* Financial system fundamentally sound
* System faces increased credit risk
* Markets may be subject to contagion risks (Adds details, background)
JOHANNESBURG, July 2 (Reuters) - South Africa's financial system is fundamentally sound but banks should brace for more difficult times because of potentially higher loan losses, the central bank said on Thursday.
The bank said in its Bank Supervision Annual Report 2008 that the industry had so far weathered market turmoil without big pressures. But it said the system faces increased macro-financial risks.
Top banks, which include Standard Bank
"Notwithstanding the turmoil experienced in international financial markets and the domestic cyclical economic developments during 2008, the South African banking system again remained stable," the central bank said, adding that banks had enough capital and were profitable.
But the increase in interest rates, other cyclical economic developments and market turmoil had contributed to worsening credit risk ratios in 2008.
The central bank hiked interest rates by 5 percentage points in the two years to June 2008 to fight inflation, and has trimmed them by 4.5 percentage points since December to ease pressure on the economy.
The report said markets for money, foreign exchange and capital were relatively developed, but that they may face contagion risks given their links with foreign markets.
It recommended more stringent stress testing, vigilance on credit risk and a focus on liquidity and funding. (Reporting by Stella Mapenzauswa; Editing by Jan Dahinten)