EUROPEAN BANKS are becoming safer in the wake of the financial crisis but rising funding costs could prompt some institutions to revert to risky practices to boost profits, the European Central Bank has warned.

The ECB’s annual report on the banking sector, published yesterday, also concludes that while the sector’s return on equity turned positive in 2009, the recovery has been uneven and sizeable risks remain.

The report said new capital and liquidity requirements by global and national regulators would increase financial stability, but it warned the rules would crimp profits and increase competition for deposits, causing some institutions to lose out. “Limited funding resources together with the increased demand are likely to result in increased competition and funding costs in the medium-term . . . Rising funding costs may also encourage risk-taking behaviour by banks seeking to restore profitability.”

ECB analysts said, on the whole, diversified banks were more stable than specialist lenders, but predicted most institutions would have to concentrate on core markets to remain competitive. “The possibility both of a setback in the recent recovery in profitability and of an adverse effect on the supply of credit to the economy remain important risks,” the ECB said, adding that it was particularly concerned about “the continued reliance” of some banks on central bank support. – Copyright The Financial Times Limited 2010