Localized areas of the global financial system are increasingly showing signs of distress, raising the risk of more severe, even systemic financial market dislocation and economic disruption. In recent weeks, several developments around the world indicate that the risk of financial crises is rising. In the United Kingdom, significant volatility in government bond markets almost drove several insurance companies into default in late September and early October. Had it not been for the Bank of England's intervention, U.K. financial markets might have suffered even more severe dislocation. In China, property prices are under pressure against the backdrop of financial difficulties of real estate developers. And in the United States, equity markets have sold off sharply since the beginning of the year, failing 25%. Important asset classes, such as U.S. high-yield bonds and leveraged loans, have also come under market pressure. In the global banking sector, the spreads of credit default swaps insuring against a default of the Swiss international investment bank Credit Suisse surged in early October, forcing the company to insist that it was in good financial shape. In addition, spreads on credit default swaps on more than a dozen emerging and developing economies are trading in the distressed territory, pointing to imminent default and debt restructuring. Several others are in the midst of default and restructuring.

Yields on 10-year bonds issued by the U.K. government increased a massive 135 basis points within the space of two weeks (September 16-27), forcing UK pension funds to sell additional gilts to cover their derivatives positions, further exacerbating market moves.

An increasing number of emerging and developing markets — including Argentina, El Salvador, Egypt, Ghana and Kenya — are seeing a widening in their credit default swap spreads, a measurement often used to gauge default risk. Spreads of Credit Suisse credit default swaps also increased to 355 basis points on Oct. 3.

Chinese house prices dropped 6% in July after having increased at an annual rate of nearly 8% in the past two decades, representing a dramatic slowdown and pointing to significant underlying risks that could affect Chinese banks and the broader economy.

Tightening global financial conditions following a prolonged period of ultra-loose monetary policy and rising asset prices have begun to expose financial vulnerabilities around the world. Nearly every central bank in advanced and emerging economies has been raising interest rates, often quite forcefully so, in the past 12 months. In addition, many central banks are pursuing so-called quantitative tightening, namely rolling off or even selling outright assets accumulated during the COVID-19 crisis and forcing up long-term interest rates. A prolonged period of near-zero interest rates and large-scale quantitative easing led (or forced) investors to take on greater risks and hunt for yield and investment returns. The tightening of monetary conditions is happening very quickly and somewhat unexpectedly, as both central banks and markets initially expected higher inflation to be transitory — virtually making it inevitable that some investors will be caught on the wrong foot.

The U.S. Federal Reserve's funds rate has increased from 0-0.25% to 3.25-4.0% since the beginning of the year. The European Central Bank has raised its benchmark deposit rate from -0.5% to 0.75% during the same period. Yields on 10-year U.S. Treasury bonds are currently at 3.9%, while yields on 10-year bonds issued by the German government are at 2.3%. In early 2022, U.S. yields stood at only 1.5% and German yields were negative. 30-year mortgage rates in the United States is close to 7%, the highest level in more than 15 years and more than double the level a year ago.

According to the Council on Foreign Relations, most of the central banks in 54 of the world's largest economies have been raising interest rates over the past year — with only China, Russia and Turkey being the exception.

Negative-yielding global debt has declined to $2 trillion from $18 trillion in early 2021, pointing to less permissive global financing conditions.

The U.S. dollar is trading at 20-year highs in trade-weighted terms and at multi-decade highs against the U.K. pound and the Japanese yen. A stronger U.S. currency contributes to financial distress in emerging and developing countries with large dollar debts because it makes debt service more onerous in local-currency terms.

On Oct. 11, the International Monetary Fund (IMF) warned of a ''disorderly'' sell-off in financial markets. This is strong language coming from the IMF and points to worse to come.

Financial market conditions will continue to worsen due to higher interest rates and weaker economic conditions, increasing the risk of localized financial instability. A sharp global economic slowdown (which is highly likely in the coming months) will add to financial woes, putting even greater downward pressure on financial assets and exposing excessive risk-taking by private investors. In addition to the expected increase in U.S. corporate defaults and non-performing loans, the U.S. housing market may come under stress, potentially eroding the value of banks' collateral. Higher interest globally will also have deleterious effects on other housing markets around the world.

Central bank policy rates in the United States, the United Kingdom and Europe are far below their projected peaks. The U.S. Fed predicts that interest rates will rise to 4.4% this year and 4.6% next year, meaning rates will continue to rise and will stay higher for longer. Higher interest rates will weigh on financial asset prices and lead to greater financial losses.

In its latest World Economic Outlook published on October 11, the IMF downgraded the economic growth outlook for 90% of the world's countries. The international financial institution also expects a third of the world's economies will be in recession in 2023 — including the United States and the euro area, which together account for more than 40% of global GDP. This will inevitably lead to higher credit losses among banks and a further tightening of financial conditions due to banks' greater reluctance to provide credit.
A wave of sovereign defaults and debt restructurings is rolling in, mostly affecting low- and lower-middle-income countries. A growing number of countries are requesting IMF programs, including Bangladesh, Ghana, and Serbia. Sovereign defaults will increase tangibly over the next 12 months.
While banks, especially in the developed world, are better prepared to face crises than in the past, other less regulated sectors of the financial system still present significant risks. Financial instability in one part of one country's financial system has the potential to lead to destabilization in other parts, potentially transforming a localized issue into a more pervasive problem. While the far-reaching reforms introduced following the global financial crisis of 2008-09 led to stronger and less vulnerable banking systems in advanced economies, some risks remain. Systemically important banks remain well-capitalized and sit, generally speaking, on sufficient liquidity. This means that widespread banking crises in advanced economies are unlikely to turn systemic, though the risk is higher for banks in emerging and developing economies. Unlike in 2008, financial risks will have likely migrated to the less regulated and supervised parts of the financial system, such as open-end investment funds and private equity funds. These areas stand to register greater losses and instability this time.

The IMF has warned about the risks associated with open-end investment funds, where investors can liquidate their investment on short notice and potentially force funds into fire sales, further depressing prices and triggering more sales.

While private equity funds may also have loaded up on risk, this has not become evident yet, as parts of the industry remain less highly regulated in terms of financial disclosure requirements.

Developing economies are at higher-than-normal risk of financial instability and crisis due to the large increase in external debt and the combined shocks from the COVID-19 pandemic, the war in Ukraine and global monetary tightening.