By Nicolas Charnay, Senior Director, EMEA Financial Institutions Sector Lead, S&P Global Ratings
European banks will need to come to terms with a new economic environment in 2023, when the unfolding economic reset delivers on its unwelcome promises of higher-for-longer inflation, tighter funding conditions and lower economic growth.
This will mark a significant change for European banks, the 2022 results of which demonstrated the immediate benefits of last year’s shifts in policy rates. Those shifts resulted in widespread profitable growth, underpinned by rising net interest margins (NIMs), while inflation had only a muted effect on banks’ cost bases. At the same time, volatility generated opportunities for banks with capital-markets and treasury-services operations but undermined investment-banking revenues.
In 2023, S&P Global Ratings expects that weaker credit markets will weigh on European banks without tipping the balance of risk into negative territory. Stagnating but generally resilient European economies and powerful though easing tailwinds from rising rates support our base case that rated European banks have the capacity to absorb higher costs and remain comfortably profitable. We expect a median return on equity (ROE) of about 7 percent in 2023, up from 6.3 percent in 2022 (see Figure 1). Even under our more negative scenarios, European banks should, on aggregate, remain broadly (though only barely) profitable. We also believe that public authorities’ past market reforms and banks’ improved risk management will enable markets to avoid financial accidents that turn into full-blown financial crises, though that remains one of the main downside risks on our radar.
At the same time, we expect the end of extremely low interest rates and low inflation will usher in greater differentiation among European banks’ profitability and balance-sheet strength. This divergence will be driven by factors including:
- Europe’s economic slowdown in the first half of 2023 and likely slow recovery, which will weigh on business growth and contribute to higher credit costs. This will predominantly hurt banks that serve less resilient domestic economies; those most exposed to consumer, small and midsized enterprise (SME) and commercial real estate (CRE) lending; and those that were less prudent during the latter part of the previous economic cycle.
- Inflation’s growing effects on banks’ cost bases through wages and the prices of services. This will weigh most heavily on banks that haven’t streamlined costs or have delayed investments (for instance, in the digital transition) and on those in countries where wages are contractually inflation-linked.
- Tighter funding conditions and the end of central banks’ cheap and indiscriminate term funding, which will hurt banks with weaker deposit franchises, uncertain access to market funding and an inability to pass higher funding costs on to clients. We fundamentally see this as an issue of cost rather than funding availability.
- Market volatility and tighter funding conditions, which could expose the riskiest nonbank financial intermediaries to funding issues, with ripple effects on banks that have significant counterparty risks or rely significantly on income from these companies.
It also seems clear that a volatile political environment will continue to provide challenges through 2023. The possibility that the Russia-Ukraine conflict will escalate remains a key risk, with adverse economic consequences extending far beyond the warzone. On the domestic front, some European governments’ targeting of banks with windfall taxes (or other forms of social contributions) is likely to continue into 2023, underpinned by the continuing cost-of-living crisis, government fiscal constraints and rising profitability of the banking sector.
Higher rates will continue to support net interest margins, while asset quality should remain broadly stable under our base case.
The sharp rise in nominal market interest rates had a nascent positive impact on European banks’ NIMs in 2022, as most banks and many market participants predicted. We expect the majority of rated European banks’ NIMs will continue to grow over 2023 and 2024, rising to a median of 1.55 percent by the end of 2024, up from 1.42 percent as of the end of 2022 (see Figure 2). The main drivers will be the gradual repricing of loans, most of which carry fixed interest rates that delay higher rates’ positive effects until refinancing or new origination occurs, as well as the boost from structural hedge programs.
However, the expected increase in NIMs over the next two years is relatively modest because:
- Bank profitability is influenced by both the overall level of interest rates and the shape of the yield curve, which flattened toward the end of 2022 (and inverted in some countries). Our current NIM forecast assumes a slightly upward-sloping yield curve, but the shape of the yield curve will be a key indicator to monitor in 2023.
- European banks are preparing to gradually reprice customer deposits, which account for around 56 percent of the total liabilities of European Union (EU) banks. The European Banking Authority (EBA), in the results of its latest Risk Assessment questionnaire (December 2022), indicated that 57 percent of surveyed EU banks planned to increase the rates offered to retail clients, up from about 20 percent in the Spring 2022 survey, while 68 percent planned to increase rates for corporate clients, up from around 30 percent.
Against the background of a stagnating economy, we expect credit costs to rise as a proportion of loans over 2023 but remain contained at a median of 25 basis points (bps) for rated banks, up from 16 bps in 2022 and 3 bps in 2021 (see Figure 3). We expect the median NPL (nonperforming loan) ratio to be a modest 2.1 percent in 2023, up from 1.9 percent in 2021 and similar to its level in 2019 (see Figure 4).
