Financial regulators and central bankers delivered a grim assessment of the credit market upheaval on Saturday, warning that worse may lie ahead as banks tighten lending and an economic slowdown spreads.
In an interim report to the Group of Seven finance ministers, the Financial Stability Forum cautioned against a rush to regulate into this vicious cycle of credit writedowns, preferring to allow markets-based systems to operate.
But authorities must remain on heightened alert, ready to jump in and impose discipline to the messy repricing of credit risk where necessary, it said.
FSF President Mario Draghi told a news conference that the next 10 days to two weeks would be crucial to understanding the extent of damage to the financial system as many banks issue their first audited accounts since the the crisis started.
Asked about the extent of total exposure to the U.S. sub prime mortgage sector, he replied, "the only thing we know is that it's big and we keep on discovering new dimensions to it."
Draghi, also the governor of the Bank of Italy, said it was not appropriate to draw conclusions from the fact that bank writedowns had been far lower in Europe than in the United States.
"We are in the middle of the road. It's not over yet," he said.
Already the credit crisis has claimed British bank Northern Rock as its first victim. French bank Societe Generale is embroiled in a rogue trader scandal and huge international banks from Citigroup to Merrill Lynch have resorted to Middle Eastern and Asian funds to bolster their faltering capital.
The FSF did not discuss the SocGen case, Draghi said.
Policymakers are considering a range of steps to innoculate the world from future bouts of excessive risk-taking, which led to the current credit crisis. Tougher disclosure standards for ratings agencies, strengthened capital standards for banks and better risk management systems were on the FSF's list.
Risk of More Shocks
More immediately though, the group of central bankers and regulators studying the causes of the credit crisis that began in the U.S. subprime mortgage sector and has spread through financial institutions around the world and sent stock markets tumbling, said further upheaval may lie ahead.
"As institutions adjust to these conditions, the potential exists that risk shedding could tighten credit constraints on a widening set of borrowers and thereby slow economic growth, which could further impair credit," the FSF said in its interim report.
"There remains a risk that further shocks may lead to a recurrence of the acute liquidity pressures experienced last year. It is likely that we face a prolonged adjustment, which could be difficult," they said in the report.
Central banks since last August have pumped many billions of dollars of cash into money markets to grease the wheels of the financial system, which threatened to seize up when complex credit derivatives lost value.
Banks stopped lending to each other, spooked by credit writedowns and spreading uncertainty about the value of structured assets.
Banks already have taken more than $100 billion in writedowns to clean up their balance sheets and have bolstered their capital base and and German finance minister Peer Steinbrueck said write-offs could reach $400 billion.
As well, the credit markets are still creaking, with few buyers willing to pay prices for assets of uncertain value leaving masses of debt on bank books.
The FSF recommended a number of steps to address these problems, and promised more specific recommendations when it delivers its final report in April.
-- Bank capital may need strengthening. Supervisors should consider supplementary capital buffers to complement risk-based capital measures, and the Basel Committee should assess whether refinements are needed to new Basel II capital standards.
Supervisors also need to examine the incentives that prompted banks to move some assets off balance sheet, even though they still held the risk exposure.
-- Liquidity risk supervision should be examined by supervisors and central bankers for cross-border banks.
-- U.S. regulators should review weakness in the underwriting system for credit derivatives and possible fraud.
-- Credit ratings agencies must improve the information they provide investors on structured finance products and take steps to address potential conflicts of interest, whereby they are paid by the issuer they rate.
-- Cooperation among bank supervisors, central bankers and financial regulators needs to improve at the national and international level. Better methods of handling weak and failing banks are necessary.