On Wednesday, the European Central Bank (ECB) issued its annual report on the European Union (EU) banking system. The report reviews the financial condition of the entire EU banking system for 2009 and provides extended coverage through the first half of 2010 for large EU banks. Also considered are the main risks facing the EU banking sector and issues concerning the financial health and resilience of EU banks against systemic disruptions.

The report generally describes a banking system that is stronger than it was two years ago. Bank profitability improved over the course of 2009, with the aggregate return on equity edging into positive territory versus an overall loss recorded in 2008. Large banks continued to show advancing earnings in the first half of 2010. Banks also increased their capital reserves in advance of mandatory raises to be phased in by 2015. “The shock-absorbing capacities of most E.U. banks have improved,” the report said. In all, banks have “sufficient loss absorption capacity to withstand possible further shocks.”

Yet, the report concludes that the EU system has not yet fully recovered. Despite increased returns, fiscal performance remains at “very low” levels among banks of all sizes. Moreover, national-level performance showed “significant deterioration” in a number of EU countries, suggesting that while banks may have weathered the first stages of the international financial crisis that began in 2007, the continued recessionary macroeconomic environment has taken its toll.

The report also identifies numerous risks EU banks face, including ongoing concerns surrounding the condition of sovereign credit, despite coordinated efforts by the European Council, the International Monetary Fund and other national organizations to preserve national solvency across Europe nations. Of greater concern is weakness in household credit among EU states, created by expectations of continued high unemployment rates in certain economies. Household balance sheets worsened in 2009, leading to increases in non-performing loan ratios and tightening credit. According to the report, the outlook for the household credit sector “remains challenging” given the slow economic recovery. Accordingly, banks face further losses on household lending portfolios, which stands to reduce margins and restrict liquidity. Said the report, “Conditions in both short and long-term funding markets were still far from normal in August 2010, and funding challenges for some banks remained substantial.” In yet another concern, banks appear to be taking on increased risk, creating discomfort among potential investors at a time when fresh sources of capital are needed.

Notwithstanding the various risks and uncertainties facing EU banks, the report states reasons for optimism about the future. Citing the “commitment by national authorities” to “monitor capital raising plans by the weakest banks” and “outstanding government commitments” to support banking sectors where market resources are insufficient, the report expects EU banks to remain viable as a broad-based recovery develops.