Washington D.C., 3 March 2010

The Institute of International Finance's Market Monitoring Group (MMG), an independent forum of private-sector leaders in international finance and experienced market practitioners, today issued a statement on potential systemic risks following its regular quarterly meeting. This is in keeping with its mandate to advise market participants and policymakers of emerging vulnerabilities in the global financial system. IIF Managing Director Charles Dallara stated, "The MMG believes it appropriate at this time to signal concerns about risks arising from the current high level of uncertainty, both on the regulatory front and in the conduct of fiscal policy. In particular, uncertainty related to fiscal policy challenges-both near-term, as in the case of Greece, and medium-term, such as those facing many important countries-have unsettled markets and could generate market pressure on interest rates, weakening investor and consumer confidence and undermining global recovery."

MMG co-chairman Jacques de Larosière, former Managing Director of the International Monetary Fund and former Governor of the Banque de France, said "There is a clear need for regulatory reform, which is essential for progress towards a stable, more resilient financial system. However, uncertainties about the prospects for reform-which have been heightened by the recent proliferation of national proposals-are thought by MMG members to pose additional risks to economic recovery. Reforms will inevitably have an impact on both the supply of and the demand for credit, as well as prospects for raising capital. It is essential that in their deliberations on the nature and timing of new regulatory measures, policymakers remain mindful of the paramount need not to undermine the recovery of the banking sector and the wider global economy."

Mr. de Larosière cautioned that the valuable framework for international coordination of reform efforts laid out by the G-20 in Pittsburgh last year was at risk of fragmentation. He said, "Globally coordinated agreement on a core set of reforms, focusing on capital, liquidity, cross-border resolution and enhanced risk management, remains the principal responsibility of the Group of 20, the Financial Stability Board and the Basel Committee on Banking Supervision."

Meeting participants highlighted the considerable uncertainty faced by financial markets about the repercussions of fiscal problems. Specifically, they expressed serious concerns about the prospect of large fiscal deficits and rising debt-to-GDP levels for many mature market countries extending into the foreseeable future, that to date lack credible medium-term plans for fiscal consolidation. The consequent high levels of government bond issuance will put upward pressure on interest rates, and will also have a crowding-out effect-a number of members noted the buildup of holdings of government bonds and other securities on bank balance sheets and a concomitant decline in lending. Hence many financial institutions have considerable exposure to sovereign risk at a time when sovereign risk is on the rise.

Many financial firms also face a backlog of non-performing assets, notably in commercial real estate and to a lesser extent in residential real estate. Against this backdrop, MMG participants pointed out that the forthcoming end to the U.S. Federal Reserve's purchases of mortgage-backed securities (MBS) will have considerable repercussions for mortgage rates and home prices, and thus for the banks that hold mortgages and mortgage-related securities.

The winding down of exceptional central bank support programs such as the Fed's MBS purchases will have a significant impact on banks' capacity to lend, as will the timing and pace of necessary fiscal consolidation. MMG co-chairman David A. Dodge, former Governor of the Bank of Canada, noted, "The necessary adjustments in many mature market economies will have a potentially significant impact on the banking system both directly, as support for the financial sector and markets is withdrawn, and indirectly via the drag on consumer and business demand." Members were of the view that early, resolute and credible commitments to medium-term fiscal consolidation would, however, be essential to avoid excessive market pressure on interest rates and spreads.
At present, financial markets are focused on fiscal strains within the Euro area, where a number of countries-Greece especially-are struggling to varying degrees with high debt levels and significant fiscal deficits. These strains have driven affected credit spreads higher and have resulted in considerable market volatility. However, on balance most MMG members judged that over time, with a combination of strenuous domestic adjustment accompanied by official sector support, these problems-though complex-could be resolved. The group welcomed Greece's Stability and Growth Program, reinforced by subsequent measures, and encouraged the European and international communities to support Greece's efforts at implementation. This requires perseverance from the country and would benefit from a unified European voice.

Some members cautioned that other systemic risks might lie elsewhere. Specifically, the market spotlight now focused on some countries in the Euro area could shift to systemically important countries such as the U.S., where budget deficits are projected not to fall much below 4% well into the future. Concerns about rising debt levels in the U.S. or other countries could-in the absence of strong fiscal reform-destabilize financial markets, particularly if economic growth does not soon return to the strong, sustainable pace needed to stabilize debt-to-GDP ratios. This underscores how vitally important it is at this time for mature market economies to tackle medium-term fiscal problems with credible adjustment plans.

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