WASHINGTON: Despite signs that the financial system has stabilized, banks remain threatened by billions of dollars of bad loans on their balance sheets, and more could fail if the economy worsens, a congressional watchdog reports.

In its latest assessment of the $700 billion financial system bailout, the Congressional Oversight Panel warns that banks still hold many risky loans of uncertain value. If unemployment rises sharply or the commercial real estate market collapses — as many economists fear — the banking system could again lose its footing, the panel says in a report to be released Tuesday.

"The financial system (remains) vulnerable to the crisis conditions that (the bailout) was meant to fix," the panel wrote in a draft copy of Tuesday's report.

The Congressional Oversight Panel was created as part of the Troubled Asset Relief Program, or TARP. It is designed to provide an additional layer of oversight, beyond the Special Inspector General for the TARP and regular audits by the Government Accountability Office.

The report says many of the Obama administration's financial stability efforts are working — including infusions of new capital for banks, heightened scrutiny of capital ratios, "stress-testing" of large financial firms. It also pointed to a public-private investment plan designed to buy up bad assets that has yet to get off the ground.

But with banks still holding the assets at the heart of the crisis, they remain vulnerable, the panel says.

"These steps have ... allowed the banks to take significant losses while building reserves," the panel wrote in the draft report. "Nonetheless, financial stability remains at risk if the underlying problem of toxic assets remains unresolved."

Small banks are especially vulnerable, the report notes. The troubled assets weighing on their balance sheets generally are in the form of complete loans, as opposed to the mortgage-backed securities formed from bundles of numerous loans that have been divvied up. The Treasury Department's main program for buying up bad assets, however, currently targets only those securities and not the so-called "whole" loans.

In addition, the report says, regional and smaller banks hold greater numbers of commercial real estate loans, "which pose a potential threat of high defaults." It said the adequacy of small banks' capital cushions against losses hasn't been tested by the government, which performed "stress tests" in May only on the 19 biggest U.S. banks — including Bank of America Corp., Capital One Financial Corp., Citigroup Inc., GMAC, Goldman Sachs Group Inc., JPMorgan Chase & Co. and Wells Fargo & Co.

Owners of shopping malls, hotels and offices have been defaulting on their loans at an alarming rate, and the commercial real estate market isn't expected to hit bottom for three more years, industry experts have warned. Delinquency rates on commercial loans have doubled in the past year to 7 percent as more companies downsize and retailers close their doors, according to the Federal Reserve.

The commercial real estate market's fortunes are tied closely to the economy, especially unemployment, which registered 9.4 percent last month. As people lose their jobs, or have their hours reduced, they cut back on spending, which hurts retailers, and take fewer trips, affecting hotels.

Ten months into the federal rescue program, the troubled assets "remain a substantial danger to the financial system," the report says. "Financial stability remains at risk if the underlying problem of toxic assets remains unresolved."

The oversight panel has issued a series of reports on the government's financial bailout programs, raising a series of questions about their management and oversight. It is headed by Harvard Law School professor Elizabeth Warren. The other members are Rep. Jeb Hensarling, R-Texas; Richard Neiman, superintendent of banks at the New York State Banking Department; Damon Silvers, associate counsel at the AFL-CIO; and former Republican Sen. John Sununu of New Hampshire.

The new report was adopted by the panel 4-1 Monday with Hensarling voting against it.