Governments must slash budget deficits decisively and central banks should not wait too long to raise borrowing costs as side effects from measures prescribed to tackle the global recession may create the next crisis, the Bank for International Settlements said.
The global economy as well as financial markets were on the mend, though the recovery remained fragile in the advanced economies and in the euro zone the debt crisis put the recovery at risk, the BIS said in its annual report, published on Monday.
Global leaders meeting in Toronto agreed to take different paths for shrinking budget deficits and making banking systems safer and Washington in particular has warned against cutting too fast.
The head of the BIS said there was no time to waste.
"We cannot wait for the resumption of strong growth to begin the process of policy correction," BIS general manager Jaime Caruana told the bank's annual general meeting.
"In particular, delaying fiscal policy adjustment would only risk renewed financial volatility, market disruptions and funding stress."
Caruana later told a news conference that recently announced fiscal consolidation in some countries together with the publication of bank stress tests in Europe and the support of the G20 for regulatory reforms were important steps forward.
The BIS, which acts as a bank to central banks and a discussion platform for policymakers, said reforms of the financial system remained key to prevent further crises.
Caruana said the benefit of making the financial system more resilient through tighter regulation outweighed any short-term growth losses.
Top central bankers met at the BIS annual meeting June 26-28 in Basel, following the G20 summit where leaders acknowledged the uneven and fragile economic recovery in many countries.
In a reversal from the unity of the past three crisis-era Group of 20 summits, the leaders left room to move at their own pace and adopt "differentiated and tailored" policies.
But the BIS warned powerful support measures had strong side effects and said their dangers were starting to emerge.
"To put it bluntly, the combination of remaining vulnerabilities in the financial system and the side effects of such a long period of intensive care threaten to send the patient into relapse," the BIS report said.
The BIS said if the extraordinary measures were kept in place for too long, policymakers ran the risk of creating "zombie" banks or companies, dependent on direct support.
But it acknowledged the tricky situation for policymakers as the stakes were high and the risks from capping lifelines too early loomed large.
Central banks especially were walking a fine line.
The banking system was still far from sound, as recent profits from fixed income and currency trading and the low interest rate environment were hard to repeat and not all crisis-related losses may have been booked.
"But the longer that policy rates in the major advanced economies remain low, the larger will be the distortions they create, both domestically and internationally," the BIS said.
Extremely low real or inflation-adjusted rates altered investment decisions, postponed the recognition of losses, increased risk-taking in the search for yield and encouraged high levels of borrowing, the BIS said.
In addition, central bankers may underestimate inflation risks as the crisis may have lowered potential growth rate.
Markets have pushed back expectations for rate increases in the United States and in the euro zone in the wake of the Greek debt crisis, and central bankers urged Europe to solve the crisis so as not to endanger uneven global recovery.
Speaking to Reuters on Monday, Jassim Al-Mannai, director general of the Abu Dhabi-based Arab Monetary Fund, said banks and policymakers had to beware of fuelling bubbles.
"We have to avoid, every economic authority, not to see bubbles. Our economic policy needs to be prudent, especially monetary and even fiscal policy," he said.
Challenges for emerging economies were different as they were recovering strongly and inflation was picking up, the BIS said.
"Some EMEs could rely more on exchange rate flexibility and on monetary policy tightening," the BIS said.
The Greek debt crisis had highlighted that many governments had to consolidate their finances immediately as highly indebted countries would not be able to rescue banks as a buyer of last resort in another crisis.
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