ECB says debt crisis risks destabilising banks

FRANKFURT, June 15 Wed Jun 15, 2011 11:05am EDT

FRANKFURT, June 15 (Reuters) - The euro zone debt crisis risks sparking a destabilising chain reaction through the bloc's financial sector, the European Central Bank said on Wednesday.

In its twice yearly Financial Stability Review, the ECB urged those countries under European Union fiscal programmes -- Greece, Ireland and Portugal -- to meet their deficit reduction goals or risk triggering "adverse financial reactions".

The ECB is concerned that any form of sovereign debt default could trigger another Lehman-type crisis, pushing up bond yields for countries like Spain and dragging them into the mire.

"The interplay between the vulnerabilities of public finances and the financial sector, with their potential for adverse contagion effects, arguably remains the most pressing concern for euro area financial stability at the moment, despite several encouraging signs of containment," the ECB said.

Highlighting contagion risks from the Greek crisis, shares in top French banks tumbled on Wednesday after credit ratings agency Moody's said it might downgrade them because of their exposure to Greece's debt-stricken economy. [ID:nLDE75E0JG]

The EU and the International Monetary Fund bailed out Athens to the tune of 110 billion euros ($160 billion) just over a year ago, but a new rescue is now being thrashed out for Greece as it continues to sink under a debt pile that totals roughly 150 percent of its annual output.

As well as Greece, Ireland and Portugal have also tapped EU/IMF aid. The ECB urged them, and others, to meet their fiscal austerity targets or risk renewed financial market instability.

"Any delay in meeting country-specific adjustment targets agreed at the European level, in particular as regards the correction of excessive deficits, could trigger further adverse financial market reactions and undermine macroeconomic and financial stability in the euro area," the ECB said.

Turning to the euro zone money market, the ECB said it had continued to normalise, citing shorter maturity profiles, lower Euribor/EONIA spreads and lower excess liquidity as signs of improvement.

The ECB has remained careful not to withdraw support to the economy and banking system so fast as to stall the recovery or endanger banks' ability to cope with limited liquidity.

Last week, the ECB said it would carry on providing unlimited funding at its three-month liquidity operations for at least the next three months. [ID:nLDE7580TV]

"Looking forward, a further phasing-out of non-standard measures may continue to spur more interbank activity, but it may also represent a challenge for some banks in euro area countries under stress," the ECB wrote in the review. (Reporting by Paul Carrel and Sakari Suoninen, editing by Mike Peacock)