- Europe’s banking sector has proved remarkably resilient in the face of recent macroeconomic headwinds, but there are still significant uncertainties and downside risks
- Banks are heading into a precarious time as the impact of higher interest rates on loan books starts to take effect
- Higher geopolitical risks may impact the overall operating environment and contribute to higher-for-longer interest rates, a higher cost of risk and asset quality deterioration
Experts anticipate the deterioration of banks’ asset quality and loan books as high interest rates and geopolitical tensions persist, and expect a rise in non-performing and impaired loans.
But so far, Europe’s banking sector has proved remarkably resilient, having withstood the macroeconomic headwinds of the last few years arising from higher inflation and the accompanying rise in interest rates, low real GDP growth, the Russian invasion of Ukraine and the long-term effects of the Covid-19 pandemic.
However, Andrea Enria, chair of the supervisory board of the European Central Bank, said in a press conference on December 19 2023 that “the resilience we are seeing should not lead to complacency as there are still significant uncertainties and downside risks”.
Starting resilient
European banks’ profitability surged in 2023, with net interest income soaring and credit costs remaining low. Banks in the European Economic Area, which includes EU countries as well as Iceland, Lichtenstein and Norway, remain well-capitalised and profitable, with all indicators pointing to a soft landing for the region’s lenders despite challenging economic headwinds.
According to ECB data, the aggregate Common Equity Tier 1 ratio of significant institutions stood at 15.61 per cent in the third quarter of 2023. Meanwhile, the aggregated annualised return on equity stood at 10.01 per cent in Q3 2023, compared with 10.04 per cent in the previous quarter and 7.55 per cent in Q3 2022.
Third-quarter data from the European Banking Authority showed resilient asset quality with the aggregate non-performing loan ratio remaining relatively stable at 2.27 per cent, compared with 2.51 per cent in the same period in 2022.
Stage-two loans, which are loans showing a significant increase in credit risk, have risen recently, but only slightly, from 9.19 per cent in the previous quarter to 9.29 per cent.
Overall, the size of loan portfolios remains broadly unchanged, says Derek Halpenny, head of research, global markets Emea and international securities at Mitsubishi UFJ Financial Group.
“While loan growth is very weak — and demand for loans is expected to fall — the overall cost of taking loans has surged. There’s been limited retrenchment,” says Halpenny.
Lowering inflation will also ease banks’ prospective challenges, with the EU’s average annual inflation expected to ease to 3.5 per cent in 2024 and 2.4 per cent in 2025.
Asset quality challenges ahead
However, experts warn that a turning point has been reached, with some deterioration in asset quality metrics expected to surface this year. Banks are heading into a “precarious time” says Jan Bellens, global banking and capital markets leader at EY. “The impact of higher interest rates on loan books will come through: NPLs and stage-two loans will increase.”
Still, NPL levels across eurozone banks are not expected to rise significantly, with the current expectation for the NPL ratio to rise from around 2 per cent to 3 per cent, adds Bellens.
Some sectors will face greater challenges than others, such as commercial real estate and consumer lending, according to Maria Rivas, senior vice-president, global financial institutions at DBRS Morningstar. So far, however, mortgage lending has remained resilient despite interest rate hikes, says Rivas.
Retail funding — an important aspect of overall bank funding — has come under strain as households seek and find alternative investments through long-term deposits, says Halpenny.
“The longer that policy rates remain at these levels, the more banks are going to feel the retail funding issue, and they’ll either have to raise their rates and squeeze their net interest margins, or risk further flight to higher-yielding-type instruments,” he adds.
Higher geopolitical risks may impact the overall operating environment and contribute to higher-for-longer interest rate environments for Europe’s banks. This could translate into a higher cost of risk and asset quality deterioration, although to what extent Rivas says it is “still too early to tell”.
Large bank failures remain unlikely, although smaller institutions may face challenges keeping up with demand for investment, adds Bellens. “Banks need to make more investments in technology, in risk and risk protection, and in regulatory compliance. This can often be a challenge for institutions that do not have the management bandwidth, the talent, and sometimes the investment capacity to cope with that.”
Cyber risks
With banks continuing to invest in transforming their legacy platforms, Bellens anticipates technology “breakthroughs” this year. “That will hopefully improve the cost-to-income ratios and the efficiency ratios of banks, which have remained challenging,” he says.
As the macroeconomic environment continues to evolve, operational risks that are not traditionally considered in banks’ loan books will be a priority, adds Bellens. “Everything related to cyber should remain a top concern for regulators and banks.”
The EBA’s Q3 2023 risk dashboard cites key risk drivers as communications technology and cyber-related risks, in addition to countering fraud and anti-money laundering.
In the meantime, the euro area economy will likely reflect stagnation — not crisis — but it will remain difficult for banks to beat last year’s highs.
