The return of rising interest rates should be good news for banks in Europe, the Middle East, and Africa (EMEA). Banks reported strong performance in the first three quarters of 2022, supported by solid capital and funding profiles, and still-good asset quality. Margins were boosted by the increase in interest rates. Nevertheless, S&P Global Ratings believes that Europe's gloomier economic outlook could counteract this effect, denting banks' business prospects, weighing on asset quality, and increasing operating costs in 2023 and possibly beyond.

Over the next one to two years, we expect Europe's macroeconomic environment to become more challenging. That said, banking sectors in some of EMEA's emerging markets--such as the commodity-exporting countries of the Middle East--could continue to benefit from a supportive macroeconomic environment, allowing higher rates to bolster profitability.

Given the ongoing energy price crisis, we expect downside risks to increase. Russia has been compensating for its lack of progress in the military conflict with Ukraine by weaponizing its position as a key energy supplier, which is fueling inflation across Europe. Governments are facing demands to support consumers and businesses, given the growing inflationary and cost-of-living pressures. The tightening financing conditions could exacerbate the problem, undermining more-vulnerable economies and weaker players. A prolonged period of rising inflation and low economic growth would increase risks for financial institutions.

In our view, the key risks for banking sectors in EMEA over the next two years include:

• A fully fledged recession in Europe, which could have a severe impact on asset quality, and on banks' business and profitability prospects.
• Persistently high inflation, which would drive up the cost of living and squeeze financial conditions for households and corporates. This would erode demand for new lending and weaken asset quality and make it difficult for banks to contain operating costs.
• Heightened market turbulence, which could restrict access to financing and increasing the cost of funding. This would put riskier borrowers at even greater risk, ultimately pushing up banks' credit costs and depressing their profits. Banks could also see higher mark-to-market losses and weaker earnings from activities such as asset management, and an increase in unexpected event risk.
• Fierce competition between the best-in-class banks and those that lag behind. By delivering a commercially viable and operationally resilient business model that offers improved efficiency and digital transformation, more advanced banks and fintech providers are able to cope with rapid changes to the operating environment--and in particular, to customer preferences.
• Widespread, high-impact cyber attack events and threats to critical infrastructure. Banks have invested heavily to protect their systems and clients against potential threats, and have managed their respective risks well so far. However, recent threats to some infrastructure elements considered critical (such as the transcontinental underwater data cables that connect Europe with other parts of the world) prompted a pledge from the European Commission to increase protection of critical infrastructure.

Economic Slump Has Yet To Dent The Stable Bias

Our ratings on financial institutions in EMEA still have mostly stable outlooks. Similarly, we see stable economic and industry trends for most of our Banking Industry Country Risk Assessments (BICRAs) on EMEA markets. There are a few, mostly negative, exceptions--the economic risk trends for Germany, Malta, and Turkiye are negative, and Austria, Poland, Turkiye, and Tunisia also have negative industry risk trends. At the same time, we see a positive industry risk trend for Greece.

The stable bias indicates that we still expect most financial institutions in EMEA to demonstrate resilient performance over the next 12-24 months. Although the waning outlook for economic growth and the deteriorating environment will take a toll on them, EMEA banks are well prepared for the coming period of uncertainty. 2021 likely saw a peak in bank capitalization, even as distributions to shareholders resumed. Even though we expect some decline in banks' capital positions, they are likely to remain solid. Many EMEA banks have reported that profitability has remained strong since the beginning of 2022, which will support their capital buffers. Many banks have also tried to hang on to the residual, sometimes substantial, pandemic-related overlay provisions they created back in 2020. Despite reporting still-good asset quality through the end of the third quarter, asset quality indicators, and therefore credit costs and provisioning, are likely to deteriorate as we move into 2023.

Forecast GDP Has Been Shrinking Across EMEA

The prolonged Russia-Ukraine conflict has exacerbated Europe's energy crisis and increased inflation. This forced central banks in Europe to tighten monetary policy, and created a growing burden for governments as they implemented measures to protect households and businesses from exorbitant energy bills and supply shortages over the winter. On average, EU countries have announced packages valued at about 3% of GDP on a net basis at present prices, and accepted the risk that costs to government could increase if energy prices rebound, having receded since August. This has weighed on Europe's growth prospects.

