European banks could trigger fresh credit crunch, warns IMF The IMF expects Europe's biggest banks to slim down 7% by the end of next year. Photograph: Vladimir Rys/Getty Images Europe's banks risk triggering a major credit crunch if they all take drastic action to repair their balance sheets at the same time, the International Monetary Fund said on Wednesday. In its half-yearly look at the state of the global financial system, the IMF said it was "essential to continue to avoid a synchronised, large-scale, and aggressive trimming of balance sheets that could do serious damage to asset prices, credit supply, and economic activity in Europe and beyond." The IMF said it expected 58 of the biggest banks in the European Union to slim down by $2.6bn (£1.6bn) by the end of 2013, or almost 7% of their assets. While 75% of the deleveraging would be as a result of asset sales, credit would also be harder to obtain. In the event governments stalled on reforms or were overwhelmed by fresh shocks to the system, the Global Financial Stability Review warned of a much more severe credit crunch that would see balance sheets reduced by almost $4 trillion and credit supply cut by 4.4%. The review said risks to global financial stability were high despite the actions taken at the end of 2011 to deal with an intense crisis in the eurozone. Pressures on European banks remain elevated. Banks are coping with sovereign risks, weak economic growth, high rollover requirements, and the need to strengthen capital cushions to regain investor confidence. Together, these pressures have induced a broad-based drive to reduce the size of bank balance sheets. Although some deleveraging is both inevitable and desirable, its precise impact depends on the nature, pace and scale of asset shedding. It said there was a risk of conditions deteriorating if current policies fell short of what had been agreed, national policies faltered, political solidarity underpinning euro area reforms fragmented, or shocks overwhelmed the firewalls. In this scenario, credit spreads would widen, making government funding costs prohibitive and adding to the deleveraging pressures on banks. In the worst case, the IMF said, the eurozone would have a deeper recession than that currently forecast by its economists. It believes that the 17 nations that are part of monetary union will contract by 0.3% in 2012 before growing by 0.9% in 2013 but a more pronounced credit crunch would see gross domestic product cut by 1.4% after two years. There is a risk that a large-scale reduction in assets by European banks could lead to a credit crunch. It added: "European firms are particularly vulnerable to reduction in bank credit because of their greater reliance on banks for funding and often limited ability to adjust labour costs, at least compared with their US peers." The IMF identified two short-term and two medium-term policies that would help create financial stability. The immediate need, it said, was for a credible firewall that was big enough to stem contagion, and for further progress on bank restructuring and resolution. In the longer term, it urged measures to complete the architecture of European monetary union - a road map for a pan-euro area financial stability framework and progress towards greater fiscal risk sharing. The path ahead has significant political and implementation risks, and policies need to be further strengthened to secure and entrench financial stability. Policymakers should therefore build on recently agreed reforms and complete the policy agenda. Policymakers also need to co-ordinate a careful mix of financial, macroeconomic and structural policies to ensure a smooth deleveraging process that puts the financial system in a good position to support the economy. While the eurozone was the focus of the report, it noted that both Japan and the United States had yet to forge a political consensus for medium-term deficit reduction, which was crucial to secure debt sustainability and preserve market confidence.