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The balance sheets of eurozone banks are showing “early signs of stress” after a rise in loan defaults and late repayments from historic lows, the European Central Bank has warned.

Officials urged lenders to increase provisions to cover rising loan losses and predicted their profits would be hit by a drop in lending volumes and increased funding costs. The ECB has increased interest rates by an unprecedented 4.5 percentage points in the past year.

“A longer period of high interest rates is likely to lead to higher provisions, which in turn will be a drag on profitability further down the line,” the central bank said at its twice-yearly financial stability review.

The ECB said the banking system was “well placed” to cope with a deterioration in asset quality due to its “strong capital and liquidity” levels and surging profitability, which recently hit its highest level for more than a decade.

The system remained resilient during turmoil in the sector earlier this year, when several US and Swiss lenders, including Silicon Valley Bank and Credit Suisse, collapsed or had to be rescued.

ECB vice-president Luis de Guindos said that while “risks to financial stability may appear less acute, they remain elevated”, pointing to the impact of weaker economic growth, tighter financing conditions, rising loan defaults and a downturn in property markets.

He also said an “escalation of the conflict in the Middle East could trigger a sharp increase in risk aversion in financial markets, unravelling the prevailing vulnerabilities”, by disrupting energy markets, undermining confidence, slowing growth and pushing up inflation.

The ECB outlined three main “headwinds” for banks’ profitability: increased funding costs as they pass on higher rates to depositors; an increase in loan defaults as the economy weakens and debt service costs rise; and “a substantial drop in lending volumes”.

“Default rates on both corporate and retail exposures have started to increase and the share of loans which are less than 90 days past due but still performing has also picked up and stands above the historically low levels seen in 2022,” it said.

It warned this trend was likely to “translate” into a rise in non-performing loans which typically follows an increase in payment arrears with a lag of a few quarters. The level of NPLs in the eurozone banking sector has fallen steadily to almost 2 per cent of total loans, down from a peak of 7.5 per cent at the height of the region’s debt crisis a decade ago.

The recent downturn in European property markets has led to an increase in NPLs in both loans to commercial real estate companies and on residential mortgages, albeit from low levels, the ECB said. After a long period of decline, there were net inflows of about €2.5bn among commercial real estate loans and €1bn for consumer loans in the second quarter.

But it warned: “Countries with predominantly variable rates would be likely to see a more pronounced deterioration in asset quality going forward if the labour market were to weaken notably, adding to the squeeze on households due to rising mortgage debt service costs and a higher cost of living.”

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