The world's financial market system remains fragile and the European Union should regulate if the private sector fails to make changes quickly enough, a draft report for next week's meeting of EU finance ministers said.
The report by the EU's Council of Finance Ministers, obtained by Reuters, said many banks had improved transparency on their multi-billion dollar exposures to products hit by the credit crisis. But uncertainty remained about the scale and distribution of further losses overall.
"At the same time, indications of contagion have started to appear in other credit markets," the report said.
Policymakers are concerned that banks are still unveiling huge writedowns on complex structured products linked to defaulted subprime U.S. mortgages.
In light of developments in the final quarter of 2007, "further and possibly larger mark-to-market valuation losses on securities can be expected," the report said.
Defaults on risky U.S. mortgages began unnerving markets last August, turning into a full-blown credit squeeze. However, a full picture of the fallout has yet to emerge, partly due to the lack of readily available data on exposures.
Ministers will develop an early warning system at EU and global levels so that the financial system is more resilient, the report said.
"Particular priority by the EU should be given to improving international crisis prevention and management, including strengthening the role of the International Monetary Fund in overseeing macro-financial stability," the report said.
The European Commission was seeking to boost market liquidity by proposing to extend the scope of EU rules on collateral to include credit claims, the report said.
Credit ratings agencies, criticized for being too slow to warn investors on the risks of structured products, were told to alter their business practices quickly.
"While preferring market-led solutions, if market participants prove unable or unwilling to rapidly address these issues the EU stands ready to consider regulatory alternatives," the report said.
Banks and brokers using off-exchange debt markets will be urged to standardize products to some degree, the report said.
The report said a survey by national banking watchdogs in the EU showed that transparency in respect of structured products and vehicles "is not fully satisfactory."
The EU, the IMF and the G7 have agreed a "roadmap" to review many aspects of regulation to see what changes may be needed in light of what has become known as the subprime crisis.
The report said many years of good profitability had left most of the bloc's banks in a strong position to deal with the current shocks that show no sign of abating.
"At this point, it seems that we are facing a prolonged adjustment and that the risk of a spillover to the real economy is more likely to materialize," the report said.
The report is an update from EU finance ministers for a meeting next month of EU leaders, who will be asked to give a preliminary nod to regulatory changes if initiatives by banks are inadequate.