The European Union's banking sector remains vulnerable and is recovering from the financial crisis in a slow and uneven fashion, the European Central Bank (ECB) said yesterday (29 September).
In its annual banking sector stability report, it said the continued reliance of some parts of the banking sector on ECB refinancing was also a concern, while there was a risk of renewed spillover from the euro zone's debt problems.
"Risks to banking sector stability remain," the ECB said in the annual report. "In particular, the risks increased in the early months of 2010 with a progressive intensification of market concerns about sovereign credit risk in some euro area countries."
Despite major financial institutions reporting improved profits this year, the STOXX 600 European index of banks has lost 4.6% of its value over the past six months, with a 2.7% decline in September alone.
The ECB said the debt crisis has highlighted the link between countries' creditworthiness and banking sector and economic performance, increasing the chance of recurring problems.
And although banks appear to be over the worst regarding asset write-downs, other pressures remained.
"While country-level information suggests that the increase in non-performing loans is likely to be slowing down in many parts of the EU in 2010, the decrease in coverage ratios could put some upward pressure on provisioning costs," it said.
The report also warned that banks were likely to be hit with further losses on their household lending portfolios, especially consumer loans.
"Looking ahead, the outlook for household sector credit risk remains challenging owing to the sluggish economic recovery, the rising or still elevated unemployment in several countries, the tightness of credit conditions and, in some countries, the further decline in house prices," it said.
The report, which was finalised before the agreement on the Basel III banking regulation framework, reviewed the entire EU banking sector in 2009 and until June 2010 for large banks.
On a brighter note it pointed to improving bank profits.
"Profitability has improved slightly and could improve further over the next six months, giving firms the means to decrease their high indebtedness," it said.
Risk stemming from the corporate sector have also declined over the last year, although it warned they remained substantial due to an expected rise in insolvencies and tight credit conditions for small and medium-sized firms.
A separate feature also looked at the likely development of the banking sector in the months and years ahead.
It concluded that banks would have to review their businesses in the light of tougher, post-crisis markets and new regulation, although the true impact of new banking rules was not yet clear.
It predicted that banks would have to bulk up key parts of their operations such as consumer lending and asset management that provide a steady source of longer-term funding. In contrast they may have to jettison more volatile parts that lack scale and security.
"Banks' return on equity is likely to decrease under the influence of several drivers, especially given that banks are expected to continue to deleverage," the report also predicted.
Banks were expected to concentrate on basic repo funding, simple securitisation and covered bond issuance to gather wholesale funds rather try and rekindle more complex pre-crisis practices.
There was also a warning about tight money market liquidity.
"The new regulatory proposals are creating a feeling among market participants that there might not be enough term liquidity for all institutions, which could have an impact on the funding costs for banks and may generate tensions in term money markets," the report said.
"The Basel III proposals for improvements in capital and liquidity endowments, the withdrawal of state support and the expiry of unconventional central bank policy measures will create additional pressure on banks' funding," it added.
(EURACTIV with Reuters.)