In the document, the agency looked at how low loan impairments sunk to in the past decade in trying to estimate how high they will get to as a result of the crisis.
"The Spanish and UK banks, primarily because of their exposures to the deeply troubled domestic construction and commercial real estate sectors, unsurprisingly come out among the worst," said Fitch.
"In Spain for example, lending to the construction and real estate development sectors accounted for 25% of total lending in the system at end-June 2009."
Fitch said that La Caixa, Caja Madrid and BPE were likely to be more at risk than more internationally diversified peers such as Banco Santander or BBVA.
At the end of last week, Banesto said its fourth quarter net profit had plunged by more than 95% as a result of increased loan loss provisions. The provisions rose by more than 27% in 2009 to Eu382m.
The agency said that in the UK there would likely be a big difference between the best and worst performers, saying that even though HSBCs level of impaired loans would probably increase from the current 2.2% of its customer book, they would unlikely reach Lloyds Banking Groups 7.2%.
Fitch is not alone in being worried about the deterioration in asset quality. In a speech on Monday, Lorenzo Bini Smaghi, a European Central Bank board member, said that "banks profitability remains fragile. The expected losses on loan exposures to households and corporations are likely to increase, as a lagged effect of last years recession."
Fitch believes that impaired loans levels in France and Germany are likely to peak at lower levels because of relatively lower levels of household indebtedness.
Funding under pressure
While deteriorating asset quality is an area for concern for Fitch, the agency is also worried about the potential funding challenges faced by the major European banks in 2010 and beyond.
"Fitch believes that the competition for funding between now and 2012 will be great given the likely financing requirements of corporates and increasingly governments to fund their deteriorating finances. The competition for finite sources of funding will lead to increased cost of funding which will put yet further pressure on bank profitability."
Heavy volumes of issuance have taken their toll on the market despite the year being only three weeks old. Recent new issues have widened, sometimes by as much as 30bp-40bp and as a result, market participants expect that borrowers will either have to pay bigger new issue premiums, or wait until the market digests the glut of supply.
In its report, Fitch says that Eu2.2tr of EMEA bank debt will mature before the end of 2012, alongside Eu544bn of corporate debt. There is also Eu2.2tr of EMEA corporate lending facilities from the banks which will need to be renewed over the same period.
As a result, the agency expects that banks will be forced to compete aggressively for limited retail funds, reduce or restrict lending and extend maturities for market funding.
"Increased funding costs will have to be passed on to customers via loan rate increases or the banks may try to reduce their balance sheets by restricting the amount of new lending or by cutting unutilised credit facilities," Fitch said.
Pre-provision earnings represent banks first line of defence against loan impairment charges. However, there are concerns in that area as well, as highlighted by ECBs Bini Smaghi on Monday. "The short term profits obtained through trading activities hide risks which may materialise over the medium term and weaken banks profits over time," he said.
"This second factor appears to be widely underestimated, as banks seem to be conducting carry trades, including those in the same currency which exploit maturity mismatches, ie borrowing short term to buy long term bonds, on the assumption that such activities are risk-free."Meanwhile, Fitch said that while asset margins were being repriced, it would take time for this adjustment to feed through earnings while the latter would be under pressure from higher funding costs and the need to boost liquidity.