Our current GDP growth forecasts are thus lower than those we published at the beginning of this year. Regions and countries that are more dependent on Russian gas and suffering from higher inflation will experience the highest economic hit; these include Germany, Italy, Central and Eastern Europe, and the U.K. Political uncertainty has increased the risks to some countries in the region.

Solid Performance So Far In 2022, But Future Progress Is Clouded

Over the next few quarters, we expect net interest margins to widen further, thus boosting banks' pre-provision earnings; at the same time, central banks are likely to continue tightening monetary policy. Banks have enjoyed access to ample and inexpensive funding in recent years. Going forward, by contrast, they will seek to pass along their own higher funding costs to borrowers, as policy rates are expected to continue rising. Eurozone banks are due to repay €1.5 trillion of targeted longer-term refinancing operations (TLTROs) borrowings in 2023. Banks have accumulated sizable liquidity buffers and many tapped the markets earlier in the year, anticipating that this would put them in a comfortable position when their TLTRO borrowings came due. However, if they intend to issue additional debt to partly replace their TLTRO borrowings, that debt will now carry a substantially higher price.

Rising inflation across EMEA will weigh on operating costs, especially in banks that operate in countries where salaries are indexed to inflation. Banks that actively invested in digital transformation may have gained some protection against the growing cost burden.

Worsening Asset Quality Will Have An Uneven Effect On Banks' Lending Books

To date, asset quality has largely held up, but we anticipate the deterioration through 2023 will take credit costs back to pre-pandemic levels and potentially beyond. We expect to see significant variation in the performance of borrowers over the next 12-24 months. As consumers gained confidence that pandemic restrictions were behind them, the recovery in sectors like tourism and travel has gained strength. However, rising energy prices are likely to take a toll on energy-intensive sectors such as transport, chemicals, utilities, metals, autos, building materials, and construction. Performance is also likely to deteriorate for consumer discretionary sectors, as high inflation erodes purchasing power in various economies across EMEA. Commercial and residential real estate valuations have also started to fall. Rising financing costs will squeeze sectors that are less able to pass on higher costs to customers--some are already suffering from tighter financing conditions. In addition, small and midsize enterprises are likely to be more vulnerable than large companies.

We Expect Mortgage Portfolios To Remain Resilient

The growing cost of living has started to produce early warning signs for the unsecured retail lending segment. That said, we expect mortgage portfolio performance at most of the large European lenders to remain resilient over the next 12-24 months. We also observed a strong savings trend across EMEA over the first two years of the pandemic, which should help mortgage borrowers weather the deteriorating environment. In addition, governments have deployed measures to help households weather the energy crisis, and stronger bank underwriting standards in previous years--including stress-testing of affordability--should mean that borrowers have some capacity to absorb higher borrowing costs.

Employment dynamics are still relatively supportive. We consider that this, combined with government support measures in response to the energy crisis and the prevalence of fixed-rate mortgages in certain markets, will provide some additional protection to borrowers from the increasing debt burden. This should help keep credit quality under control for the next few years.

Nevertheless, we will monitor property market trends, particularly markets that show signs of overvaluation and that experienced a rapid growth in prices and mortgage volumes during the years when interest rates were at historically low levels. In these markets--which include the U.K., Iceland, Sweden, Czech Republic, Luxembourg, Netherlands, Austria, and Denmark--weaker confidence and rising rates could lead to price corrections. The affordability of houses in Europe has been declining over the past thirty years, and rising interest rates are likely to prompt a slowdown in house price growth in the major European housing markets (see "Economic Research: European Housing Markets: Soft Landing Ahead," published July 13, 2022).

Not Calling Hybrid Instruments At The Optional Call Date May Become More Common

The key question for investors in bank hybrid capital instruments is whether banks will call their hybrid instruments when they hit an optional call date. Recently, Sabadell decided to not call its 6.125% €400 million additional Tier 1 (AT1) security. Given the rising interest rates, more banks might follow the same route. In our view, this is economically rational behavior, rather than an indication of capital or credit strains.

