* Capital ratios of Austrian banks still lag peers
* Eastern Europe exposure generally positive but risks remain (Adds comments from news conference)
By Michael Shields and Angelika Gruber
VIENNA, July 7 Austrian banks should stay in eastern Europe but need to heed risks and bolster their balance sheets to compete with more strongly capitalised rivals, the country's central bank said on Monday.
Last week, Erste Group, emerging Europe's third-biggest lender, highlighted the riskiness of doing business in the region when it warned that new hits to its business from Romania and Hungary would lead to a record 2014 loss.
Austrian National Bank Governor Ewald Nowotny said much of Erste's trouble was specific to that bank. But he said Austrian banks in general had relied in the past too much on lending in foreign currencies and pushing loans at an unsustainable pace.
Austrian banks' foreign-currency loans in the region still amount to more than 74 billion euros ($101 billion), but banks are getting a grip on these problems, he told a news conference on the central bank's semi-annual financial stability report.
"Our overall assessment has not changed. We see this as a positive and promising engagement, but one which needs especially efficient risk management," he said of the region.
Deputy Governor Andreas Ittner dismissed speculation that banks such as Erste, Raiffeisen Bank International or UniCredit's Bank Austria might be better off quitting the region.
"I don't think the time has now come for most banks to consider exit scenarios, other than for a few countries. On the contrary ... in many countries growth rates are expected to be higher than in (western) Europe," he said.
He declined to comment on whether European Central Bank-led health checks of big euro zone banks' balance sheets were likely to produce more big writedowns at Austrian lenders.
MIND THE GAP
The central bank - which shares supervision of lenders with the Financial Market Authority watchdog - encouraged banks to do more to bulk up their balance sheets, especially given that fewer markets in the region - primarily Russia, the Czech Republic and Slovakia - were generating the bulk of profits.
"Banks should continue strengthening their capital levels - by retaining earnings and/or tapping capital markets - to close the gap between them and their international peers," it said.
Capital increases and a reduction of risk-weighted assets helped banks increase their aggregate tier 1 ratio by nearly a percentage point to 11.9 percent of risk-weighted assets in 2013, but this lagged peers active in the region, it added.
Capital levels at Austria's top three banks at 11.4 percent trailed European rivals at 13.6 percent and those active in central, eastern and southeastern Europe at 12.7 percent, the stability report found.
But big Austrian banks' leverage ratios - which do not weight assets by risk - were more solid than those of their peers.
Ittner said Erste Bank appeared most exposed among its Austrian peers to measures that the Hungarian government plans to aid local borrowers. Hungary's parliament approved legislation on Friday that the country's central bank estimates could cost the financial sector up to 900 billion forints ($3.94 billion) in compensation for borrowers.
Ittner said the impact of the latest measures would not be as severe as similar steps by Budapest in 2011.
($1 = 228.3700 Hungarian Forints)
($1 = 0.7331 Euros) (Editing by Louise Heavens and Jane Merriman)