European banks will need to come to terms with a new economic environment in 2023, when the unfolding economic reset delivers on its unwelcome promises of higher-for-longer inflation, tighter funding conditions, and lower economic growth.

This will mark a significant change for European banks, whose results for 2022 can be expected to demonstrate the immediate benefits of last years' shift in policy rates. That resulted in widespread profitable growth, underpinned by rising net interest margin (NIM), while inflation had only a muted effect on banks' cost bases. At the same time, volatility generated opportunities for banks with capital markets and treasury services operations, but undermined investment banking revenues.

S&P Global Ratings expects that, in 2023, weaker credit markets will weigh on European banks without tipping the balance of risk into negative territory. Stagnating but generally resilient European economies, and powerful, though easing, tailwinds from rising rates support our base case that rated European banks have the capacity to absorb higher costs, and so remain comfortably profitable. We expect an average return-on-equity of about 7% in 2023, up from 6.3% in 2022. Even under our more negative scenarios, European banks should, on aggregate, remain broadly (though only barely) profitable (see "Rising Recession Risks Cloud Eurozone Banks’ Earnings Prospects," Sept. 30, 2022). We also believe that public authorities' past market reforms and banks' improved risk management will enable markets to avoid financial accidents that turn into full-blown financial crisis, though that remains a risk.

At the same time, we expect the end of extremely low interest rates and low inflation will usher in greater differentiation among European banks' profitability and balance sheet strength. This divergence will be driven by factors, including:

• Europe's economic slowdown during winter, and a likely slow recovery, which will weigh on business growth and contribute to higher credit costs. This will predominantly hurt banks that serve less resilient domestic economies, those most exposed to consumer and small and midsized enterprise (SME) lending, and those that were less prudent during the latter part of the previous economic cycle.
• Inflation's growing effect on banks' cost bases, through wages and the price of services. This will weigh most on banks that haven't streamlined costs or delayed investment (for instance in the digital transition), and those in countries where wages are contractually inflation-linked.
• Tighter funding conditions and an end to cheap and indiscriminate term funding from central banks, which will hurt banks with weaker deposit franchises, uncertain access to market funding, and which are unable to pass higher funding costs to clients. We fundamentally see this as an issue of cost rather than funding availability.
• Market volatility and tighter funding conditions that could expose the riskiest, nonbank financial intermediaries to funding issues, with ripple effects on banks that have significant counterparty risk or rely significantly on income from these companies.

It also seems certain that a volatile political environment will continue to provide challenges over 2023. The possibility that the Russia-Ukraine conflict will escalate remains a key risk, with adverse economic consequences that would extend far beyond the warzone. On the domestic front, some European governments' targeting of banks with windfall taxes (or other forms of social contributions) is likely to continue into 2023, underpinned by the continuing cost-of-living crisis, government fiscal constraints, and the rising profitability of the banking sector.

Finally, we expect a handful of long-term business trends will gain in importance in 2023 and could lead to further ratings differentiation. Stakeholders' will ensure that green and digital transitions, which are both a risk and opportunity, remain a priority for banks' management teams. Established banks will continue their digitalization journey, trying to harness the associated efficiencies and defend their market share from new entrants. We expect that banks with strong funding franchises will be able to use this digital transformation to reinforce their competitiveness against neobanks and nonbank players.

The Economic Reset Will Be Central To European Bank Ratings In 2023.

Banks' fates are largely determined by macroeconomic conditions and more specifically the interplay between the three main variables of economic growth, inflation, and interest rates. That is especially true in Europe, where operations remain focused on deposit-taking and lending in domestic markets.

Prior to 2022, European banks operated in an environment of persistently low inflation, low interest rates, and modest economic growth. Those conditions left most European banks struggling to generate sufficient profit but contributed to an overall improvement in asset quality that facilitated balance sheet strengthening through the prudent building of capital buffers. That, in turn, undermined banks' equity valuations, while leaving them better placed to withstand an economic downturn from a credit standpoint.

The war in Ukraine and the ensuing energy crisis shattered that equilibrium, triggering a macroeconomic reset that will remain a key theme for European banks in 2023. That still unfolding situation means forecasts remain subject to significant uncertainties, but our economists expect headline inflation to gradually recede, while remaining above 2% in the eurozone until at least 2024 (see "Economic Outlook Eurozone Q1 2023: Reality Check," Nov. 28, 2022). We note that the European Central Bank (ECB) forecast is for inflation to remain above the 2% target until 2025.

Higher inflation will lead inevitably to higher interest rates, and our economists forecast the ECB's main deposit facility will reach a terminal rate of 3% in this cycle, up from the current 2%. Higher ECB rates have implications for other European central banks, including the Swiss National Bank (SNB) and the Bank of England (BoE), which despite a recession in the U.K. is likely to increase rates to 4% before pausing, according to our economists (see "European Housing Prices: A Sticky, Gradual Decline," Jan. 11, 2023).

