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The ECB said weak bank profitability and persistent financial fragmentation still presented a threat to stability. Banking union would be "an important contribution" to resolving these hurdles.
The ECB said the improvement in overall conditions in part reflected better economic fundamentals on the back of fiscal and structural reforms. But a lack of reform in the months ahead threatened to derail these improvements, raising tensions in sovereign debt markets.
Unforeseen bank recapitalization also posed a threat. "Although provisioning is increasing, it has barely kept pace with the deterioration in asset quality, on average, highlighting a potential further need for additional reserves to strengthen bank balance sheet resilience in case asset quality deteriorates further."
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The ECB cut its main refinancing rate earlier this month to a record low in a fresh bid to bolster the currency bloc's shaky economic recovery and said there were still further tools it could use.
Speaking in a press conference on Wednesday, Vítor Constâncio, the ECB's vice-president, appeared to downplay the likely use of one of those tools: cuts that would push the ECB's deposit rate into negative territory.
Such a move could only be considered in "extreme situations" he said, while reiterating that the ECB was technically prepared to cut the rate, which is now at zero. Mr Constâncio noted that negative rates had been used in Denmark, but he said it was a different matter introducing them in a large economy such as the euro area.
Discussing the finances of the euro area banks, Mr Constâncio said that profits had been driven sharply down by the cost of provisioning for non-performing loans. This situation had been "aggravated" by banks boosting their provisions as they prepared for the forthcoming comprehensive assessment of the banking system that will be conducted by the ECB, he said.
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This was likely to be a temporary situation, he argued, predicting that the comprehensive assessment would dispel remaining doubts about the robustness of euro area banks.
The exercise is essential to rebuilding trust in the banks and reducing the fragmentation of the region's financial system, he added. The ECB would do the exercise in a "very vigorous and credible way" he said, acknowledging that the reputation of the planned Single Supervisory Mechanism was at stake.