The global financial system still faces threats to its stability, the Institute of International Finance’s Market Monitoring Group warned Tuesday.

The MMG, which is co-chaired by David Dodge, former governor of the Bank of Canada and Jacques de Larosière, former managing director of the International Monetary Fund and former governor of the Banque de France, agreed that, “prolonged economic weakness could pose notable risks for financial stability.”

The MMG cited limited further support from monetary policy and a number of significant potential headwinds to growth, including ongoing deleveraging, lingering financial sector vulnerabilities, and pressure to move ahead with fiscal consolidation, as threats to future growth.

Nevertheless, the group also stressed that the need for fiscal consolidation, most notably in some of the Euro area’s smaller economies, “remains urgent”. While a number of highly indebted governments, including Greece, have shown serious commitment to fiscal consolidation, they noted that the increased likelihood of an extended period of slow growth in major economies in 2011 and beyond, “will make the task of deficit and debt reduction more challenging.”

“A sustained period of weak growth would also exacerbate existing financial sector vulnerabilities, particularly for many smaller, regional U.S. and EU banks,” the MMG warned. “These weaknesses include significant exposure to real estate and sovereign debt, high upcoming refunding needs, heavy reliance on central bank funding in some cases, and more stringent capital requirements.”

The MMG also called on policymakers to look for ways to revive the securitization market. And it cautioned that the full impact of regulatory changes on economic growth, such as new global capital requirements for banks, and U.S. market reforms, have not been factored in.

IE