RPT-UPDATE 1-Financial Stability Forum delivers grim assessment

(Repeats to add UPDATE 1 to headline) (For more stories from the Tokyo G7 meeting click [G7/G8])

By Gavin Jones

TOKYO, Feb 9 (Reuters) - Financial regulators and central bankers delivered a grim assessment of the credit market upheaval on Saturday, warning that worse may lie ahead as banks tighten lending and an economic slowdown spreads.

In an interim report to the Group of Seven finance ministers, the Financial Stability Forum cautioned against a rush to regulate into this vicious cycle of credit writedowns, preferring to allow markets-based systems to operate.

But authorities must remain on heightened alert, ready to jump in and impose discipline to the messy repricing of credit risk where necessary, it said. Already the credit crisis has claimed British bank Northern Rock as its first victim. French bank Societe Generale (SOGN.PA: Quote, Profile, Research) is embroiled in a rogue trader scandal and huge international banks from Citigroup (C.N: Quote, Profile, Research) to Merrill Lynch (MER.N: Quote, Profile, Research) have resorted to Middle Eastern and Asian funds to bolster their faltering capital.

Policymakers are considering a range of steps to innoculate the world from future bouts of excessive risk-taking, which led to the current credit crisis. Tougher disclosure standards for ratings agencies, strengthened capital standards for banks and better risk management systems were on the FSF's list.

More immediately though, the group of central bankers and regulators studying the root causes of the credit crisis which began in the U.S. subprime mortgage sector and has spread through financial institutions in the United States and Europe and sent stock markets tumbling, said further upheaval may lie ahead.

"As institutions adjust to these conditions, the potential exists that risk shedding could tighten credit constraints on a widening set of borrowers and thereby slow economic growth, which could further impair credit," the FSF interim report said.

"There remains a risk that further shocks may lead to a recurrence of the acute liquidity pressures experienced last year. It is likely that we face a prolonged adjustment, which could be difficult," said the interim report.