Transition between states of equilibrium creates costs and benefits, as well as risks and opportunities for banks, though these different elements typically manifest at different speeds on profit and loss statements and balance sheets.

A new equilibrium will emerge this year in which banks' risks and costs become more prominent--though to what extent remains uncertain (see table 1). Under our base case, our economists expect a short-lived recession, which should limit costs and risks, while the European job market will prove resilient. This scenario envisages banks reporting slightly rising profits over 2023 (see chart 1). That will still leave many banks failing to make profits that cover their cost of capital--we expect the lowest quartile of rated banks will have an average ROE of under 5%.

Table 1

Chart 1

Higher Rates Continue To Support Net Revenue Growth

The sharp rise in nominal market interest rates had a nascent positive impact on European banks' NIMs in 2022, as predicted by most banks and many market participants. Aided by sustained loan growth of 7% year-on-year, significant eurozone banks' net interest income grew 9%, or about €18 billion over the first nine months of 2022. Rising rates also led to a decline in the fair value of securities held by European banks, though this represents only a minor drag on profits and capital, so far (see "Will Unrealized Losses On Financial Assets Affect Ratings On European Banks?," Jan. 19, 2023).

We expect the majority of rated European banks' NIMs will continue to grow over 2023 and 2024, rising to a median of 1.55% by the end of 2024, up from 1.42% as of the end of 2022. The main drivers will be the gradual repricing of loans, most of which carry fixed-interest rates that delay higher rates' positive effect until refinancing or new origination, as well as the boost from structural hedge programs.

Chart 2

The expected increase in NIMs over the next two years is relatively modest because:

• Bank profitability is influenced by both the overall level of interest rates and the shape of the yield curve, which flattened toward the end of 2022 (and inverted in some countries). Our economists expect that central banks will continue to increase policy rates at least in the first half of 2023, which should support short-term yields. Long-term yields will be influenced by the effects of gradual quantitative tightening policies recently launched or announced by the major European central banks. The central banks' retreat from the bond markets should lead to higher yields, all else being equal, but long-term yields also reflect market expectations of growth and inflation. Our current NIM forecast assumes a slightly upward-sloping yield curve, but the shape of the yield curve will be a key indicator to monitor in 2023.
• The ECB recently changed the terms of its targeted longer-term refinancing operations (TLTRO) terms, and we expect TLTRO repayments to happen quickly in 2023. Anecdotal evidence suggests that the NIM boost from TLTRO was non-negligible for many banks, though that is hard to quantify given banks' various hedging strategies. The boost was likely particularly significant in the second half of 2022, when rising deposit facility rates exacerbated the positive carry trade effect. This will create a negative base effect for 2023.
• European banks are preparing to gradually reprice customer deposits, which account for around 56% of the total liabilities of EU banks. The European Banking Authority (EBA), in the results of its latest Risk Assessment questionnaire (December 2022), indicated that 57% of surveyed EU banks plan to increase the rates offered to retail clients, up from about 20% in the Spring 2022 survey, while 68% planned to increase rates for corporate clients, up from around 30%. Increases in deposit cost remained modest over 2022--we estimate that eurozone banks' deposit betas (the share of policy rate increase that fed through to average deposit costs) was a very low 15% until end November 2022. That was much lower than in the U.S. and U.K., where bank communications suggest deposit betas of around 30%. We consider that eurozone banks' low betas reflect the sizeable liquidity buffers that allowed them to avoid immediate deposit competition, while the regional discrepancy is largely because the ECB raised its policy rates after the U.S. and U.K. authorities and then did so extremely rapidly. European banks' deposit betas should gradually rise over 2023, resulting in a significant drag on NIM (see charts 3, 4, and 5).

The normalization of monetary policy and the tighter funding environment mean that access to cheap and stable sources of funding will, once again, be a source of competitive advantage for some European banks, and therefore a driver of rating differentiation. Where funding weaknesses and strengths were previously obscured by abundant and low-cost liquidity, banks will find the capacity to mobilize resources to fund business growth and seize business opportunities is a key advantage in 2023.

Chart 3

Chart 4

Chart 5

We expect that the positive effect on NIM of rising rates will be limited by slower growth in customer loans due to the economic slowdown and a cooling of the real estate market. These will reduce demand for loans at the same time as banks curb supply by tightening underwriting standards (see chart 6).

Chart 6

Eurozone banks' noninterest income proved resilient over 2022, with fee and commission income growing 5%, to about €124 billion, in the first nine months of the year, despite a contraction in investment banking and asset management revenues. We expect the economic slowdown will continue to weigh on those revenues in 2023.

