"We are on the road to recovery, but this does not mean that risks have disappeared,”José Viňals, Director of the IMF’s Monetary and Capital Markets Department.

The report points to the need to further repair bank balance sheets to enable the institutions to make loans needed to support the economic recovery. Without this step, downside financial and economic risks could reemerge, the report said.

"If we fail to meet the challenges still being faced by the financial system in the present crisis, we risk reigniting systemic risks and even derailing the economic recovery now in train. As you know, that is something we simply cannot afford," Viňals told a press briefing in Istanbul, Turkey, where the IMF released the report ahead of its annual meetings.

Markets regain footing

The IMF says wide-ranging government policy actions since mid-2007 to inject liquidity into markets, stabilise bank balance sheets, and restore credit market functioning have allowed financial markets to regain their footing. As a result, risk appetite has rebounded, leading to a powerful rally in risk assets such as stocks.

Stability in core markets has helped reduce risks in emerging market economies, especially in Asia and Latin America, while the new lending facilities and augmented resources of the IMF have helped lessen tail risks (those that are unlikely but with potentially devastating consequences) in vulnerable countries.

Still, a plan to mitigate the buildup of systemic risks and to ground expectations is necessary for sustained economic growth, the IMF report say. The IMF is worried that improving markets could result in a loss of urgency that allows the much-needed policy agenda to lapse - - that is, complacency could take over.

Banks back from brink

The GFSR report says a gradual reopening of capital and funding markets to banks and a recovery in their earnings are signs that banking systems have stepped back from the brink of collapse.

For both banks and other financial institutions, the GFSR calculates that actual and potential writedowns from bad assets such as loans and securities have fallen by some $600 billion over the past six months - - from about $4 trillion to $3.4 trillion, as a lessening in financial stress has narrowed spreads. The IMF says although writedown estimates are subject to considerable uncertainty, the analysis shows that the financial system is on the mend.

Nevertheless, banks still confront substantial challenges. The GFSR estimates that commercial banks have already recognised $1.3 trillion through the first half of 2009, but face another $1.5 trillion of potential asset writedowns ahead. Hence, overall, banks have recognised slightly less than half of their expected losses. US banks have recognized slightly more than have those in the UK and Eurozone.

More bank capital needed

Even though bank earnings are recovering, they are not expected to be big enough to offset fully the anticipated writedowns over the next 18 months. The insufficient earnings, combined with continuing deleveraging pressure, means banks will have to raise more capital. Additionally, banks must refinance a massive amount of maturing debt over the next two to three years. An unprecedented $1.5 trillion in bank borrowing is due to mature in the Eurozone, the United Kingdom, and the United States by 2012.

The GFSR suggests that although their balance sheets have been stabilised, some of it because governments have injected capital, banks are not yet in a strong position to lend support to the economic recovery.

With pressures on financial institutions’ balance sheets and a dormant private securitization market, the GFSR projects that a “financing gap” could arise - - that is, projected credit capacity will be insufficient relative to the demands of sovereign borrowers and the private nonfinancial sector. Such a situation constitutes a downside risk to the recovery and the IMF report suggests that continued policy intervention may be needed to keep credit flowing.

Risk to governments

Public interventions and fiscal stimulus packages have already led to an increased supply of public debt, most notably in advanced countries. As the economy recovers and private demand for credit strengthens, countries will have to articulate medium-term plans to consolidate their fiscal positions.

The IMF says historical evidence from 31 advanced and emerging economies points to the higher costs to sovereign borrowers of taking on too much debt - - a persistent 1 percentage point increase in the fiscal deficit leads to a 10 to 60 basis point increase in long-term interest rates (a basis point is 1/100^th of a percentage point).

Many private sector financial risks were transferred to the public sector during government rescue operations, leaving the governments vulnerable to future shocks. Countries with high debt-to-GDP ratios and large contingent liabilities (such as bank asset or liability guarantees) are particularly vulnerable, the report shows. This suggests that countries can reduce their exposure to systemic risks by designing and implementing medium-term fiscal consolidation plans that take into account the unwinding of the actual and contingent interventions in the financial sector.

Emerging market vulnerabilities

Emerging markets have in general withstood the crisis well, but vulnerabilities remain, the GFSR said. Although foreign portfolio investment has returned to emerging markets, cross-border bank credit is still falling. Those countries heavily dependent on bank credit have suffered most, especially in emerging Europe. The recovery of portfolio flows has helped mostly Asia and Latin America. In fact, in Asia, property and equity prices have appreciated, partly as a result of inflows from mature markets.

Although portfolio investment flows are resuming and signs of a recovery in the real economy are emerging, the global recession continues to take its toll. Corporate defaults are rising in all regions, with loan losses thus putting pressure on banking systems. Refinancing needs of emerging market businesses and banks are large, revealing substantial rollover risks. For instance, debt service of bonds and syndicated loans denominated in foreign currencies is estimated at $400 billion over the next two years, with much of it concentrated in late 2009 and early 2010.

Reforming the financial system

The GFSR also examines the need to reform financial regulation to curb some of the excesses that led to the global economic crisis, such as the risky lending to subprime US home buyers, which triggered the downturn. The report says regulation must be reformed to do the following:

• Restore market discipline by increasing the level and quality of capital, which should encourage shareholders to monitor risk-taking more carefully.
• Widen the perimeter of regulation to include systemically important institutions and assess some type of charge for the contribution they make to systemic risks.
• Institute a macroprudential approach to policymaking to reduce regulations that amplify the ups and downs of the economic cycle and formulate policies that better account for the potential interactions of monetary, fiscal, and financial policies.
• Improve international collaboration and coordination to cope with the challenges posed by cross-border institutions that function globally, but become the responsibility of the home government if they fail.