FRANKFURT, Germany (AP) -- The European Central Bank says the continent's financial system remains fragile and exposed to risks including a sudden drop in currently buoyant stock and bond markets as well as trouble among banks as they face more bad loans in a weak economy.
The ECB's latest financial stability review said Wednesday that the weakening of the banking sector is a key risk factor that could cause a flare-up in the 17 country eurozone's 3½ year crisis over too much government debt.
The cost of rescuing banks is one of the sources of the crisis, having overwhelmed the public finances of several European governments.
To ease those concerns, the ECB has pushed for the creation of stronger banking regulation at the EU level that would shield a single government's public finances from the costs of expensive bailouts for banks. Next year, the ECB is expected to take over as centralized banking supervisor. European officials are still deciding on a second key element of the reform, an agency that could restructure banks and distribute losses among their creditors so that taxpayers can be spared.
That system isn't in place yet, and the ECB emphasized that the current drop in banks' earnings is a key concern. It said the percentage of banks' loans that do not get repaid has risen in several countries, mainly because the economy was weakening.
The ECB said national governments have made some progress in cutting deficits but need to continue those efforts, as well as press ahead with pro-growth reforms that can improve competitiveness. Slowing those efforts could reignite market tensions and raise bond market borrowing costs for governments.
Troubled countries "have made considerable efforts to adjust their public finances," the report said, but added that "this should not unravel now."
It also said the financial system could face stress from a sudden reversal of the recent strong gains in markets. Stock and bond markets have rallied globally in recent months as investors cheered the efforts of major central banks to steady the world economy. During such rallies, traders put their money in higher risk investments — such as stocks — as they search for higher returns. Interest rates are very low due to benchmark rate reductions by central banks, meaning conservative investments such as a savings account or U.S. Treasury bonds yield little.
Trouble would arise, however, if that willingness to seek out more risk suddenly goes into reverse.
The ECB warned that banks should make sure they have enough financial padding to absorb potential losses in case of a sharp drop in financial markets.