As Europe enjoys a long-awaited summer heat wave, a sense of sunny optimism has taken hold of its financial capitals. Many in the region's beleaguered banking community reckon the worst of economic downturn is over. Equities markets have rallied since early 2009, property prices are leveling off, and signs of a recovery in consumer and industrial confidence are starting to surface.

But before Europe's financial-services industry pats itself too hard on the on the back, bankers and investors may want to heed the sobering analysis released recently by the European Central Bank [ECB]. Analysts at the ECB, which oversees the 16-country bloc that uses the euro, forecast that euro-zone banks could still record a further 283 billion [$398 billion] in writedowns by the end of next year, predominantly from defaulting corporate and consumer loans.

If that eye-popping figure were to be reached, it would bring the total for European bank writedowns since 2007 to 649 billion [$913 billion] -- about equal to the damage wreaked on the balance sheets of U.S. institutions, including such stalwarts as Morgan Stanley (MS) and Merrill Lynch (BAC). The impact on workers also could be acute: In Britain alone, the Confederation of British Industry, a trade body, figures the country's financial-services industry could shed an additional 28,000 jobs by the fourth quarter of this year.

Most of the problems for Europe's banks are linked to struggling economies. Although financial markets have largely recovered, the European Commission still expects the European Union's gross domestic product to contract by 4% this year and a subsequent 0.1% in 2010. The broader downturn has hit consumer spending and led to rising loan-default rates, particularly among small and midsize businesses. The expected jump in defaults also has raised concerns that major banks, such as Germany's Deutsche Bank (DB) and Spain's BBVA (BBV), may be undercapitalized and will need to raise more money from investors to cover their exposure.

lower consumer spending will hurt "Banks still have a number of problems on the horizon," says Pete Hahn, a fellow at City University's Cass Business School and a former managing director at Citigroup (C). "Debt levels have come down, but [the banks] must come to terms with lower consumer spending and a sharp drop in business activity."

Until now, investors looking for a recovery have piled into the market. So far this year, the Dow Jones Euro Stoxx Bank Index, a composite of leading financial stocks in the euro zone, has risen 16.2%. The wider DJ Stoxx 600 Bank Index, which adds institutions from Britain and other non-euro countries, has jumped 16.7%.