Banks across the European Union experienced a jump in souring loans to small and medium sized companies in the first quarter of the year, though their profitability held up, the bloc's banking watchdog said on Thursday.

The European Banking Authority (EBA) said in its quarterly "risk dashboard" that credit risks have started to materialise with an increase in non-performing loans (NPLs) in the three months to March.

"Profitability of EU banks remains resilient although the sector is confronted with materialising credit risks," EBA said in a statement.

"The majority of banks surveyed expect further asset quality deterioration in CRE (commercial real estate), SMEs loans and consumer credit in the next 6-12 months," EBA said.

Interest rates in the euro zone have risen sharply to quell inflation, making loans more expensive, though the European Central Bank began cutting rates this month, signalling that the euro zone's peak in borrowing costs has passed.

EU banks expect a slowdown in profits in the next 6-12 months amid interest rate cuts, though loans are expected to grow, EBA said.

Banks reported that NPLs rose by 2%, quarter on quarter, equivalent to 7 billion euros ($7.51 billion).

Banks' cost of risk of banks, an indicator of loan losses, also rose to levels not seen since the COVID-19 pandemic in 2020, EBA said.

Regulators have begun scrutinising links between banks and 'non-banks' such as investment funds and insurers, an area where data for assessing systemic risk is patchy.

The EU's executive European Commission is considering whether new rules are needed.

John Berrigan, who heads the Commission's financial services unit, said on Wednesday there were financial stability concerns about links between banks and funds.

"We don't want the banks to re-risk through another channel, that is the concern," Berrigan told a Politico event.

Most banks, however, argue that direct links with non-banks are of limited risks, EBA said.

($1 = 0.9327 euros)

(Reporting by Huw Jones. Editing by Jane Merriman)