The IMF paper describes the conceptual framework that guides assessments of financial stability risks for multilateral surveillance, as presented in the Global Financial Stability Report. The framework emphasizes consistency in measuring financial vulnerabilities across countries and over time and offers a summary statistic to quantify aggregate financial stability risks. The two parts of the empirical approach – a matrix of specific vulnerabilities and a summary measure of financial stability risks – are according to the authors distinct but highly complementary for monitoring and policymaking.
IMF staff discussion note – SDN/19/06
26 August 2019
Source: International Monetary Fund
Tobias Adrian, International Monetary Fund
Dong He, International Monetary Fund
Nellie Liang, International Monetary Fund
Fabio Natalucci, International Monetary Fund
Since the inception of the Global Financial Stability Report (GFSR), its framework for financial stability monitoring has continued to evolve and improve. This paper describes the conceptual framework that underpins the current approach in the GFSR for evaluating global financial stability risks. By doing so, this paper aims to contribute to financial stability by enhancing transparency about how it makes its assessments and improving communication. The GFSR is one of the IMF’s flagships assessing financial stability, and it is released following a discussion by the Executive Board.
The conceptual framework is one in which cyclical financial stability risks arise as macro-financial imbalances increase because of greater risk-taking by lenders and borrowers. High imbalances can amplify negative shocks and create an adverse feedback loop as prices fall and financial firms are forced to deleverage, leading to a sharp decline in economic growth. This framework is based on a growing body of research from policymaking institutions and academia that explores macrofinancial linkages, many of which were ignored before the financial crisis.
The first part of the approach involves monitoring a set of indicators in a matrix defined by types of macro-financial imbalances across types of lenders and borrowers in the financial system. It involves assessing asset valuations, leverage and funding mismatches of financial intermediaries, and credit of borrowers. This structured and consistent framework for monitoring across countries and time also facilitates investment in better data and models that will contribute to better risk assessments in the future.
The second part is a summary aggregate measure of financial stability risk, expressed as downside risks to forecast GDP growth conditional on financial conditions, or growth at risk. Financial conditions measure the cost of funding and reflect the underlying price of risk in the economy. The key innovation of this measure of financial stability risk is that it reflects that the entire distribution of forecast GDP growth is linked to financial conditions. That is, it is important to consider not only expected growth but risks to expected growth. In addition, there may be an intertemporal trade-off for risk, which suggests it is important to consider risks to growth over time. While loose financial conditions raise growth and reduce risks to growth in the near term, they may increase downside risks to growth in the medium term because vulnerabilities have built up in response.
The two parts of this approach are complementary, with the more granular analysis of various specific vulnerabilities providing necessary nuance and depth to the aggregate summary measure of downside risks to growth. The focus on vulnerabilities highlights potential targets for macroprudential policies. In addition, because growth at risk is a continuous measure and can be updated regularly along with forecasts for expected growth, it allows financial stability risks to be incorporated into decision-making frameworks for prudential or monetary policy, rather than only intermittently when financial risks are very high. By offering a concrete measure of financial stability risks in terms of a common metric – GDP growth – it provides a path to better communication and coordination among financial regulators and central banks, which is important for effective macroprudential policymaking.