Frankfurt: Despite recent improvements in the health of European banks, they remain vulnerable to a daunting array of hazards that are expected to produce another round of sizable write-offs during the next couple of years, the European Central Bank (ECB) said on Monday, in a report that catalogued in alarming detail the problems facing the region’s financial institutions.

Warning signs: Jean-Claude Trichet, president of ECB, (right) with Ewald Nowotny, governor of Austrian National Bank. Bloomberg

200The challenges for banks in the 16-nation euro zone include exposure to a weakening commercial real estate market, hundreds of billions of euros in bad debts, economic problems in East European countries, and a potential collision between the banks’ own substantial refinancing needs and government demand for additional loans, the central bank said.

In its twice-yearly review of risks facing the nations that use the euro currency, the central bank expressed particular concern about banks’ need to refinance long-term debt of an estimated €800 billion, or $984 billion, by the end of 2012.

Borrowing costs could rise as the banks compete with governments in the bond market, “making it challenging to roll over a sizable amount of maturing bonds by the end of 2012", the report said.

Lucas D. Papademos, the departing vice-president of the central bank, presented the semi-annual report at a news conference on Monday, called the Financial Stability Review. While attempts by European governments to reduce debt will cut economic demand, he said, growth could ultimately improve as economies became more productive.

European banks will need to set aside an estimated €123 billion in 2010 for bad loans, and an additional €105 billion in 2011, the report said. That would be in addition to the €238 billion they set aside from 2007 to 2009.

While profitability of larger banks has improved, their shares are likely to fall in the near future, the central bank said, citing an analysis of options.

The report also noted that some banks remained dependent on the central bank for loans.

Since the advent of the financial crisis, the central bank has granted almost unlimited credit to banks at 1% interest to offset a reluctance by banks to lend to one another.

Issuance of corporate bonds has declined since the end of last year, especially for banks and other financial institutions. In addition, the market for securitizations, in which banks package loans and resell them to investors, is “dysfunctional", the report said.

Bond issues and securitizations are crucial ways that banks raise money to lend to companies and individuals.

“The tensions in the sovereign bond markets spilled over to other market segments, such as the foreign exchange market and equity markets," the European Central Bank president, Jean-Claude Trichet, said on Monday during a speech in Vienna. Trading volumes and liquidity became erratic, and volatility spiked.

Euro zone governments must ultimately create a system for disciplining countries that violate treaty limits on debt and deficits, he said.

“I call on euro-area governments in particular to work actively together to reach agreement on a quantum leap of the effectiveness of their collegial surveillance," Trichet said.