Losses from the credit crisis by financial institutions worldwide are set to balloon to almost $1 trillion (£500 billion) threatening to trigger severe economic fallout, the International Monetary Fund said today.

In a grim assessment of the worsening situation just days before this week’s Washington talks among ministers from the Group of Seven (G7) leading economies, the IMF warns governments, central banks and regulators that they now face a crucial test to stem the turmoil.

“The critical challenge now facing policymakers is to take immediate steps to mitigate the risks of an even more wrenching adjustment,” it urges in its twice-yearly Global Financial Stability Report. The Dow Jones industrial average fell 80.8 points to 12,531 in the first minutes of trading.

The IMF sounds an alert over the danger that banks’ escalating losses, along with credit market uncertainties, could now spark a vicious downward spiral as they weaken economies and asset prices, leading to higher unemployment, more loan defaults and still deeper losses.

“This dynamic has the potential to be more severe than in previous credit cycles, given the degree of securitisation and leverage in the system,” the Fund argues.

It says that it is now clear that global financial upheavals are now more than just a shortage of ready funds, or liquidity, but are rooted in “deep-seated fragilities” among banks with too little capital.

This “means that its effects are likely to be broader, deeper and more protracted”, the report says.

It also says that “a broadening deterioration of credit is likely to put added pressure on systemically important financial institutions,” warning that the risks of a full-blown credit crunch that could undercut economic growth have increased.

The report highlights the threat posed by the rapid spreading of the credit crisis from its roots in US subprime home loans to more mainstream lending markets, and worldwide.

“The corporate debt market appears vulnerable as default rates are set to rise,” it finds. Loan defaults on high-risk corporate debt - so-called junk bonds - have already begun to increase in both the US and Europe, which the IMF singles out as “an area of specific concern”.

At the same time, strains over lending between commercial banks have intensified, despite interventions from central banks.

The report cautions: “This leaves financial institutions, most recently hedge funds, vulnerable to mutually reinforcing funding and market liquidity spirals, in which investors sell assets to meet funding requirements, creating price declines, a loss of confidence, and further funding pressures.”

While banks have so far declared losses and writedowns over the crisis totaling $193 billion (£98 billion), the IMF expects the ultimate toll to reach $945 billion.

Global banks are expected to shoulder about half of the total losses - between $440 and $510 billion - with the rest being borne by insurance companies, pension funds, hedge funds and money market funds, and other institutional investors, across by the United States and Europe.

The vast bulk of the losses are expected to stem from defaults in the US, with $565 billion written off in US subprime and prime mortgages alone, and a further $240 billion expected to be lost on commercial property lending. Losses on corporate loans are projected to mount to an eventual $120 billion, and those on consumer lending to $20 billion.

Three-quarters of the losses are expected to flow from loans parceled out from the original lender to other institutions through securitisations, in the form of asset-backed securities. The remaining losses would be direct defaults on unsecuritised loans.

The IMF says that the immediate challenge confronting governments and officials is now to “reduce the duration and severity of the crisis”, by bolstering confidence.

Ahead of the critical G7 talks on Friday, the report sets out a series of short-term and longer-term measures to tackle the turmoil.

It calls for steps to hasten banks’ disclosure of losses, and risks of further exposure, and for them to make early write-downs to “cleanse balance sheets”.

Banks with weak capital bases should also immediately seek to raise new funding “even if the cost of doing so appears high”.

The IMF calls for regulators to promote consistency is the way that institutions account for losses.

With the G7 to debate some far-reaching measures to be laid out for ministers this week by leading economies’ Financial Stability Forum, the Fund also backs the potential case for public funds to be used to stem the crisis if it continues to escalate.

Action being debated by ministers and central banks includes potential moves to remove illiquid, hard-to-trade mortgage backed securities from banks’ balance sheets, to end uncertainty, bolster capital positions and allow more normal lending to resume. There are huge issues over the use of taxpayers’ funds to do this, however.

Despite those qualms, the IMF concludes: “National authorities may wish to prepare contingency plans for dealing with large stocks of impaired assets if writedowns lead to disruptive dynamics and significant negative effects on the real economy.”

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