An easing cycle from central banks has the potential to encourage further risk-taking from investors, which may threaten the stability of the global financial system, the International Monetary Fund cautioned Oct. 16.
While central banks' interest rate cuts are supporting the global economy amid heightened trade risks and slower growth, looser financial conditions "are encouraging financial risk-taking and are fueling a further buildup of vulnerabilities" in some areas, the IMF said in its latest Global Financial Stability report.
"With financial conditions still easy, and with vulnerabilities building, policymakers should act now to reduce the vulnerabilities that could exacerbate the next economic downturn," IMF Financial Counsellor Tobias Adrian said at a news conference in Washington, D.C.
Regulators should keep up with their stringent supervision of bank lending practices, and they should make efforts to increase disclosure and transparency in the nonbank sector, the IMF recommended. That may include adding minimum solvency and liquidity standards for institutional investors, the report said.
Lower interest rates, including some $15 trillion in negative-yielding bonds, are encouraging corporations to take on more debt, the report noted.
The ability of companies to service their debts is weakening, a development that "would be sobering" in case of an economic slowdown, Adrian told reporters. If the global economy sees a downturn half as severe as the financial crisis, the debt owed by companies unable to cover interest payments with their earnings may rise to $19 trillion, above levels seen during the crisis.
Policymakers should consider developing a regulatory framework for highly indebted companies in countries where corporate debt is posing systemic risks, the report said.
Vulnerabilities are particularly notable among nonbank financial institutions, where risks are elevated in 80% of economies with major financial sectors, similar to crisis-era levels. Insurers are subject to significant risks, given that their search for higher returns can expose them to shocks during periods of market stress, the report said.
"Similarities in investment funds' portfolios could magnify a market sell-off, pension funds' illiquid investments could constrain their ability to play a role in stabilizing markets as they have done in the past, and cross-border investments by life insurers could facilitate spillovers across markets," the report said.
The banking sector is much more resilient today due to safeguards that regulators implemented after the crisis, but "pockets of weaker institutions remain," the report said. Bank profits are expected to drop due to flatter yield curves, negative yields in some countries and a more tepid global growth outlook, and banks outside the U.S. could also face U.S. dollar liquidity strains, the IMF said.
As an example, the report noted that Chinese authorities intervened in three regional banks that came under pressure.
The IMF also called for greater focus on environmental, social and governance principles, saying that policymakers should require heightened corporate disclosures on climate threats and other financial system risks.