S&P Global Ratings believes that French banks are going into 2021 able to absorb COVID-19 shocks. However, a quick return to prepandemic profitability is unlikely. Our ratings outlooks have been negative on most French banks since April 2020 when the COVID-19 pandemic broke out and triggered recession in Europe and many other countries. The negative outlooks reflect possible downgrades if threats to profitability mount, and we may be in a position to take rating actions on some banks in the first half of 2021. However, the ratings also factor in our view that the fundamentals of French banks, which have robust balance sheets and diversified banking and insurance activities, remain sound and support their creditworthiness.

French banks have proven to be better prepared for this crisis than the 2008-2009 financial crisis, and this time they were buffered by unprecedented support to the local economy from domestic and European authorities. Unlike the previous crisis, banks are not to blame for this one and instead are part of the solution, helping companies and households overcome it. The French economy should continue to recover in 2021, but its strength depends on how the pandemic plays out. S&P Global Ratings forecasts that France's GDP will grow 6.2% this year, down from our previous 7.7% forecast because of the effects of a second lockdown in autumn 2020, though less disruptive than the first one in spring, and the persistence of weak public health conditions in early 2021. For last year, we estimate that COVID-19 shocks shrank GDP a real 9%. Nevertheless, we see several hazards for French banks' earnings this year:

• New COVID-19 variants in France, which may require restrictions to remain in place or increase until the vaccination program builds critical mass.
• A rise in defaults and nonperforming loans from mainly corporate borrowers. Despite being relatively low to date because of fiscal and monetary support, they are set to increase this year. This is due to the planned phasing out of stimulus and the debt-like, not equity, nature of the support. We expect defaults to rise, particularly in sectors most affected by lockdowns and changes in customer consumption patterns.
• Continued ultralow interest rates, which will constrain revenues even as the economy rebuilds.

Therefore, the search for cost reductions is critical to avoid a pronounced erosion of profitability. It is even more important for French banks as their efficiency is modest in a European context.

As vaccine rollouts in several countries continue, S&P Global Ratings believes there remains a high degree of uncertainty about the evolution of the coronavirus pandemic and its economic effects. Widespread immunization, which certain countries might achieve by midyear, will help pave the way for a return to more normal levels of social and economic activity. We use this assumption about vaccine timing in assessing the economic and credit implications associated with the pandemic (see our research here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

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Systemic And Idiosyncratic Risks

Our economic risk and industry risk trends for the French banking sector are negative. If our view of both economic risk and industry risk worsen, the starting point we use in rating a domestic bank in France would decline to 'bbb' from 'bbb+' currently.

This could happen if prolongation of the health crisis delays a return to economic activity that sustainably worsens operating conditions for French banks. Downgrades could not only result from a change in our view of the banking sector but also of an individual bank. That could be the case if, for example, a drop in profitability forces a bank to restructure its business model. Other triggers could be pronounced weaknesses in asset quality, earnings, or capitalization, or declining cost efficiency compared with domestic and international peers'.

Subdued Revenues

Revenue will continue to be under pressure in the year ahead. That's because large, costly inflows of deposits and weak efficiency are bumping up against the need to invest more in digitization as well as low lending margins--such as on residential mortgage loans--among a mix of other factors.

With the pandemic, French banks have been accumulating large inflows of deposits from retail and corporate clients--fueled by risk aversion and fear of an economic crisis--that are reducing net interest margins. French households have curbed consumption and massively increased savings, while corporates, as a precaution, have drawn on credit lines or benefitted from state-guaranteed loans. We believe deposit inflows improve liquidity, but running excess liquidity can be costly because of the European Central Bank's negative rate (-0.50%) on its deposit facility. It remains to be seen whether French banks will pass those negative rates onto an increasingly wider range of clients, other than currently high net worth individuals, institutions, and large corporates. However, it is unlikely, in our view, that French banks will impose negative rates on retail clients. Instead, they will favor strategies to redirect savings into products like unit-linked life insurance, which could generate fees and commissions.

