The need to deleverage could cause European banks to shrink their balance sheets by as much as US$2.6 trillion, potentially harming the economic recovery, says a new report from the International Monetary Fund.

The IMF says that European banks continue to face various pressures, including sovereign risks, weak euro area growth, high rollover requirements, and the need to strengthen their capital cushions to regain investor trust. And, these pressures have combined to induce a drive to reduce bank balance sheets.

The report finds that, as a result, large EU-based banks could shrink their combined balance sheets by as much as US$2.6 trillion (€2.0 trillion) through the end of 2013, or almost 7% of total assets. It estimates that about 25% of this deleveraging could occur through a reduction in lending, with the rest coming largely from sales of securities and non-core assets. And, the impact on the euro area credit supply is estimated at about 1.7% of credit outstanding.

“Some balance sheet reduction by individual banks is necessary because high leverage is no longer supported by either markets or regulators and some activities are no longer viable,” it says. “But the potential consequences of a synchronized and large-scale deleveraging warrant supervisory efforts to avoid serious damage to asset prices, credit supply, and economic activity in Europe and beyond.”

The IMF says European policymakers need to implement reforms swiftly. “Avoiding fresh setbacks will be critical, especially on the difficult path ahead, which is fraught with political and implementation risk,” it says. It recommends that policymakers set a course to further financial and fiscal integration within the Economic and Monetary Union.

It cautions that emerging markets could see their resilience tested in a downside scenario, notably in emerging Europe. Elsewhere, the US and Japan have yet to forge a political consensus for medium-term deficit reduction, which it says is “perpetuating latent risks to financial stability.”

And, it notes that reform to the global financial regulatory framework needs to finalized; adding that the transition could also add to cyclical challenges facing financial institutions.