While such forecasts may seem largely benign, they include potentially significant divergences across rated European banks that will be driven by:
- The variable resilience of domestic economies and, in particular, domestic job markets. This significantly affects European banks due to their typical focus on domestic lending activities.
- High inflation and a slowdown in consumer confidence. This will predominantly affect consumer, SME and CRE loan portfolios, together representing around 30 percent of European banks’ aggregate loans and traditionally exhibiting higher delinquency rates (see Figure 5). Meanwhile, we expect only limited losses from residential mortgages, which account for nearly one-third of European banks’ customer loans.
- Banks’ differing capacities to manage and mitigate credit risks and thus limit asset-quality deterioration and increased credit costs. This will be determined largely by the quality of underwriting during the last part of the previous economic cycle and by a bank’s capacity to identify troubled borrowers early and offer them remedial solutions.
Exploring four key downside risks for European banks in 2023
Despite the stable outlook under our baseline scenario, European banks face four main downside risks in 2023:
- A protracted and painful recession leading to material asset-quality deterioration. Our economists expect Europe’s economies to recover gradually in the second half of 2023. Yet, the chance that this recovery will be derailed due to either external or internal factors remains a key risk. A negative shock could materially depress the economic outlook and prompt banks to adopt protective measures, such as tightening underwriting standards, further provisioning against effective or anticipated credit costs, and, potentially, curtailing shareholder distributions. We expect European banks would still post aggregate profits, though barely, under our downside scenarios. These profits, however, wouldn’t cover the costs of capital for many banks.
- A faster-than-expected rise in funding costs driven by deposits. We expect short-term rates to continue to rise over the first half of 2023 as major European central banks continue tightening monetary policy to stem the risk that core-inflation expectations become de-anchored. Banks’ funding costs have so far trailed policy-rate increases and hikes in lending rates. We expect this gap to gradually close over 2023, notably due to higher funding costs. This shift comes with the risk that funding costs will increase more rapidly and precipitously than expected and with notable variations across banks. Customer deposits are European banks’ main funding source, and competition for these deposits could rapidly increase, leaving banks with weaker brands at a disadvantage.
- Rising operating costs due to pressure from core inflation. While headline inflation is expected to fall during 2023, core inflation could remain elevated, raising the prospect that it will materially outpace European bank revenues. That is problematic as core inflation includes key costs for banks, such as labor and services, while headline inflation’s unexpected persistence was driven by energy prices. We do not view this risk as particularly elevated at the start of 2023, notably due to recent cost-cutting programs, some of which are still focused on delivering nominal cost reductions. Those plans will likely prove challenging in a higher-inflation environment but could still deliver real-term cost reductions.
- Market volatility triggering financial instability. Monetary policy tightening had consequences beyond its intended impact on demand and economic growth in 2022, notably in financial markets, where it led to a repricing of risk and a negative revaluation of many financial assets. This volatility hurt some actors, notably in the nonbank financial-intermediation space, which had been operating with elevated leverage or structural liquidity and maturity mismatches. Further episodes of financial stress are likely to prove just as unpredictable and could unearth new dangers for the broader financial system and banks—for instance, the default of a major systemic nonbank counterparty. We believe that the most egregious sources of market risk have been addressed since the financial crisis of 2008—for instance, with the migration of huge volumes of derivatives from bilateral markets to central marketplaces with clearing features. At the same time, we recognize that a feature of those reforms has been transforming some counterparty credit risk into liquidity risk, while market volatility has translated into the potential for a liquidity squeeze due to margin calls.
Satisfactory capital and liquidity buffers will continue to support resilience.
European banks’ regulatory capital ratios proved slightly more volatile than usual in 2022 but remained at very high levels—the aggregate CET 1 (Common Equity Tier 1) ratio for EU/EEA (European Union/European Economic Area) banks was 15 percent as of September 2022. S&P Global Ratings’ preferred metric for capital adequacy, the Risk-Adjusted Capital (RAC) Ratio, likely remained broadly stable and elevated over 2022, reflecting most European banks’ satisfactory capitalization (see Figure 6). Banks recommenced distributions to shareholders in 2022, ending a pandemic-triggered hiatus, but took a relatively prudent approach, reflecting the heightened macroeconomic uncertainties. We expect this to continue in 2023.
From a broader funding perspective, the gradual normalization of monetary policies marks the end of an era for European banks. As of September 2022, EU banks’ reported regulatory funding and liquidity ratios were still very high, at 126.9 percent and 162.5 percent, respectively, down from 129.3 percent and 174.8 percent in December 2021. We expect these ratios to trend downwards as central banks withdraw liquidity from the banking system.
Banks that rely heavily on central bank funding will need to diversify their funding sources, likely impacting costs (see Figure 7). We expect that the lack of access to stable and cheap funding will prove a drag on competitiveness for some banks—and potentially prevent them from reaping the full benefits of higher rates on the lending side.