All French banks are aiming to increase efficiency while investing in digitization to meet customers' needs. The questions are how this joint effort will streamline their universal banking operations and develop fee-generating activities at the same time that some historic core revenue is inevitably eroding for profitable activities, like payment services, where competition is fierce.

A lack of pricing discipline on residential mortgage loans, to attract or retain customers, has translated into extremely low retail interest margins. By comparison, in many other European markets, banks' margins have been large enough to sustain profitability last year and previously as interest rates sank. In France, a wave of home loan refinancing as interest rates declined, combined with intense competition among banks and the presence of large mutual banking groups, dampened profitability in past years. As long as credit losses were low, which was the case until the pandemic started, this was not a major issue. However, now that credit losses are set to grow, the low margins on housing loans have become an increasing area of concern.

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Among other factors helping or hindering revenue prospects for 2021, we also note the following:

• The diversified earnings streams of French banks are sustaining their resilience, which depend less on declining interest margins than peers in Germany or the Benelux (Belgium, the Netherlands, and Luxembourg). French banks' share of interest revenue is generally lower because of their universal business model, which typically includes insurance, asset management, or investment banking activities.
• Lockdowns above all are reducing volumes of new consumer credit. This is hurting not only consumer-focused lenders but also larger banks that pushed this activity because of their wider margins than on housing loans. However, loan volumes for other types of loans, including corporate and housing loans, should remain strong, supporting the generation of annuity-like revenues.
• Investment bank revenues are cyclical and may struggle to match last year's highs, which relied on exceptionally strong fixed-income, currency, and commodity trading returns. Equity revenues were much weaker because of a decline in global markets flow and the more limited scale of French operations than at other banks, especially U.S. banks. Banks like Societe Generale and Natixis (a fully owned subsidiary of the BPCE group) reported large losses in the first half of 2020 when their structured equity derivative activities tanked after a wave of dividend payment cancellations, which the banks had not factored into their equity products and strategies.
• Finally, neobanks do not yet pose a competitive threat because their business models have not proven to be profitable and they remain niche players. With large IT investments, incumbent banks are becoming more digital, which should in principle open new routes to revenue creation.

Impairment Charges To Remain High In 2021

We estimate that the cost of risk for French banks' domestic loans will remain elevated in 2021 at around 50 basis points (bps)--and perhaps with a higher run rate in the fourth quarter of 2020 and first part of 2021. This is well above the long-term French average. However, some of the country's banks, especially BNP Paribas, Societe Generale, Credit Agricole, and, to a lesser extent, BPCE/Natixis, are also active globally. Therefore, domestic cost of risk is just a fraction of the total for those groups, notably as they are also active in higher-risk jurisdictions like Italy (BNP Paribas and Credit Agricole), Russia (Societe Generale), and Turkey (BNP Paribas), and have large international corporate portfolios.

For French banks, we estimate that cost of risk in 2021 will remain high but come in lower than in 2020. That's because banks had to create substantial provisions last year according to IFRS 9's forward-looking approach, even though defaults had not yet increased. Banks will largely use these forward-looking provisions this year as defaults occur. But at the same time, because loan quality will weaken as banks move exposures to weaker credit risk stages, they will continue to face high cost of risk.

The COVID-19 crisis will increase cost of risk on some types of loans more than others. Corporates, small and midsize enterprises (SMEs), and entrepreneurs in the sectors hardest hit by the pandemic will contribute to most of the increase in domestic cost of risk.

Household creditworthiness raises fewer credit concerns than corporates and SMEs, for the time being. One reason is that housing loans in France continue to present little fundamental risk. Underwriting criteria focus mainly on repayment capacity rather than property value, so the link between house prices, interest rates, and defaults is weaker than in other markets. Plus, fixed-rate rather than flexible-rate loans are more prevalent. This is positive, as such loans typically represent a substantial part of the business of large domestic banks (see chart 2), especially Credit Agricole, BPCE, or Credit Mutuel. Second, the slow relaxation in underwriting standards for housing loans observed in recent years was stopped by France's Haut Conseil de Stabilité Financière (High Council for Financial Stability). This explains in part their resilient business profiles. Cost of risk in the housing loan portfolio is more likely to hinge on a rise in unemployment than in house prices. We think the unemployment rate, which we forecast increasing in the next two years to just below 10%, will shape default rates and, ultimately, credit costs on mortgages. That said, it has been extremely low over the past 25 years and should remain well below 10 bps in 2021.

