European Banks Risk New Global Financial Crisis, IMF Warns

European banks risk creating a new global financial crisis as they shrink their balance sheets by more than $2 trillion through the end of next year, the International Monetary Fund said Wednesday.

Without careful oversight by euro-zone authorities, the potential consequences of a synchronized and large-scale reduction in banks’ portfolios could cause “serious damage to asset prices, credit supply and economic activity in Europe and beyond,” the IMF said in a new report.

The fund outlined a raft of policies it said are necessary to avoid a worst-case scenario, including furthering central-bank support, expanding the use of the region’s emergency funds to invest in banks as a way to inject needed capital and soften the impact of banks unwinding their risky assets, and accelerating financial-sector reforms.

Without action, the fund said Europe risks forcing an international fire-sale of bank assets, with banks rapidly shrinking their portfolios by an estimated $3.8 trillion. Besides a credit crunch and a resurgence of default risk in the euro zone, that would likely spark a chain reaction across the globe. Emerging markets would be whip-sawed as capital flooded out of their economies. The U.S. derivatives markets could likely face another meltdown. And near-term prospects for a global economic recovery would be shattered.

“Through derivative markets, stress could be transmitted to U.S. banks, even though their direct exposures to European banks and sovereigns are relatively low,” the fund said.

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