IMF warns of $2.6 trillion contraction of European banks' balance sheets

Financial growth in Europe could be put to risk thanks to a drastic contraction of European bank balance sheets that would happen over the next 18 months according to forecasts from the International Monetary Fund.

The fund pointed out in its Global Financial Stability Report, published yesterday, that balance sheets of European banks looked set to shrink by $2.6 trillion (€2 trillion) over that period. The IMF cautioned, unless officials move to improve their policy response, European banks would dump almost 7 per cent of their assets by the end of next year.

According to the IMF most of the deleveraging will come from sales of securities and non-core assets but it fears credit supply could also shrink by 1.7 per cent as banks try to get a grip on lending to businesses and households which would hit the broader economy.

Following an examination of the measures adopted by 58 largest banks to boost their capital ratios, shed unprofitable businesses and reduce reliance on wholesale funding, analysts at the fund predicted the deleveraging process would be more severe than previously anticipated.

Even as it accepted that balance sheets needed to shrink after the financial excess, which was evident in the run-up to the crisis, the IMF warned that the risk of a ''synchronised and large-scale deleveraging'' could trigger financial instability and hit economic growth.

According to Huw van Steenis, banking analyst at Morgan Stanley, the highly uncertain European policy backdrop was driving banks to keep shrinking, even if Europe avoided a disorderly and abrupt crunch.