Do European banks face a rocky road ahead in 2023?

The asset quality of European banks is expected to experience only a moderate decline this year, but S&P’s base case for 2024 is uncertain due to rising funding costs for borrowers and uncertainties around inflation and economic growth.

Despite facing two major macroeconomic shocks in the past three years, European banks have maintained their credit quality, with the NPL ratio reaching a historical low of 1.8% at the end of 2022. Accommodative fiscal and monetary policies have also supported banks’ asset quality, and the resilient job market has helped borrowers service their debts.

The time lag between a weakening macroeconomic environment and worsening asset quality metrics is a concern, especially as anticipated real interest rates to turn positive in 2024.

This could lead to lower investment, GDP growth, and ultimately affect banks’ asset quality. There are three areas of risk for lending, including weaker households facing difficulty in repaying unsecured consumer loans, small-to-midsize enterprises with weak balance sheets or poor pricing power, and commercial real estate loan books that are sensitive to tightening funding conditions.

The credit-risk management strategies for these portfolios will be key to determining banks’ overall asset quality and cost of risk in the medium term.

Some banks have grown these portfolios rapidly in the past three years, and likely to see changes to their risk appetite in the new environment. The quality of banks’ underwriting and their proactivity in identifying and addressing troubled borrowers will also be crucial.

Despite the rise in interest rates, anticipated rising revenues will offset increasing credit losses at the sector level in 2023.

Credit losses are expected to represent only 17% of pre-provision income. However, in a hypothetical negative scenario of weakening macroeconomic forecasts and rising delinquencies, over one-third of the top 100 rated European banks could report a loss, although they would still turn a profit, albeit much reduced, on average.

Many banks have made strides to improve their loan-to-deposit ratios. However, Nordea, Danske bank and Santander still have ratios above 100%.

Expected Credit Loss – IFRS9

From 2018, the adoption of IFRS 9 in Europe shifted the methodology for loan loss provisioning to a more forward-looking expected credit loss (ECL) impairment model. Four years on, we find the ECL approach and disclosures helpful for assessing bank asset quality as it recognizes loan losses more timely than the previous incurred loss approach. However, the ECL approach requires a greater level of judgment from banks’ management teams, which can lead to inconsistencies across banks.

In European banks, there are three factors at play that affect loan loss provisions under the ECL approach:

1. Stage transfers: The migration of loans from stage 1 to stage 2 can significantly impact loan loss provisions as it shifts the basis of provisioning from 12-month ECL to lifetime ECL. While IFRS 9 rules set out some indicators for management to consider, the assessment of a significant increase in credit risk (SICR) is heavily dependent on bank management’s judgment, leading to inconsistencies across banks.

2. Model assumptions and management overlays: ECL models use historical data to estimate parameters such as probability of default, loss-given default, and loss rates. However, sudden or unexpected changes in economic conditions can result in management overlays, based primarily on judgment, as an add-on or deduction from the ECL estimate derived from the ECL models.

3. Macroeconomic scenarios and weighting: The ECL approach requires an unbiased, probability-weighted estimate derived from a range of macroeconomic scenarios, which can significantly influence the final ECL estimate reflected in financial reporting. The application of multiple economic scenarios and their weightings can vary across banks, leading to differences in loan loss provisions that are not solely attributable to differences in asset quality.

Eurozone banks have the capacity to offer new loans with improved margins due to a 50% beta estimate on new lending in January 2023 according to S&P. However, uncertainties in the macroeconomic environment may lead to more restrained lending, as evidenced by a tightening of credit standards driven by banks’ assessment of risks related to the overall economic outlook and declining risk tolerance.

Serious headwinds especially in relation to the cost of living, SME lending, CRE disruption

The combination of a cost-of-living crisis and rising real interest rates could have a significant impact on the consumer, SME, and CRE portfolios. These three portfolios make up around 30% of EU banks’ customer loans, and historically have performed the worst, with NPL ratios estimated to be between 4%-5% at the end of 2022. The vulnerability of these portfolios to higher-for-longer inflation and rising real interest rates is also a concern. While household consumption credit represents only 6% of European banks’ loan portfolios, there are significant differences in the proportion of household loans (excluding mortgages) across EU banks, with relatively high exposures in Spain, Slovenia, Hungary, and Poland.

SME Lending

SME lending portfolios, particularly those with weaker borrowers, are also at risk due to falling revenues, as evidenced by the increase in corporate bankruptcies in 2022. Although EU banks have grown their SME lending books relatively fast in the past three years, with a CAGR of over 5%, recent growth in SME lending was driven by pandemic-related public guarantee schemes implemented in 2020, which still cover a significant portion of the portfolios. Weaknesses in asset quality are likely to emerge over the next two years, as many SME loans were made on three- to five-year terms, with the bulk of the repayment due only at maturity.

CRE Lending

Finally, tighter funding conditions could lead to heightened credit risks in CRE portfolios, as higher rates elevate refinancing risks and reduce underlying asset values.

Although growth in CRE loans has been relatively limited in the past three years, with a 3% CAGR at the aggregated EU level, French and Belgian banks, as well as large Israeli banks, have seen double-digit CAGRs. Large EU banks hold around 75% of the CRE lending market, while smaller banks hold only 25%. The quality of the banks’ underwriting in recent years will largely determine the future performance of these portfolios.

Supervisors in Europe have repeatedly called on banks to enhance their risk management capacity and have singled out CRE as a source of potential vulnerability, urging banks to take a conservative approach to the asset class by increasing the quality and frequency of their collateral valuation.

Several banks are closely monitoring their exposure to Commercial Real Estate (CRE), as it is an area of particular concern. As of June 2022, there are 49 European banks whose CRE exposures are equal to or greater than their common equity Tier 1 (CET1) capital. Of these, the top 20 banks have experienced rapid growth in their CRE portfolios in recent years.

However, it is important to note that the European Banking Authority’s (EBA’s) classification is relatively broad and does not distinguish between different types of underlying CRE collateral, such as office, retail, or industrial properties, which have varying risk profiles.

Credit costs

In 2023, the credit costs of rated European banks are expected to normalize to 24 basis points from 13 basis points in 2022. Provisioning models should not present any huge shocks, and actual defaults remain limited. Banks are expected to benefit from high and rising interest rates, and credit losses are expected to represent only around 17% of pre-provision earnings for the top 100 rated European banks, providing headroom to absorb credit losses. However, there are significant differences across banks, with two banks facing losses if credit costs double and 10 others facing the same result if credit costs triple. Regulatory stress tests later this year will provide further insight into the relative quality of banks’ portfolios and the sensitivity of their credit costs to potential asset quality deterioration.

In summary

According to a new report by Fitch Ratings, most of the 20 large banks in their latest quarterly credit tracker have solid fundamentals following strong results in 2022, which will help them to weather market volatility caused by rising interest rates and shaky investor confidence.

The banks have maintained strong liquidity, including significant proportions in cash, and have access to central bank funding lines in their normal course of business. However, banks can be vulnerable to a loss of market confidence, as evidenced by rapid funding outflows at Credit Suisse that led to its acquisition by UBS. Liquidity positions will remain under scrutiny until market confidence is restored, and that liquidity coverage ratios ranged from 129% to 194% at the end of 2022, with high-quality liquid assets accounting for at least 15% of the banks’ total assets throughout the year. At least the G-SiBs have surplus regulatory capital running into this potential tightening of credit conditions.

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