Global Financial Stability Report:With financial markets worldwide facing growing turmoil, internationally coherent and decisive policy measures are required to restore confidence in the global financial system, the International Monetary Fund (IMF) says in a new report. The IMF estimates that the losses on US subprime assets and securities will ultimately total $1.45 trillion (€1.07trn; £828bn), more than 50% above its April 2008 estimate of $945bn, and it called for "a comprehensive set of measures that could arrest the currently destructive process".

"Failure to do so could usher in a period in which the ongoing deleveraging process becomes increasingly disorderly and costly for the real economy,"it said in its Global Financial Stability Report (GFSR), released on Tuesday. Financial institutions have been shedding bad assets, reducing borrowing and seeking new capital, but strains on the system intensified dramatically in mid-September following the collapse or near-collapse of several key institutions.

Confidence in financial institutions and markets has been badly shaken by the global credit turmoil that has its roots in the U.S. subprime mortgage market but that has spread globally to other financial sectors. The GFSR said that risks in a number of areas have risen, especially credit risk, and market and liquidity risks.

The latest GFSR examines how credit deterioration has continued to spread to more sectors and countries—from subprime to prime mortgages, and from residential mortgages to consumer credit, commercial real estate, and now to the corporate sector. European countries are also feeling the pain—some of them also had high house prices and overextended borrowers. Emerging markets appear increasingly at risk as well.

Also on Tuesday, John Lipsky, First Deputy Managing Director of the IMF, who is a former JP Morgan manager, said in a speechto the National Association of Business Economics in Washington DC, that "there is no doubt that the financial sector in general is still overscaled. At the same time, the sector is in the midst of a high-speed restructuring in terms of both institutions and instruments."

"It is clear that financial institutions' inevitable deleveraging will involve three aspects: reducing assets, raising capital, and, ultimately, implementing new business models," Lipsky said. "The difficult and protracted nature of this deleveraging process is likely to keep credit growth under pressure for some time, representing a drag on the economic recovery," he added.

Consistent and coherent

"Today's GFSR report shows how serious a crisis we currently face,"IMF Managing Director Dominique Strauss-Kahn stated."The time for piecemeal solutions is over. I therefore call on policymakers to urgently address the crisis at a national level with comprehensive measures to restore confidence in the financial sector. At the same time, national governments must closely coordinate these efforts to bring about a return to stability in the international financial system."

Experience from past global financial crises suggests that the policies to tackle systemic instability need to be consistent and coherent across the affected countries. The GFSR provides a set of principles on which to guide the scope and design of measures that can help to bolster confidence in financial institutions and markets. Most important: developing a three-part approach to break the downward spiral of disorderly deleveraging—taking illiquid and impaired assets from banks, injecting capital into viable institutions suffering unduly from incorrect market perceptions, and aiding dysfunctional funding markets get back to normal.

"A comprehensive approach, if consistent among countries, should be sufficient to restore confidence and the proper functioning of markets and avert a more protracted downturn in the global economy. We believe that a more resilient financial system will ultimately emerge from the restructuring and deleveraging process that is under way," Jaime Caruana, Director of the IMF's Monetary and Capital Markets Department, told a press briefing.

Mounting losses

Financial institutions' losses continue to mount, and unless they receive sufficient capital infusions, the viability of some of them is uncertain. The GFSR estimates that losses on U.S.-based loans and securities may rise to some $1.4 trillion—a significant increase from the estimate of $945 billion in the April 2008 GFSR.

While roughly $560 billion of the losses had already been realized through end-September 2008, bank share prices have continued to plummet and their revenue prospects have stalled. Raising new capital has become much harder, making it much more difficult for banks to repair their aching balance sheets.

The most serious risk going forward is an intensifying adverse feedback loop between the financial system and the real economy— in which financial institutions' distress leads to impaired credit intermediation and slower economic growth, which in turn leads to further credit deterioration. The GFSR—using forecasts from the IMF's World Economic Outlook—projects that credit growth in the United States, the euro area, and the United Kingdom, will slow to near zero over the next year before picking up again in 2010.

Deleveraging: necessary, inevitable

The GFSR says that the deleveraging process is both necessary and inevitable—but it need not be disorderly. Current market conditions have meant that asset sales and the run-off of maturing assets have made the process difficult because prices of the many illiquid mortgage-backed securities are depressed and buyers are scarce. Private market solutions to put a floor under these securities haven't worked.

Recently, the U.S. government approved a plan to have the U.S. Treasury use about $700 billion, under some restrictions, to purchase U.S.-based troubled assets with the hope of curtailing "fire sales" of these assets and establishing realistic prices. But a major issue for the plan is the difficulty for anyone, include a cadre of government-chosen experts, to determine future cash flows from these assets under such uncertain conditions.

Three-part solution

Supporting asset prices is necessary, but it is only one element in a three-part solution, the GFSR notes. Financial institutions need to raise more capital—an estimated $675 billion—but cannot do so under current conditions. Some potential investors stepped forward earlier, but now are reluctant. Current business models and revenue streams are more uncertain because mortgage securitization has nearly halted, making private capital investments in banks more chancy.

Without the ability to obtain new capital from private markets, recapitalization using the public sector balance sheet should now be considered, as solvency concerns have led to a seizing up of interbank funding markets. Finally, public action is being taken to provide much-needed liquidity to the financial sector and its clients.

Spread to emerging markets

The IMF said until recently, emerging markets had appeared resilient to spillovers from mature markets. But in recent weeks that changed. Capital outflows have intensified, leading to tighter external and, in some cases, domestic liquidity conditions. The problems were more serious in those economies with leveraged banking systems and corporate sectors that rely on international financing.

Although "decoupling"—the notion that emerging markets' dependence on mature economies has declined—had faded from most economists' vocabularies, some held out hope that this time emerging markets would not succumb. It is true that emerging economies have made progress on a number of fronts.

Overall, they have higher fiscal balances, less sovereign debt, more foreign exchange reserves, better policy making structures, and healthier economies. Many of these improvements are related to the recent commodity price boom. Nonetheless, the linkages to global markets and economies have continued to grow and these have begun to overwhelm the improved domestic fundamentals.

Moreover, although many emerging economies made fiscal and financial improvements, others remain vulnerable. The report highlights the reasons some countries may be at particular risk—for instance those dependent on terms-of-trade improvements or external credit.

The IMF said that Emerging European economies have relied on credit supplied by foreign banks or foreign investors through the issuance of local bank bonds abroad. This latter source has dried up and even though foreign banks say they remain committed to their subsidiaries in these countries, if funding conditions in their home country become difficult they may have little choice but to slow their credit extension abroad as well as at home.