By José Viñals
The quest for lasting financial stability is still fraught with risks. The latest Global Financial Stability Report has two key messages: policy actions have brought gains to global financial stability since our September report; but current policy efforts are not enough to achieve lasting stability, both in Europe and some other advanced economies, in particular the United States and Japan.
Much has been done
In recent months, important and unprecedented policy steps have been taken to quell the crisis in the euro area. At the national level, stronger policies are being put in place in Italy and Spain; a new agreement has been reached on Greece; and Ireland and Portugal are making good progress in implementing their respective programs. Importantly, the European Central Bank's decisive actions have supported bank liquidity and eased funding strains, while banks are reinforcing their capital positions under the guidance of the European Banking Authority. Finally, steps have been taken to enhance economic governance, promote fiscal discipline, and buttress the "firewall" at the euro area level.
[Related -Germany Is On The Rebound - Time To Buy?]
These actions and policies have broughtmuch-needed relief to financial markets since the peak of the crisis late last year.
But it is too soon to say that we have exited the crisis, because lasting stability is not yet ensured. Indeed, we have been reminded in recent weeks that sentiment can quickly shift and rekindle sovereign financing stress, leaving many sovereigns and banking systems caught in a vicious circle.
[Related -Is Drought Risk In The American West An Economic Threat?]
Furthermore, pressures on European banks remain from high rollover requirements, weak growth, along with the need to strengthen balance sheets, including by shrinking. Some deleveraging is healthy—when banks increase capital, cut noncore activities, and reduce reliance on wholesale funding that results in more robust balance sheets.
But like Goldilocks, the amount, pace, and location of deleveraging must be just right at the aggregate level—not too large, too fast, or too concentrated in one region or country.
So far current policies have prevented a generalized "credit crunch", but we still anticipate a considerable squeeze on credit which will impede growth. We estimate that large European Union-based banks could shrink their combined balance sheet by as much as $2.6 trillion—or about 7 percent of their total assets—by the end of 2013, with about a quarter of that shrinkage leading to a cutback in lending. Overall, we estimate that deleveraging by EU banks could reduce the supply of credit in the euro area by about 1.7 percent over two years.