Risks to global financial system instability have intensified in recent months, the International Monetary Fund says, and it worries that many banks may not have enough capital to weather the economic downturn.

“In spite of extensive policies, the global financial system remains under intense stress,” the IMF notes in the latest edition of its global financial stability report. Additionally, it points out that worsening economic conditions are producing new, large writedowns for financial institutions. In response, balance sheets are being cut back through asset sales and the retiring of maturing credits, it says. “These actions have increased downward pressure on asset prices and reduced credit availability,” it adds.

“Notwithstanding public injections of capital, many banks around the world may have an insufficient capital cushion to weather a deep global economic downturn,” it warns. It also raised its estimate of the potential deterioration in U.S.-originated credit assets held by banks and others from US$1.4 trillion in the October 2008 GFSR to US$2.2 trillion.

Banks will need even more capital as expected losses continue to mount, it says. It estimates that the capital shortfall for European and U.S. banks will be at least USUS$500 billion.

Policymakers have had a hard time keeping up with the scale of the bank writedowns, and credit intermediation and confidence are severely impaired, “which will weigh heavily on recovery prospects and the ability of institutions to attract needed capital from private investors,” it says.

“Absent further firm action from policymakers, this situation threatens to worsen, given that banks, both advanced country and emerging market corporations, and to a lesser extent, sovereign entities, face risks that they will not be able to roll over large amounts of existing debt in coming years,” it observes.

It stresses that more aggressive actions by both policymakers and market participants are needed to ensure that the necessary deleveraging process is less disorderly. “A broad three-pronged approach—including liquidity provision, capital injections, and disposal of problem assets—should be implemented fully and quickly so as to encourage balance sheet cleansing,” it say sin the report. “At the same time, international cooperation will be required to ensure the policy coherence and consistency needed to re-establish financial stability.”

Several asset classes recovered towards the end of 2008, but the IMF says that, “the negative interaction between the economy and the financial sector has intensified as the credit crunch bites harder and extends globally, with confidence among financial counterparties remaining strained. Indeed, the recent shock to bank earnings and other bad economic news has put further downward pressure on bank equity prices, and the width of credit default swap spreads points to still-elevated systemic risks.”

Beyond the banking system, systemic concerns are rising for insurance companies and pension funds, it cautions. “Insurance companies have significant exposure to assets whose quality is deteriorating sharply. Pension funds have also been hit severely on the asset side,” it says.

“The speed and size of the impact of the adverse feedback loop between the economy and the financial system has overwhelmed policy responses so far. Decisive and urgent action is now needed to stem the downward spiral of accumulating losses. The costs are likely to be higher than the amounts currently allocated—though much depends on the speed with which confidence is restored,” it concludes, adding that a comprehensive and coordinated approach needs to include: recapitalization and measures to deal with distressed assets; that short-run policies are consistent with the long-run vision for the structure of a viable financial system; rules governing the process toward a more stable financial system need to be clear and consistent; and, international cooperation on a common framework for financial policies should receive high priority.

IE