European banks face increased risks in the second half of this year as a result of the US subprime meltdown, the European Central Bank (ECB) warned on Wednesday.
"The market turmoil which started in July and August 2007 is likely to have repercussions on the earnings of many EU banks in the second half of 2007," the ECB's banking supervision committee said in a report on sector stability.
"This is because over recent years a significant share of banking sector profitability has been driven by fee, commission and trading income, a substantial fraction of which may be of a non-recurrent nature," the bank said.
"Increasing funding costs, coupled with tightening lending criteria, may also contribute to a slowdown in profit growth in the medium term," it said.
Major international banks have written off billions of dollars, euros and Swiss francs to cover losses incurred after the US market for high-risk mortgages collapsed this year.
But the healthy profitability of banks based in the EU over several years should have generated adequate buffers against both expected and unexpected losses, the bank said.
Short-term risks facing the banking sector and uncertainties about its earnings prospects have nonetheless increased, the report warned.
"This could be further aggravated by unexpected developments in the US subprime mortgage market and if the problems in structured credit markets were to spill over to the broader credit and capital markets," the bank said.
Pockets of vulnerability had grown in EU mortgage markets, particularly with respect to rising household mortgage indebtedness, though the risks to both households and banks' balance sheets were rather limited, the ECB said.
"Nevertheless, such relatively benign conditions may be masking a build-up of risks that has been driven, to a certain extent, by a general easing of banks' credit standards," the report said.