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.