Europe is facing a difficult and uncertain geopolitical and economic outlook. The energy supply squeeze that is fueling exorbitant energy prices, the threat of rationing, political instability, disrupted supply chains, and other inflationary pressures have triggered disparate national fiscal measures to support consumers and businesses, while central banks are recalibrating policy rates in quick order (see Credit Conditions Europe Q4 2022: Hunkering Down For Winter, published Sept. 27, 2022).

S&P Global Ratings' economists now consider that a sharp economic slowdown in the eurozone is imminent. This would mainly be driven by a contraction in consumer spending, which could be quite severe in the final quarter of 2022 and the first quarter of 2023 (see: Economic Outlook Eurozone Q4 2022: Crunch Time, published Sept. 26, 2022). Investment is also likely to suffer from the lack of visibility around developments in the Russia-Ukraine war and as companies see a dampening in consumer spending. For eurozone banks, this will undoubtedly lead to reduced business activity and lending volumes. However, full-year 2022 results should remain broadly positive given the strong first half. We estimate that significant eurozone banks (i.e., the 110 largest banking groups directly supervised by the European Central Bank) will post an average 6.1%-7.0% return on equity (RoE) in 2022, broadly stable compared to last year (6.7%).

For 2023, the range of potential outcomes is broad and will ultimately depend on whether a full-blown eurozone recession scenario materializes. Our economists now estimate this to have a 47% probability, albeit with a relatively more benign stagnation scenario under their base case. This scenario would likely see a slight increase in profits for eurozone banks, with the gradual benefits of rising interest rates more than offsetting rising costs. Under our downside case--a full-blown but short-lived recession--the rise in net interest income would be more moderate as net lending would decline, while credit costs could jump to levels seen at the start of the pandemic. In this case, eurozone banks would experience depressed profitability, far below their cost of capital, with an average RoE estimated at 2.4%-4.6%.

For most eurozone banks, a recession would materially dent profits. It could also erode regulatory capital ratios as higher risks inflate risk-weighted assets (RWAs). These factors are unlikely to pose a severe threat to banks' overall financial resilience and soundness, however, given the backdrop of rising rates. What's more, eurozone banks entered this crisis with elevated capital and liquidity buffers, which should help them to weather these risks. Asset quality will be key to this, and the final impact of a recession on bank provisions would largely depend on each bank's relative exposure to sectors that are most at risk. The strength of their risk management frameworks and potential government intervention to accelerate the ensuing recovery and mitigate the impact on borrowers--and therefore indirectly on banks' asset quality--will also be crucial factors that we will monitor as the eurozone enters this difficult economic period.

Table 1

Chart 1

Base Case

A sharp economic slowdown leading to reduced business activity and a pick-up in credit costs

After a strong first half, our economists now expect a sharp slowdown in eurozone activity in the fourth quarter of 2022 and first quarter of 2023. Overall, they estimate that the eurozone economy will be close to stagnation in 2023 (+0.3% GDP growth compared with 1.9% in their previous forecast) with inflation remaining elevated (5.2% in 2023 after 8.2% in 2022). According to our economists, the slowdown will mostly result from a contraction in consumer spending that will likely be quite severe in the final quarter of 2022 and the first quarter of next year. The impact on unemployment is unlikely to be significant, however, with a slight potential increase to 7% in 2023 from 6.7% this year. At the same time, the ECB has frontloaded its interest rate hikes, and our economists now expect that the terminal refinancing rate of the ECB could be reached at 2.5% by the end of first-quarter 2023.

Although volatile and prone to downside risks, this economic environment is not entirely negative for banks. First, rising interest rates have already started to boost eurozone banks' net interest income since the beginning of this year. Significant eurozone banks' aggregate net interest income rose 5% year on year in the last quarter, and the largest European banks reported revenue growth in the high single to double digits in the first half (see European G-SIBs Monitor H1 2022: Rising Margins Offset Higher Inflation, published Sept. 19, 2022). We expect the benefits of rising rates to continue to boost eurozone banks in the coming quarters, particularly following the ECB's policy rate moves and guidance for further hikes ahead. We now expect low-double-digit growth in net interest income in 2023, which could bring around €30 billion-€40 billion in additional annual revenues in 2023 to significant eurozone banks--a material buffer against potentially rising costs.

