The European Central Bank cautions that European bank profits are likely to remain under pressure for some time, and that a significant number of risks to market stability remain.

In its latest review of systemic stability the ECB said Monday that while loan losses are expected to peak this year, they will likely remain “considerable” in 2011, too. “This prospect, combined with continued market and supervisory authority pressure on banks to keep leverage under tight control, suggests that banking sector profitability is likely to remain moderate in the medium term,” it says.

The central bank notes that many of the region’s large banks did return to profitability last year, and they have also rebuilt their capital positions to well above pre-crisis levels. As a result, the financial industry’s dependence on government support has declined, it says. However, the ECB also notes that the profitability of some large financial institutions that are receiving government support remained relatively weak.

“Outside the financial system, the progressive intensification of market concerns about sovereign credit risk among the industrialized economies in the early months of 2010 opened up a number of hazardous contagion channels and adverse feed back loops between financial systems and public finances, in particular in the euro area,” it warns, noting that this has hampered liquidity and impairing monetary policy enough that both the ECB and the EU Council introduced measures to try and stabilize the region.

Still, the main risks for the euro area financial system include concerns about the sustainability of public finances, and adverse feedback between the financial sector and public finances continuing. Within the euro area financial system, important risks include the possibility of: a setback to the recent recovery of the profitability of large banks; concentrated lending exposures in commercial property markets and to central and eastern European countries hurting bank balance sheets; and, heightened financial market volatility if macroeconomic outcomes fail to live up to expectations.

Other smaller risks include vulnerabilities being revealed on corporations’ balance sheets, because of high leverage, low profitability and tight financing conditions, and greater-than-expected household credit losses if unemployment rises by more than expected.

“A key concern is that many of the vulnerabilities highlighted in this [review] could be unearthed by a scenario involving weaker-than-expected economic growth,” it says, warning that sizeable fiscal imbalances remain.

“Against this background, the problems of those financial institutions that remain overly reliant on enhanced credit measures and government support will have to be tackled decisively,” it concludes. “At the same time, fundamental restructuring will be needed when long-term viability is likely to be threatened by the taking away of state support. This could involve the shrinking of balance sheets through the shedding of unviable businesses with a view to enhancing profit-generating capacities.”

IE