The International Monetary Fund says the global financial system is more vulnerable than at any point since the 2008 financial crisis.
Risks to banks and financial markets have increased in recent months, the global lending organization said in a report Wednesday. The European debt crisis is affecting its banking system to the point where banks may pull back on lending to conserve cash, which threatens to worsen growth in the region.
Meanwhile, there are growing doubts that the U.S. lawmakers can forge the political consensus needed to reduce its growing budget deficits. Rising deficits were a key reason Standard & Poor’s downgraded long-term U.S. debt last month.
European leaders should quickly implement an agreement reached in July that provides the region's bailout fund with more flexibility, while the U.S. and Japan must phase in steps to reduce their deficits, the IMF said.
“Risks are elevated, and time is running out to tackle vulnerabilities that threaten the global financial system and the ongoing economic recovery,” the IMF said in its semi-annual Global Financial Stability report.
The report is the second warning from fund in as many days. On Tuesday, the IMF sharply cut its growth forecasts for the global economy, the United States and Europe for this year and 2012.
The 187-member group is holding its annual meeting at the end of this week in Washington. The meeting brings together finance ministers and central bankers from around the world.
The IMF has been stepping up its pressure on Europe to resolve its financial problems, which the fund sees as major threats to the global economy. Political squabbling between European leaders has interfered with the region's ability to reach a sustainable solution, the report said.
Olivier Blanchard, the IMF's chief economist, said Tuesday that “Europe must get its act together." He criticized its leaders for being "one step behind the action.”
The IMF contributed $41 billion to a $150 billion rescue package for Greece assembled by European leaders in May 2010. Officials from the IMF and European Central Bank are reviewing Greece’s progress in cutting its government budget deficit before providing the next installment of funds from that loan.
Europe’s larger banks, which hold substantial amounts of Greek and other troubled government bonds, should boost their capital reserves, the IMF said. That would protect them in case the bonds lose more of their value or Greece defaults on its debts.
The capital should come from private markets, the IMF said. But if that isn’t available, governments should provide the funds.
The IMF said that banks were exposed to €200 billion ($274 billion) in credit risk from shaky government bonds and €300 billion if the risk of losses on loans to other banks were included. The IMF said the figure didn't represent the amount of capital banks needed to raise.
The IMF stance that banks need to quickly raise large amounts of new capital is at odds with that of the European Central Bank, whose president, Jean-Claude Trichet, has said that banks have trillions in securities they can pledge as collateral for loans from the ECB.
European stress tests earlier this year flunked eight banks and found 16 with barely enough capital to weather a new downturn; governments have in many cases resisted pushing for recapitalization, instead disputing the methodology of the tests.
Recapitalization of banks can be a painful process, since shareholders are pressed to put up more money or see their holdings diluted, and share values can fall sharply. Hard-pressed governments are reluctant to put up the money themselves, after pouring billions of taxpayer euros into bank rescues during the earlier years of the crisis.
In the United States, policymakers should take steps to improve the financial position of U.S. households, the report said. One way to do that would be to reduce mortgage debt for those Americans who owe more on their homes than they are worth. About one-quarter of U.S. homeowners are in that position. Reducing that debt burden would improve consumer demand and support growth, the report said.
"Restoring confidence in the stability of the U.S. housing market is the key to bolstering the prospects for U.S. banks," which have been hurt by slower growth, the report said.