Central banks could keep interest rates higher for longer as they fight to curb inflation that remains stubbornly high in many countries and slow their economies by doing so.
Such an environment hasn’t confronted the world’s financial markets in a generation. That means financial supervisors must sharpen their analytical tools and regulatory responses to address emerging threats. And the new risks gathering in the banking system and beyond mean it’s time to redouble efforts to identify the weakest lenders.
Accordingly, we enhanced our stress-testing tools to focus on risks from rising interest rates and incorporate the kind of funding pressures that toppled some banks in March. We also developed a new surveillance tool for tracking emergent banking fragilities using analyst forecasts and traditional bank metrics. These monitoring tools, based on public data, aim to complement stress tests by supervisory authorities and by IMF-World Bank teams in Financial Sector Assessment Programs, which use more granular confidential supervisory data.
Rising rates are a risk for banks, even though many benefit by collecting higher interest rates from borrowers while keeping deposit rates low. Loan losses may also increase as both consumers and businesses now face higher borrowing costs especially if they lose jobs or business revenues. Besides loans, banks also invest in bonds and other debt securities, which lose value when interest rates rise. Banks may be forced to sell these at a loss if faced with sudden deposit withdrawals or other funding pressures. The failure of Silicon Valley Bank was a dramatic example of this bond-loss channel.
The banking system appears broadly resilient, according to our new global stress test of almost 900 lenders across 29 countries, outlined in a chapter of our latest Global Financial Stability Report. Our exercise, which shows how lenders would fare under the baseline scenario we project in the latest IMF World Economic Outlook, identified 30 banking groups with low capital levels, together accounting for about 3 percent of global bank assets.
But if beset by severe stagflation high inflation with a 2 percent global economic contraction coupled with even higher central bank interest rates, the losses would be much greater. The number of weak institutions would rise to 153 and account for more than a third of global bank assets. Excluding China, there are many more weak banks in advanced economies than in emerging markets.