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Table 2

French banks may face higher credit risk upon the expiration of moratoriums on loan repayments, a COVID-19 measure to protect borrowers. As of June 2020, French, Spanish, and Italian banks reported the highest volumes of loans subject to moratoriums among European banks. For French banks, about 60% of the moratoriums expired in September 2020. Credit Agricole stated in its third-quarter 2020 earnings report that 97% of loans, whose payment holidays in France had expired, resumed payments. We believe the proportion is roughly the same for other large French banks. However, some neighboring countries where French banks have substantial operations have announced an automatic extension of the moratoriums beyond the year end, such as Italy or Belgium. Also, in France, banks are considering offering new moratoriums, where required, given the resurgence of the pandemic early 2021.

In contrast to retail loans, we expect corporate and small business loans to come under more intense pressure at French banks. Yet, bank-specific credit concentration matters, given the uneven economic impact of this crisis. The main pockets of credit risk include SMEs and cyclical sectors such as tourism, hospitality, energy, and transportation. Accommodation and catering are among the sectors that have made extensive use of France's state-guaranteed loan scheme.

Another corporate sector we closely monitor is commercial real estate. As economies recover into a new normal, offices and shopping centers may face higher vacancies and changes in demand from lessees, with more people working from home and shopping online. This could divert investors into other assets, lead to lower prices for French commercial property, ultimately increasing refinancing risk for borrowers. However, we believe French banks can generally manage the risks of their commercial real estate exposure, which we estimate at more than €220 billion, or about 2.5% of total assets, with more than one-half in France. The exposure grew before the crisis but only enough in our view to weaken asset quality, not jeopardize banks. The exposure to riskier property developers and real estate dealers is smaller, at about one-third of the total exposure to commercial real estate.

The Need For Leaner, More Profitable Business Models

The pandemic no doubt reinforced the need for French banks to move to leaner and more agile business models. For several years already, banks have been making large investments not only to adapt their IT systems and products to the digital age, but also to meet increased compliance and regulatory requirements. At the same time, they are aiming to develop new personalized services to create new sources of revenue to reverse the downward trend in topline revenues, in response to competition from fintechs and potential moves by Big Tech. Banks are faced with the urgent task of generating productivity gains through automation, artificial intelligence, and a reduction in their branch networks.

With the change in the expectations of customers, their relationships with banks are becoming more digital--an opportunity to reduce operational costs. French banks therefore are aiming to adapt retail networks to clients' changing needs as well as their own profitability targets. Banking customers, particularly SMEs and corporates, will continue to require physical interactions for value-added services; households will need them for home loans. Still, in some countries, such as the Netherlands, the number of branches for 100,000 inhabitants is only 8, versus 54 in France, 32 in Germany, and 12 in the U.K. (see chart 5). France is now the major European market with the highest number of branches because banks have been much slower in closing branches, given that their most profitable clients tend to be older and attached to their local branch, and the country is larger and less densely populated. Nevertheless, now that customers are engaged in more transactional banking and more actively embracing new technologies, the value of large branch networks is coming under increased scrutiny.

In a move that will involve more branch closures, Societe Generale has announced two major strategic initiatives in French retail. First, a merger of its retail networks with those of Credit du Nord in France. Second, acceleration of the development of its French online bank, Boursorama. Still, the branch network is just one, among many other aspects of the efficiency equation. Equally important as absolute cost reduction is the capacity of French banks to leverage cross-selling opportunities in insurance, private banking, and asset management and to operate via digital platforms, which open the capacity to operate with modest fixed costs and scalability. The point for French banks is investing to generate more revenue streams through digital channels and customer advisory rather than solely reducing absolute physical network costs.

