The U.S. credit crunch has mushroomed into a stress test for the global financial system, Moody’s Investors Service says in a new report.

The credit squeeze initiated by woes in the U.S. subprime sector began as an overdue and disorderly risk reappraisal but ballooned into crisis due to a combination of too much leverage, financial innovation, price-sensitive accounting rules and opacity, Moody’s says.

“This cocktail has proved explosive,” said Moody’s vice chairman Christopher Mahoney, co-author of the report with Pierre Cailleteau, Moody’s chief economist. “The credit crisis has imposed a major stress test on the modern disintermediated financial system while also offering the possibility of corrective reforms.”

Causes for the panic identified by Mahoney and Cailleteau include: an extended period of credit risk under-pricing due to a temporary shift in the balance of power between lenders and borrowers; a pervasive illusion of liquidity; the bursting of the U.S. housing price bubble; and very poor performance of subprime mortgage securities, which imposed market losses on many institutions and cast a shadow over the valuation of certain classes of structured securities.

The rating agency’s report draws some tentative but important lessons for the “post-disintermediation” financial system “in which an arm’s-length financial model now has precedence over the traditional relationship model centered on banks.”

In the report, Mahoney and Cailleteau argue that while credit crunches in earlier days resulted from tight monetary policy, modern credit crunches are caused by psychological shocks to market confidence. This leads to a flight from risk and liquidity stresses for financial actors dependent upon confidence-sensitive funding.

“The problem is that central banks were designed to handle bank runs, not market confidence crises,” says Mahoney. “The challenge is to ensure not just ‘liquidity’ but ‘fluidity’ throughout the system, ensuring that systemically important non-bank financial institutions obtain vital funding.”

Most of the deficiencies exposed by the current crunch were identified in the aftermath of the Long-Term Capital Management Crisis in 1998, said Mahoney. The signals include the modern financial system’s over-reliance on the presumption of liquidity; increasingly difficulty localizing risk; increase of asset correlations in times of stress; and leverage that changes the scale of market dynamics, on the upside as well as on the downside.

“We expect market and official pressure to require greater transparency from financial actors, to introduce larger liquidity buffers into the system, and to consider ways to introduce automatic stabilizers to counter some of the pro-cyclicality inherent in an increasingly market price-sensitive accounting system,” says Mahoney.