The IMF, while cutting its estimate for global asset writedowns by about 4.3 percent, warned that confidence in the financial industry has not fully returned after the European debt crisis highlighted banks’ links to sovereign-debt risk.

“Funding is perhaps the major challenge confronting banks at present everywhere,” Jose Vinals, director of the IMF’s monetary and capital markets department, told a news conference in Washington in presenting the fund’s Global Financial Stability Report. “But those challenges are more pronounced in Europe.”

More than $4 trillion of bank debt will need to be rolled over in the next two years, making it “a priority” to take care of weaker financial institutions to help funding markets return to normal, the IMF said.

A “forceful response” by European policy makers to the Greece-borne sovereign debt crisis and their disclosure of banks’ stress tests results have helped ease funding for governments and banks, the IMF said. Still, IMF officials estimate that sovereign risks remain high as investors continue to focus on public debt burdens amid governments’ attempts to narrow budget deficits.

‘Achilles’ Heel’

“The global financial system is still in a period of significant uncertainty and remains the Achilles’ heel of the economic recovery,” the IMF said. “With the situation still fragile, some of the public support that has been given to banks in recent years will have to be continued.”

Plans to exit “unconventional” monetary and financial policies may need to be delayed until the situation is more “robust,” according to the institution. Vinals, the IMF official, said that exit strategies must be “carefully considered.”

“We do not see a risk of generalized asset bubbles in the emerging markets at large, but we can see certain hot spots that require close monitoring and in some cases policy action,” Vinals said.

Banks have reduced the value of loans and securities by $2.2 trillion since 2007, more than three-quarters of which had been realized by mid-2010, down from the IMF’s April estimate of $2.3 trillion, the fund said.

At the same time, the cost of credit-default protection for financial institutions has increased, reflecting higher tensions in the banking industry, the IMF said. Credit-default swaps for banks of the euro region have risen above those of the U.S. and the U.K. because of “the relatively greater pressure in European banking systems from both sovereign risks and wholesale funding strains,” it said.

‘Funding Shock’

European banks are more vulnerable to a “funding shock” than their U.S. counterparts, because they rely more on interbank loans, debt markets and central bank credit lines for day-to-day operations, the IMF said.

“If the economy recovers as planned and sovereign and bank funding strains continue to subside, European banks should be able to repair balance sheets and gradually rebuild capital buffers,” the IMF said. “However, banks remain vulnerable to periods of renewed stress.”

To retain access to funding markets, banks in “a number of countries” in the region may need additional recapitalization and higher quality capital, the IMF said.

Non-viable institutions also need to be taken care of and announced restructuring plans must be implemented “rigorously,” the IMF said, citing Germany’s landesbanken and Spain’s regional savings banks as examples.

In the U.S., “although banks have been able to raise a substantial amount of capital, and expected demands appear manageable, some raising of additional capital may be needed to reverse recent deleveraging trends and possibly to comply with U.S. regulatory reforms,” the IMF said.

It also spotted “pockets of vulnerabilities” in the banking system “as the real estate sector is prone to a double dip.”

Particularly Uncertain

“The outlook for both residential and commercial property appears to be particularly uncertain,” the fund said, while stressing that most of the credit risk in U.S. housing has now shifted to Fannie Mae and Freddie Mac.

In Japan, while a disruption in the government bond markets appears unlikely in the short term, banks have “low capital and weak profitability,” the IMF said.

In contrast, emerging markets “have proven very resilient to sovereign and banking strains in advanced economies,” with risks stemming from “strong” capital inflows that are likely to increase, according to the report.

“Conditions in the global financial system now have the potential of jumping from benign to crisis mode very rapidly,” the IMF said. “Against this backdrop, policy makers should not squander opportunities to strengthen and recapitalize banking systems, address too-important-to-fail entities, reduce contingent liabilities, and place sovereigns on a credible fiscal path.”