The International Monetary Fund warned Tuesday that risks to the global recovery remain, and that the stability of the financial system has suffered a setback in recent months. The IMF encourages policymakers to continue with reforms needed to stabilize the system and their balance sheets.

In a new report, the IMF refers to the global financial system as “the Achilles’ heel” of the economic recovery. It still expects that recovery to continue, but warns that progress toward global financial stability has stumbled since its last report on the subject in April.

“The recent turmoil in sovereign debt markets in Europe highlighted increased vulnerabilities of bank and sovereign balance sheets arising from the crisis,” the IMF says, adding that sovereign balance sheets are still highly vulnerable to growth shocks, making debt sustainability less certain.

As a result, it calls on global policymakers to continue with reforms, including steps to deal with the legacy problems in the banking sector; strengthening sovereign balance sheets; and, agreeing on reforms for the banking sector, building on the latest steps to tighten capital requirements.

The IMF notes that banks have made progress on crisis-related writedowns, but says more needs to be done to address funding pressures, and resolving and/or restructuring weaker institutions — through closure, recapitalization, or merger — remains a priority, it adds.

Moreover, the IMF says that much of the proposed financial reform agenda remains unfinished. “The sooner reforms can be clarified, the sooner financial institutions can formulate their strategic priorities and business models. In the absence of such progress, regulatory inadequacies will continue for some time, increasing the chances of renewed financial instability,” it warns.

“Overall, policymakers cannot relax their efforts to reduce refinancing risks, strengthen balance sheets, and reform regulatory frameworks,” it concludes. “As apparent on several occasions over the past three years, conditions in the global financial system now have the potential of jumping from benign to crisis mode very rapidly.”

IE