Fixing 'too big to fail' banks and bringing more transparency regarding over-the-counter derivatives such as credit default swaps and the shadow banking system should be priorities for global policymakers, Lagarde said in a speech in Frankfurt.
Her remarks come as protests in Cyprusagainst taxing bank deposits as part of a bailout package worth 10 billion euros may make the parliament reject the measure decided by the troika of the European Union, IMF and European Central Bank at the weekend.
The situation in Cyprus, where people rushed to withdraw money from bank ATMs as soon as news of the bailout was announced, sparked fears of contagion across other eurozone countries.
Analysts and politicians have slammed the decision to tax all deposits, which they see as forcing small depositors to pay for too big to fail banks.
Lagarde said in her speech that while some progress had been made in revamping the global financial system, much more remained to be done and not just on the "wiring and the plumbing," which were "essential elements of a solid structure, but under the surface."
"The structure is still half-built and not safe," she said.
The fact that some banks in various countries in the world were still considered "too important to fail" because of their size, complexity and interconnectedness was "unacceptable," Lagarde added.
The implicit subsidy available to big banks in terms of lower borrowing costs due to their "too big to fail" status is estimated by the IMF at about 0.8 percentage points.
"Others have used this to derive a dollar figure for the five largest banks in the US of about $64 billion, roughly equivalent to their typical annual profits – a gift from the taxpayer," Lagarde added.
SHADOW BANKING
Another problem is the fact that there is still little transparency regarding over-the-counter derivatives, such as credit default swaps, she said, adding that available data showed that the increase in the value of centrally-cleared such instruments "has been modest."
As of September last year, only 10% of all credit default swaps were contracted through central counterparties, while data was "almost nonexistent" for commodity, equity and foreign exchange asset classes, she pointed out. Her comments echo worries expressed by Latin American policymakers regarding the use of "naked" CDS – instruments allowing investors to insure against a country’s default without actually owning the country’s bonds – in interviews with Emerging Markets during the Inter-American Development Bank annual meeting at the weekend.
On shadow banking – various financial institutions that do not fall under the current regulatory and supervisory norms – "I am afraid there is not much progress to report," Lagarde said.
"This is worrisome since regulators were largely in the dark before the crisis hit and since then, I suspect that funds have been migrating to new unregulated activities."
"For example, we have anecdotal evidence – because there is no official data – that trading is moving to unregulated hedge funds," she added.
Progress needs to be made on compensation in the financial system, with the level and structure of bank bonuses needing to be aligned with risk profiles and ultimately performance, the IMF managing director also said.
"The common goal here is to make sure that the structure of compensation curbs incentives for excessive risk-taking."
In Europe, the impact of the reforms undertaken by the ECB and by policymakers has not been felt by borrowers and in particular by small businesses and households, according to Lagarde.
Peripheral eurozone banking systems "remain relatively weak, with capital buffers still low relative to impaired assets" and are less able to absorb losses.
"This chokes off credit to viable firms and reinforces weakness in corporate sectors, perpetuating 'zombie' companies as well as zombie banks," she said.
She called for more progress on the eurozone's banking union plans to include a single supervisory and regulatory framework, a single resolution mechanism and authority and a common safety net including deposit insurance and lender of last resort.
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