Bothe the IMF and the Federal Reserve are out with new assessments. I will review both and try and provide some insights. Later on I have some thoughts about the Fed’s proposal to adjust the stress tests.

The IMF Seems Very Worried

Global Economic Outlook

The Global Economy Enters a New Era

The IMF’s Director of Research Gourinchas with some pretty stark statements.

The global economic system under which most countries have operated for the last 80 years is being reset, ushering the world into a new era. Existing rules are challenged while new ones are yet to emerge.

Our World Economic Outlook’s reference forecast includes tariff announcements between February 1 and April 4 by the US and countermeasures by other countries. This reduces our global growth forecast to 2.8 percent and 3 percent this year and next, a cumulative downgrade of about 0.8 percentage point relative to our January 2025 WEO update.

Global inflation is revised up by about 0.1 percentage point for each year, yet the disinflation momentum continues. Global trade was quite resilient until now, partly because businesses were able to re-route trade flows when needed. This may become more difficult this time around.

… we have lowered our US growth estimate for this year to 1.8 percent. That’s 0.9 percentage point lower than January, and tariffs account for 0.4 percentage point of that reduction. We also raised our US inflation forecast by about 1 percentage point, up from 2 percent.

For trading partners, tariffs are mostly a negative demand shock, driving foreign customers away from their products, even if some countries can benefit from the trade diversion. Consistent with this deflationary impulse, we have lowered our China growth forecast for this year to 4 percent, a 0.6 percentage point reduction, and inflation is revised down by about 0.8 percentage point.

Risks to the global economy have increased, and worsening trade tensions could further depress growth. Financial conditions could tighten further as markets react negatively to the diminished growth prospects and increased uncertainty. While banks remain well capitalized overall, financial markets may face more severe tests.

World Economic Outlook: A Critical Juncture amid Policy Shifts (IMG - April 2025)

Elevated uncertainty also intensifies the trade-off between anchoring inflation expectations and safeguarding financial stability. Where central banks’ efforts to stabilize inflation expectations lead to a tightening of financial conditions, this may exacerbate vulnerabilities within the financial system, complicating operations for financial institutions (Bergant and others 2025). Therefore, it is crucial to strike a balance between maintaining stable inflation expectations and ensuring that financial stability is not compromised, particularly amid financial market volatility.

Global Financial Stability Report

The GFSR is overseen by one of the sharpest economist/systemic risk thinkers I know: Tobias Adrian. He’s been through the financial wars, the GFC, I respect him a lot.

IMF Global Financial Stability Report: Enhancing Resilience amid Uncertainty (IMF - Apr. 2025)

The October 2024 Global Financial Stability Report highlighted stretched asset valuations, growing financial system leverage, and low financial market volatility against a backdrop of heightened levels of economic uncertainty. … Against the heightened volatility of asset prices, this Global Financial Stability Report assesses that global financial stability risks have increased significantly, primarily due to the tightening of global financial conditions (Figure ES.2). According to the IMF’s Growth-at-Risk model, macrofinancial downside risks to growth have increased meaningfully.

Our assessment of elevated financial stability risks is also supported by three key forward-looking vulnerabilities.

• First, despite the recent turmoil in markets, valuations remain high in some key

  segments of equity and corporate bond markets, meaning that readjustments in valuations could go further if the outlook were to deteriorate.

• Second, some financial institutions could come under strain in volatile markets, especially highly leveraged ones. As the hedge fund and asset management sectors grew, so have their aggregate leverage levels and the nexus with the banking sector from which they borrow (Figure ES.4), raising the specter of weakly managed nonbank financial intermediaries being pushed to deleverage when they face margin calls and redemptions.

• Third, further turbulence could descend upon sovereign bond markets, especially in jurisdictions where government debt levels are high.

Non-Bank Financial Sector

Over the last decade, NBFIs have grown faster than banks. In particular, investment funds—including mutual funds, hedge funds, and private equity and credit funds—have gradually gained a share of the global financial system assets from banks, insurers, and pension funds … This increased role of NBFIs in financial intermediation proceeds in tandem with growing linkages between banks and nonbanks. … excessive growth among NBFIs predicated on borrowing from banks could make the financial system more vulnerable to high levels of leverage and interconnectedness. While contagion due to the tariff turmoil seems limited so far, it highlights some of the potential risks

Private credit funds’ reliance on bank credit … Besides term loans, most direct lenders offer revolving facilities to borrowers, … To manage this volatility, direct lenders often depend on revolving credit lines from banks. … In addition to private credit funds’ connection with banks, the cross-border nexus has also increased.

