ECB : BANKS WILL SUFFER CONSIDERABLE LOAN LOSSES IN 2010, 2011 / THE WALL STREET JOURNAL ( HIGHLY RECOMMENDED READING )

BUSINESS

MAY 31, 2010, 4:19 P.M. ET.

ECB: Banks Will Suffer Considerable Loan Losses In 2010, 2011 .

By NINA KOEPPEN

FRANKFURT — Banks in the euro zone will suffer "considerable" loan losses this year and next, which could amount to an additional €195 billion ($239.26 billion) in write-downs and could weigh on banks' profitability, the European Central Bank said.

The prospect of write-downs on loan values together 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," the ECB said in its semiannual Financial Stability Review released Monday.

It estimated that banks in the euro bloc may suffer net write-downs on loans and securities of €90 billion in 2010, and an additional €105 billion in net losses in 2011.

"We are experiencing now a second wave of write-downs, which relate to the performance of loans," ECB Vice President Lucas Papademos said at a media briefing. "This is not unexpected. Although write-downs on loans will decline, they will continue, simply reflecting the overall performance of the economy," he said, speaking on his last day in office.

Mr. Papademos will retire from his position at the end of Monday. Portugal's Vitor Constancio will take up the post from Tuesday.

The ECB cautioned that loan losses in 2011 may even exceed current estimates.

"Heightened sovereign risks and possible second-round effects of the fiscal consolidation that is necessary in most euro area countries could pose some downside risks to economic growth in the area," the central bank said. "Should these risks materialize, loan-loss provisions should most likely be higher in the period ahead."

The ECB lowered its previous estimate of cumulative write-downs on loans and securities from 2007 to 2010, to €515 billion from €553 billion previously.

"The overall [financial sector] resilience has increased, taking into account that capital buffers have been strengthened," Mr. Papademos said. "But, at the same time, we are aware of the challenges ahead, particular with respect to public finances."

The ECB estimates that large euro-zone banks will have to extend, or roll over about half of their longer-term debt outstanding by the end of 2012.

"With several euro area governments also facing heavy financing requirements over the coming years this raises the risk of bank bond issuance being crowded out," the ECB cautioned in its report.

The euro zone's aggregate budget deficit this year is expected to be 6.6% of gross domestic product, more than twice the 3% maximum allowed by the European Union's Stability and Growth Pact.

Mr. Papademos warned about the dangers of an "adverse feedback between the financial sector and public finances continuing."

"The emphasis is on continuing, because it's already going on," he said.

A small number of financial institutions in the euro zone are heavily reliant on support from the ECB and governments, Mr. Papademos said, but he declined to provide further details, or name banks.

"The problems of those financial institutions will have to be tackled decisively," because the ECB and national governments will eventually phase out stimulus measures, he said.

According to the ECB, the most important driver of large euro-zone banks' net income in 2009 and the first quarter of 2010 was income from interest payments on loan books and other investments.

Most investors consider "a flattening of the [bond] yield curve as the most probable medium-term prospect," the ECB said, but cautioned "this means that they may not be sufficiently prepared for an unexpected further steepening of the yield curve, as occurred in the US bond market in 1994."

The slope of the yield curve signals people's expectations of economic growth and inflation. A steep yield curve usually indicates prospects of high economic growth and/or inflation.

"This might leave banks and other investors exposed to risks of large losses on fixed income portfolios and interest rate derivative positions," the ECB said.

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