The profitability of European banks is improving, according to a new report published today by European Central Bank. The ECB says it sees both upside and downside risks to the sector’s outlook.

The report, prepared by the Banking Supervision Committee of the European System of Central Banks, examines the implications of recent macroeconomic and financial market developments for the performance of the banking sectors of the 25 EU member states in 2004 and the first half of 2005 and for their risk outlook.

It finds that EU banks’ profitability continued to improve, consolidating upon the recovery that began in 2003. “Overall, notwithstanding some differences across countries, EU banking sectors benefited from generally benign credit and liquidity conditions,” it notes.

The main drivers of the further improvement in profitability since 2003 were a reduction in the flow of provisions, an increase in lending to households (especially for housing purposes) and a recovery in lending to non-financial corporations, including small- and medium-sized enterprises. At the same time, cost-cutting, which had been a significant contributor to the strengthening of profitability in 2003, abated.

There are both downside and upside risks to the overall positive outlook for banks, it notes. “On the negative side, there are uncertainties surrounding the macroeconomic outlook (particularly related to the rise in oil prices), the persistence of large global financial imbalances and the increasing household sector indebtedness,” it says.

“Although the still generally conservative loan-to-value ratios for households and the overall good condition of household balance sheets make a material deterioration in households’ creditworthiness rather unlikely,” it notes.

“Concerning the effect of a potential abrupt unwinding of global imbalances, if it were to materialise, its impact would likely be limited, as EU banks’ direct exposure to exchange rate risk remains contained and there are indications that banks’ direct exposure to interest rate risk is in general small in relation to banks’ capital,” the EU adds.

“On the positive side, banks’ risk management systems have improved, although the ways in which risks have been redistributed by credit risk transfer products, both within the banking system and between banks and other financial institutions, have yet to be tested by a stress situation,” it says. “Nonetheless, banks’ favourable financial results in 2004 and the first half of 2005 have provided them with resources to increase their buffers.”

The generally positive assessment of the financial condition of banks outlined in the report is also corroborated by a set of forward-looking market-based indicators for a sample of large EU banks, it says. “These indicators have continued to improve since 2003, pointing to an ongoing positive reassessment of the outlook for banks’ profitability and for their operating environment in the near future. This can also be seen as a sign that the risks facing banks are manageable for the majority of large banks in the EU,” it adds.