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IMF warns that time is running out to sort out global financial system

• Europe and US must urgently tackle threats to recovery
• Action needed on banking reforms as soon as possible
• European banks’ exposure to debt estimated at €300bn
• US needs political consensus on fiscal policy

The International Monetary Fund warned on Wednesday that time was running out to tackle weaknesses in the global financial system as the exposure of European banks to debt in the weakest parts of the eurozone ballooned to €300bn.

In its half-yearly Global Financial Stability Report (GFSR), the fund said that the recent turmoil in markets had increased instability and was the result of investors losing patience with the inadequacy of reforms since the start of the crisis more than four years ago.

“Since our previous report, financial stability risks have increased substantially – reversing some of the progress that had been made over the previous three years. So we are back in the danger zone,” José Viñals, the IMF’s financial counsellor, told journalists in Washington DC.

Viñals cited a trio of shocks to the financial system: unequivocal signs of a broader global economic slowdown, turbulence in the euro area and the credit downgrade in the US.

“This has thrown us into a crisis of confidence, which is being driven by three main factors: weak growth, weak balance sheets and weak politics.”

Viñals added that the Fund had sought to quantify the financial strain put on Europe’s banks by the sovereign debt crisis since 2010.

“During this period, banks have had to withstand an increase in credit risk coming from high-spread euro area sovereigns that we estimate amounts to about €200bn (£175bn). If we include exposures to other banks in high-spread euro area countries, the total estimated spillover increases to €300bn.”

This increased credit risk means that some banks have already been frozen out from private funding markets, the IMF warned.

“This raises the risk of more severe deleveraging, credit contraction, and economic drag unless adequate action is taken to deal with the sources of credit risk – through credible fiscal consolidation strategies – and to address the potential consequences for the financial system through enhancing the robustness of banks,” the report explained.

Viñals said it was still possible to find a way through to sustained recovery. “But for this, we need to act now; we need to act boldly; and we need to act in a globally co-ordinated manner. There is a way; now we need the political will”.

Financial reform needed now

The IMF said in its report that: “Financial stability risks have increased substantially over the past few months. Weaker growth prospects adversely affect both public and private balance sheets and heighten the challenge of coping with heavy debt burdens,”

It added that the crisis had moved into a new, more political phase.

“Risks are elevated, and time is running out to tackle vulnerabilities that threaten the global financial system and the economic recovery. The priorities in advanced economies are to address the legacy of the crisis and conclude financial regulatory reforms as soon as possible in order to improve the resilience of the system.”

In the euro area, the Fund said important steps had been taken to address current problems, but political differences within economies undergoing austerity programmes and among countries providing support had impeded achievement of a lasting solution.

“Meanwhile, the US is faced with growing doubts over the ability of the political process to achieve a necessary consensus regarding medium-term fiscal adjustment, which is critically important for global stability.”

The report said an extended period of low interest rates could carry longer-term threats to the financial system, although cheap borrowing costs are still needed today given the state of the global economy.

“Low rates are diverting credit creation into more opaque channels, such as the shadow banking system. These conditions increase the potential for a sharper and more powerful turn in the credit cycle, risking greater deterioration in asset quality in the event of new shocks.”

The IMF said the financial reform agenda needed to be completed as soon as possible and implemented internationally in a consistent manner. This includes the finalisation of the Basel 3 agreement governing capital requirements of banks, the treatment of systemically important financial institutions, and addressing the challenges posed by the shadow banking system.

“For the first time since the October 2008 GFSR, risks to global financial stability have increased, signalling a partial reversal in progress made over the past three years.”

“Recent market turmoil suggests that investors are losing patience with the lack of momentum on financial repair and reform. Policymakers need to accelerate actions to address long-standing financial weaknesses to ensure stability.”

This year’s report said four years of financial crisis had left governments saddled with onerous debt burdens and sharply higher funding needs. “Lower tax revenue, weaker growth prospects, and large-scale support for ailing financial institutions have driven public finances into precarious territory.

“The latest bout of market volatility has reminded some investors of the collapse in asset prices following the September 2008 Lehman Brothers bankruptcy. Although the current reaction has not been as severe or as widespread as it was after that event, risk perceptions are greater for European banks and sovereigns. There is a risk of a further deterioration if appropriate policies are not implemented,” the report warned.

On Tuesday, the IMF cut its UK growth forecast to 1.1% this year and warned that the world economy will also grow slower than previously forecast, leaving the US and Europe vulnerable to a double-dip recession. © 2011 Guardian News and Media Limited or its affiliated companies. All rights reserved. | Use of this content is subject to our Terms & Conditions | More Feeds