The International Monetary Fund’s No. 2 official urged policy makers to clean up banks and strengthen oversight of their financial systems or risk stalling a recent rally in global markets.

With the world economy still subdued, further repair of banks’ balance sheets is necessary, which may require more capital for some lenders and closure for others, David Lipton, the fund’s first deputy managing director, said in a speech in Washington Tuesday. He also called for unwinding of excessive public and private debt.

“If these medium-term challenges are not adequately addressed, the recent rally in global markets may prove unsustainable,” Lipton said, according to his prepared remarks. “And the still fragile confidence in banks and the wider financial system could turn into fear, which could trigger a renewed sense of crisis.” 

The MSCI World Index of stocks has risen 7.1 percent this year as equity markets in the U.S., Japan and Europe rallied.

Still, the Washington-based IMF earlier this year cut its global growth forecast for 2013. Recently it said it would lower its prediction for the U.S., where $85 billion in federal government spending cuts have started to take effect.

Speaking to members of the Chartered Financial Analyst Society of Washington, Lipton said the global financial system is not yet safe, even if it is in a better shape than five years ago.

“Think of it as a huge safety net that has been mended and strengthened, but still has enough holes that we cannot yet feel protected,” he said.

He criticized “delays and dilutions” in a reform agenda agreed upon by the Group of 20 economies, calling “a particular worry” the delay in implementation of Basel III international capital standards in the European Union and the U.S.

Lipton said less progress has been made in the derivatives market. “National authorities have not met recent deadlines to implement these reforms, reflecting the legal complexities of this opaque industry,” he said.

Another area Lipton called “particularly troubling to many global stakeholders” is a lack of movement to a single set of financial reporting standards that the G20 called for. He cited diverging views of the International Accounting Standards Board and Financial Accounting Standards Board on the “credit loss recognition models based on expected rather than incurred losses is a major setback to the convergence process

‘’That will leave European and U.S. banks estimating loan loss provisions with different methodologies,’’ he said. 

(Bloomberg)