In the wake of COVID-19, European banks face an even longer period of margin compression resulting from ultra-low interest rates and flat yield curves. Approaching the seventh anniversary of the European Central Bank's (ECB's) negative interest rate policy, low inflation means that rate hikes remain a distant prospect right across Europe, even when economies begin to recover from the pandemic.

S&P Global Ratings observes that margin erosion accelerated following the onset of COVID-19 due to strong deposit inflows and the launch of government-guaranteed loan programs. However, the resulting boost to interest-earning assets mitigated the hit to revenues. The ECB has additionally shielded eurozone banks' profitability through cheap long-term refinancing operations and tiered interest rates on reserves. Nevertheless, there is a clear downside risk to the sector's revenues and earnings if it becomes less adept at mitigating the adverse side effects of prolonged expansionary monetary policies.

Low-for-even-longer interest rates are a catalyst for European banks to address more decisively their two structural weaknesses: inefficiency and overcapacity. Some banks have made progress on managing costs, but the sector as a whole has a lot more to achieve. Banks have an opportunity to leverage the changes in working practices and customer preferences that accelerated during COVID-19 lockdowns. Consolidation is far from a silver bullet, but well-executed mergers and acquisitions have potential to strengthen pricing power and realize synergies, and regulators have adopted a more supportive stance.

Many Western European banks suffered from mediocre profitability even before the onset of the pandemic, and therefore had limited capacity to absorb the sharp increase in IFRS 9 credit impairments. Although core capitalization holds up reasonably well under our base-case rating scenario, banks' sensitivity to more adverse operating conditions is the main reason why the proportion of our ratings with negative outlooks is higher in Western Europe than in other regions. We could revise selected outlooks to stable if we become more confident in the trajectory of the economic recovery from the pandemic and the medium-term profitability of banks' business models. Conversely, we could lower selected Banking Industry Country Risk Assessments (BICRAs) and/or bank ratings if systems or individual institutions struggle to overcome the long-term drag on revenues from prolonged ultra-low interest rates.

Yield Curves Set To Remain Low And Flat

Central bank interest rates stand at ultra-low levels across Europe (see table 1). Those with headroom above zero lowered their policy rates in response to the COVID-19 pandemic to support their economies. The ECB and Swiss National Bank maintained their negative rates and expanded their balance sheets to ease monetary conditions. Denmark and Sweden's central banks swam against the tide by raising their policy rates last year, although Denmark's remained in negative territory. Sweden ended its period of negative rates in January 2020 as inflation moved closer to its target rate, and it also cited a risk of adverse consequences if negative rates came to be perceived as a more permanent state. In contrast, the Bank of England has become more vocal about the possibility of introducing negative rates, which we see as a contingency measure that would increase U.K. banks' margin pressure but appears unlikely to be implemented in practice.

Table 1

Since commercial banks generally borrow short and lend long, the slope of the yield curve is more important to profitability than central banks' policy rates. The euro curve became significantly lower and flatter after COVID-19 hit (see chart 1). Whereas the trajectory of U.S. inflation has become a hotter topic in light of the new administration's proposed stimulus, inflationary expectations in Europe remain subdued. Markets anticipate that European interest rates will stay at very low levels for years to come.

Chart 1

The yield curves for the four major Western European currencies have converged around a similarly flat profile (see chart 2). These curves have steepened a little in response to progress on COVID-19 vaccines and the general expectation of economic recovery, but remain much shallower than the historic average.

Chart 2

Banks' Margins Feel The Squeeze

Ultra-low rates erode banks' net interest margins primarily due to practical constraints on passing them on to depositors, particularly retail customers. Banks' criticisms of the ECB's negative rates policy are therefore strongest in countries with high household saving rates and excess deposits, notably Germany. ECB research indicates that negative interest rates did not weaken eurozone banks' overall earnings prior to the pandemic, largely because they kept impairment losses lower and credit demand higher than would have been the case if monetary policy were tighter. Strict lockdown measures changed this equation as the rapid deterioration in economic prospects sent IFRS 9 credit impairment charges sharply higher.

European banks proved reasonably proficient at managing their margins prior to the pandemic (see chart 3). The onset of COVID-19 triggered sharp margin compression but also an acceleration in interest-earning assets, meaning that aggregate net interest income declined only moderately. Deposits surged as corporates hoarded cash and households increased savings as lockdowns curtailed leisure activities. Banks largely placed these funds in low-yielding central bank accounts and government bonds, partly because deposit flows will likely reverse once the economic recovery begins in earnest (see The European Sovereign-Bank Nexus Deepens By €200 Billion, published on Sept. 21, 2020). The launch of government-guaranteed loans further increased banks' low-margin asset balances. Central banks' long-term refinancing operations and tiered interest rates on reserves support bank profitability but could not prevent the margin decline.

