European banks' asset quality is set to worsen this year as inflation dents corporate profits and tighter financial conditions put households under pressure.

In a sample of 21 large European banks, 17 are expected to have higher nonperforming asset (NPA) ratios year over year in 2023, according to analyst consensus estimates compiled by S&P Global Market Intelligence. Of those, nine will see asset quality deteriorate further in 2024, the data suggests.

Italy-based Banco BPM SpA, whose NPA ratio of 4.20% was the highest in the sample at the end of 2022, will also finish 2023 and 2024 with the weakest asset quality according to consensus estimates. Four Spanish banks — Banco Bilbao Vizcaya Argentaria SA, Banco de Sabadell SA, Unicaja Banco SA and Banco Santander SA — are expected to have the next-highest NPA ratios at end of this year.

Nonperforming loans at European banks are expected to increase in 2023, mainly among corporates, as higher interest rates and a higher cost of living weighs on demand and impacts profits, Scope Ratings wrote in a May 11 report.

The commercial real estate sector is vulnerable due to higher rates, rising construction costs and weakening property prices. Meanwhile, the number of bankruptcies in other vulnerable sectors including accommodation and food, transport, education and healthcare doubled in the fourth quarter of 2022, the rating agency wrote.

Tighter financial conditions could lead to more households, as well as companies, defaulting on loans, Scope said.

Banks may need to put more money aside to cover losses and manage credit risk, the ECB said in its financial stability review, published May 31. Higher interest rates mean lower lending volumes and increased funding costs, and this may impact profits. Signs of asset quality deterioration are already appearing in commercial real estate portfolios, the central bank said.

Unrealized losses

Many European banks also have incurred unrealized losses on bond portfolios due to rising interest rates, although this is not expected to significantly impact stability. Higher central bank rates across the world have eroded the value of outstanding bond holdings, which was a factor in the downfall of US-based SVB Financial Group and Signature Bank in March.

In a sample of European banks, KBC Group NV, Intesa Sanpaolo SpA, BBVA and Barclays PLC recorded the highest level of net unrealized losses on available-for-sale (AVS) bond portfolios as of the end of March. For KBC, they totaled 4.71% of common equity Tier 1 capital, for Intesa they totaled 4.47%, for BBVA 3.66% and for Barclays 3.07%.

The data does not capture held-to-maturity (HTM) portfolios. Banks recognize AVS losses in capital, but do not recognize those in HTM books since they do not crystallize unless they are sold.

European banks are unlikely to face forced sales of securities, partly due to hedges against valuation swings and deposit guarantee schemes that protect most household deposits, rating agency Moody's wrote in an April 19 report. There is more scope for unrecognized losses among smaller banks since their securities portfolios account for a higher share of total assets, but they have bigger equity buffers on average and a greater share of stable retail funding, Moody's said.

Problem loans

Italy's Banca Monte dei Paschi di Siena SpA had the highest ratio of nonperforming loans as a percentage of total loans among large European banks at the end of the first quarter, Market Intelligence data shows.

UniCredit SpA's ratio increased the most over the quarter — by 40.33 basis points — while KBC achieved the biggest decline, at 23.32 basis points.

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