Bad loans at European banks are set to rise in 2023 as borrowers struggle with the impact of rising interest rates, offsetting some of the gains lenders are expected to see from widening margins.

Nonperforming assets — loans for which the principal or interest payment remains overdue for a period of 90 days — are set to creep above 2.5% on average across Europe's largest banks in 2023, S&P Global Market Intelligence data based on analysts' estimates shows. The 2023 forecast of a 9-basis-point increase in nonperforming assets, or NPAs, follows a jump of 13 basis points in 2022 as interest rates rose rapidly across the continent, the data shows.

The expected deterioration in the quality of European lenders' assets comes as borrowers wrestle with a sharp rise in interest rates, high energy prices and a slowing global economy, making the repayment of loans more difficult. The weaker outlook follows a decade of gradual improvement in banks' asset quality as lenders emerged from the flood of bad loans generated by the 2008 global financial crisis.

"In every cycle, when rates increase, the cost of risk tends to follow," Flora Bocahut, European bank equity analyst at Jefferies, said in an interview. "It's just mechanical because the cost of credit is rising."

Banks have been increasing provisions for bad loans in anticipation of more challenging times ahead and are likely to continue doing so in the coming quarters. These provisions dented the profits of several U.K. lenders in the third quarter, Market Intelligence previously reported.

Analysts expect a majority of Europe's largest lenders — 22 out of a sample of 27 — to record year-over-year increases in NPAs in 2023, Market Intelligence data shows. But just under half are forecast to report rises in NPAs in 2022 when full-year results are released in the coming weeks.

Belgium's KBC Group NV is predicted to have the largest NPA increase for 2023 at 76 bps to 2.62%. Italy's Banco BPM SpA, the lender in the sample with the highest estimated NPA ratio at year-end 2022 at 4.87%, is expected to retain its position in 2023 as NPAs increase by 18 bps to 5.05%, the data shows.

Credit losses among Western European banking systems are expected to rise 20% to $87 billion in 2023 and remain at that level in 2024, S&P Global Ratings said in a December report.

"These forecasts reflect our view that the ongoing energy shock and monetary tightening will see problem loans emerge across Europe's banking systems," the report said.

The negative impact of rising rates and high inflation on economic growth will compound difficulties for borrowers. The eurozone is expected to grow at just 0.3% in 2023, with inflation remaining high at 6.1%, well above the European Central Bank's target of 2%, according to the European Commission's latest economic forecast. The U.K. economy is projected to contract by 1.9% this year, while inflation is expected to slow dramatically to 5.2%, according to the Bank of England's latest projections.

"If we see a very severe recession [across Europe], NPLs and cost of risk would probably increase more than what we are expecting," said Gonzalo López, bank equity analyst at Redburn.

The big question

Ratings sees corporate borrowers as the most likely source of problem loans in 2023. Corporates with "stretched debt and affordability metrics" and those more directly affected by higher costs — particularly if they have limited ability to pass them on to consumers through prices — will be most affected, Ratings said.

"That's the question: Where are the pockets of risk?," said Nicolas Hardy, deputy head, financial institutions ratings at Scope Ratings. "The usual suspects these days are companies that are sensitive to higher energy prices, supply chain issues and variable interest rates."

Leveraged loans and commercial real estate are also areas where bad loans are more likely to surface, according to Bocahut.

For now, the prospects for loans to individuals are less of a concern due to near-record-low levels of unemployment. In the European Union, unemployment is expected to rise to 6.5% in 2023 from 6.2% in 2022, according to the European Commission's latest economic forecast. Meanwhile, unemployment in the U.K. is forecast to rise to 4.9% by the end of 2023 from 3.7% in the last quarter of 2022, the Bank of England said.

"I can't see NPL formation starting to pick up on the retail side if you don't have a [material] increase in unemployment," said Johann Scholtz, bank equity analyst at Morningstar.

Manageable impact

Any significant deterioration in asset quality in 2023 should be manageable for most of Europe's largest banks, said Sam Theodore, senior consultant at Scope Insights. Many already have sizable loan loss reserves in place, while NPLs will only rise from "historically low levels," said Theodore.

The positive impact of higher rates on European lenders' revenues should also help to offset a deterioration in asset quality. Analysts expect Europe's largest lenders to enjoy another significant increase in lending income in 2023 of almost 9.5% after a 16.5% increase forecast for 2022, Market Intelligence data shows.

Targeted government support for borrowers in some European countries should further limit the damage to lenders' loan books. Spain, Poland and Hungary are among the countries that have introduced legislation to protect homeowners from rising rates. Meanwhile, the remnants of the state-guaranteed loan programs undertaken across Europe at the outset of the COVID-19 pandemic should provide additional protection to banks from borrowers struggling to repay such loans.

'Different story'

Still, the evolution of asset quality in 2023 will depend on how quickly inflation falls and where interest rates finally settle, said Pablo Manzano, vice president, financial institutions at credit rating agency DBRS Morningstar. While many banks are benefiting from a surge in lending income due to higher interest rates, hikes beyond a certain point could cause a damaging rise in bad loans and turn those gains negative.

"It's a different story if, instead of 3%, the ECB goes to 4% or 5%," said Manzano. "That's more tricky and there are many, many more risks."