The International Monetary Fund (IMF) has warned that a new financial crisis could be looming large on the horizon, adding that global output could decline by 4% over the next five years.
The fund, which delivered its traditional half-yearly global financial stability report, said over 30% of banks in the Eurozone faced "significant challenges" to be sustainably profitable and called for regulators and policymakers to take urgent actions.
Banks in the 19-country bloc would have to be closed in order to deal with excess capacity, the fund said, adding drastic measures had to be employed to deal with the €900bn (£715bn, $1.02trn) of non-performing loans (NPLs) currently on the books of Eurozone banks.
"In the euro area, market pressures also highlighted long-standing legacy issues, indicating that a more complete solution to European banks' problems cannot be further postponed," the IMF said.
"The hardest hit banking systems within the euro area in February have been those of Greece, Italy, and to a lesser extent, Portugal, along with some large German banks, reflecting some or all of the following factors: structural problems of excess bank capacity, high levels of NPLs and poorly adapted business models."
Legacy issues place banks under pressure
The fund conceded that banks in developed economies had become better placed to deal with financial strains but, even so, 15% of lenders in advanced economies faced an uphill challenge to achieve sustainable profitability.
Unresolved legacy issues coupled with a decline in profitability meant external capital and funding could become more expensive.
"Italian banks face a particular challenge in this regard, as marked pricing has reflected investor confidence that some banks may face difficulties in growing out of their substantial non-performing loan overhang, despite constructive steps taken by Italian authorities to facilitate balance sheet repair."
The IMF indicated that threats to the global economy had increased in the six months since it published its last report and warned markets could soon find themselves in turmoil again if adequate precautions are not taken.
"Additional measures are needed to deliver a more balanced and potent policy mix for improving the growth and inflation outlook and securing financial stability," it said.
"Disruptions to global asset markets could increase the risks of tipping into a more serious and prolonged slowdown marked by financial and economic stagnation."
Global output at risk
The IMF added the global economy could run the risk of finding itself in a very difficult scenario, whereby investors would demand higher interest rates, while tougher financial conditions would generate a "pernicious feedback loop" of fragile confidence, slower expansion as well as lower inflation and rising debt.
Financial stability could deteriorate to such an extent that economic growth and financial stability could both be affected to the point where world output could be 3.9% lower by 2020 than the IMF is expecting.
The fund also expressed concerns over China's ability to transform its economy from an export-focused model to a system that makes consumer demand its focal point,
"Policymakers need to build on the current economic recovery and deliver a stronger path for growth and financial stability by tackling a triad of global challenges – legacy challenges in advanced economies, elevated vulnerabilities in emerging markets, and greater systemic market liquidity risks," the IMF said.
"Progress along this path will enable the world's economies to make a decisive break toward a strong and healthy financial system and a sustained recovery. In such a scenario, world output could expand by 1.7% relative to the baseline by 2018."