After a strong start to the year, we expect noninterest income to slow down later this year and in 2023, in line with economic activity. We could see varying outcomes, however. Trading activities, for example, will likely remain strong as market volatility augments client demand for hedging products. On the other hand, the likely deceleration in economic activity could hamper advisory and other fee-related businesses.

On the cost side, eurozone banks have started to report higher operational expenses in the first half in line with rising inflation. The effect is uneven, though, as some countries have a rigid wage review structure linked to inflation, while the transmission is slower and more negotiable in others--but the trend is unmistakable. Credit costs have remained modest, with only limited pockets of risk necessitating additional provisioning (such as exposures to Russia).

For 2023, we expect new provisions to represent a still-manageable 60-70 basis points (bps) of customer loans. This is in line with 2019 and pre-pandemic trends and higher than the 50bps reported in 2021. A sharp but short-lived economic slowdown will likely damage the creditworthiness of weaker borrowers, starting with small and midsize enterprises (SMEs) facing higher costs and lower demand, and having limited capacity to diversify their revenue streams. Similarly, subprime borrowers with unsecured retail loans will likely find it difficult to service their debt.

So far, banks have not reported any asset quality deterioration and we don't expect larger corporates or average households to face material difficulties in servicing their debt under our base case. Notably, we expect household strength and a preponderance of fixed-rate borrowing to help residential mortgage asset quality to remain generally strong. This view is supported by the still-benign situation in the job market, with only a moderate uptick in unemployment expected by our economists for 2023.

Overall, we expect significant eurozone banks' pretax profits to be broadly stable in 2022-2023 compared to 2021. This will depend on individual banks' rate sensitivity, though, as well as their relative exposure to sectors that are most at risk, such as SME and unsecured retail lending.

Chart 2

Downside Case

A full-blown eurozone recession, coupled with elevated inflation, significantly denting eurozone banks' profits in 2023

Our economists see a significant risk of a full-blown recession by 2023, currently assessed at a 47% probability according to their models. A full-blown recession would mean a contraction in activity greater than one standard deviation from potential growth for at least two consecutive quarters, spreading across geographies, sectors, incomes, and the labor market. Under this scenario, central banks would hike interest rates, which would further tighten financing conditions.

This scenario would undoubtedly be detrimental for eurozone banks as rising operational and credit costs would significantly dent profits. We would also expect to see the following:

• Limited impact on net interest income compared with our base case, as higher interest rates would offset a decline in net lending;
• Depressed noninterest income as this tends to correlate with overall economic activity;
• Significantly higher costs than under our base case, with inflation fueling noninterest expenses;
• Recessionary trends that could lead banks to hike provisions to a level similar to that seen at the height of pandemic (i.e., in the range of 80-100 bps of total customer loans; and
• Largely declining profits of significant eurozone banks, with RoE likely decreasing to around 2.4%-4.6% in 2023.

Chart 3

Under this scenario, we estimate that new provisions could reach up to €100 billion in 2023, close to levels seen in 2020 at the onset of the pandemic (€118 billion for all large eurozone systemic banks, representing 1.1% of total customer loans at the time). We also ran a sensitivity analysis on this provisioning amount--up to 1.2% of total customer loans--in the event that provisioning levels rise even further. In this worse-case scenario and depending on the assumed level of loan growth, the provisioning amount could reach a maximum of around €150 billion. Nonetheless, we expect that eurozone banks would still post positive pretax profits in 2023 in aggregate, even under this scenario and all else being equal. That said, we would not rule out that some eurozone banks could be lossmaking under this scenario given their diverse business models and loan book composition.

Table 2

We therefore think that most eurozone banks would be able to manage a full-blown recession as it would mainly represent an earnings event rather than erode their capital bases. First, net interest income would still rise (although less than in our base case due to negative loan growth) thanks to higher interest rates providing a buffer against some of the increased costs. Second, risk-based regulatory capital ratios would likely tighten in a recession scenario as rating migration in portfolios would drive RWAs higher. We note, however, that eurozone banks entered this crisis with generally very high capital ratios (see chart 4). Facing a recession, eurozone banks would also be able to lower shareholder distributions to preserve their capital, and we believe that regulators would likely push weaker banks in that direction.

