The euro area debt and banking system crisis still threatens global financial markets despite the recent policy relief, the International Monetary Fund (IMF) said Wednesday.

Recent important policy steps have brought some much-needed relief to euro area financial markets, with sovereign spreads declining, bank funding markets being reopened partly, and equity prices recovering, the IMF said in its latest Global Financial Stability Report.

"While subsequent policy actions eased euro area bank funding strains and helped stabilize sovereign markets, the risks to global financial stability remain elevated," the report noted.

For European banks, there are still heavy pressures from sovereign risks, weak euro area growth, high rollover requirements, and the need to strengthen capital cushions to regain investor trust.

These pressures, together, have induced a broader drive to reduce balance sheet size. The report estimated that large EU- based banks could shrink their combined balance sheet by as much as 2.6 trillion U.S. dollars by the end of 2013, nearly 7 percent of total assets.

Some balance sheet reduction by individual banks is necessary as high leverage is no longer supported by either markets or regulators. But these moves might also cause "serious damage" to asset prices, credit supply and economic activity in Europe and beyond, the Washington-based agency asserted.

"It is too soon to say that we have exited the crisis, because lasting stability is not yet ensured," said IMF Monetary and Capital Markets Department Director Jose Vinals at the launch ceremony of the report.

"We have been reminded in recent weeks that sentiment can quickly shift and rekindle sovereign financing stress, leaving many sovereigns and banking systems caught in a vicious circle."

Against this backdrop, European policymakers have to implement the agreed reforms swiftly on the basis of recent improvements, the report noted, citing the recent decision to combine the European Stability Mechanism with the European Financial Stability Facility is welcome.

"Current policy efforts are not enough to achieve lasting stability. This refers to Europe and to other advanced economies," Vinals noted.

To prevent the materialization of downside risks, continued adjustment efforts are needed at the national level, especially by countries currently under strain, said Vinals, adding the euro zone "firewall" should also be able to take direct stakes in banks to help break the adverse feedback loop between sovereigns and banks.

The problem in Europe right now is to adjust fiscal position to let taxpayers and businesses trust it again, said IMF Deputy Managing Director David Lipton at a roundtable discussion organized by IMF on Wednesday afternoon.

Expansionary fiscal policy is not sustainable for growth, and Europe has to build credibility gradually, noted Vitor Gaspar, Portugal's Finance Minister at the roundtable seminar.

Though most emerging economies have policy room to buffer deleveraging forces emanating from Europe, their resilience could be tested in a downside scenario, especially in emerging Europe, the report added.

Elsewhere, the United States and Japan have yet to forge a political consensus for medium-term deficit reduction, perpetuating latent risks to financial stability.

In addition, the global financial regulatory framework is being strengthened, but key agreements still need to be finished. "The transition to this new setting could add to cyclical challenges facing financial institutions," the IMF added.

The report was released prior to the Spring Meetings of the IMF and its sister agency World Bank, scheduled to kick off on April 20 in Washington D.C., gathering central bank governors, finance ministers and other experts to discuss key global economic issues and policy action.