Chart 3

In addition to trends in product spreads, lower income from structural balance sheet hedges is a contributing factor to European banks' falling net interest margins. These hedges reduce sensitivity to interest rate changes by smoothing the yield on equity and liabilities with indefinite maturity. There are significant differences in banks' structural hedging policies, instruments, and tenors, but a common feature is a diminishing level of protection against the prolonged period of ultra-low rates. For example, the yield on a rolling interest rate swap program remains above spot rates but provides a steadily reducing return (see chart 4). Depending on their internal policies and risk appetites, banks may be less willing to renew structural hedges at current market levels.

Chart 4

Despite ongoing ultra-low interest rates, our base case financial projections for the 50 largest rated European banking groups anticipate that their net interest margins will remain compressed but show greater stability in 2021-2022 (see chart 5). We think interest-earning assets will continue to grow but at a slower pace than last year, which should still underpin the sector's aggregate net interest income. Of course, there is significant dispersion around the sector average depending on the profile of each bank's balance sheet. The risk to banks' medium-term revenues is that interest-earning assets may slow more significantly following the pandemic as fiscal support tapers, government-guaranteed loan programs close to applications, and corporate credit demand eases. Although they are declining following the Federal Reserve's March 2020 interest rate cuts, U.S. banks' margins are notably stronger at over 2%, partly due to differences in lending mix.

Chart 5

Banks' interest rate sensitivity disclosures indicate the effect of yield curve movements on revenues and/or the economic value of equity. These sensitivities are often based on unrealistic scenarios, such as an instantaneous parallel shift in rates across the curve, and are not directly comparable between banks because they are based on differing behavioral assumptions. Still, they have value in terms of showing the positioning of each bank's balance sheet. The disclosures confirm that the majority of the sector is asset-sensitive and therefore its net interest income would benefit if rates increase and the yield curve steepens. We see Banco Santander as typical in this respect (see chart 6).

Chart 6

The vast majority of European corporate and household financing is routed through bank balance sheets rather than capital markets. Accordingly, net interest income represents close to 60% of the sector's total revenues, with sizable contributions also from fees and trading revenues (see chart 7). Again, there is considerable dispersion around the sector average depending on the extent to which each institution participates in activities that generate material non-interest income, including asset management, insurance, and investment banking. Banks with diversified revenue profiles should be more resilient to margin erosion provided they maintain strong, profitable franchises in each business segment.

Chart 7

Mitigating Actions To Limit Revenue Attrition

Banks cannot turn back the tide of prolonged ultra-low rates, but they are taking action where possible to mitigate the resulting margin and revenue pressures. There are five main areas where banks have levers to pull, subject to the constraints of the economic, competitive, and regulatory environments.

1. Re-price deposits lower

Deposits were historically a valuable revenue source for European banks, but this is no longer the case. As negative euro interest rates have persisted, banks are re-evaluating the potential to pass on this cost to customers. There is very little prospect of charging negative rates on deposits from mass-market retail customers, but there has been a steady increase in the pass-through to corporates, institutions, and higher net worth individuals. European banks' outstanding deposits from households are significantly higher than those from corporates, and the constraints on retail deposit pricing are therefore a particular burden on banks' margins.

Banks take a nuanced approach to deposit pricing for corporate and institutional customers, taking into account the depth and profitability of each relationship, both currently and prospectively. Banks are most likely to apply negative rates on euro deposits when customers have no other products or services. There are no signs that this policy has weakened the volume or stability of banks' corporate and institutional deposits, indicating that customers have limited alternatives and the level of negative rates is not sufficiently high to change behavior. Within the eurozone, the average rate paid on overnight euro deposits from corporates has now turned negative, with Dutch and German banks at the forefront of this repricing trend (see chart 8). We expect negative rates on euro corporate and institutional deposits will become even more widespread the longer the current monetary policy remains unchanged.

Chart 8

There are several eurozone countries where the average interest rate paid on overnight euro deposits from households is zero, but none where it is below zero. Negative rates in the retail segment have been targeted at higher net worth individuals with large account balances. Exceptions include certain small German banks that charge negative rates on all their deposits. Although we do not expect major banks to adopt a similar policy, several have lowered the balance threshold above which they charge negative rates.

Danish banks have been proactive in charging negative rates on Danish Krone retail deposits. The market leaders currently pay -0.6% (in line with the central bank's policy rate) on balances above DKK250,000 (about €33,500 or $41,000). We do not see such low thresholds in the eurozone but, for example, the major German banks commonly charge negative rates on retail balances above €100,000. The Netherlands' ING Bank and Spain's Banco Bilbao Vizcaya Argentaria (BBVA) recently announced that they would follow suit, indicating that this may become a broader trend. As for corporates, the application of negative rates to high retail deposit balances often depends on the depth of customer relationships, such as the number of other products held with the bank.

