The International Monetary Fund says that the global financial system is getting better, but it isn’t out of the woods yet, and faces new, emerging risks.

In the latest issue of its’ report on the health of the global financial system released Tuesay, the IMF says that the system’s condtion has improved as the economic recovery has gained steam, but stability risks remain elevated as the recovery remains somewhat fragile, and there is still balance sheet repair to be carried out.

Improving economic and financial market conditions have reduced banks’ expected writedowns — from $2.8 trillion to $2.3 trillion — and bank capital positions have improved substantially, the IMF reports. “But some segments of country banking systems remain poorly capitalized and still face significant downside risks.”

It warns that delays in dealing with weak banks could complicate exits from extraordinary policy support, and it could also weigh on economic growth. “Banks must reassess business models, raise further capital, de-risk balance sheets and stabilize funding,” it says, adding that the “credit recovery will be slow, shallow, and uneven as banks continue to repair balance sheets.”

Additionally, the report suggests that the multi-speed global recovery poses stability challenges for emerging markets. There is some risk that this could stoke inflation and asset price bubbles in these regions. “Prospects for strong growth, appreciating currencies, and rising asset prices are pulling portfolio capital flows into Asia Pacific (ex-Japan) and Latin American countries, while push factors — particularly low interest rates in major advanced economies — are also key,” it explains.

Moreover, the report notes that sovereign risks in developed countries “could undermine stability gains and take the credit crisis into a new phase”. New risks to market stability have emerged, it says. “More recently, spreads have widened in some highly indebted economies with underlying vulnerabilities, as longer-run fiscal sustainability concerns have telescoped into strains in sovereign funding markets that could have cross border spillovers. The subsequent transmission of sovereign risks to banking systems and feedback through the economy could undermine financial stability.”

It counsels that to maintain the momentum in the reduction of systemic risks, further action is required by policymakers in several areas. “Careful management of sovereign risks is essential. Governments need to design credible medium term fiscal consolidation plans in order to curb rising debt burdens and avoid taking the credit crisis into a new phase.”

Policymakers also need to ensure that the next stage of the deleveraging process unfolds smoothly, it says. “Swift resolution of nonviable institutions and restructuring of weak institutions with a commercial future is vital to enable a permanent exit from extraordinary policy support and to ensure that a healthy core of viable financial institutions is able to support credit.”

“Looking further ahead, regulatory reforms need to move forward expeditiously, but be introduced in a manner that accounts for the current economic and financial conditions,” it says. “Continuing to strengthen the banking sector’s capital base will help prepare the financial system for changes to the capital adequacy framework. Greater clarity is needed in defining the new financial system framework to give banks more certainty over their future business models. Addressing the issue of “too-important-to-fail” institutions is critical for restoring market discipline and insulating sovereign balance sheets.”

IE