Despite recent improvements in the health of European banks, they remain vulnerable to a daunting array of hazards that are expected to produce another round of sizable write-offs during the next couple of years, the European Central Bank said on Monday, in a report that catalogued in alarming detail the problems facing the region’s financial institutions.
The challenges for banks in the 16-nation eurozone include exposure to a weakening commercial real estate market, hundreds of billions of euros in bad debts, economic problems in East European countries and a potential collision between the banks’ own substantial refinancing needs and government demand for additional loans, the central bank said.
In its twice-yearly review of risks facing the nations that use the euro currency, the central bank expressed particular concern about banks’ need to refinance long-term debt of an estimated 800 billion euros (US$984 billion) by the end of 2012.
Borrowing costs could rise as the banks compete with governments in the bond market, “making it challenging to roll over a sizable amount of maturing bonds by the end of 2012,” the report said.
The increased demand for credit is likely to place further strain on banks, as well as companies that need to borrow.
As it is, many European companies are suffering from low profitability and too much debt, the report said.
“The financial markets remain fragile and especially the developments in recent weeks have shown the necessity of heightened alertness,” Bundesbank President Axel Weber, a member of the European Central Bank’s governing council, said on Monday during a speech in Mainz, Germany.
Lucas Papademos, the departing vice president of the central bank, struck a more upbeat tone at a news conference on Monday to present the semi-annual report, called the Financial Stability Review. While attempts by European governments to reduce debt will cut economic demand, he said, growth could ultimately improve as economies became more productive.
“It is possible that the short-term impact will not be as severe as seems to be expected at the moment,” said Papademos, whose term ended Monday.
European banks will need to set aside an estimated 123 billion euros this year for bad loans, and an additional 105 billion euros next year, the report said. That would be in addition to the 238 billion euros they set aside from 2007 to last year.
That projected sum for this year, however, was lower than previous estimates. Banks also benefited from a rebound in securities markets, the report said.
While profitability of larger banks has improved, their shares are likely to fall in the near future, the central bank said, citing an analysis of options — securities that investors use to bet on the direction of stock prices.
The report also noted that some banks remained dependent on the central bank for loans.
Since the advent of the financial crisis, the central bank has granted almost unlimited credit to banks at 1 percent interest to offset a reluctance by banks to lend to one another.
“The continued reliance of some smaller or medium-sized euro-area banks on central bank refinancing continues to be a cause for concern,” the report said.
Papademos said the number of banks involved was small, but he declined to give details. He also expressed concern about what he called “adverse feedback” between the government debt crisis and the banking system. The report noted that higher risk premiums for government debt fed through into the private sector and raised the cost of credit for companies.
The problems would be exaggerated if growth or unemployment were worse than expected, increasing the chances that companies and individuals would be unable to repay their loans.
The report also noted that some financial markets were still not functioning normally. Issuance of corporate bonds has declined since the end of last year, especially for banks and other financial institutions. In addition, the market for securitizations, in which banks package loans and resell them to investors, is “dysfunctional,” the report said.
Bond issues and securitizations are crucial ways that banks raise money to lend to companies and individuals.
The report, as well as separate statements by central bank officials on Monday, also shed light on the bank’s decision on May 10 to buy government and corporate bonds on open markets.
In the days leading to the decision, trading in some government debt had come nearly to a standstill, the report said. The lack of a market for government bonds endangered the functioning of the whole financial system, in part because banks typically use government debt as collateral in making loans to one another.
“The tensions in the sovereign bond markets spilled over to other market segments, such as the foreign exchange market and equity markets,” European Central Bank President Jean-Claude Trichet said on Monday during a speech in Vienna. “Trading volumes and liquidity became erratic, and volatility spiked.”
“In view of these exceptional circumstances prevailing in the financial markets, we decided that exceptional intervention was necessary,” he said.
Weber, in his speech on Monday, repeated his criticism of the bond purchases and said that they would remain limited in scope. Some economists see the bond purchases as breaking a taboo and risking inflation, since they amount to the central bank financing governments that have borrowed irresponsibly.
Trichet repeated that the central bank was “permanently alert and always prepared to act when necessary” in response to crises.
He made clear, however, that the bank could do only so much to restore stability to the financial system.
Eurozone governments must ultimately create a system for disciplining countries that violate treaty limits on debt and deficits, he said.
“I call on euro-area governments in particular to work actively together to reach agreement on a quantum leap of the effectiveness of their collegial surveillance,” Trichet said.
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