Inflation is more likely to prompt an increase in provisioning at Europe's large banks in the coming months than direct exposure to Russia and Ukraine, industry observers said.

Of the 25 largest European banks, 20 booked higher provisions for the first quarter of 2022 than they did a year earlier, S&P Global Market Intelligence data showed. Among them are Italy-based UniCredit SpA and France's Société Générale SA, which have high levels of exposure to Russia.

Spain-based Banco Santander SA was the only bank to book provisions higher than €2 billion. UniCredit reported €1.28 billion in provisions, while SocGen, HSBC Holdings PLC, Intesa Sanpaolo SpA, Banco Bilbao Vizcaya Argentaria SA, Crédit Agricole Group and ING Groep NV all booked in excess of €500 million.

For Santander, the increase was mostly driven by the improvement of some currencies against the euro, primarily the Brazilian real, a spokesperson told Market Intelligence in an email. Excluding foreign-exchange effects, impairments were broadly flat.

The increase in direct war-related provisions was concentrated at banks most exposed to Russia and Ukraine, who are trying to manage the situation, said Marco Troiano, head of financial institution ratings at Scope Ratings, via email.

UniCredit's Russian exposure amounted to roughly €7 billion at the end of April. A spokesperson said the Italian bank's "extreme loss assessment" in case of a further deterioration of the situation is a 40% recoverability. UniCredit was recently reported to be in early talks to sell its Russian unit.

Meanwhile, SocGen's offshore international exposure to Russia was €2.8 billion as of March 31, down from €3.2 billion at the end of 2021, a spokesperson told Market Intelligence. The exposure at risk on this portfolio is estimated at less than €1 billion, the spokesperson added. The French bank recently sold its Russian unit PJSC Rosbank along with its insurance activities in the country at a net loss of roughly €3.2 billion, to be booked in the second quarter.

Any future increase in European banks' provisions would likely be due to deterioration in the creditworthiness of their clients, which could be war-driven or not, said Jerry del Missier, chief investment officer at Copper Street Capital, via email. "Absent a major expansion of the theatre of war or [a] significant escalation, it is unlikely that the conflict will directly impact provisioning," he said.

Rising inflation, driven by various geopolitical and macroeconomic factors, is a key concern that could impact the banks' loan loss provisions. Inflation in the euro area hit another record-high of 8.1% in May, according to data from the bloc's statistics agency. This would "eat into household budgets," Scope said in a May 18 research note. Rising mortgage rates may put pressure on customers with variable rates mortgages, Scope said, adding that government interventions would not fully offset clients' repayment constraints.

In its latest financial stability review, the European Central Bank also warned that inflation, along with the war, has led to an increase in the downside risks to households' financial position. The rise in house prices during the COVID-19 pandemic also stimulated potential price reversals, which could affect financial stability, the central bank said.

Other potential drivers include margin pressure, higher interest charges and economic slowdown, said del Missier.

Pre-provision profits safe

In spite of the current situation, large European banks are still likely to report profits for 2022 and 2023, S&P Global Ratings said in a recent commentary. This was due to the banks' geographic and business diversification, how they came through COVID-19 largely unscathed and their adequate buffers.

Banks can absorb rising credit loss out of their ordinary profits, according to Scope. Svenska Handelsbanken AB (publ), Swedbank AB (publ), KBC Group NV and UBS Group AG are expected to remain profitable even if their provisions rise 10x, according to the agency.

Nordic banks in particular exhibit high profitability prospects, as do those with exposure to emerging markets, Scope said. German banks could be among those most affected, although their profitability is improving.

Despite the war becoming an overarching concern for the financial sector, 13 of the banks in the sample still reported higher first-quarter profits. Santander, which booked the highest provisions, yielded a net income of €2.54 billion, second only to HSBC's €2.93 billion.

This all comes amid an almost-certain rise in interest rates in the coming months. ECB President Christine Lagarde said an initial hike could happen in July, with the rate potentially exiting subzero territory by the end of the third quarter.

Rates moving from negative to zero would cut the cost of excess liquidity held at central banks, which has hurt profitability, especially of those in core Europe, said Scope. Additional hikes in short-term rates will boost revenues, particularly for retail-heavy players, the agency added. But these higher rates could become a headwind for banks with significant wealth management activities, as low rates in recent years have made higher-yielding investment products more attractive, according to Scope.

Banks could also take a boost from higher volatility as this could result in an increase in corporate and private risk aversion, said Roberto Frazzitta, senior partner and global head of banking practice at Bain & Co. This could make protection services and insurance products more appealing, Frazzitta said via email.

Cost management is key, with Copper Street Capital's del Missier saying banks that have "shown the most discipline" on costs are better positioned to withstand any deterioration. Their cost management abilities will be tested all the more in an inflationary environment, said Scope.

Well capitalized

Banks maintain they have adequate capital levels to withstand any shocks, including those linked to the war. "With few exceptions, the industry is very well placed from a capital and quality-of-balance sheet point of view […] this makes the sector very resilient to [an] economic downturn," said del Missier.

Even heavily Russia-exposed banks like UniCredit and SocGen expressed confidence in their capital and distribution plans.

"UniCredit is positioned to incorporate possible spillover macroeconomic effects due to strong capitalization and asset quality, including sizeable overlay [loan loss provisions]," the bank said May 5. Meanwhile, SocGen said in March that it "has more than enough buffer to absorb the consequences of a potential extreme scenario" in Russia.

Regulators had pushed banks to preserve capital during the COVID-19 pandemic in case of higher loan losses. While many of them have announced a return to capital distributions starting in the second half of 2021, their capital levels remain significant. At the end of March, sampled banks' common equity Tier 1 ratios — a key indicator of financial strength — were all above 12%, data showed.

"We can say that the European banking system has reached substantial levels of resilience," said Bain's Frazzitta. "We dare say, generally speaking, that they could not be in a better position to withstand the current crisis."

Banks in Russia and Ukraine, where government ownership means they are subject to different market dynamics than those in Western Europe, were excluded from this analysis.