The International Monetary Fund warned Wednesday that European banks are under pressure to preserve capital and could cut back sharply on lending over the next two years, slowing the region's growth.
The predicted credit crunch is a major reason why Europe's economy is expected to suffer a mild recession this year and barely grow in 2013, the IMF said in a report on the global financial system released Wednesday.
The 17 countries that use the euro will see their economies shrink by 0.3 percent this year, and expand by only 0.9 percent in 2013, the IMF has forecast.
But the slowdown could be worse if European governments don't follow through on pledges to cut budget deficits and build up their bailout fund, the global lending organization said.
Large banks based in the European Union may reduce their balance sheets _ which include outstanding loans, securities and other assets _ by as much as $2.6 trillion through the end of 2013, the IMF said. That's about 7 percent of their total assets.
About one-quarter of that reduction will come from reduced lending and could shrink the amount available for credit by 1.7 percent.
Some reduction in credit, or "deleveraging," is necessary, the IMF said. Banks aren't able to borrow as freely as in the past and governments are requiring them to hold more capital.
"But like Goldilocks, the amount, the pace, and location of deleveraging must be just right," said Jose Vinals, the IMF's financial counselor. "Not too large, too fast or too concentrated in one region or country."
European leaders have taken many positive steps to shore up their financial system, the IMF said. The European Central Bank has provided roughly $1 trillion in cheap, low-interest loans to European banks since December. New governments in Italy and Spain are cutting budget deficits and reforming their labor markets. And European leaders have agreed to set up a bailout fund, or "firewall," to backstop debt-ridden countries if they are unable to borrow on private markets.
But if governments fail to carry through with those plans, European banks may cut back further on lending, the fund said. Under its "downside scenario," the amount of credit available would shrink by 4.4 percent and the eurozone's economy would be 1.4 percent smaller by the end of 2013.
Conversely, if European policymakers took additional steps, such as closing down or restructuring weak banks and using the bailout fund to recapitalize larger institutions, the economy would be 0.6 percent larger than currently forecast.
Raising capital can be a difficult step because it can dilute shareholders holdings. The IMF also warned that national regulators must restrain banks from using money for payouts of dividends to shareholders and bonuses to top bank executives.
The IMF notes that the central bank's lending has given European officials more time to push the continent's shaky banks to raise new capital. The EU's European Banking Authority is already pressing to do that. It has pressured banks to increase the size of their financial reserves compared to their risky loans and investments _ but it has urged them to do it by finding new capital, not by cutting back on loans.
Even so, the IMF points out that most responsibility for overseeing banks remains at the national level, where authorities have been slower to make banks take tough measures.