2. Re-price loans higher

Banks' net interest margins are a function of both sides of their balance sheets, and higher spreads on new lending would help to offset expensive deposits and lower-yielding balance sheet hedges. Banks are increasingly focused on the profitability of new lending and pricing has shown greater stability since the COVID-19 pandemic hit. However, lenders' capacity to manage lending spreads is constrained by strong competition in most markets and customers' ability to renegotiate interest rates and refinance with other lenders. The U.K. residential mortgage market is a notable case where lenders have raised new business margins significantly (see chart 9). As well as supporting margins in the wake of the Bank of England's interest rate cuts, this repricing was a response to strong customer demand, and we expect spreads will ease back as application volumes normalize this year.

Chart 9

3. Increase business volumes

We expect last year's strong growth in interest-earning assets will slow this year. Banks are generally tightening credit standards due to concerns over borrowers' repayment capacity as fiscal support eases in the wake of the pandemic (see chart 10). Government-guaranteed loans have satisfied corporates' demand for credit and increased their balance sheet leverage, and corporate lending volumes are likely to reduce once the guarantee schemes close to new originations. Across Europe, we expect the deep 2020 recession will trigger an increase in non-accruing nonperforming exposures (NPEs) once repayment moratoria and fiscal support measures are withdrawn, particularly in small business lending, which will act as a further headwind to revenues.

Chart 10

Rather than growing overall volumes, banks could alternatively protect margins by shifting the mix of their portfolios towards higher margin assets such as consumer credit and leveraged loans. We see limited evidence of this to date, and households have paid down consumer credit balances during the pandemic. However, we are conscious that loose monetary conditions have contributed to price inflation in various asset classes, including various financial securities and residential real estate in some countries. Some regulators have deployed macroprudential tools such as risk-weight floors to address this source of potential risk, which we take into account in our BICRA analysis. We also reflect banks' credit practices in our risk position assessments.

In countries including Italy and Spain that were hit hard by the eurozone debt crisis, banks' balance sheets and revenues suffered a multiyear decline as they deleveraged and cleaned up legacy NPEs. This phase has now ended and the sectors' loan portfolios are expanding again, helping to lessen the effect of margin attrition on net interest income (for example, see For Italian Banks, The Big Test Could Come In 2021, published on Jan. 13, 2021).

4. Tap central bank funding programs

Following the onset of COVID-19, European central banks expanded funding programs to encourage commercial banks to maintain credit availability. The ECB eased the terms of its third targeted long-term refinancing operations (TLTRO III), providing funds at an interest rate as low as -1% if banks do not shrink outstanding loans. A broad range of eurozone banks have enthusiastically accepted this cheap funding, supporting margins and showing that there is no stigma associated with it (see chart 11). In December 2020, the ECB extended the TLTRO III drawdown window to mid-2022 and increased permitted borrowing to 55% of eligible lending.

Chart 11

The ECB's lending survey indicates that banks tapped TLTRO III primarily to support their profitability. A secondary factor was to mitigate the risk of tighter conditions developing in funding markets. The funds obtained from TLTRO III were mostly used to meet the strong demand for loans during the pandemic, particularly under revolving corporate credit facilities in the early stages of the pandemic and more recently through government-guaranteed loan programs (see chart 12). Although government-guaranteed loans pay relatively low interest rates, they are low risk to the lending banks and funding them through TLTRO III supports their margin and profit contributions. A material portion of TLTRO III funds has been deposited back at the ECB or used to purchase financial assets including government bonds, in both cases delivering a positive carry.

Chart 12

As the ECB's balance sheet has expanded, banks' aggregate balances on their ECB current accounts and deposit facility have ballooned to €3.7 trillion. This is slightly more than twice the outstanding funding under TLTROs. Similar to other central banks with negative interest rate policies, the ECB's tiered rates policy reduces the extent of margin dilution from these central deposits. Specifically, the ECB pays 0% interest on balances up to six times banks' minimum reserve requirements, and -0.5% on the excess. Therefore, banks can earn 50-100 basis points by borrowing from TLTRO III and placing the funds back with the ECB.

5. Grow non-interest income

As interest income remains under pressure, banks are looking to grow non-interest income where possible. This includes introducing or increasing fees and commissions when competitive conditions allow and subject to conduct-of-business regulatory requirements. Asset management, private banking, and insurance products have also been a growth opportunity for banks active in those markets as depositors look for better returns, with increased cross-sales through digital channels. Still, fees and commissions have provided limited uplift to revenues and were notably lower after banks waived certain charges in response to the pandemic (see chart 13).

