BERLIN (MNI) - Banks in the Eurozone have significantly improved their financial situation but banking sector profitability is likely to remain moderate over the medium term, the European Central Bank said in its latest Financial Stability Review released Monday.

The two most important risks to financial stability are a persistence or even intensification of concerns about the sustainability of public finances, with an associated crowding-out of private investment, and the possibility that the adverse feedback between the financial sector and public finances could continue, the report stated.

Outgoing ECB Vice President Lucas Papademos, briefing journalists about the report on his last day in office, warned that "downside risks to growth could increase" due to the risk of such feedback.

There is "no room for complacency," Papademos warned. Echoing language from the ECB report, he noted that sizeable loan losses are still expected through next year and could be a "lasting drag" on bank profitability. "The situation has improved, but there are still challenges ahead," he said.

Papademos said there were a small number of banks still dependent on public support and that they would have to restructure to become less so. There are also relatively few banks still reliant on ECB liquidity, he said, but he declined to specify the types of banks concerned.

On the subject of feedback between markets and the real economy, the ECB report noted that there is a risk of heightened financial volatility if macroeconomic outcomes fail to live up to expectations. "A key concern is that many of the vulnerabilities highlighted in this Financial Stability Report could be unearthed by a scenario involving weaker-than-expected growth," it said.

Uncertainty regarding the economic outlook of the Eurozone "continues to remain elevated," the central bank acknowledged. Still, risks to the macroeconomic outlook appear to be broadly balanced, it said.

Less tangible concerns include the possibility of vulnerabilities being revealed on the balance sheets of non-financial corporations and of greater-than-expected household sector credit losses should unemployment remain higher than currently expected, the ECB said.

The central bank noted that many of the large and complex banking groups in the Eurozone returned to modest profitability last year and that their financial performances strengthened further in the first quarter of 2010.

"This, together with a bolstering of their capital buffers to well above pre-crisis levels, suggests that the bulk of these institutions have made important progress on the road to financial recovery," the report stated.

Still, it cautioned that the profitability of some large financial institutions receiving government support remained relatively weak.

Potential loan write-downs confronting the Eurozone banking system will likely peak this year, the ECB predicted. Yet, "it is probable that loan losses will remain considerable in 2011 as well," it said.

Eurozone banks may need to set aside provisions for an additional E123 billion in loan losses this year and around E105 billion more in 2011, the ECB predicted.

The expected loan losses constitute a "significant and lasting drag" on banking sector profitability and give rise to the risk that "the recent recovery of profits will not prove durable," the central bank reckoned.

Banking sector profitability is likely to remain moderate over the medium term also due to pressure on banks from markets and supervisory authorities to keep leverage under tight control, the report asserted.

The ECB also noted that the maturity structure of interest options prices suggests that there is "a broad base of financial institutions" that may not be sufficiently well prepared for a yield curve steepening, which could be triggered, for example, by a further intensification of sovereign risks.

Concerns remain also about pockets of vulnerability within the banking sector connected with exposure to weakened commercial property markets and fragilities in some central and eastern European economies, the ECB noted.

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