European banks' exposures to the hospitality and construction industries are the biggest threat to asset quality, the latest European Banking Authority stress tests show.

Nonperforming exposures in the accommodation and food service segment would total 11% of performing exposures in a worst-case scenario, while provisions would total 3.3% of the exposure, the data shows. For the construction industry, exposures and provisions would total 8.2% and 2.8%, respectively.

The same two sectors show the biggest signs of stress at present for banks. As of the end of 2022, more than a third of all accommodation and food service exposures were classified as either stage 2 — those at heightened risk of default — or stage 3, or nonperforming. For construction, 20% of exposures were either stage 2 or stage 3.

The 2023 edition of the European Banking Authority (EBA) stress test is the first to address banks' sectoral exposures to corporates and small and medium-sized enterprises. The regulator called on lenders to enhance their collection of granular data from borrowers and improve how they aggregate and report it, noting that several institutions relied on sectoral sensitivities rather than models to calculate potential losses.

The adverse scenario in the 2023 test factors in persistent and higher inflation across the EU, increasing interest rates and credit spreads, high unemployment, substantial declines in asset prices and severe recessions globally. The test covers 70 banks representing about 75% of the EU's banking assets.

Overall, banks are well positioned to handle more challenging conditions. They entered the 2023 test with an average nonperforming exposure ratio of 1.6%, compared with 2.1% at the outset of the 2021 test. As a result, the impact from heightened credit risk is lower than in the previous test. Banks also have higher provision overlays at present, the EBA said.

Cumulative credit risk losses over the three-year period assessed by the test would total €347 billion in an adverse scenario, with the biggest impact felt in the first year. Corporate exposures account for 40.9% of all expected losses, while retail exposures comprise 35.5% of the total.

The EBA noted a substantial deterioration in commercial real estate asset quality over the three-year window assessed. Under the adverse scenario, stage 2 loans would increase from 14.5% to 24.8% of total exposure. Stage 3 loans would rise from 3.2% to 10.3% of all loans in the sector.

Commercial real estate exposures totaled €1.30 trillion at the end of 2022, representing 6.3% of total exposures. Banks project €27 billion of losses on this exposure, or 7.9% of total losses, in an adverse scenario.

– Download the EBA 2023 stress test excel template. – Read more about credit risk at European banks.