BERLIN (MNI) – Banks in the Eurozone have significantly improved
their financial situation but banking sector profitability is likely to
remain moderate over the medium term, the European Central Bank said in
its latest Financial Stability Review released Monday.

The two most important risks to financial stability are a
persistence or even intensification of concerns about the sustainability
of public finances, with an associated crowding-out of private
investment, and the possibility that the adverse feedback between the
financial sector and public finances could continue, the report stated.

Outgoing ECB Vice President Lucas Papademos, briefing journalists
about the report on his last day in office, warned that “downside risks
to growth could increase” due to the risk of such feedback.

There is “no room for complacency,” Papademos warned. Echoing
language from the ECB report, he noted that sizeable loan losses are
still expected through next year and could be a “lasting drag” on bank
profitability. “The situation has improved, but there are still
challenges ahead,” he said.

Papademos said there were a small number of banks still dependent
on public support and that they would have to restructure to become less
so. There are also relatively few banks still reliant on ECB liquidity,
he said, but he declined to specify the types of banks concerned.

On the subject of feedback between markets and the real economy,
the ECB report noted that there is a risk of heightened financial
volatility if macroeconomic outcomes fail to live up to expectations. “A
key concern is that many of the vulnerabilities highlighted in this
Financial Stability Report could be unearthed by a scenario involving
weaker-than-expected growth,” it said.

Uncertainty regarding the economic outlook of the Eurozone
“continues to remain elevated,” the central bank acknowledged. Still,
risks to the macroeconomic outlook appear to be broadly balanced, it
said.

Less tangible concerns include the possibility of vulnerabilities
being revealed on the balance sheets of non-financial corporations and
of greater-than-expected household sector credit losses should
unemployment remain higher than currently expected, the ECB said.

The central bank noted that many of the large and complex banking
groups in the Eurozone returned to modest profitability last year and
that their financial performances strengthened further in the first
quarter of 2010.

“This, together with a bolstering of their capital buffers to well
above pre-crisis levels, suggests that the bulk of these institutions
have made important progress on the road to financial recovery,” the
report stated.

Still, it cautioned that the profitability of some large financial
institutions receiving government support remained relatively weak.

Potential loan write-downs confronting the Eurozone banking system
will likely peak this year, the ECB predicted. Yet, “it is probable that
loan losses will remain considerable in 2011 as well,” it said.

Eurozone banks may need to set aside provisions for an additional
E123 billion in loan losses this year and around E105 billion more in
2011, the ECB predicted.

The expected loan losses constitute a “significant and lasting
drag” on banking sector profitability and give rise to the risk that
“the recent recovery of profits will not prove durable,” the central
bank reckoned.

Banking sector profitability is likely to remain moderate over the
medium term also due to pressure on banks from markets and supervisory
authorities to keep leverage under tight control, the report asserted.

The ECB also noted that the maturity structure of interest options
prices suggests that there is “a broad base of financial institutions”
that may not be sufficiently well prepared for a yield curve steepening,
which could be triggered, for example, by a further intensification of
sovereign risks.

Concerns remain also about pockets of vulnerability within the
banking sector connected with exposure to weakened commercial property
markets and fragilities in some central and eastern European economies,
the ECB noted.

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