BERLIN (MNI) – The significant near-term funding requirements of
Eurozone governments could crowd out issuance of bonds by banks, thereby
raising the possibility of a setback to the recovery in banking sector
profitability, the ECB said it its latest Financial Stability Review
released Monday.

The rise of aggregate Eurozone long-term real interest rates in
recent weeks to levels not seen in at least a year suggests that the
likelihood of their impinging on the nascent economic recovery and the
sizeable refinancing requirements of banks is beginning to rise, the ECB
observed.

“In view of the considerable near-term funding needs of euro area
governments, a particular concern is the risk of bank bond issuance
being crowded out, making it challenging to roll over a sizeable amount
of maturing bonds by the end of 2012,” the central bank said.

Yet, not only do higher sovereign funding costs raise banks’ own
funding cost of funds, they also create the risk of losses on leveraged
government bond positions such as yield curve carry-trades, the report
warned.

ECB Vice President Lucas Papademos, asked about the recent
downgrade of Spain’s sovereign debt by Fitch Ratings, said it had been
expected and noted that Spanish government paper still had a high rating
of AA+. He added that the situation in Spain is “is quite different” to
that of Greece.

Looking further ahead, ECB report argued that the deterioration of
public sector balance sheets can create risks for longer term economic
growth by raising precautionary savings to shoulder the risk of future
fiscal correction, thereby lowering future investment and productivity
growth.

The inevitable fiscal contraction can also impinge on the prospects
for financial sector profitability and soundness, it added. Nonetheless,
“it is essential that governments implement fiscal consolidation to
ensure the sustainability of public finances,” the ECB stressed.

Large fiscal imbalances call for significant fiscal consolidation
efforts over the medium term and this will also require that governments
ensure timely exits from financial sector support, the central bank
demanded.

“The legacy for the period ahead is the considerable curtailment of
the room for fiscal policy manoeuvre in the future, should another
episode of systemic risk materialise,” it observed.

Commenting on financial market regulation, the ECB said proposals
made recently by former U.S. Federal Reserve Chairman Paul Volcker would
not be ideal for Europe.

The so-called Volcker rule aims to prevent banks that have access
to central bank and deposit insurance facilities from trading on their
own account, as well as from owning and investing in hedge funds and
private equity.

The introduction of a Volcker-style rule could hinder the smooth
provision of financial services in the EU, the ECB argued. Moreover, it
might trigger unintended effects such as the migration of riskier
activities to less regulated areas of the financial system.

“Against this background the functional separation does not seem
the most promising way forward in the European context,” the central
bank said.

Overall, it appears more promising to extend supervision and
regulation to a wider range of potentially riskier activities, it
reckoned.

–Berlin bureau: +49-30-22 62 05 80; email: twidder@marketnews.com

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