Chart 4

Finally, we note that large eurozone banks already hold large amounts of provisions, which they built up in 2020 and have mostly maintained until now through management overlays (see chart 5). We have not assumed the release of these provisions as an offsetting factor in our modelling, meaning that they provide a buffer to our base and downside projections for the cost of risk.

Chart 5

Managing The Downside

A full-blown recession triggered by a sharp contraction in consumer spending and falling investment would test the resilience of corporate borrowers and households.

First, weaker corporate borrowers (e.g., SMEs) that face exorbitant energy bills and declining demand for their products will likely encounter margin erosion and, for the weakest, difficulties in servicing their debts. For banks, this will translate into requests for bridge financing and restructuring of existing credits, for instance to extend repayment maturities. In their internal ratings-based (IRB) models, significant eurozone banks tend to assume higher probabilities of defaults and loss rates for SMEs relative to other corporates, a sign of the typically weaker performance of this sector (see chart 6).

Chart 6

Second, households will likely increase savings to protect their financial positions. The energy price caps that several governments introduced as fiscal support will curtail some of the budget squeeze, but households with the weakest financial positions may need to start prioritizing the most necessary payments (such as food and housing). Given that households tend to prioritize mortgage and car loan payments, we expect to see asset quality weaken fastest in other unsecured borrowing, including revolving exposures like credit cards. Once again, the probability of defaults assigned by eurozone IRB banks to qualifying revolving exposures is significantly higher than that assigned to retail exposures overall (see chart 7).

Chart 7

Beyond this, the performance of banks' broader retail portfolios will largely depend on the strength of the job market. This is particularly the case for residential mortgages, which account for around 60%-90% of total retail portfolios in most European countries. Significant rises in retail loan delinquencies tend to be primarily correlated with unemployment. Until now, the eurozone job market has continued to show strong progress despite the cloudier economic outlook. Our economists expect that a strong job market would remain a supporting factor for the eurozone and, in turn, for European banks' credit quality.

For rated European banks, the two portfolios that are most imminently at risk (SMEs and unsecured retail) tend to represent a small relative share of total exposures (see charts 8-10). For SME lending, rated Danish and Swedish banks are most exposed, with SME loans accounting for about one third of total corporate exposure at default (EAD)--equivalent to around 10% of total EAD. On the retail side, qualifying revolving exposures (credit cards) tend to represent a minor share of total EAD--the highest share is for U.K. rated banks, representing around 9% of total retail EAD (though equivalent to less than 3% of total EAD only). The highest exposures are outside the eurozone.

Chart 8

Chart 9

Chart 10

A full-blown recession could lead to higher provisions for eurozone banks in 2023. However, a more effective credit risk management framework could help banks to mitigate this to a certain extent. This includes early identification of troubled borrowers, proposed solutions to restructuring loans, or an early exit from the most affected segments to manage down their overall exposures. Another source of differentiation could be the speed at which banks recognize significant increases in credit risk, and therefore migrate portfolios to Stage 2 and start booking provisions against lifetime expected credit losses.

Finally, as seen the during pandemic, intervention from public authorities can also help to mitigate, or even suppress, deteriorating asset quality over time. Should a full-blown recession occur in 2023 because of the war in Ukraine and the ensuing energy crisis, governments will again face difficult decisions around how to distribute the economic impact between households, private corporates, banks, and public balance sheets. The length and depth of the recession will also depend on the measures that national governments take. Policy measures will be selective, reflecting the constraints that each government faces, as well as national preferences. We would also expect to see some degree of European economic solidarity, in the same vein as that established during the pandemic.

A Modest, Though Uneven, Rating Impact

Our expectations for eurozone banks' resilience under our base case support our stable outlook and indicate that we would take few, if any, negative rating actions. These would be limited to banks where there is idiosyncratic weakness or a wider gulf with similarly rated peers.

However, given that our economists ascribe a material probability to the downside scenario, this is highly relevant to our rating view on the sector. The modelled resilience implies that we would not take widespread negative rating actions but could assign negative outlooks or even downgrade banks that we see as less resilient in this downside scenario than our current ratings anticipate.

Finally, we cannot exclude a more negative downside scenario--even if the probability is low. This could occur, for instance, if the geopolitical situation escalates further and would have a greater impact on bank ratings.