European banks' asset quality should deteriorate only moderately this year. However, our base case for 2024 is subject to increasing uncertainty around the evolution of inflation and economic growth against a backdrop of rising funding costs in real terms for borrowers.

In the space of three years, European banks have faced two major macroeconomic shocks--the COVID-19 pandemic and the Russia-Ukraine war--but these have not dented the credit quality of their assets so far. We note, for example, that the nonperforming loan (NPL) ratio reached a historical low of 1.8% at the end of 2022. Very accommodative fiscal and monetary policies in the region have also supported banks' asset quality, particularly with real interest rates turning sharply negative in the past two years. In this context, and despite the weakening economic environment in the second half of 2022, the European job market has remained very resilient, which is key to supporting borrowers' debt-servicing capacity.

Looking ahead, we are mindful of the inevitable time lag between a weakening of the macroeconomic environment and a worsening of banks' asset quality metrics, which can take several quarters to materialize. Further, we expect that real interest rates will turn positive in 2024, meaning a significant tightening of funding conditions for borrowers compared to the deeply negative real interest rates that prevail today. Positive real interest rates are typically associated with lower investment, lower GDP growth, and can ultimately cloud prospects for banks' asset quality.

In terms of lending, we see three pockets of risk. First, cost-of-living pressures mean that weaker households could face difficulties in repaying unsecured consumer loans. Second, declining customer demand could hit small-to-midsize enterprises (SMEs) with weak balance sheets or poor pricing power--we see smaller, owner-managed enterprises as particularly vulnerable. Third, commercial real estate (CRE) loan books are typically more sensitive to tightening funding conditions, as they both heighten refinancing risks and lower the value of the underlying properties. At end-2022, we estimate that NPL ratios in the three portfolios were 4%-5%, well above the average. Together, these portfolios represent over 30% of total loans for European banks, but the averages mask significant differences across jurisdictions.

Banks' credit-risk management strategies for these portfolios will be a key driver of their overall asset quality and cost of risk in the medium term. Some banks have grown these portfolios rapidly in the past three years, and we will closely monitor how their risk appetite evolves in the new environment. The quality of banks' underwriting, as well as their proactivity in identifying and addressing troubled borrowers, including the effectiveness of their collection practices, will also be key differentiators of asset quality performance. Rising revenues increase both banks' loss-absorption capacity and their incentive to quickly identify the areas of weaker asset quality that will require higher provisions. Nevertheless, this remains a discipline that management decisions on resourcing and provisioning influence heavily.

With strong tailwinds from last year's sharp rise in interest rates, and further rate hikes expected in the first half of this year, we anticipate that rising revenues will more than offset increasing credit losses at the sector level in 2023. In addition, credit losses will likely only represent 17% of pre-provision income. Under a hypothetical negative scenario of weakening macroeconomic forecasts and rising delinquencies, and assuming conservatively that banks would book all additional provisions within one year, our top 100 rated European banks would still turn a profit, albeit much reduced, on average. However, we estimate that over one-third of them could report a loss.

Asset Quality Should Deteriorate Only Slightly In 2023, But Positive Real Interest Rates Cloud The Outlook For 2024

We anticipate only a limited rise in credit costs and positive, albeit declining, lending growth in 2023. European banks' asset quality has improved dramatically in the past decade, as evident from a drop in EU banks' aggregate NPL ratio to 1.8% at end-2022 from 6.5% in December 2014. This was largely due to banks' efforts to reduce their NPL stock, which has decreased by 60% in nominal terms since 2014, and loan growth of over 40% over the same period.

The two macroeconomic shocks in 2020 and 2022 have not yet derailed these positive improvements (see chart 1). First, banks with legacy NPLs have continued their active divestment policies. Over the past six years, this balance sheet strengthening has been a leading driver of positive rating actions among banks in the European periphery. Second, and most importantly, massive fiscal and monetary policy measures have supported borrowers' debt-servicing capacity, with real interest rates turning deeply negative in the past two years.

