In a report examining financial system stability published Thursday, the ECB says, “The overall economic and financial situation is still fraught with risks for financial stability.”

It points to sovereign debt problems and vulnerabilities in parts of the European banking sector as the main area of worry. Another important source of risk is the re-emergence of global imbalances and the possibility of their disorderly unwinding, it adds. “These two vulnerabilities have the potential to generate negative surprises of potential systemic importance,” it warns.

The financial system risks of which the ECB warns include: renewed strains due to heightened funding vulnerabilities and dampened profitability prospects; banks with concentrated commercial real estate lending exposures; heightened market volatility if the economic recovery disappoints.

Other sources of risk include: concerns about the sustainability of public finances creating a negative feedback loop into economic growth; potential weaknesses in corporate balance sheets; and, greater-than-expected household credit losses amid persistently high unemployment.

While government actions have successfully contained some of these risks in recent months, it says that, “Strong commitments by governments to rein in public sector imbalances and to implement measures that support the competitiveness of and confidence in the euro area economy are necessary to ensure financial sector soundness in the future.”

This may be complicated by the divergent pace of recovery, and the differing state of financial markets, in various countries, it notes. “The importance of getting the timing of exit from public support measures to the financial sector right should not be underestimated,” the ECB says. “Withdrawal of public support must proceed with caution and care, so as not to spark a setback to financial stability which would ultimately threaten the economic recovery.”

Additionally, the ECB advises banks to bolster their capital buffers, and further improve their resiliency towards possible shocks in the period ahead.

IE