In our view, noncalls are therefore unlikely to hamper a bank's ability to tap debt markets in future. Several of the banks that made such a decision in recent years have subsequently been able to issue new hybrids at comparable costs to other issuers. Under our criteria, a bank's decision not to call the hybrid instrument on an optional call date does not constitute a default. Indeed, the optional nature of a call (and, thus, an issuer's ability to choose whether to call or not) is a key equity-like feature of hybrids, which enhances an issuer's flexibility in how it uses a hybrid instrument to manage its capital.

Some Emerging Economies Are Better Positioned Than Others

Tightening financing conditions, slower growth in China, weaker economic prospects in Europe, and a recession in the U.S. that could prove deeper than expected all signal tough times ahead for EMEA's emerging markets. Rising inflation and the growing cost of international borrowing will increase the vulnerability of markets that depend on external financing, such as Turkiye.

At the same time, large commodity-exporting countries could benefit from the current price trends--especially those that derive significant revenue from the oil and gas sector. We view Kazakhstan, Azerbaijan and the oil-producing emerging markets of the Gulf Cooperation Council (GCC) as well positioned to benefit from current energy price dynamics.

Similarly, since the Russia-Ukraine conflict broke out, we have observed that some of the neighboring countries have benefitted from an inflow of people and capital and the redirection of trade flows within the region. This occurred because of concerns related to the conflict and the sanctions imposed on Russia, and because many businesses have decided to leave Russia since the beginning of the conflict. As a result, we forecast strong GDP growth for Armenia, Georgia, and Uzbekistan. That said, the positive changes may not last into the medium-to-long term.

Key Banking Sector Risks In EMEA

The table below presents S&P Global Ratings' views about the key risks and risk trends affecting the banking sectors in EMEA where we rate banks. For more detailed information, please refer to the latest Banking Industry Country Risk Assessment (BICRA) on a given country. According to our methodology, BICRAs fall into groups from '1' to '10', ranging from what we view as the lowest-risk banking systems (group '1') to the highest-risk (group '10').

Selected Research

We recently published several articles highlighting our views on EMEA banking sectors:

• Inflation's Impact On Argentine And Turkish Banks Will Depend On Its Pace And Banks' Balance Sheet Structure, Oct. 10, 2022
• Bulletin: U.K. Bank Ratings Are Not Directly Affected By The Sovereign Outlook Revision, But Macroeconomic Risks Are Rising, Sept. 30, 2022
• Rising Recession Risks Cloud Eurozone Banks' Earnings Prospects, Sept. 30, 2022
• The Resolution Story For Europe's Banks: The Final Push To Resolvability, Sept. 30, 2022
• Nigerian Banks Face Earnings Dip After Latest Policy Rate Hike, Sept. 30, 2022
• GCC Banks Return To Form, Can It Last? Sept. 22, 2022
• U.K. Banks Face The Weakening Macroeconomy From A Resilient Balance Sheet Position, Sept. 21, 2022
• European G-SIBs Monitor H1 2022: Rising Margins Offset Higher Inflation, Sept. 19, 2022
• Various Rating Actions Taken On Portuguese Banks Amid Easing Funding Risks And Sovereign Upgrade, Sept. 16, 2022
• Nordic Banks: Robust Capital Provides Cushion Against Tougher Times, Sept. 6, 2022
• Islamic Finance In The U.K. Is Still Learning To Crawl, Sept. 1, 2022
• Sub-Saharan Africa Remains Out Of Step With Islamic Finance, Aug. 16, 2022
• Multiple Point Of Entry Resolution: Analytical Considerations For Groups Designed To Fragment In Crisis, Aug. 11, 2022
• Higher Rates Spur U.K. Banks' Strong First-Half Earnings Amid A Weakening Economic Outlook, Aug. 10, 2022
• Outlook On 11 Italian Banks Revised To Stable From Positive Following Similar Action On Sovereign; Ratings Affirmed, July 29, 2022
• Polish Banks To Be Hit By Government Action Allowing Broad-Based "Credit Holidays", July 20, 2022
• Global Bank Credit Loss Forecasts: Higher Losses Ahead, July 20, 2022
• ECB Stress Test: Eurozone Banks Need To Do More To Comprehend Climate Risk, July 11, 2022
• The New Normal For Eurozone Banks: Strong Funding Franchises Are Back In Vogue, July 7, 2022
• Bulletin: Geopolitical Risks Add Headwinds For German Banks, Despite Robust Capitalization, July 19, 2022

