The global financial system remains under severe stress as the crisis broadens to include households, corporations, and the banking sectors in both advanced and emerging market countries. Shrinking economic activity has put further pressure on banks’ balance sheets as asset values continue to degrade, threatening their capital adequacy and further discouraging fresh lending. Thus, credit growth is slowing, and even turning negative, adding more downward pressure on economic activity. Substantial private sector adjustment and public support packages are already being implemented and are contributing to some early signs of stabilization. Even so, further decisive and effective policy actions and international coordination are needed to sustain this improvement, to restore public confidence in financial institutions, and to normalize conditions in markets. The key challenge is to break the downward spiral between the financial system and the global economy. Promising efforts are already under way for the redesign of the global financial system that should provide a more stable and resilient platform for sustained economic growth.

Systemic risks remain high and the adverse feedback loop between the financial system and the real economy has yet to be arrested, despite the wide range of policy actions and some limited improvement in market functioning. Further effective government action— particularly geared toward cleansing balance sheets and strengthening institutions—will be required to stabilize the global financial system and to provide the foundation for a sustainable economic recovery. The banking system needs additional equity to absorb further writedowns as credit deteriorates, and risks are broadening to encompass nonbank institutions. The crisis has spread to emerging markets with the collapse of international financing, posing challenges to corporates, households, and banks as well as raising sovereign risk. The global policy response, including the IMF’s enhanced lending framework, should help to mitigate crisis risks. There remains considerable scope for further public commitments in larger economies, but extensive provision of financing and the transfer of balance sheet risk from the private to the public sector have increased tail risks for certain mature market sovereigns.
Against this backdrop, Chapter 1 first outlines the key financial stability risks that have materialized since the October 2008 Global Financial Stability Report. Then, it examines the deleveraging process and its effects on the real economy. The following section assesses the vulnerability of emerging markets to global stress, especially focusing on the refinancing risks facing corporates. The outlook for global credit markets is then evaluated, along with IMF staff estimates of potential global financial writedowns. The stability risks facing financial institutions are assessed and the effectiveness of the policy response evaluated. The chapter concludes with a discussion on sovereign risks.
Box 1.1 summarizes the key financial stability challenges and policy priorities detailed in the chapter.

The rise in the complexity and globalization of financial services has contributed to stronger interconnections or linkages. While more extensive linkages contribute to economic growth by smoothing credit allocation and allowing greater risk diversification, they also increase the potential for disruptions to spread swiftly across markets and borders. In addition, financial complexity has enabled risk transfers that were not fully recognized by financial regulators or by institutions themselves, complicating the assessment of counterparty risk, risk management, and policy responses. Thus the importance of assessing the systemic implications of financial linkages.
The current crisis has highlighted how systemic linkages can arise not just from financial institutions’ solvency concerns but also from liquidity squeezes and other stress events. This chapter illustrates the type of methodologies that can provide some prospective metrics to facilitate discussions on systemic linkages and, specifically, the “too-connected-to-fail” problem, thereby contributing to enhanced systemically focused surveillance and regulation. By contrast, Chapter 3 presents other methodologies that examine systemic risk by looking at the conditions under which financial institutions experience simultaneous stressful events.
This chapter presents four complementary approaches to assess direct and indirect financial sector systemic linkages:
• The network approach, which tracks the reverberation of a credit event or liquidity squeeze throughout the banking system via direct linkages in the interbank market;
• The co-risk model, which exploits market data to assess systemic linkages among financial institutions under extreme events;
• The distress dependence matrix, which examines pairs of institutions’ probabilities of distress, taking into account a set of other institutions; and
• The default intensity model, which measures the probability of failures of a large fraction of financial institutions due to both direct and indirect systemic linkages.
The chapter argues that, although each approach by itself has its limitations, together they represent a set of valuable surveillance tools and can form the basis for policies to address the tooconnected- to-fail problem. More specifically, this chapter assists policymakers in two areas under current discussion:
• Perimeter of regulation. To maintain an effective perimeter of prudential regulation without stifling innovation, the tools provided in the chapter could help address questions such as whether to limit an institution’s exposures, the desirability of capital surcharges based on systemic linkages, and the merits of additional liquidity regulations.
• Information gaps. The chapter also discusses the importance of filling existing information gaps on cross-market, cross-currency, and cross-country linkages to refine analyses of systemic linkages. Closing information gaps would require improved data collection procedures and impose additional demands on financial institutions, but would be a far better alternative to waiting until a crisis ensues to obtain information as events unfold.