Rising Operational And Credit Costs Will Drag On Profit

Noninterest expenses increased in 2022, rising an annualized 5% over the first half of the year. That increase remained below headline inflation, due in part to the lag in banks' main operational costs including wages, which are negotiated annually, and IT services, which are subject to medium/long term contracts. The extent to which core inflation rises or remains elevated, and feeds into higher wage and service costs, will be a key issue for banks over the coming year. We expect banks' noninterest expenses will increase but not rapidly accelerate beyond the 2022 levels (see chart 7). This is because most banks in Europe structurally lowered their cost base in recent years, and are likely to maintain or set ambitious cost-cutting targets. Higher inflation should also favor real-terms cost cutting as it reduces the need for painful nominal cuts.

The likelihood of moderate cost increases coupled with positive revenue developments means we expect rated banks' cost-to-income ratios will improve over 2023 (see chart 8).

Chart 7

Chart 8

We expect credit costs will rise as a proportion of loans over 2023, but remain contained at a median of 25 basis points (bps) for rated banks, up from 16 bps in 2022, and 3 bps in 2021 (see chart 9). The moderate nature of that expected increase is due in part to banks' forward-looking provisions on nonperforming loans (NPL). We expect the median NPL ratio to be a modest 2.1% in 2023, up from 1.9% in 2021 and similar to its level in 2019 (see chart 10).

While such forecasts may seem largely benign, they include potentially significant divergence across rated European banks that will be driven by:

• The variable resilience of domestic economies and, in particular, domestic job markets. This has a significant effect on European banks due to their typical focus on domestic lending activities. European economies' strength and resilience to external shocks differ, although redistribution mechanisms and the temporary suspension of budgetary rules have enabled useful fiscal support in the EU.
• High inflation and a slowdown in consumer confidence that will predominantly affect consumer and SME loan portfolios, which together represent over 20% of European banks' aggregate loans, and traditionally exhibit higher delinquency rates (see chart 11). Meanwhile, we expect only limited losses from residential mortgages, which account for nearly one third of European banks' customer loans (see "European Banks’ Residential Mortgage Losses Should Remain Contained Even As Economies Slow," Nov. 15, 2022).
• Banks' differing capacity to manage and mitigate credit risk and thus limit asset quality deterioration and increased credit costs. This will be determined to a large extent by the quality of underwriting during the last part of the previous economic cycle and by a bank's capacity to identify troubled borrowers early and offer them remedial solutions.
• Intervention from public authorities, which could help to mitigate, or even suppress, deteriorating asset quality in some jurisdictions. Policy measures will likely be selective, reflecting the constraints faced by governments and national preferences. They could be supportive, though early examples in Spain and Poland have resulted in additional taxes on/ contributions from banks, while also encouraging them to accommodate struggling borrowers.

Regulatory stress tests conducted later this year by the EBA and the U.K.'s Prudential Regulatory Authority (PRA) will shed further light on the relative quality of banks' portfolios. The results will undoubtedly be an important source of information for market participants in 2023.

Chart 9

Chart 10

Chart 11

Satisfactory Capital And Liquidity Buffers And Improved Resolution

Banks' regulatory capital ratios proved slightly more volatile than usual in 2022 but remained at very high levels--the aggregate CET 1 ratio for EU/EEA banks was 15% as of September 2022. S&P Global Ratings' preferred metric for capital adequacy, the Risk-Adjusted Capital (RAC) Ratio, likely remained broadly stable and elevated over 2022, reflecting most European banks' satisfactory capitalization (see chart 12). Banks recommenced distributions to shareholders in 2022, ending a pandemic-triggered hiatus, but took a relatively prudent approach reflecting the heightened macro-economic uncertainties. We expect this to continue in 2023.

Chart 12

Over the coming year we will monitor the path of the EU's Capital Requirements Directive V and Capital Requirements Regulation III, which include the implementation of the remaining elements of Basel III, from 2025 onward. We anticipate final legislation will remain close to the Commission's proposal (see "Basel III Bank Capital Rules In Europe: Delayed And Diluted," published Oct. 28, 2021). We will also watch the evolution of countercyclical buffers (CCyB), after many European authorities announced planned hikes in response to perceived overheating risks. We expect that, if economies materially underperform central bank expectations and lending markets weaken, authorities will opt to keep CCyB on hold.

Because most rated EU banks will maintain substantial headroom over their Supervisory Review and Evaluation Process-Maximum Distributable Amount (SREP-MDA) thresholds, we expect additional Tier 1 (AT1) coupon nonpayment risk will remain low. However, we will watch leverage ratio (L-MDA) headroom, which is likely to increasingly become a constraint for European GSIBs in 2023. The end of the era of cheap hybrid financing, for now, means we could see further non-call events by European banks, but this likely carries no credit implications in our view (see "Credit Implications Of Hybrid Noncall Decisions," Nov. 24, 2022).

