The International Monetary Fund says that it will likely take some time for markets to fully digest the effects of the U.S. sub-prime crisis.

The IMF’s latest Global Financial Stability Report says that, “markets are likely to go through a protracted adjustment period following recent financial turbulence triggered by the collapse of the U.S. subprime mortgage market.”

The report, released on September 24, said the turbulence represents the first significant test of innovative financial instruments and markets used to distribute credit risks through the global financial system, with markets recognizing the extent that credit discipline has deteriorated in recent years. This has caused a repricing of credit risk and a retrenchment from risky assets that, combined with increased complexity and illiquidity, has led to disruptions in core funding markets and increased market turbulence in August.

Despite the efforts of central banks in several countries to help stabilize markets and mitigate the impact on the broader economy, the GFSR said the period ahead may still be difficult as bouts of turbulence are likely to recur and the adjustment process will take time. “Credit conditions may not normalize soon, and some of the practices that have developed in the structured credit markets will have to change,” it stated.

The report, prepared by the IMF’s Monetary and Capital Markets Department twice a year, said the turbulence could impact global economic growth. “Although the dislocations, especially to short-term funding markets, have been large, and in some cases unexpected, the event hit during a period of above-average global growth. Our assessment is that credit losses and the liquidity constriction experienced to date will [nevertheless] likely slow the global expansion,” it stated. The IMF will give its next forecast for world growth on October 17.

The GFSR noted that systemically important financial institutions began this episode with adequate capital to absorb the likely level of credit losses. “Corporations, have, for the most part, been able to secure the financing they need to maintain their operations. However, the adjustment period is continuing and if the intermediation process stalls and financial conditions deteriorate further, the global financial sector and real economy could experience more serious negative repercussions,” the report added.

The report added that tighter monetary and credit conditions could reduce economic activity through a number of channels. “A tightening of the supply of credit to weaker household borrowers could exacerbate the downturn in the U.S. housing market, while falling equity prices could reduce spending through the wealth effect and a weakening of consumer sentiment,” it said. “Capital spending could also be curtailed owing to a higher cost of capital for the corporate sector. In addition, the dislocations in credit and funding markets could slow the overall provision and channeling of credit.”

Jaime Caruana, the IMF’s Counsellor and Director of the Monetary and Capital Markets Department, said that the task for policymakers and market participants now was to learn lessons from the turbulence and use them to help make the global financial system stronger. “This does not require, as some have suggested, a new regulatory paradigm, but we must be ready to reexamine some elements of the framework we have, and to enhance it where necessary,” he stated.

Key components of that framework include: greater transparency, better risk monitoring, improvements by rating agencies, better valuation, and a wider risk perimeter.

Policymakers face a delicate balancing act, the report stated. They must refine their prudential frameworks to encourage investors and institutions to maintain high credit standards and strengthen risk management systems in good times as well as bad, while preserving the enormous benefits from financial innovation seen in recent years.