A year on, European banks are in good health

Author: Marco Troiano, head of financial institution ratings, Scope Ratings

The European banking sector has emerged unscathed from the collapse a year ago of Silicon Valley Bank and the takeover of Credit Suisse, and appears to be in good health for the remainder of 2024.

Although there were fears that Europe would suffer a violent transmission of the banking crisis in the spring of 2023, the European sector weathered the storm and survived the ensuing market volatility without any real fallout.

We always felt that the fears expressed a year ago were exaggerated and that the longer-term sector aspects would return to the forefront of the sector's narrative. Market volatility subsided relatively quickly and wholesale funding windows reopened after a brief closure, including the AT1 asset class, which had raised some concerns following the depreciation of Credit Suisse's hybrid instruments.

However, the episodes of a year ago are a reminder that large uninsured depositors remain prone to absconding and that bank liquidity can evaporate quickly when confidence wanes.

European banks maintained - and continue to maintain - capital buffers well in excess of regulatory requirements. Last year, several European national regulators increased countercyclical capital buffers or introduced new systemic risk buffers related to specific segments of loan portfolios, but European banks face the increased requirements from a strong position.

Indeed, most banks' capital exceeds their own management targets and they have committed to return excess capital through high dividend distributions and share buybacks. In our view, this reflects the lack of profitable growth opportunities in a mature and heavily regulated market.

The repayment of TLTRO provisions went smoothly. Repayments reduced liquidity coverage ratios, as expected, but liquidity indicators also remain comfortably above and away from regulatory requirements and remain strong.

Rising interest rates have had a material beneficial impact on banks' results, boosting profitability and return on equity in 2023 as net interest margins widened. Our sample of Spanish banks (BBVA, Santander, Caixabank, Sabadell) recorded an average ROE of 13%, in 2023, above the 2018-2022 average. Our sample of Italian banks (ISP, UCG, BPM, BMPS, BPER, Mediobanca, Credem, BPSondrio) recorded an average ROE of 14.6% in 2023, almost double the previous year. However, not all banks benefited to the same extent. French banks' margins have declined, at least temporarily. This reflects the faster revaluation of regulated savings and limitations on mortgage revaluation under French usury law.

We anticipate a rise in global banking costs this year. Although some cost-saving programmes have begun to yield results, certain entities have also utilised improved profitability to finance capital expenditure in areas such as information technologies. Overall, cost escalation is expected to surpass income growth in 2024 and 2025, resulting in a marginal decline in profitability and efficiency ratios, albeit from notably high levels. Nonetheless, despite the likelihood that the sector's peak profitability was attained in 2023, our anticipation of sustained higher interest rates will continue to bolster banks' outcomes, albeit to a lesser extent.

The foremost driver of revenue and profit growth for banks in 2023 was the revaluation of balances following the cessation of the prolonged period of low interest rates. This metamorphosed the interest rate landscape from a hindrance to an advantage for the sector. Balance sheet revaluation, characterised by swift asset reassessment and significant deposit rigidity on the liability side, profoundly altered the dynamics of retail and commercial banking, which form the crux of the business models of most large and medium-sized European banks. It is probable that the revaluation phenomenon will abate this year.

As central banks curtail excess liquidity, heightened competition for deposits will ensue. The ascent in rates has already prompted some customers to transition from sight deposits to pricier term deposits, thereby diminishing interest margins and profitability. We anticipate the tightening pressure on net interest margins to become more pronounced in the latter half of this year as base effects dissipate and quantitative tightening persists in siphoning off excess liquidity from the system. The average net interest margin is projected to contract from 1.71% in 2023 to 1.63% in 2024 and 1.52% in 2025, albeit it is noteworthy that the 2024 figure surpasses the 1.3% observed in 2022.

Given the elevated interest rate environment and the anaemic economic growth forecast for the EU in 2024, loan volumes will stagnate owing to lacklustre demand dynamics. Under our foundational assumption, income growth is poised to be marginally negative in 2024, notwithstanding some offset from non-financial income growth. Concurrently, the same market conditions are anticipated to precipitate a moderate and gradual uptick in asset quality deterioration, although apprehensions of a repeat of the swift accumulation of delinquencies witnessed after the global financial crisis are unfounded. While we envisage banks to accrue higher provisions for insolvencies, these are expected to be absorbed through operational profitability.