An international group of market watchers says that it is worried about the re-emergence of possible systemic risks due to regulatory reform uncertainty and the fiscal policy tightrope that many countries are walking.

The so-called Market Monitoring Group, a collection of finance industry veterans attached to the banking industry lobby group, the Institute of International Finance, issued a statement following its regular quarterly meeting today outlining those dual concerns.

The group’s participants highlighted the uncertainty faced by financial markets due to the repercussions of fiscal problems in a number of countries. 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 lack credible medium-term plans for fiscal consolidation. The resulting high levels of government bond issuance will put upward pressure on interest rates, and will also have a crowding-out effect, they noted.

A number of the group’s members noted the buildup of holdings of government bonds and other securities on bank balance sheets and a decline in lending. “Hence many financial institutions have considerable exposure to sovereign risk at a time when sovereign risk is on the rise,” they said.

Many financial firms are also still carrying a backlog of non-performing assets, notably in commercial real estate and to a lesser extent in residential real estate, and MMG participants pointed out that the end to the U.S. Federal Reserve’s purchases of mortgage-backed securities will have considerable repercussions for mortgage rates and home prices, and for the banks that hold mortgages and mortgage-related securities.

MMG co-chairman, David 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potentially significant impact on the banking system both directly, as support for the financial sector and markets is withdrawn, and indirectly via the drag on consumer and business demand.”

Nevertheless, the group’s members were of the view that early commitments to medium-term fiscal consolidation are essential to avoid excessive market pressure on interest rates and spreads.

While, financial markets are focused on fiscal strains within the Euro area, where a number of countries, such as Greece, are struggling with high debt levels and significant fiscal deficits, 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.” And, the group welcomed Greece’s Stability and Growth Program.

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,” it said. “This underscores how vitally important it is at this time for mature market economies to tackle medium-term fiscal problems with credible adjustment plans.”

The group also expressed concerns about the uncertainty accompanying possible regulatory reforms facing financial firms. “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,” said MMG co-chairman, Jacques de Larosière, former managing director of the International Monetary Fund and former governor of the Banque de France.

“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,” de Larosière added, warning that the framework for international coordination of reform efforts laid out by the G20 in Pittsburgh last year was at risk of fragmentation.

IE