European banks will also, in 2023, finalize the issuance of instruments to meet their regulatory minimum requirement for own funds and eligible liabilities (MREL), which enters into force on Jan. 1, 2024. Most European banks already meet these requirements, as evidenced by the aggregate shortfall for eurozone banks of just €32 billion as of June 2022, but Greek banks notably have some work to do. Beyond building financial resources, we expect European banks will continue to enhance their operational readiness and funding in resolution.

From a broader funding perspective, the gradual normalization of monetary policies marks the end of an era for European banks. As of September 2022, EU banks' reported regulatory funding and liquidity ratios were still very high, at 126.9% and 162.5%, respectively, down from 129.3% and 174.8% in December 2021. We expect these ratios will trend downwards as central banks withdraw liquidity from the banking system.

Banks that are heavily reliant on central bank funding (See chart 13) will need to diversify their sources of funding, which is likely to have an impact on cost. We expect that a lack of access to stable and cheap funding will prove a drag on competitiveness for some banks--and potentially prevent them from reaping the full benefits of higher rates on the lending side.

Chart 13

Green, Digital, And Competitive

Several long-term trends will continue to gain in importance in 2023.

We believe that green and digital transition will remain high on bank management teams' agendas, driven by demand from customers, regulators, employees, and investors. Delivering a seamless digital experience for retail and SME customers will take years, as will meeting the green transition ambitions of corporate borrowers, but both are must-haves for banks.

The climate transition events and topics we will be watching in 2023 include:

• The first set of climate disclosures as part of European banks' Pillar 3 reports, which are due in 2023 in accordance with EBA standards. These disclosures should help us gauge the level of banks' exposure to climate risks, although disclosures on Scope 3 emissions--which are the most relevant for banks--have been postponed to 2024.
• Further announcements relating to the transition to net-zero, including some banks' plans to exit certain energy-intensive exposures. We also expect banks will develop new initiatives in support of clients' carbon neutrality, including suitable financing solutions.
• Emerging litigation risk for some banks as investors, NGOs, or policymakers highlight discrepancies between stated intentions and actions to reach carbon neutrality.
• Regulatory demands to strengthen the management of climate-related risks, starting with the collection of data for disclosure and risk management purposes.

With regards to the digital transition, the key themes to watch in 2023 include:

• Regulation of the cryptocurrency markets to protect consumers and ensure prudential safeguards. This could create opportunities for banks that have platforms and capacity to meet regulatory demands more effectively than many cryptocurrency firms.
• Further clarity on the roles that banks will fill in the provision of central bank digital currencies (CBDCs). We expect banks will continue to play an important intermediary role. That will likely require technology and commercial investment, the magnitude of which could become clearer as central banks communicate their preferred design for CBDCs.
• Cyber security's increasing importance in bank risk management. This will likely be driven by regular cyberattacks, the battle to attract and retain skilled staff, and increasing regulatory demands. Banks will also need to continue to invest in operational resilience to ensure business continuity.
• The opportunity for banks to acquire technology by purchasing financial technology (fintech) companies whose valuations have fallen. The fintech sector's depreciation could also attract bigger technology players seeking to expand their financial services operations.

While addressing these economic and societal transitions, European banks will also have to ensure they remain competitive, including with regards to non-European banks, non-bank financial intermediaries, and technology firms targeting lucrative banking segments. Rising profits due to higher interest rates may have provided a false sense of respite in this regard, but most banks will still barely cover their cost of capital, suggesting they remain under significant financial pressure.

The threat of an underinvested and inefficient banking sector remains a significant long-term source of risk for the European economy. Consolidation of the banking sector, facilitated by banking union, would be a key breakthrough in alleviating that risk, but further legislative progress toward that has been ruled out for 2023. Meaningful change, such as progress on the European Deposit Insurance Scheme, will thus have to wait until the next legislative cycle, which starts in the second half of 2024. Progress toward long-awaited European bank mergers and acquisitions also remains barred by the usual roadblocks of business uncertainty, prohibitively low market valuations, and legislative and regulatory hurdles. But we will continue to monitor the situation, because addressing the competitiveness gap remains European banks' biggest long-term challenge.

Appendix

Chart 14

Table 2

Related Research

• Greek Banking Sector 2023: Banks Face A Challenging Year As Economic Prospects Darken, Jan. 20, 2023
• Slides: Spanish Banks In 2023: Navigating Rough Seas Again, Jan. 18, 2023
• UK banks to enjoy higher profits in 2023 despite macro headwinds-S&P Global, Jan. 11, 2023
• Italian Banks Outlook 2023: Prepared For Challenges Ahead, Jan. 11, 2023
• Global Credit Outlook 2023: No Easy Way Out, Dec. 1, 2022