Third-quarter loan loss provisions at Europe's largest banks dropped from second-quarter highs but analysts expect increases to resume in the fourth quarter and early 2021 as the COVID-19 impact, delayed by loan moratoriums and government aid schemes, hits the sector.

Loan loss provisions fell at all 25 of Europe's largest banks in the third quarter, with 15 registering quarter-over-quarter drops of 50% or more, S&P Global Market Intelligence data shows. Finland-headquartered Nordea Bank Abp, Belgium-based KBC Group NV and U.K. banks NatWest Group PLC, Lloyds Banking Group PLC and HSBC Holdings PLC booked the steepest drops of more than 80%.

The promising third-quarter levels, however, are not sustainable as the COVID-19 pandemic fallout are expected to materialize in the coming quarters. New lockdowns across parts of Europe amid the second wave of the pandemic will delay economic recovery and prolong the liquidity woes of households and companies affected by the crisis.

After warning during its October policy meeting that some eurozone countries should expect a double-dip recession, the ECB said in its latest financial stability review that eurozone banks should prepare for a rise in pandemic-induced nonperforming loans in the coming months, following a similar statement by the EU's Single Resolution Board, which projected NPLs to rise in the first and second quarters of 2021.

Year-end catchups?

Default rates and NPL ratios have been "deceptively" low so far in 2020 thanks to government support programs but as the these measures start to wrap up, "sharp increase in nonperforming loans is a question of when, not if," ING analysts wrote in their 2021 European bank outlook.

Furloughs and government-mandated loan payment holidays are among other measures that have limited the increase in bank NPLs, Osman Sattar, director at S&P Global Ratings' EMEA financial institutions group, said in an interview. However, these aid schemes "were intended to help through a short-term liquidity crunch, not a long-term solvency crisis for borrowers."

Given that some of them have been extended into 2021, the market is concerned about the subsequent delay of the emergence of asset quality problems at banks. As support schemes unwind, there will inevitably be borrowers unable to meet repayment requirements, resulting in an uptick in NPLs and loan loss provisions, Sattar said.

"As more evidence comes to light of nonperforming borrowers, it may well be the case that the banks that haven't made significant provisions, or as significant provisions, in the half year and the third quarter may have some catching up to do in the year-end and into 2021," he said.

Regional differences

Asset quality and provisioning will vary greatly between European banks both because of idiosyncratic factors like loan book composition and the provisions already taken in 2020, according to Sattar. While provision levels at Nordic banks, which generally have better asset quality, spiked in the first half of the year, the cost of risk increase at some southern European banks was more subdued. That disparity "caused some head scratching" in the market, he added.

The evolution of asset quality has diverged across Europe, "partly reflecting less abrupt economic contractions" in certain countries, including the Nordics, credit analysts at DBRS Morningstar said in a third-quarter review.

"While a reduction of NPLs was more pronounced on average for our sample of banks in Portugal and Italy and Spain to a lesser extent, these countries still continue to hold high levels of NPLs and among the highest NPL ratios across European banks," the analysts said.

ING analysts estimate that NPLs are likely to continue to be challenging in Greece, Cyprus, Italy, Portugal and Ireland, given their legacy NPL levels as well as exposure to sectors vulnerable to COVID-19 and to small and medium-sized enterprises.

The low third-quarter levels of cost of risk and NPLs are not sustainable in the medium term, the DBRS Morningstar analysts said. The spate of new lockdowns will likely lead to a "more negative economic shock" than banks have modeled for, which will result in higher fourth-quarter provisions, they said.

Furthermore, asset quality deterioration is expected to become "more visible" from the fourth quarter "as moratoria periods start to run off, and new moratoria no longer benefit from the current preferential regulatory treatment, which was in place until the end of September", the analysts added.

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