The Future Of Banking

Technological disruption leads to new customer expectations and new forms of competition, but also offers new opportunities for banks. All these trends may ultimately influence the credit profiles of banking industries across the globe. We have published several articles highlighting our views on the readiness of various banking sectors to face the challenges and opportunities arising from the development of financial technology and digital transformation:

• The Future Of Banking: Adding A Banking License To Companies' Menus Might Be A Recipe For Success, Oct. 11, 2022
• The Current Crypto Downturn Is A Timely Wake-Up Call, May 13, 2022
• Tech Disruption In Retail Banking: Portuguese Banks' Adaptation To Digital Needs Heavy Investments, April 4, 2022
• Cryptos Won't Blunt The Sting Of Sanctions On Russia, March 4, 2022

Economic, Sovereign, And Other Research

• Sector And Industry Variables | Criteria | Financial Institutions | Banks: Banking Industry Country Risk Assessment Update: October 2022, Oct. 27, 2022
• Credit Trends: Credit Cycle Indicator Q4 2022: Course Correction, Oct. 10, 2022
• Research Update: United Kingdom Outlook Revised To Negative On Rising Fiscal Risks; 'AA/A-1+' Ratings Affirmed, Sept. 30, 2022
• Q4 2022 Credit Conditions Report Indicates Clouds Are Gathering In Emerging Markets, Sept. 27, 2022
• Economic Research: Economic Outlook Eurozone Q4 2022: Crunch Time, Sept. 26, 2022
• South Africa's Risk From FATF's Grey Listing Depends On Institutional Reform Momentum, Sept. 8, 2022
• Europe Braces For A Bleak Winter: A Downside Scenario Assuming A Russian Gas Cutoff, Aug. 29, 2022
• EMEA Emerging Markets Sovereign Rating Trends Midyear 2022: Hard Times, July 19, 2022
• Economic Research: European Housing Markets: Soft Landing Ahead, July 13, 2022

BICRA Changes

Over the past quarter, we made the following changes to our BICRAs.

Cyprus

We have revised our economic risk score for Cyprus to '7' from '8'. Cypriot banks have made substantial progress in the clean-up of problematic loans since 2018 and improved underwriting standards. Following four years of nonperforming loan (NPL) sales, debt-to-asset swaps, loan recoveries, and write-offs, systemwide legacy NPLs have reduced by more than €7 billion or 71% since 2018. Furthermore, banks' risk profiles have so far proven resilient to the effects of COVID-19, with only 3% of loans that benefitted from the widely used moratoriums becoming nonperforming. Banks are maintaining stricter underwriting standards, which should contribute to lower asset quality deterioration in coming quarters.

Georgia

We have revised our BICRA for Georgia to group 7 from group 8, and our economic risk score to '7' from '8'. Economic risks faced by banks in Georgia have diminished, in our view, given our expectation of national GDP growth of 8% in 2022 and 3% in 2023. This should translate into favorable growth and profitability prospects for most domestic banks. We expect credit in the Georgian banking system to expand about 5%-10% annually in 2022-2023, taking into account exchange rate adjustments, and that private sector debt will remain at stable levels.

Germany

We have revised our economic risk trend for Germany to negative from stable. We believe that economic risks for the German economy are increasing due to the country's substantial exposure to energy sourcing from Russia, which makes it vulnerable to a potential gas shutdown. Should this adverse scenario occur, the resulting economic shock and implications for the country's growth potential in the medium term could impair asset quality for corporate and consumer loans made by German banks, given the country's export dependence and the longer-than-expected disruptions in global supply chains.

