OTTAWA (Reuters) - The worst is yet to come for Canadian banks affected by the global credit market upheaval caused by exposure to U.S. subprime mortgages, the International Monetary Fund said on Wednesday.

"The turmoil in global financial markets has thus far only had a modest effect on Canadian banks' financial soundness, but some further deterioration is in the offing," the IMF said in an otherwise favorable report on the health of Canada's financial system.

Canada's banking system is fundamentally sound and even in the case of a severe recession, most major banks' capital would drop below the required minimum but would still be "adequate," the Washington-based lender said.

The report, based on visits to Canada in February and September 2007, anticipated a big credit writedown by at least one of the top five Canadian banks and smaller writedowns by others.

Canadian Imperial Bank of Commerce (CM.TO: Quote, Profile, Research), Canada's fifth-largest bank, said last month it would take a further C$2.46 billion in pretax writedowns and that it would issue at least C$2.75 billion in new shares.

"Other major banks also face writedowns, though apparently on a more modest scale," the IMF said.

The top five Canadian banks -- Royal Bank of Canada (RY.TO: Quote, Profile, Research), TD Canada Trust (TD.TO: Quote, Profile, Research), Bank of Nova Scotia (BNS.TO: Quote, Profile, Research), Bank of Montreal BMO.TO and CIBC -- represent about 60 percent of total financial system assets.

The IMF warned of a potential loss of investor confidence if credit market turmoil is protracted and said the government and regulators must remain vigilant and encourage market players to disclose their holdings of the highly-complex debt products.

"OSFI (Office of the Superintendent of Financial Institutions) may wish to consider allocating additional resources for cross-checking of the submissions provided by financial institutions, including in on-site inspections," it said.