MercoPress. South Atlantic News Agency

IMF blames credit crunch on “collective failure” & liquidity spiral

The International Monetary Fund has warned that potential losses from the credit crunch will reach 945 billion US dollars and could be even higher as losses are spreading from sub-prime mortgage assets to other sectors, such as commercial property, consumer credit, and company debt.

The IMF Global Stability report says that there was a "collective failure" to appreciate the risky borrowing by financial institutions and warns that tough measures and government intervention may be needed. "Despite unprecedented intervention by major central banks, financial markets remain under considerable strain, now compounded by a more worrisome macroeconomic environment, weakly capitalized institutions, and broad-based de-leveraging." IMF, which oversees the global economy, says that the effects of the credit crunch are likely to be "broader, deeper and more protracted" than in previous downturns, due to the "degree of securitization and leverage in the financial system". "Leading indicators point to a tightening of credit conditions across many economic activities" said Jaime Caruana, head of the IMF Monetary and Capital Markets Department, and author of the report. The report has been released ahead of a gathering of world financial leaders at the IMF spring meeting in Washington D.C. this weekend. On Wednesday the IMF is also expected to downgrade its forecast for the world economy, and accept that a sharp slowdown is likely in the US. The report blames lax regulation by governments and poor supervision by banks for allowing the situation to develop. And it warns that national governments must prepare contingency plans "for dealing with large stocks of impaired assets" if "write downs lead to significant negative effects on the real economy". The report is sharply critical of banks and other financial institutions, which it accuses of "excessive risk-taking" and "weak underwriting". It says they were "too complacent" about liquidity risks - the problems that would happen if they ran out of ready cash - and too ready to rely on wholesale money markets and central banks to help them if they got into trouble. It also points out to a failure of banks' risk management systems to appreciate that the new "structured finance vehicles" that they used to offload their risky sub-prime investments were not really viable. The new instruments increased the danger of a "liquidity spiral" in which markets and institutions' funding problems reinforced each other. IMF warns that banks will have to concentrate on rebuilding their balance sheets by raising additional funds and limiting future lending. The IMF report says that financial sector supervision and regulation "lagged behind the rapid innovation and shifts in business models, leaving scope for excessive risk-taking" and says more fundamental changes are needed in the medium term. But it warns against "a rush to regulate" which could stifle innovation and make the credit crunch worse. However, it says that there should be tougher rules to stop banks putting assets off the balance sheet, and requiring banks to put aside more capital to protect against losses. It points out that it is not securitization itself, but "lax underwriting standards in the US mortgage market, the extension of securitization into increasingly complex and difficult to understand structures based on increasingly lower quality assets", and low interest rates which led to a situation where "risks were insufficiently appreciated". And it suggests that central banks will have to take into account worries about excessive asset prices, such as house price bubbles, when setting interest rates. In recent days, both the US Treasury Secretary Hank Paulson and IMF boss Dominique Strauss-Kahn have both urged major changes in international and national financial regulation. Last week, Mr Paulson proposed a major shake-up of the US system of financial regulation, giving more power to the central bank, the Fed, to intervene to rescue stricken banks and other financial institutions. And on Monday, Mr Strauss-Kahn said that the need for public intervention to tackle the credit crunch at the global level was "becoming more evident" every day. This, along with more intervention in the banking sector, would offer a "third line of defense", Mr Strauss-Kahn said.