The IMF says financial-sector assessments are gauging the effects of elevated borrowing costs, and the prospect that central banks may keep policy rates higher for longer than investors expect

By Tobias Adrian, Hiroko Oura*

Interest-rate increases by global central banks to contain the biggest inflation outbreak in four decades generated strains for banks in the United States and Europe this year. Rate hikes are generally positive for lenders if they can collect more on lending than they pay depositors, but this time was different. Some banks lost money on bond holdings - even from safe US Treasuries. This rattled some customers, who quickly made withdrawals, amplified by technology and social media. A number of banks failed.

Our Financial Sector Assessment Program is a crucial pillar of our surveillance that closely tracks financial stability risks for individual countries and gauges how resilient they may be. FSAPs also assess whether the financial sector supervision, regulation, crisis management tools, and safety nets - like emergency liquidity support and deposit insurance—follow international best practices. FSAPs always “stress test” potential risks to banks, and more recently have enhanced the risk assessment of nonbank financial intermediaries, such as pension managers, insurers, and asset managers.

Our work is taking place amid continued central bank interest-rate increases, and the potential for borrowing costs to remain higher for longer than investors, businesses and households expect. This could increase financial stability risks and weigh on growth, as we noted in July.

Market volatility and runs

Rapid monetary policy tightening could make bond and interest-rate derivatives markets volatile. Even the value of safe US Treasury securities drop by as much as 30 percent when yields go up by 400 basis points - the actual shock to 10-year Treasury note yields since 2020.

Before March, we emphasised the risks from such shifts in bond markets to nonbank financial companies. Many of them have large investments in bonds and suffer from valuation losses. Especially, investment funds could face rapid redemptions - runs - as their customers can quickly exit unprofitable funds.

Runs are rare for pension and life insurance companies as policyholders must incur penalties with early withdrawal. However, companies that use derivatives and other complex transactions to boost returns may suffer from margin calls as they would be required to provide cash should those instruments lose value - as occurred for some UK pension funds last year.

Then, the events in March reminded us of the importance of bank runs. The regulatory reforms after the global financial crisis required banks to hold more cash and bonds. Further, in many countries after the global financial crisis, banks can now borrow more easily from central banks to avoid selling bonds into falling markets. Yet, in the case of the Silicon Valley Bank, these safeguards did not work well. The value of its bond holdings slumped amid rapid monetary tightening, hitting earnings, capital, and cash buffers. Depositors saw these strains and withdrew funds. The bank was not prepared to access central bank liquidity in time and failed, as did other US lenders.

Better gauges

Seeing these episodes, we see three important evolutions for FSAP risk assessments:

• Risk analyses should pay more attention to potentially vulnerable smaller financial companies, starting with assessing business models and risk management related issues. For example, the US authorities relaxed stress testing requirements for small- and medium-sized banks in 2019, which was criticised in the 2020 US FSAP recommendations. As a result, the Federal Reserve’s annual stress test and the 2020 US FSAP omitted Silicon Valley Bank and other regional banks.
   
• Analyses should closely investigate the interlinkages of asset market stress, financial companies’ earnings, and their run risk, especially for banks. Standard FSAP stress tests consider stress on bank capital and run risks separately, but do not fully account for their interaction.
   
• FSAPs should continue the efforts to better understand the funding risk spillovers across financial companies - called systemwide liquidity risks. For example, bond market turbulence could trigger liquidity stress in some companies and then spill over to the whole ecosystem as they sell off their assets, reducing their prices, and withdrawing funding from one another. Several FSAPs applied a simple, new systemwide liquidity stress testing tool, including Türkiye, Jordan, Chile, and the Philippines. Moreover, the 2022 Mexico FSAP took a more tailored  and looked at the impact of capital outflows as global policy rates and financial conditions tightened. Similarly, the 2020 US FSAP examined how turmoil in corporate bond markets is amplified or mitigated by investment funds, banks, and insurers.

The FSAP will also continue to incorporate evolving international standards on regulation and supervision, and crisis management. Previous FSAPs for the United States and Switzerland highlighted the regulatory and supervisory shortcomings revealed in the bank failures earlier this year. They underscored that while principles underlying post-global financial crisis regulatory reforms remained appropriate, financial supervisors may have lacked the willingness, legal backing, and resources to put problematic banks back on track.

FSAP in 2023

This year, our program covers four economies with systemically important financial sectors that must be assessed every five years: Belgium, Finland, Sweden, and Türkiye. Preparation for 2024 FSAPs is also underway, including mandatory cases like China, Indonesia, Japan, Luxembourg the Netherlands, Saudi Arabia, and Spain.

In-depth and comprehensive surveillance of the financial sector now should be even more valuable than usual, given the increased attention to financial stability in a major global monetary tightening cycle.

Tobias Adrian and Hiroko Oura are senior managers at the International Monetary Fund. This article was originally posted here.