IMF fears dangers of €200bn hole in European banking system

The global financial system is "back in the danger zone" and there is potentially a €200bn (£175bn) hole in the European banking system, according to the International Monetary Fund. In its latest Global Financial Stability Report (GFSR), published yesterday, the IMF warns that risk levels across the international financial system are higher than at any time since the collapse of Lehman Brothers in 2008 and that governments and regulators must take urgent action to avoid a similar disaster occurring.

"Time is running out to address existing vulnerabilities," said the report, which singles out European banks as being particularly at risk. The IMF asserts that banks across the Continent urgently need to raise capital if they are to withstand the economic turmoil. It said: "Weak banks need to be restructured and where necessary resolved. If private capital is not available and national public balance sheets have no spare capacity, EU-wide public backstops should be used."

The managing director of the IMF, Christine Lagarde, caused a diplomatic row last month when she said that European banks were undercapitalised, a claim that embarrassed the leaders of eurozone governments. Though Ms Lagarde seemed to retreat from that assessment at the G7 meeting in Marseille earlier this month, yesterday's report confirms the IMF's original hardline position and will ratchet up the pressure on European governments to restructure their banking sectors.

The IMF reached its €200bn figure by looking at credit default swaps to calculate how the risk of holding the bonds of troubled European nations had increased since 2009. The fund then looked at how many of these bonds are held by European banks and calculated the potential decline in value of those holdings.

Jose Vinals, the IMF's director of monetary and capital markets, said of the potential losses of European banks yesterday: "Some may have been recognised [by banks]. Some may have been provisioned. But there is not enough transparency."

Previous official "stress tests" of banks by European regulators have been based on the assumption that European governments would always act to prevent these credit risks from materialising by bailing out any European country at risk of defaulting on its loans. In July, the European Banking Authority found that only eight European banks were lacking in capital, with a combined shortfall of just €2.5bn. It said: "European banks have significantly strengthened their capital positions and are able to withstand adverse macroeconomic scenarios." That view was directly challenged by the IMF yesterday.

The IMF also warns that the low interest rates maintained by Western central banks, though justified by the weakness of their economies, could be storing up financial risks for the future. The GFSR says that low rates are encouraging some financial firms to increase their leverage in pursuit of higher returns and also driving private investors into the shadow banking system. "These conditions increase the potential for a sharper and more powerful turn in the credit cycle," it said.

The report also suggests that investors' flight to safety into US bonds is reducing the pressure on the American government to get to grips with its public finances, something that could have dangerous financial consequences. "By reducing the urgency to act," the report said, "it increases the potential for a negative credit event to have a significant adverse market reaction."

There is also a health warning about the Chinese banking system. The report points out that the country's post-2008 credit boom, which helped it weather the global downturn, has left a legacy of "doubtful" loans. It does add, however, that the Chinese government's strong fiscal position should enable the country to rescue its banking sector should a bust occur.

The report also stresses that the impact of a European banking crisis would be felt across the world, highlighting that the US money market funds, which have $2.7 trillion (£1.7trn) in assets, have large holdings of European financial sector debt. There have been signs in recent weeks that European banks have been finding it increasingly difficult to roll over these dollar loans. The world's central banks announced last week that they would make unlimited three-month dollar loans available to banks to ease these funding pressures.