S&P Global Ratings' European financial institutions conferences in Paris (Oct. 5), London (Oct. 10), and Frankfurt (Oct. 12) provided an opportunity to explore insights from our keynote speakers--a selection of European bank chief financial officers--on European banking trends; hear a range of views from senior industry experts on bank funding, liquidity, and emerging risks; and better understand S&P Global Ratings' views on the ratings outlook for the European banking sector.

The views below do not necessarily represent the views of S&P Global Ratings. For more insights on our views, please refer to our publications, some of which are listed in the "Related Research" section and touch on many of the themes discussed at this year's conferences. A full list of external speakers is provided in the appendix.

European Banks Have Been Net Beneficiaries From Higher Interest Rates So Far

European banks recorded good results in the first half of this year and benefited from higher interest rates, thanks to rising net interest margins and very limited asset quality erosion.

Key ratios proved relatively stable, funding profiles were broadly diversified, and banks adapted their funding plans to account for the European Central Bank's (ECB's) recalibration of the third series of targeted longer-term refinancing operations (TLTRO III). Some participants viewed the European deposit insurance scheme (EDIS) as positive since it could improve the EU funding markets' resilience, prevent liquidity panics, and increase the credibility of the system. Others see domestic institutional protection scheme structures as sufficient and thus believe they should be exempt from EDIS participation.

Still, higher rates mean higher funding costs that will hit net interest margins over time. Among others, the ECB revised TLTRO III, meaning banks that want to borrow funds under the facility now have to pay higher interest rates. The collapses of Silicon Valley Bank and Credit Suisse earlier this year also put a strain on the banking sector. Customers withdrew huge amounts of deposits from these banks over the course of just a few weeks, which highlighted the importance of a diversified funding base and access to the wholesale market. Additionally, deposit competition increased, with customers moving their savings to investment funds that could provide higher returns.

Though liquidity started to tighten, bank reserves, accumulated during years of quantitative easing, provide a comfortable cushion for banks to fall back on. What's more, liquidity squeezes will only become a problem if quantitative tightening intensified significantly--and even then, it would likely affect capital markets before banks.

In addition to this broad picture, conference participants noted a few banking system specifics, including:

• For French banks, interest rate rises haven't boosted net interest margins to the same extent as for European peers, because French banks' liabilities reprice more quickly than their assets, such as fixed-rate mortgages. Higher rates will have a more favorable effect on French banks by mid-2024. Since French banks have a more stable cost of risk than other European banks, credit costs will normalize rather than spike.
• U.K. banks face headwinds on multiple fronts, be it in the form of increasing technologization, mispricing risk, or geopolitical instabilities, to name just a few.
• For banks in Germany, the economic stagnation and ongoing downturn in the property market weighs on business prospects, but German small and midsize enterprises and borrowers at large prove resilient so far. High inflation affects cost bases and emphasizes the need to further digitalize bank services to reduce costs. Going forward, funding costs will be a key variable to watch as deposit betas are set to rise. The ECB could consider additional measures, with negative effects on banks' bottom lines, such as an increase in required reserves.

The overarching sentiment of conference participants and audience members toward European banks was sanguine. This was also evident in our audience polling in London, which showed that most expect that the sector's profitability will remain stable or increase in 2024 and 2025, even as European economies slow (see chart 1). Some participants voiced frustration about regulatory discrepancies between banks and non-banks but also pointed out that the gap should shrink and that the principle of "same activity, same regulation" should ultimately prevail.

Chart 1

Still, the weak macroeconomic backdrop keeps investors alert to possible rapid changes in bank performance and sentiment

47% of the audience in London considered protracted recession and rising unemployment as the key risks for European banks in 2024 and 2025 (see chart 2). Banks' commercial real estate exposure is limited and therefore less of a worry for now. Yet, contagion effects that originate in the real estate sector might play a role further down the line, for example if mortgage resets in the U.K. affect the broader economy more than expected.

Chart 2

Non-banks expand their footprint, raising a greater concern about contagion than about competition

According to the Financial Stability Board, non-bank financial institutions (NBFIs) now account for $250 billion or almost 50% of global financial assets. NBFIs benefited from the period of low interest rates, which forced investors to look for yields outside the traditional banking system, and stricter banking regulations. The latter dampened banks' risk appetite and made it easier for NBFIs to gain a foothold in riskier categories.

Banks' exposure to NBFIs is low and only comprises 4%-5% of their liabilities. Even so, some conference participants in Paris worried about a possible contagion effect to banks from NBFIs' vulnerabilities. In particular, NBFIs' liquidity is generally more fragile than banks'. For example, some real estate funds, which tripled in size in Europe over the past decade, have restricted refunding windows and could be at risk. When NBFIs' activities give rise to liquidity mismatches or higher levels of leverage, this could amplify stress in the wider financial system.

Banks Face External Cyber Threats

Cyber risk is increasingly on the radar for bank investors, with most recognizing it as a risk that needs to be actively considered. Yet, many face challenges in meaningfully quantifying it (see chart 3). As one panelist put it: It's hard to get a handle on something that's difficult to analyze, let alone measure.

Chart 3

Conference participants in London agreed that financial institutions in Europe are in a good position to tackle cyber threats. Banks' strong defenses make them a tough nut to crack for criminal actors, who focus on easier targets. The latter include third-party providers, whose cyber security standards may not be up to scratch--which, in turn, makes them a liability for banks. Accordingly, cyber threats in the banking sector are more diffuse and intertwined with third and fourth parties.