In this context, European banks built provisions against a potential deterioration of asset quality in 2020, and again--though to a lesser extent--in 2022. So far, however, loan delinquencies and actual defaults have remained muted, as evident from the declining share of Stage 3 loans. This is consistent across most European banking systems, although we note significant variations in Stage 2 ratios (see chart 2). Some of these differences undoubtedly stem from varying levels of credit risk, which therefore inform potential delinquencies. However, we think that Stage 2 classifications also reflect differences in banks' prudence and proactiveness in recognizing mounting credit risks, and therefore are not fully comparable across banks or jurisdictions (see box below).

Chart 1

Chart 2

For 2023-2024, our economists see a complicated but not dire economic outlook (see Economic Outlook Eurozone Q2 2023: Rate Rises Weigh On Return To Growth, published March 27, 2023). Despite the eurozone economy's solid start to 2023, our baseline scenario remains one of stagnation, with an elevated risk of a mild recession further down the road. Sticky inflation will force the European Central Bank to raise rates for longer than we previously expected, probably until the deposit facility rate reaches 3.5% by the summer. We expect that real interest rates will turn positive in 2024 (see chart 3), weighing on investment demand as well as consumption. At the same time, consumer spending will get relief from government measures, accelerating wages, and slowing inflation, while external demand will benefit from China's reopening. Public investment will also help cushion the cyclical slowdown, adding half a point of GDP per year for the coming three years, and could enhance long-term GDP.

Chart 3

We consider that, in this economic environment, any deterioration in European banks' asset quality should remain moderate in 2023. First, the rise in new delinquencies and defaults should remain limited this year, especially in banks' residential mortgage portfolios. Support for this view comes from the still-resilient European job market, with both the employment rate and the number of job vacancies near historical highs at the beginning of 2023. We expect this situation to normalize over time, but the effect on banks' asset quality metrics should remain moderate in 2023.

Second, we expect reducing, but still slightly positive, net lending growth in 2023, from around 5% last year. In the second half of 2022, we saw a sharp decline in loan demand, especially for residential mortgages, with 74% of eurozone banks reporting a record decline in demand in that segment. On the corporate side, loan demand also contracted, but less sharply and in a mixed way. While demand for fixed investments and long-term loans declined, demand for working capital and short-term loans continued to grow. In 2023, we expect demand for long-term loans (mortgages and corporate investments) to remain relatively subdued as interest rates continue to edge higher and the housing market correction takes hold. At the same time, the demand for shorter-term loans (working capital and other consumer loans) could pick up a little with the rebound with the economy in the second half of this year.

On the loan supply side, banks have the balance sheet capacity to write new loans at improved margins. We estimate betas on new lending at roughly 50% for eurozone banks in January 2023 (and still increasing), while deposit betas continued to trail behind at around 15%. That said, the appetite for lending is likely to be more restrained given uncertainties in the macroeconomic environment. This is evident from the latest ECB bank lending survey (conducted in the last quarter of 2022), which indicated a further tightening of credit standards by banks. This was primarily driven by banks' assessment of risks related to the overall economic outlook and their declining risk tolerance.

Chart 4

Looking beyond 2023, we are mindful of the inevitable time lag between a weakening of the macroeconomic environment and a worsening of banks' asset quality metrics, which can take several quarters to materialize. Further, we expect that real interest rates will turn positive in 2024, meaning a significant tightening of funding conditions for borrowers compared to the deeply negative real interest rates that prevail today. Positive real interest rates are typically associated with lower investment, lower GDP growth, and ultimately cloud prospects for banks' asset quality. In particular, higher-for-longer inflation and interest rates will strain weaker retail borrowers' and SMEs' debt-servicing capacity and heighten credit risks in CRE portfolios. These pockets of risk could lead to some asset quality deterioration for banks with the greatest exposure to these portfolios.

The Cost-Of-Living Crisis And Rising Real Interest Rates Could Hit The Consumer, SME, And CRE Portfolios The Hardest

Together, these three portfolios represent roughly 30% of EU banks' customer loans, and typically perform the worst, with NPL ratios standing at an estimated 4%-5% at end-2022 (see chart 5). We consider that these portfolios are also most vulnerable to higher-for-longer inflation and rising real interest rates.

