The euro area's big banks have been strong and profitable in recent months but the risks they face have grown and need to be monitored carefully, the European Central Bank said on Friday.
Bank revenues in recent months have depended largely on fee, commission and trading income, while interest income has been flat, the ECB said in its twice-yearly Financial Stability Review. "The strength of growth in some of the more volatile components of non-interest income may prove difficult to sustain in the medium term, which suggests a potential risk of future income deterioration," the ECB said.
Banks will also have to contend with a flat yield curve and a possible slowdown in lending to euro area households ahead, which will also limit their ability to generate revenues.
The ECB said there were signs that banks had been taking on more risk in face of intense competition. Credit risk exposures have risen due to rapid lending to households and companies, low loan impairment charges and signs that credit standards have weakened, the ECB said.
"Pockets of vulnerability could be developing in some parts of the euro area household and corporate sectors, where credit losses could prove greater than expected in a more challenging environment," the central bank said.
Competition to lend to leveraged buyout firms may have pushed banks to take on excessive risk in pursuit of market share, though it was unclear to what extent banks were transferring their credit risks outside the banking system to financial markets, it said.
The ECB said the direct risks faced by banks from an upturn in long-term interest rates and credit risk premiums were likely to be manageable, but it worried about counterparty risk management for some banks.
"It is unclear whether the intensity of competition, for instance in the securitisation markets or in the provision of prime brokerage services to hedge funds, may have compromised standards at the margin, especially for medium-sized banks."
Banks need to keep careful watch on their assumptions for their credit limit, margining and collateral policies, it said. The review also covered risks facing euro area insurance companies, which have seen profits jump in recent months.
It said life insurers could be challenged by weakness in the financial markets, while non-life insurers were facing intense competition and a higher risk of natural disasters in 2007. "Market indicators have been signalling greater uncertainty and a potential for deterioration in the financial condition of large euro area insurers," the ECB said.