LONDON, Nov 24 (Reuters) - Banks on mainland Europe have cut their exposures to Britain since the Brexit vote last year and are concerned about the legality of cross-border deals once the UK leaves, the European Union's banking watchdog said on Friday.
The European Banking Authority (EBA) said banks in the EU's 27 member countries have cut exposures in terms of assets from just over 1.9 trillion euros in June 2016 when the referendum took place, to just under 1.6 trillion euros by June 2017.
Liabilities fell from just under 1.7 trillion euros ($2.03 trillion) to just over 1.3 trillion euros over the same period.
The drop mainly reflects a sharp pullback in derivative deals, which could become a worry for London which competes with New York in this global sector.
EBA said in a regular risk assessment report that banks are worried about a "cliff-edge" if Britain, the bloc's most important financial market, leaves the EU without an agreement on trading terms.
"The Brexit negotiations continue to be a source of political risk for the EU financial market as a cliff-edge scenario could lead to substantial disturbances for the European banking sector," EBA said.
In one of the starkest warnings yet from a European regulator, it said a major worry for banks is continuity of financial contracts or ability to fulfil obligations that have been entered into once Britain is no longer part of the EU legal system.
Consumers and companies in the EU27 could face cancellation, amendment or renegotiation of contracts, loss of protection, disruption and financial losses, EBA said.
"It is important that banks and their counterparties, as well as consumers and public authorities, consider appropriate mitigating actions and contingency plans to address these concerns," it said.
Britain hopes for a breakthrough in EU divorce talks next month that will lead to transition arrangements and an outline of new trading terms to avoid a cliff edge, which would help to dispel doubts about derivatives and other financial contracts.
Banks in the EU27 may also not be able to clear derivatives transactions in London, leaving companies and households unable to access wholesale and retail financial services in Britain. Deutsche Boerse has already launched a push to lure clearing to Frankfurt from London.
"A disruption of financial flows ... coupled with diminishing confidence of market participants, could lead to the drying up of market liquidity ... affecting financial stability in the EU banking system," EBA said.
The EBA report backs arguments made by the City of London financial district and others that mainland Europe has as much to lose as Britain from failure to at least agree on a transitional deal.
The watchdog also said that the EU's banks are still improving their resilience to shocks and whittling away at their 893 billion euro mountain of bad loans.
While profitability has improved, the average return on equity is 7 percent, its highest level since 2014, but still typically below the cost of capital, EBA said. It remains unclear if poor profitability is due to current market conditions or the sector's structure. ($1 = 0.8377 euros) (Reporting by Huw Jones. Editing by Jane Merriman)