The European Central Bank published a report on EU banking sector stability, warning that short-term risks have increased.

The report was prepared by the Banking Supervision Committee of the European System of Central Banks, which comprises representatives of EU national central banks and banking supervisory authorities and the ECB.

The report reviews the financial condition of the banking sectors of the 27 EU Member States in 2006 and the first half of 2007, primarily on the basis of balance-sheet data. It notes that the financial condition of the EU banking sector continued to develop positively throughout 2006, and indications are that this continued in the first half of 2007.

The profitability of EU banks increased further in 2006, although the average performance conceals marked differences among banks. And, the solvency position of EU banks in 2006 and in the first half of 2007 remained stable, with ratios well above the minimum regulatory requirements.

The market turmoil which started in July and August is likely to have repercussions on the earnings of many EU banks in the second half of 2007, it notes. “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. Increasing funding costs, coupled with tightening lending criteria, may also contribute to a slowdown in profit growth in the medium term,” it says. “This notwithstanding, the sound profitability of EU banks over several consecutive years, which has underpinned robust solvency positions, should have generated adequate buffers against both expected and unexpected losses.”

Among the main vulnerabilities for EU banking sectors is the likely evolution of the credit cycle, the report says. The cycle could be affected by the recent re-pricing of credit risk, should it prove lasting – and its impact on borrowers’ credit quality and banks’ credit risk.

“The rise in demand for liquidity, in the context of the recent turmoil, has also increased concerns about banks’ liquidity and credit commitments, which has underlined the importance of banks’ liquidity risk management, including stress-testing and contingency planning,” it says. “In addition, for large banks in particular, there are uncertainties about the extent to which their financial performance could be impaired by declining revenues from non-interest income sources if, for instance, activity in the market for securitized loans were to remain depressed for a more protracted period.”

“Finally, the continued expansion of foreign currency lending to households in some EU countries could be posing increasing risks to the banks involved if housing market developments are reversed in the countries affected or if exchange rate volatility increases,” it adds.

“The forward-looking assessment based on market indicators, which partially takes into account the possible impact of the market turbulence in the second half of 2007, suggests that near-term risks facing the banking sector have increased,” the report cautions. “Uncertainties among market participants about the banking sector’s earnings prospects have also increased, and this could be further aggravated by unexpected developments in the US sub-prime mortgage market and if the problems in structured credit markets were to spill over to the broader credit and capital markets.”