Chart 5

Depending on the pace of inflation and wage growth, real disposable incomes could continue to decline, weakening consumer spending and hurting the debt-servicing capacity of weaker retail borrowers. For banks, the first impact would be in the unsecured consumer lending segments. As such, we have seen early signs of worsening performance in European credit card asset-backed securities, with a slight increase in charge-offs and a slight decrease in payment rates (see European And U.K. Credit Card ABS Index Report Q4 2022, published Feb. 10, 2023). Overall, household consumption credit represents only 6% of European banks' loan portfolios, and this includes some secured loans (such as car loans), where typical delinquency and default rates are very low.

However, we see significant differences across EU banks concerning household loans excluding mortgages (see chart 6). In France, the number appears very high, but the EBA definition also includes housing loans which are guaranteed but not mortgaged--these are therefore not consumer loans. Correcting for this effect, we estimate that the proportion of French consumer loans would be close to the European average. Aside from this, we note relatively high exposures to household lending (excluding mortgages) in Spain, Slovenia, Hungary, and Poland. Overall, this lending segment has not grown very rapidly in the past three years, with a compound annual growth rate (CAGR) of 3% in aggregate for large EU banks. Growth rates are, however, more elevated in certain countries such as Slovenia and Hungary. In the latter, this largely reflects certain government programs aimed at increasing lending to households, with various subsidies lowering the eventual risk to lenders.

Chart 6

The secondary impact of weakening consumer demand would likely be in the SME lending portfolios, with weaker borrowers less able to withstand falling revenues. In particular, this relates to smaller, owner-managed enterprises. We already have evidence of a rise in corporate bankruptcies in 2022, as reported by Eurostat. EU banks have grown their SME lending books relatively fast in the past three years, with a CAGR of over 5%. Overall, SME loans represent a meaningful 19% of total loans for large EU banks, with differences across jurisdictions (see chart 7). Among major European banking systems, we have seen double-digit CAGRs in France, Belgium, and Hungary, where SME loans represent 20% or more of total loans.

That said, in many cases, recent growth in SME lending was spurred by the pandemic-related public guarantee schemes implemented in 2020, which still cover a sizable share of the portfolios (see chart 8), and thus protect lenders against potential credit risk. That is not the case for Belgium and Hungary, though, both of which have double-digit CAGRs. Many SME loans were made on three- to five-year terms, with the bulk of the repayment due only at maturity, and so any weaknesses in asset quality are likely to emerge over the next two years. Moreover, SMEs are a broad category, and in many cases, larger industrial SMEs are better positioned to meet debt-servicing obligations, having recently benefitted from significant order book backlogs. We believe that small SMEs in service-oriented sectors, such as retail, or food and accommodation, are most susceptible to financial pressures.

Chart 7

Chart 8

Finally, tighter funding conditions will likely heighten credit risks in CRE portfolios, as higher rates elevate refinancing risks and reduce the underlying asset values (see When Rates Rise: Softening Demand Threatens European Homebuilders Amid Climbing Costs, published Aug. 12, 2022). On aggregate, CRE loans represent about 10% of large EU banks' total lending portfolios. Germany and Sweden stand out among the major EU countries, with 19% and 17% of CRE loans relative to total loans, respectively (see chart 9). Importantly, these figures are for the larger banks at a consolidated level and so include, for example, large German banks that hold a share of their CRE portfolios internationally, primarily in the U.S.

Growth in CRE loans has been relatively limited in the past three years, with a 3% CAGR at the aggregated EU level. Notable exceptions are French and Belgian banks, which have double-digit CAGRs, as do large Israeli banks. Overall, we estimate that large EU banks (with above €200 billion of total assets) hold around 75% of the CRE lending market, while smaller banks (below €200 billion) hold only 25%.