Following the sharp decline in global equities, … Treasury selling by leveraged NBFIs in response to margin calls and the unwinding of basis trades may have played a role in amplifying the moves. The nature of the risk is similar to the March 2020 dash-for-cash episode …

Asset managers … have significantly expanded their use of leveraged positions in recent years by employing long futures positions in Treasuries and US equities … Some asset managers use futures contracts … to extend the duration of portfolios that tilt more heavily toward corporate credit … A sudden increase in Treasury market volatility could lead to higher margin requirements, while a rise in the repo rate could make the trade unprofitable. Both developments (or either) can potentially trigger a disorderly unwind of the trade. This unwinding reportedly happened to an extent in the period after the April 2 tariff announcement …

China

China’s economic outlook remains highly uncertain amid mounting external and domestic challenges. … Reflecting investors’ concerns over a weakening growth outlook and deflation pressures, China’s government bond yields have continued to decline … As historically high tariffs imposed by the United States may intensify deflationary pressures, accommodative macroeconomic policies along with structural and promarket reforms are urgently needed to bolster near-term activity and business and consumer confidence, as well as to prevent a further downward spiral in inflation expectations. … Managing interest rate risk is now important for China’s financial stability.

Dealer Constraints

Heightened volatility of bond yields … following the April 2 tariff announcements have reportedly pushed the intermediation capacity of US primary dealers … toward its limit. Even before the episode, the Treasury market had outgrown dealers: its size is now five times dealers’ balance sheets, a significant increase from just one-and-a-half times around 20 years ago

From a longer-term perspective, decline in dealers’ intermediation capacity in government bonds may also be a consequence of increased usage of balance sheets to provide equity margin loans to hedge funds and other clients

According to market contacts, smaller dealers have tilted their lending toward equity margin loans, whereas major institutional dealers with deep client relationships have maintained diversified exposure across asset classes. This shift has contributed to a weakening in collateralization levels …, exposing dealers to losses if hedge funds are unable to repay loans during market stress.

Cross-border Funding

Cross-border funding dynamics may be amplifying vulnerabilities in the international dollar market. Euro area banks, which previously benefited from deeply negative repo rates … have faced rising funding costs … [and] have reportedly increasingly turned to US repo markets, borrowing dollars against Treasury collateral and swapping proceeds back into euros. … Growing reliance among euro area banks on US repo funding exposes them to rollover risk … Given the scale of their dollar borrowing, a sudden loss of access to US repo funding could widen the euro-to-dollar basis, signaling rising dollar scarcity … Elevated fragility of cross-border dollar liquidity underscores the importance of globally coordinated backstops—such as standing repo facilities and central bank swap lines—to mitigate systemic risks and prevent disorderly spillovers.

Federal Reserve Financial Stability Report

Financial Stability Report - Apr. 2025 (Federal Reserve)

The Federal Reserve's current assessment is that while systemic vulnerabilities remain notable—particularly around asset valuations and nonbank leverage—the near-term systemic risk outlook is dominated by exogenous risks (trade disruptions, fiscal uncertainty) rather than endogenous financial imbalances.

Since the November Financial Stability Report, liquidity has worsened, and hedge funds and leveraged players are under more stress (position unwinds). Asset valuations remain stretched, but funding risks have modestly improved.

We have a dichotomy; the consumer has deleveraged while the hedge fund sector was highly leveraged:

Total debt of businesses and households as a fraction of gross domestic product (GDP) continued to trend down to its lowest level in the past two decades.

In the first quarter of 2025, the most recent quarter for which the Securities and Exchange Commission's form PF data are available, hedge funds' leverage reached historical highs.

Comparing The April 2025 IMF and Federal Reserve Financial Stability Assessments

My takeaway is that the IMF believes that the April 2025 trade shock has already meaningfully raised the probability of systemic disruption, particularly through nonbank leverage, sovereign fragility, and liquidity breakdowns, while the Fed views financial vulnerabilities as elevated but manageable if external shocks do not intensify.

Interestingly, both use identical language to summarize things — the devil is in the details.

… global financial stability risks have increased significantly, driven by tighter global financial conditions and heightened economic uncertainty.

I suspect the Fed plagiarized (coordinated is charitable) as they also directly include the IMF’s Growth-at-Risk model:

According to the IMF's Growth-at-Risk (GaR) model, in the year ahead and with a 5 percent chance, global growth could fall below 0.4 percent, highlighting an elevated level of financial stability risk.

The IMF report is more granular, detailed and insightful, and is more prescriptive on the actions that should be taken; the Fed is cautious and descriptive.

The Fed describes the near term risks as including a shift toward global trade disruptions, policy uncertainty, and fiscal debt sustainability. The IMF expresses acute worries about global financial tightening, sovereign debt vulnerabilities, and nonbank-banking system contagion.

