standards in
nonbank credit intermediation and to tackle liquidity risks by asset
• For emerging market economies, reducing vulnerabilities and maintaining
robust policies and sound policy frameworks remains critical. This includes
building and maintaining adequate foreign exchange reserves and using these
reserves judiciously.
• Regulators and supervisors must respond to new threats, including cyber
risks. They should also support fintech’s potential contribution to innovation,
efficiency, and inclusion while safeguarding against risks to the financial
This is no time for complacency. More proactive measures should be adopted to
safeguard financial stability. As noted in Chapter Two of the Global Financial Stability Report, released earlier, the financial regulatory reform agenda should be
completed and a rollback of reforms avoided. And finally, international cooperation
is crucial for maintaining global financial stability and fostering sustainable
economic growth.


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