The future performance of these books will largely depend on the quality of the banks' underwriting in recent years. It is hard to gauge this consistently, given the lack of standardized data on this topic. One positive element is the relatively modest growth rates of these portfolios in recent years. Also, the average loan-to-value ratios of CRE portfolios seem relatively low, providing banks with some protection against a potential fall in property values. Data from the European Systemic Risk Board (ESRB) indicates that the majority of CRE loans are at LTVs of 60% or less, though with disparity across countries--for example, more than half of CRE loans in Greece have LTVs above 80%; in France the proportion is around one fifth, and lower still in Germany. However, we note that the ESRB itself indicates that LTV data should be used with caution owing to the quality of the data.

Finally, we note that supervisors in Europe have repeatedly called on banks to enhance their risk management capacity, and have singled out CRE as a source of potential vulnerability, nudging banks to take a conservative approach to the asset class. A key request in that regard is for banks to increase the quality and frequency of their collateral valuation.

Chart 9

CRE exposure is a particular area of attention for several banks that have high concentration on this segment. As of June 2022, there are 49 European banks for which CRE exposures are equal to or higher than common equity Tier 1 (CET1) capital. Among the top 20 of these banks, some have experienced rapid growth in their CRE portfolios in recent years (see table 1). These statistics reflect the European Banking Authority's (EBA's) classification, which is relatively broad, and do not differentiate between the types of underlying CRE collateral--for example, office, retail, or industrial properties--which have different risk profiles. As such, we consider these findings as a starting point for our analysis of CRE-related risks for banks. Among the 49 banks with CRE lending exposures equal to or higher than CET 1 capital, we rate 28 (see Appendix for our rating scores and credit cost forecasts).

Table 1

Risk appetite and proactive risk management are key determinants of asset quality

We see unsecured consumer, SME, and CRE loans as pockets of risk that could present problems in 2023 and 2024, especially if high inflation persists and as real interest rates continue to rise and turn positive. Depending on their business model and country of operation, banks enter this next phase of the credit cycle with different levels of exposure to these portfolios. Importantly, the credit-risk management strategy they adopt, and their effectiveness in implementing it, will shape their asset quality trends. The following two factors in particular will inform our view on future asset quality performance:

Banks' overall risk appetite for consumer, SME, and CRE lending.   With the main engine of lending demand in recent years, residential mortgages, likely to underdeliver in 2023, banks may start to compete for lending to these segments, which typically offer higher margins but carry higher risk. This could lead to increased risk-taking or a deterioration of underwriting quality over time. For instance, some real estate investment trusts may face difficulties in refinancing debt on the capital markets, and may therefore turn to banks for funding. How banks will react to these demands in terms of pricing and lending will be an area to watch.

Banks' proactivity in identifying and addressing troubled borrowers.   We believe that European banks have improved their credit-risk management in recent years, enhancing their overall risk culture and taking a more structured and proactive approach to the identification and remediation of troubled credits. In 2022, for instance, this enabled banks to quickly identify borrowers with direct or indirect exposure to Russia, and to take prompt action to reduce exposures. As and when portfolios start to show early signs of deterioration, strong and proactive credit risk management will be a credit strength, supporting the resilience of the banks' asset quality.

Credit Costs Should Remain Manageable In 2023, But Could Dent Profits Significantly In A Hypothetical Negative Scenario

In 2023, we expect rated European banks' credit costs (credit losses as a proportion of customer loans) to normalize to 24 basis points (bps) from 13 bps in 2022 (see chart 10). Barring a new external shock or a material worsening of macroeconomic expectations, provisioning models should not present any huge shocks in 2023, and actual defaults so far remain very limited. Furthermore, we expect that banks will continue to benefit from high and rising interest rates, and therefore we expect credit losses to represent only around 17% of pre-provision earnings for the top 100 rated European banks excluding Switzerland (see chart 11). This indicates a comfortable amount of headroom for banks to absorb credit losses using earnings. However, there are significant differences across banks. For two banks, a doubling of credit costs from the level we forecast would lead to losses, while for 10 others, a tripling of credit costs would yield the same result.

