With governments facing “heavy financing requirements over the coming years” there’s a “risk of bank bond issuance being crowded out,” the Frankfurt-based ECB said in its biannual Financial Stability Report yesterday. “The risk that this implies for bank funding costs also raises the possibility of a setback to the recovery in banking sector profitability.”

The report reflects the aftershocks of a global financial crisis that led to more than $1.7 trillion in writedowns and credit losses since early 2007. In Europe, governments increased borrowing to fund bank bailouts and stimulus programs to haul the economy out of recession. Now they are trying to shrink bulging budget deficits that triggered a sovereign debt crisis.

“The consolidation measures can be expected to have some short-term negative impact on growth and employment,” ECB Vice President Lucas Papademos, whose term ended yesterday, said at a press briefing to discuss the report. Still, “I don’t think we should be too pessimistic about the impact on the economic performance,” he said.

The ECB this month launched an unprecedented bond purchase program in an attempt to ease concern that some euro-area nations may fail to get their finances under control.

Budget Deficits

Greece’s budget deficit of 13.6 percent of gross domestic product is the second-highest in the euro zone after Ireland’s 14.3 percent. The European Commission expects the euro region as a whole to post a revenue shortfall of 6.6 percent this year, more than double the European Union’s deficit limit.

“The legacy for the period ahead is the considerable curtailment of the room for fiscal policy maneuver in the future, should another episode of systemic risk materialize,” the ECB said in yesterday’s report.

Profitability in the banking sector will remain “modest” over the short to medium term, “given the prospect of continued loan losses, lasting pressure on the sector to reduce leverage and market expectations of higher funding costs,” the ECB said. “New estimates indicate that loan losses are likely to be higher in 2010 than they were in 2009 and sizeable losses are also expected for 2011.”

The ECB report said the euro region’s banks may see 90 billion euros ($110 billion) of net writedowns on loans and securities in 2010. As long as profitability continues at the levels of recent years, lenders “should not be confronted with major problems in absorbing these,” the report said.

Loan-loss provisions of about 105 billion euros may be needed next year, according to the ECB’s calculations.

Source: Bloomberg