The stability of the global financial system is being bolstered by favourable economic conditions, but some financial market risks have crept up in recent months, the International Monetary Fund said on Tuesday.
”Global economic conditions have been supportive of a benign financial environment, but underlying risks and conditions have shifted somewhat since … September 2006, and have the potential to weaken financial stability,” the IMF said in its semi-annual Global Financial Stability Report.
Jaime Caruana, director of the IMF’s monetary and capital markets department, said overall economic risks had diminished worldwide, but recent market corrections were a reminder that risks exist and things could turn for the worse quickly.
”We think markets are going to be more focused on the outlook on the economies, especially on the outlook of the US economy, and therefore they will focus on the news,” Caruana told a news conference.
Caruana cautioned that investors would be inclined to react to financial data but that they may not be paying enough attention to the downside risks and were assuming that low risk premia and low volatility will remain.
The IMF pointed to potential risks from the rapid decline in the United States subprime mortgage market, involving borrowers with poor credit history. It said the decline was more rapid than expected at this point in the overall housing downturn.
While the fallout in the subprime market has been limited to a small number of lenders, the IMF warned that problems could spread to other asset markets.
In particular, it said looser underwriting standards may have gone beyond the subprime sector into portions of so-called ”Alt-A” mortgages, the next-riskiest area. In addition, there could be losses in other consumer credit markets, including credit card and subprime auto loan asset-backed securities, it said.
”Financial supervisors need to identify the potential for spillovers from the cooling of the housing market and continue ensuring that mortgage underwriting standards are maintained,” the IMF said.
Wave of big buyouts
The fund also pointed to the potential risk from the recent wave of corporate buyouts, which showed a weakening of credit discipline.
”So far, target firms are mostly those with high cash flows and low leverage,” the fund said. ”However, there are signs that credit risks have risen as valuations of target companies are rising along with leverage, while credit discipline is eroding, reflecting the continued weakening of loan covenants.”
A collapse in one or more high-profile deals could expose banks and trigger a wider reappraisal of risks, the IMF said.
Looking at regions, the IMF said available indicators point to resilient financial systems in most areas.
In shifts in the financial system, the IMF said financial globalisation — the purchase of cross-border financial assets — had tripled, with increased investment in hedge funds.
”The increased diversity of investors should contribute to financial stability, however, the speed that these changes are taking place may temporarily distort prices in financial markets and create pockets of vulnerabilities,” the IMF said.
In some emerging market countries, demand has outpaced available local financial assets, leading to a sharp rise in asset prices, rapid credit growth and a rise in the value of currencies, the fund said.
Creditors have also moved into investments in which they have little experience and which are untested, it cautioned.
”The growing role of leveraged investors, such as hedge funds, may have introduced a propensity for asset prices to overshoot during good times, increasing the probability of downside risks when financial conditions worsen,” the IMF said. – Reuters