Greece

We have revised our economic risk score for Greece to '7' from '8'. Greek banks have made material progress since 2018, significantly reducing their nonperforming asset (NPA) stock and NPA ratios. Following three years of nonperforming loan (NPL) sales and securitizations in large amounts, with the help of the Hercules Asset Protection Scheme, systemwide legacy NPLs have reduced by more than €50 billion since 2019. This prompted the systemwide NPA ratio to drop to 15.9% in 2021 from 42.0% in 2019. Asset quality's resilience to COVID-19 fallout supported the NPA improvement. Given the upcoming sales of additional NPLs, we expect the systemwide NPA ratio to drop below 10% by year-end 2022. As a result, the cost of risk should be less of a burden for banks in the next 12-18 months. Furthermore, domestic property prices have continued to rise steadily, even during the pandemic, which supports the recovery prospects of the remaining NPLs.

We have also revised our industry risk trend for Greece to positive from stable. Strong deposits formation since 2018, alongside the massive balance-sheet clean-up, supports our view that Greek banks have continued to rebalance their funding profiles, thanks to improving confidence of domestic depositors. However, medium-term challenges remain. In the past five years, systemwide deposits in Greece increased by more than €50 billion to €188 billion. This marked a turnaround for the banks, considering the loss of about €40 billion of their €173 billion in deposits during 2014. Improving macro fundamentals since 2017 allowed Greek banks to tap debt markets abroad for their senior secured, unsecured, and subordinated debt needs. This was also thanks to the ongoing support from the European Central Bank in various forms.

Iceland

We have revised our economic risk score for Iceland to '5' from '4'. We believe that significant and persistent property price growth over the past two years has rapidly raised the economic risks facing Iceland's lenders. In the two years to April 2022, property prices rose 30% above the general level of other consumer prices in the economy. This has decoupled house prices from their fundamental determinants, most notably wages. In addition, the jump in household debt to above 80% of GDP--structurally higher than close to 75% before the pandemic--is unlikely to unwind and could rise further. We believe that, taken together, this has raised the risk of a correction and its potentially severe consequences for Icelandic banks. With the aforementioned change to Iceland's economic risk score, we have also revised our economic risk trend for Iceland to stable from negative.

We have also revised our industry risk score for Iceland to '5' from '6'. We consider that the now-lower nonbank participation in the mortgage market has reduced the threat to Icelandic banks' capacity to price rationally for risk. At the same time, we think the banks' improving risk-adjusted earnings will continue to underpin their resilience to the significant re-entry of nonbank players, should it occur. Together, these factors underpin our view that Icelandic banks now face lower industry risk.

Italy

We have revised our economic risk trend for Italy to stable from positive. Italian banks' creditworthiness remains closely intertwined with that of the sovereign and domestic economic dynamics. Firstly, the domestic banking sector has large holdings of Italian government bonds in their securities portfolios. Secondly, banks' business and financial performance has a strong correlation with the domestic economy. Finally, the cost of Italian banks' wholesale funding has historically been highly correlated with that of the sovereign. For these reasons, we believe that the sovereign's creditworthiness continues to affect, to different extents, Italian banks' credit profiles.

Portugal

We have revised our BICRA for Portugal to group 5 from group 6, and our industry risk score to '5' from '6'. Portuguese banks have significantly rebalanced their funding profiles in the past decade. Deposits account for the bulk of their funding structures, and exceed their loan books, with the system's loan-to-deposit ratio at below 80%, according to European Central Bank Supervisory Statistics, down from more than 130% a decade ago. In 2021, customer deposits rose by almost 9% year on year. Historically, deposits have proven fairly stable, even in difficult times. In addition, Portuguese banks' reliance on external debt is now much more limited than a decade ago. Banks have only occasionally tapped the foreign debt markets to build up their minimum requirement for own funds and eligible liabilities in recent years. Lastly, we believe that, while they accessed targeted longer-term refinancing operations (TLTRO) facilities to a significant amount (total outstanding €22 billion as of year-end 2021, or about 10% of total liabilities, according to our calculations), Portuguese banks have the capacity to repay upcoming TLTRO maturities in 2023-2024 with existing liquidity buffers, and still maintain comfortable regulatory ratios. In particular, we estimate that the liquidity coverage ratio and net stable funding ratio of Portugal's banking system will stand at about 240% and 131%, respectively, after full TLTRO repayment.

With the aforementioned changes, we also revised our industry risk trend for Portugal to stable from positive.

Russia

We withdrew our BICRA on Russia.

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Table 3

Recent Rating Actions: EMEA Banks

Table 4