Chart 13

Trading income was a mixed picture for European banks in 2020. Market conditions were highly favorable in most segments, particularly fixed income. However, some Western European banks incurred outsized losses in structured equity derivatives after the pandemic caused a wide range of companies to cut dividends. The outlook for trading revenues depends on market volatility and client activity, which are unlikely to maintain the heights of last year, but should still remain largely favorable.

Margin Erosion Adds Further Impetus To Address Structural Inefficiencies

With margins and revenues likely to remain under sustained pressure, Western European banks have renewed incentive to tackle their structurally high costs (see European Banks Count The Cost Of Inefficiency, published on Oct. 22, 2019). Efficiency ratios vary significantly across the region but remain stubbornly high in many cases (see chart 14). There are signs of progress in addressing "run-the-bank" costs such as staff and property but this is often masked by "change-the-bank" technology investments. The pandemic has accelerated changes in working and customer service practices that banks can harness to increase the pace of efficiency improvements, albeit with some upfront costs to realize these changes.

Chart 14

In addition to organic measures to lower costs, sector consolidation has potential to achieve cost synergies and reduce excess capacity. The ECB has adopted a more supportive stance on mergers and acquisitions and this likely contributed to the in-market deals in Italy and Spain last year (see ECB Confirms Easing Of Regulatory Hurdles To Eurozone Bank Consolidation, published on Jan. 12, 2021). We still see sizable barriers to transformational cross-border mergers, but we think the catalysts for consolidation have become stronger (see chart 15). Well-designed and well-executed integration is not easy to deliver, but could offer a solution to banks' profitability challenges by establishing fewer, larger groups with greater pricing power and economies of scale.

Chart 15

Persistent revenue challenges may lead more banks to reassess the medium-term earnings potential of business units that are underperforming or are second-tier players in their markets. Those considered unlikely to meet targeted returns could be downsized or sold. For example, following the breakdown of its merger talks with BBVA, Banco de Sabadell announced that it is considering various strategic options for its U.K. subsidiary TSB Banking Group, and BBVA announced the sale of its U.S. subsidiary shortly before that. We could lower our group status classifications and ratings on subsidiaries that we think may become less integral to their parents' strategies.

Sub-Par Earnings Prospects Could Drive Further Rating Actions

Mediocre profitability is a longstanding structural weakness for many Western European banks and the COVID-19 pandemic adds further pressure by raising impairment charges. The sector's earnings would clearly benefit from interest rate hikes and a steeper yield curve, but these are currently remote prospects. Instead, we look for banks to act more decisively to tackle their weaknesses, including poor cost efficiency. Meeting stakeholders' earnings expectations is important to banks' creditworthiness because it supports long-term business stability, and strong profit generation offers valuable protection to core capitalization in a downturn.

We assess earnings prospects in our BICRA and bank analysis. We could revise selected negative outlooks to stable if we become more confident in the trajectory of the economic recovery from the pandemic and the medium-term profitability of banks' business models. However, we could lower our assessments of systems or individual institutions that, in our view, could struggle to meet our previous earnings expectations. For example, we lowered our business position assessments on HSBC Holdings and Société Générale last year for this reason (see HSBC Holdings Ratings Lowered To 'A-/A-2' On Muted Earnings Prospects And Extensive Restructuring; Outlook Stable, published on May 13, 2020 and Societe Generale Outlook To Negative On Profitability Challenges; Ratings Affirmed; Hybrid And Sub Debt Downgraded, published on May 15, 2020). In addition, we currently have negative industry risk trends on the French, German, and Irish BICRAs due to cost efficiency and profitability concerns, and these inform our negative outlooks on many banks in those countries. We could adopt a similar stance on other banking systems that exhibit comparable trends.

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.

Related Research

• Spanish Banks Need To Bolster Provisions, Cut Costs, And Preserve Capital In 2021, Jan. 25, 2021
• French Bank Outlook 2021: All About Efficiency And Asset Quality, Jan. 21, 2021
• For Italian Banks, The Big Test Could Come In 2021, Jan. 13, 2021
• Bulletin: ECB Confirms Easing Of Regulatory Hurdles To Eurozone Bank Consolidation, Jan. 12, 2021
• U.K. Banks Face A Bumpy Road To Earnings Recovery In 2021, Jan. 11, 2021
• The European Sovereign-Bank Nexus Deepens By €200 Billion, Sept. 21, 2020
• Societe Generale Outlook To Negative On Profitability Challenges; Ratings Affirmed; Hybrid And Sub Debt Downgraded, May 15, 2020
• HSBC Holdings Ratings Lowered To 'A-/A-2' On Muted Earnings Prospects And Extensive Restructuring; Outlook Stable, May 13, 2020
• Report Looks Into What Lower For Longer Means For Japanese And European Banks, Feb. 19, 2020
• European Banks Count The Cost Of Inefficiency, Oct. 22, 2019