Insurance companies and pension funds are at risk of becoming insolvent if ultra-low interest rates persist for a prolonged period, the International Monetary Fund has warned.
After almost eight years in which central banks have kept borrowing costs at record lows in an attempt to boost growth, the IMF said an over-reliance on monetary policy could have unwanted side-effects.
It used its half-yearly health check of the global financial system to advise that the calmer-than-expected conditions since the Brexit vote might not last.
While short-term risks had abated over the past six months, the IMF said big challenges remained – including the impact of record-low interest rates on pension funds and insurance companies, the fragility of banks, rapid credit growth in China and the heavy indebtedness of the corporate sector in emerging countries.
“The solvency of many life insurance companies and pension funds is threatened by a prolonged period of low interest rates,” the IMF said in its global financial stability report (GFSR).
“Low interest rates add to the legacy challenges facing many insurance companies and pension funds, along with those from ageing populations and low or volatile asset returns. Heightened concern over these important long-term saving and investment institutions could encourage even greater saving, adding to financial and economic stagnation pressures.”
The GFSR said regulators and supervisors needed to take prompt action to sustain the strength of insurance company and pension fund balance sheets, including identifying risks of insolvency and funding gaps. “Many pension funds face funding gaps, where the present value of future liabilities exceeds the market value of their assets,” the IMF said.
Poor profitability continued to blight Europe’s banks, the GFSR said, noting that a third would remain weak even if growth accelerated from the low levels recorded since the financial crisis and recession of 2007-09.
For the west as a whole, 25% of banks with assets of $11.7tn (£9.21tn) would remain in poor shape after a cyclical recovery. Since the start of the year, the market capitalisation of western banks had fallen by almost $430bn, strengthening the case for tackling vulnerabilities.
“More deep-rooted reforms and systemic management are needed, especially for European banks,” the IMF said. It said the number of bank branches in Europe should be reduced, while stronger measures were needed to tackle the high level of non-performing loans. Together, the two changes would add a net $180bn to the capital position of Europe’s banks, allowing them better to support growth.
The GFSR said the shock of Brexit had initially led to turbulence in financial markets, but they had subsequently shrugged off concerns about the risks to the UK from leaving the EU.
But it said the medium-term outlook was less rosy, with a need to look beyond monetary stimulus from central banks towards a stronger mix of policies to strengthen the foundations of the global position. The GFSR said this could help avoid financial stagnation and protectionism, which would reduce global growth by around three percentage points over the next five years.
Low interest rates raised the present value of existing long-term liabilities, steadily eroding capital and solvency buffers the longer the low-rate environment persists.
“A protracted period of low and negative policy rates and yields could undermine financial resilience in the medium term, but the risks of increased headwinds may materialise more immediately,” the IMF said, adding that falling share prices were likely to put pressure on banks to curtail lending until early 2018.
“In many European countries, a more complete solution to address legacy bank problems can no longer be postponed. Specifically, both the high level of nonperforming loans and rising strains on profitability require urgent and comprehensive action.” The IMF identified Italy and Portugal as particularly vulnerable.
While fears of a market meltdown after the Brexit vote had not materialised, there was a risk of the City losing business as a result of the decision to leave the EU, according to the report.
“The post-referendum bout of market volatility faded after central banks responded promptly; no major disorderly market events surfaced, other than a sharp sell-off in some UK-based real estate funds,” the GFSR said.
“Yet the biggest challenges remain ahead. The shape of future trade arrangements and the uncertain impact of Brexit on the United Kingdom’s large and globally integrated financial system have created uncertainty over the longer-term financial prospects of the United Kingdom. There is a high degree of uncertainty surrounding future arrangements and the implications for the UK financial sector.”
Source: Larry Elliot – The Guardian