The International Monetary Fund this week released its updated estimate of losses to the world's financial sector. The new figure, $4,050bn globally, does not come as a surprise. It is nonetheless shocking.

For more than a year, the IMF's loss estimate has swollen with each update. As late as October, it expected losses on US loans and securities of $1,400bn; it now foresees losses almost twice that size, at $2,700bn. In addition, it has now added forecast losses of $1,200bn in Europe and $150bn in Japan.

The ballooning numbers reflect two important facts. We have no certainty whatsoever as to what the real losses will eventually be – except that they get worse every time we look. Last year's gloomiest forecasts have proved far too optimistic.

The IMF bases its numbers on methods that are not too speculative. The losses on securities – about half of the total, mostly in the US – are mark-to-market estimates. Losses on loans are based on conservative models and also extra­polate information from market valuations of related securities.

Some governments may object to the IMF forecasts. The final outcomes could be better – especially if, as the US government seems to assume – markets are currently undervaluing credit-related assets. They may also be worse. At least the IMF's estimates leave no room for wishful thinking, and force us to realise there is more pain to come.

For another important lesson of the IMF's report is that the recession in the real economy is compounding losses that originated in finance: conventional loans, not exotic securities, make up half of the forecast writedowns. European institutions, less exposed to the securities that brought down US banks, face the biggest losses. The IMF expects US institutions to write down $550bn in 2009-2010, on top of $510bn already written down. Institutions in the euro area and the UK, however, stand to lose some $750bn and $200bn, respectively. (Despite a confusion about IMF numbers for the fiscal cost of UK bank rescues, its forecast of total UK bank losses has not been challenged.)

For Europe, it seems, the worst is still to come. Of particular concern are the central and east European countries' large external fin­ancing needs and west European banks' exposure to these countries. The region's governments must heed the IMF's warning of possible contagious balance-of-payments crises.

Bringing banking systems back to the leverage ratios of the mid-1990s will require massive recapitalisation: $500bn in the US, $725bn in the euro area and $250bn in the UK, says the IMF. To make this possible, authorities have to lay the ground now for converting preference stock into common equity and enforcing debt-to-equity swaps if necessary.

Governments may be hoping for the best – but must prepare for the worst.

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