The current crisis demonstrates the need for tools to detect systemic risks. Given that there are many facets and causes of such risks, this chapter presents a range of measures that can be used to discern when events become systemic. The chapter first reviews the standard financial soundness indicators’ ability to highlight those financial institutions (FIs) that proved to be vulnerable in the current crisis. For the sample of global FIs examined, leverage ratios and return-on-assets proved the most reliable indicators, while capital asset ratios and nonperforming loan data lacked predictive power.
The chapter then proceeds to examine several techniques to analyze forward-looking market data for groups of FIs in order to detect whether and when systemic risks became apparent. Market-based measures that are able to capture tail risks seem to have given forward indications of impending stress for the overall financial system. Chapter 2 provides a slightly different approach to systemic risk by examining interlinkages, both direct and indirect, between selected FIs.
Finally, proxies for “market conditions” that influence (and reflect) the risks facing FIs are examined to capture other key factors, such as investors’ risk appetite. The signaling capacity of these indicators is examined by detecting whether and when they moved from low, to medium, and to high volatility states, with the high state associated with systemic crisis. Several measures signaled periods during which the financial system suffered a systemic crisis. The various techniques clearly identify major stress events, such as those associated with the merger of Bear Stearns and the failure of Lehman Brothers, as systemic. Some indicators, as early as February 2007, also signaled rising systemic pressures. However, advance notice of systemic stress was relatively brief and the extent to which some markets remained in high volatility states was somewhat short-lived. Hence, the use of a number of market-based indicators provides a more holistic picture.
Being able to identify systemic events at an early stage enhances policymakers’ ability to take necessary exceptional steps to contain the crisis. In this regard, the chapter suggests enhancing stress tests and capital requirements to take account of the buildup of systemic risks. Some of the analysis presented could be a starting point to calibrate the risk contribution of FIs to overall systemic risk, thereby prompting additional regulatory capital and enhanced supervision to discourage practices that increase systemic risk.
In sum, although systemic events are difficult to predict, and may only become apparent concurrently in some cases, policymakers should monitor a wide range of market indicators tuned to systemic risk, and have comprehensive crisis plans in place to be implemented quickly if needed.

This statistical appendix presents data on financial developments in key financial centers and emerging markets. It is designed to complement the analysis in the text by providing additional data that describe key aspects of financial market developments. These data are derived from a number of sources external to the IMF, including banks, commercial data providers, and official sources, and are presented for information purposes only; the IMF does not, however, guarantee the accuracy of the data from external sources.
Presenting financial market data in one location and in a fixed set of tables and charts, in this and future issues of the GFSR, is intended to give the reader an overview of developments in global financial markets. Unless otherwise noted, the statistical appendix reflects information available up to February 25, 2009.
Mirroring the structure of the chapters of the report, the appendix presents data separately for key financial centers and emerging market countries. Specifically, it is organized into three sections:
• Figures 1–14 and Tables 1–9 contain information on market developments in key financial centers. This includes data on global capital flows, and on markets for foreign exchange, bonds, equities, and derivatives as well as sectoral balance sheet data for the United States, Japan, and Europe.
• Figures 15 and 16, and Tables 10–21 present information on financial developments in emerging markets, including data on equity, foreign exchange, and bond markets, as well as data on emerging market financing flows.
• Tables 22–27 report key financial soundness indicators for selected countries, including bank profitability, asset quality, and capital adequacy.