Chart 10

Chart 11

Regulatory stress tests that the EBA and the U.K.'s Prudential Regulatory Authority will conduct later this year will shed further light on the relative quality of banks' portfolios, and therefore on the sensitivity of their credit costs to potential asset quality deterioration. The EBA's 2023 stress test has more conservative macroeconomic assumptions than the last stress test it conducted in 2021, and will introduce a more granular approach, with varying stress levels for different corporate sectors (see box below).

To determine the amount of additional provisions that European banks may need to set aside, on top of their ongoing credit costs after 2023, we modelled two scenarios. Under a "back-to-2019" scenario, we have switched back banks' portfolio to their staging level at end-2019. Under a hypothetical negative scenario, we have assumed a much more material migration of loans toward Stage 2 and 3. We believe that banks would be able to absorb the extra credit costs under the back-to-2019 scenario, while just over one-third could suffer losses in the hypothetical negative scenario.

Back-to-2019 scenario

We modelled the additional provisioning that banks would need if the split of Stage 1, 2, and 3 loans reverted to what it was at the end of 2019 from its position at end-2022. We assumed unchanged coverage ratios--thereby presuming that the end-2022 coverage ratios represent a new normal for provisioning needs--and held the loan book constant. This scenario yields additional provisioning needs of 23 bps. Given their strong pre-provision earnings, we believe that banks would be able to absorb these additional credit costs without materially constraining earnings.

Hypothetical negative scenario

We also calculated the additional provisioning needs triggered by a migration of 5% of the Stage 1 book to Stage 2, and 20% of the Stage 2 book to Stage 3. At the EU level, the Stage 2 ratio would rise to 12%, close to where it was at the end of 2020, and the Stage 3 ratio would rise to 4%, twice its current level. This hypothetical negative scenario corresponds to a material lowering of macroeconomic forecasts similar to that in 2020 at the height of the COVID-19 pandemic, coupled with a significant rise in actual delinquencies. In this hypothetical negative scenario, large EU banks' additional provisioning needs would rise to 94 bps, but with significant differences across banking systems (see chart 12). These additional provisions would dent profits significantly. Assuming conservatively that our top 100 rated European banks would recognize these additional provisions over a one-year period, they would still be able to report positive--albeit much reduced--profits, on average. However, we estimate that slightly over one-third of these banks could report a loss.

Chart 12

Chart 13

We also estimated how additional provisioning needs would evolve assuming different migration rates from Stage 1 to Stage 2 and from Stage 2 to Stage 3, again, assuming no loan growth and fixing coverage ratios at their end-2022 level (see our sensitivity analysis in table 2). In almost all countries, additional provisioning needs would rise above 2022 credit costs (as indicated by the red cells in table 2), with some meaningful migration from Stage 2 to Stage 3, that is, an actual rise in loan defaults. Overall, a migration from Stage 1 to Stage 2 driven by worsening macroeconomic assumptions would not be sufficient in and of itself for material additional provisioning needs. Large Spanish banks come out positively from this analysis, but this is largely due to the lower stock of loans that they mark as Stage 2 (6.8% of total loans, versus the EU average of 9.4%), and the fact that our model assumes constant migration rates from the existing loan stages.

Table 2

Barring any new external shocks, asset quality deterioration and credit costs should remain moderate in 2023 for European banks. However, we see a much more uncertain outlook for 2024. Positive and rising real interest rates will likely weigh on loan growth and could lead to rising delinquencies. The effects on banks' asset quality, and therefore any implications for their ratings, will largely depend on the measures that they, and authorities, take to mitigate tougher conditions and support borrowers' debt-servicing capacity.

Related Research

• European Banks: Resilient And Divergent As The Economic Reset Kicks In, Jan. 23, 2023
• Economic Outlook Eurozone Q2 2023: Rate Rises Weigh On Return To Growth, March 27, 2023
• European And U.K. Credit Card ABS Index Report Q4 2022, Feb. 10, 2023
• Credit Conditions Europe Q2 2023: Costs Rising To Cure Inflation, March 28, 2023
• When Rates Rise: Softening Demand Threatens European Homebuilders Amid Climbing Costs, Aug. 12, 2022

Appendix