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Prospects Are Limited For Domestic Mergers

We will likely witness faster consolidation of the European banking sector in the next few years, starting with the most fragmented markets. In the absence of a comprehensive and finalized European Banking Union, the region is likely to primarily see domestic consolidation, as is already the case in Spain or Italy. For French banks, instead of mergers, we expect bolt-on acquisitions--large banks' preferred route for inorganic growth. Such acquisitions generally occur in combination with partnerships to expand product distribution networks in various segments: consumer finance, asset management, and insurance, for example. In the past few years, we saw a number of initiatives, including Credit Agricole Italia's cash tender offer for Italian midsize bank Credito Valtellinese, that would reinforce the French bank's market position and scale in Italy, its No. 2 market. In a similar vein, BNP Paribas Fortis (the Belgium subsidiary of BNP Paribas) intends to fully acquire Bpost bank, which provides financial services in the Belgian post office network. Cross-border consolidation of systemically important banks is a more complex task, which could result in additional equity requirements for the combined entity due to an increased in buffers for global systemically important banks. In addition, buying a network of branches in another country and migrating IT systems are time-consuming and costly tasks, which could increase restructuring costs or delay the realization of synergies.

ESG Initiatives Are Ramping Up

As for economic, social, and governance (ESG), we believe the economic disruption arising from the pandemic is an opportunity to reorient the French economy, to make it greener, more inclusive, and more productive. This will foster ESG-related initiatives at French banks that address climate change and the energy transition, as well as their financial risks. As part of the Network for the Greening of the Financial System, the French authorities (ACPR and the Bank of France) have initiated a study into conducting climate stress tests for the country's banks. At the same time, the ACPR published, in accordance with France's energy transition law, two reports on climate risks for the French banking and insurance sectors. What's more, it has established a Climate and Sustainable Finance Commission to monitor the commitments made by financial institutions and, jointly with the Autorité des marchés financiers, publish annual reports on progress. Although French banks are ahead of others across the globe in adopting sustainability strategies, transforming them into business opportunities with recurring revenues is the challenge.

Capital Ratios Should Remain Solid

The pandemic is lowering the prospects that French banks will build capital in the next two years. However, their capital ratios are much stronger than before the 2008-2009 financial crisis.

For France's cooperative banks, we typically expect capitalization to decline moderately this year even though they retain most of their earnings. This is because we generally expect their loan books to grow much faster than bottom-line profits. This decline in capitalization will not substantially change our view of the high quality of their capital bases and the absence of demands from shareholders to amend the capital policy.

The question is different for listed banks. The ECB partly lifted restrictions on payouts in late 2020, but we believe banks will unlikely normalize dividend policies for some time because supervisory authorities remain cautious. Payouts from 2020 earnings are indeed subject to tight limits (see "A Measured Resumption Of Shareholder Distributions Won’t Affect European Bank Ratings," published on Dec. 16, 2020). Still, those banks are facing more calls from shareholders to distribute profits, when allowed. Therefore, we see a prolonged period of weak profitability, which will provoke more questions about strategy and choices than at cooperative groups, which have a longer-term strategy.

As we have mentioned above, we don't expect the elevated cost of risk this year to impair the capital adequacy of large French banks and limit their ability to lend to the private sector. We expect our measure of risk-weighted assets (RWA) to increase between 3% and 5% as a result of loan growth and credit migration, in line with an increase in regulatory RWA. Market risks are to increase because of the reset of value at risk parameters in the calculation of risk weights. From a regulatory point of view, since the exposure for the guaranteed portion of loans under the state-guaranteed scheme substitutes for the French sovereign, the impact on regulatory and our own measure of RWA will be very modest. The scheme, however, increases the link between the creditworthiness of French banks and that of the sovereign.

We estimate that a worsening of our economic risk score for France to 4 from 3 would typically increase our measure of risk-adjusted capital by up to 100 bps for the country's banks that have the most limited geographical diversification.

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Related Research

• Banking Industry Country Risk Assessment: France, Aug. 26, 2020
• Domestic Credit Losses For French Banks Could More Than Double Amid COVID-19 Pandemic, July 10, 2020
• Negative Rating Actions Taken On Various French Banks On Deepening COVID-19 Downside Risks, April 23, 2020