Adjusting The Stress Tests

Federal Reserve Board requests comment on a proposal to reduce the volatility of the capital requirements stemming from the Board's annual stress test results

The proposal:

• Eliminates the occasional exploratory scenario to test banks against emerging risks,

• Recalibrates the severely-adverse scenario to be less extreme and instead reflect a plausible but still challenging economic downturn,

• Narrows the scope to focus on material risks that are common across firms, rather than attempting to cover every potential firm-specific risk,

• Places more reliance on firms’ internal stress testing processes to identify and plan for risks outside the supervisory scenarios,

• Tailors stress test requirements and severity more explicitly based on a bank’s size, complexity, and business model, and

• averaging a bank’s stress test losses across two consecutive years when determining the Stress Capital Buffer (SCB).

As you might imagine, I have some thoughts here, as a risk manager, and as a former bank supervisor.

The first thought is one I’ve reiterated many times: these required stress tests have out-lived their useful purpose and divert resources from higher priority risk management activities.

Second, the good — as a risk manager and a bank supervisor, it makes sense to tailor the stress tests to bank-specific risk profiles and to put greater reliance on firms’ internal stress testing processes. The Fed’s DFAST/CCAR tests have dominated capital planning decisions since 2014, even after CCAR qualitative objections were removed in 2019. Supervisory stress tests supplanted internal tests as the main driver of capital levels. Ideally, the Federal Reserve scenarios not longer become the binding constraint on firms risk-taking and capital actions. But I will only believe it when I see it.

Now for the bad. As a bank supervisor, I am disappointed that they will eliminate the occasional emerging risk scenario. In fact, this is going in the opposite direction from the Bank of England, which will explore scenarios across banks and other firms. Understanding the response of the SYSTEM as a whole can be a useful exercise if done properly. Scenarios around a Treasury market dislocation, cyberattack, climate event, or China shock would have proven useful.

Reducing the severity of the Severely-Adverse scenario is a mistake. One useful aspect of the Severely-Adverse scenario was to emphasize that stress tests should assess resilience, not forecastability. A scenario being “implausible” is a feature, not a bug. I’ve too often seen or heard of “pushback” from senior management about a scenario they felt was implausible that subsequently came to fruition. Weakening the scenario is just capital relief as long as the scenarios are explicitly tied to regulatory capital and published.

Stress tests should be about examining the tail of outcomes. Neutering the Severely-Adverse Scenario doesn’t help here.

From a supervisors point-of-view, reducing the commonality and comparability is a weakness. Letting each firm face a different tailored scenario without a strong common anchor reduces systemic transparency.

Finally, there is the proposal to average the stress test results across two years. This makes sense from a CFO or capital planners perspective. Volatility dampening certainly makes projections, planning and forecasting more predictable.

But from a risk manager’s point-of-view, it is dampening the signal from the stress test, and delay the necessary capital builds, particularly during periods when the environment is deteriorating. And from a bank supervisors POV, they will now have to deal with the arguments from bank management that the inadequacy of their current buffer for stress will be made up through capital planning. I just think it’s stupid. Do away with the SCB and return capital planning to the institutions and the EVALUATION of capital solvency to the supervisors with the silly rules.

• The Fed Just Puts Ribbons on Rags (Petrou)

Undermining The Global System Of Financial Regulation

Time to think the unthinkable about bank regulation (FT)

Geopolitics is undermining the global system of financial regulation

Uncertainty about global co-operation is beginning to spread. It is noticeable that the Financial Stability Board, which once led the way on climate risk, cyber risk and shadow banking, is going to spend 2025 working on a review of its own processes as its major deliverable.

Banking regulation has been a bit of an anomaly in the system of global governance. Apart from the law of the sea, no other industry — not even other sectors of finance such as insurance or securities — has a single set of regulatory standards.

The central bankers, unlike almost all other bureaucrats, had such good relationships that they felt able to keep acting as a unified source of governance. If that era of frictionless international finance has come to an end, then banking regulation might need to go back to local focus. Paradoxically, that will probably mean more regulatory burden, not less, as everyone will have to satisfy local standards everywhere they operate.

Closing Thoughts

I’m off to Italy and Croatia for the next two weeks, so no more spamming of your inbox. I have thoughts on tariffs, and on the state of the dollar, but those will have to wait.

Don’t rush the crisis; these things take time. Remember, it was about nine months from when Bear Stearns High Grade Fund had difficulties until Bear fell, and even longer until we were at the Lehman moment.

Some indication housing is weakening, but the US consumer has a lot of home equity dry powder.

Yale is reportedly selling some of its privates, Harvard too. Something, something liquidity and price discovery. Harvard is also in the bond market (raise liquidity during their idiosyncratic Trump stress; smart). West coast port traffic is reportedly way down, so we should start seeing the effect of tariff shortages in a few months. Watch the Yuan fixings to see if China will devalue or just continue with fiscal stimulus.

Peace.