Cyber risk management continues to demand significant investment from banks. But banks maybe need to be more discerning in the controls they put in place. Instead of "going for the latest shiny widget," as a panelist phrased it, banks should think carefully about the risks they need to mitigate and how best to do that.

Artificial intelligence (AI) is a blessing and a curse for cyber risk management. On the plus side, AI can help triage cyber attacks and quantify cyber risks. Conversely, AI makes the lives of criminals easier, for example by creating credible phishing emails in multiple languages.

Panelists noted that cyber risk sits within the broader operational resilience agenda. Self-inflicted operational outages and mistakes may yet pose the greatest risk of loss and franchise damage to banks.

Digitalization: Some Still Catching Up

In our Frankfurt conference, some speakers noted that digitalization isn't exactly Germany's forte. Even though investments in digital operations have increased, German banks are lagging their European peers.

Panelists agreed that decentralized finance (DeFi) is still in the early stages, not least because of its detached ecosystem with almost no relevance for the real economy, non-existent consumer protection, the lack of transparency and governance, and limited risk management. DeFi has limited interoperability with the existing financial system and, as such, panelists agreed that it is not a risk to financial stability. In the words of one panelist, DeFi is "a nice playground" that can disrupt the banking sector but won't derail it. Above all, DeFi requires three things to be successful: regulation, trustworthy payment methods, and, fundamentally, a vision for the future. The panel acknowledged that stablecoins--or "digital bearer instruments," as one panelist called them--could be a positive disruptor to global payment systems because of two relevant characteristics: faster settlement within and beyond country borders and lower transaction costs.

The euro goes digital

The role of retail central bank digital currencies (CBDCs), whose value is linked to the issuing country's official currency, was also on the agenda. A CBDC is the equivalent of physical cash, just digital. Discussion participants agreed that CBDCs' success will hinge on trust and customer acceptance. Their use case parallel to other payment solutions remains a key question. While panelists agreed that central banks need to adapt to a society that increasingly uses digital payment solutions, they also pointed out that the population must be involved when deciding about the details of a digital euro. The digital euro will likely become a reality by 2030, albeit with limited amounts in circulation.

Among the main pain points of CBDCs is their revenue potential--or rather the lack thereof. Some panelists were worried that the digital euro will be costly for intermediaries if they aren't remunerated accordingly. Panelists also agreed that wholesale CBDCs (wCBDCs) could positively disrupt payment schemes between banks and other financial intermediaries because of their efficiency in the case of cross-border payments. The tokenization of assets, such as securities, could interoperate with wCBDCs in future capital markets. Central banks and banks currently put a lot of research in wCBDCs.

What's On The Horizon For European Bank Ratings

To stand their ground, European banks must deliver sustainable business and operating models. Only then will they be able to withstand a potential decline in asset quality, rapidly rising funding costs, and market volatility. The operating environment may be weakening, but improving margins compensate for lower business volumes, at least for now.

Accordingly, most of our outlooks on European bank ratings are stable. Overall, we believe European banks' access to stable funding sources and their currently significant capital and earnings headroom will improve their resilience and help them weather liquidity tightening. Even so, sector views based on medians and averages, albeit comforting, are misleading. Rapidly tightening monetary policy, pressure in specific areas of the economy, and secular changes, such as digitalization and the rise of the shadow banking sector, will likely reveal outliers--positive and negative.

Related Research

Capital / Funding / Liquidity

• Top 200 Banks: Capital Ratios Continue To Normalize After Pandemic Peaks, Sept. 18, 2023
• As Their Funding Evolves, U.K. Banks Have Flexibility, Sept. 14, 2023
• Credit FAQ: What An Acceleration Of Quantitative Tightening Could Mean For Eurozone Banks, Sept. 13, 2023
• European Banks: Protecting Liquidity Will Come At An Increasing Cost, June 29, 2023
• European Bank AT1 Hybrids In A Post-Credit Suisse World, March 21, 2023

Macroeconomics

• Credit Conditions Europe Q4 2023: Resilience Under Pressure Amid Tighter Financial Conditions, Sept. 26, 2023
• Economic Research: Economic Outlook Eurozone Q4 2023: Slower Growth, Faster Tightening, Sept. 25, 2023
• Economic Research: European Housing Markets: Sustained Correction Ahead, July 20, 2023

Non-bank financial institutions

• Operational Resilience Is Key To Global FMIs’ Rating Strength, Oct. 4, 2023
• Uneven Liquidity And Strained Valuations Are Pushing Some Funds Toward Debt, Sept. 28, 2023

Profitability / Asset Quality

• Large French Banks' Net Interest Income Should Pick Up From Mid-2024, Sept. 26, 2023
• European G-SIBs Monitor H2 2023: Rising Rates Don't Float All Boats, Sept. 20, 2023
• U.K. Banks Enjoy Another Strong Half Year As Margins Peak, Aug. 24, 2023
• Global Banks Country-By-Country Midyear Outlook 2023: Resilience Will Be Tested, July 20, 2023
• Global Banks Midyear Outlook 2023: Resilience Will Be Tested, July 20, 2023
• SLIDES: European Banks: Potential Interest Rate Volatility Calls For Caution, July 19, 2023
• SLIDES: Global Banks: Our Credit Loss Forecasts, July 13, 2023
• U.K. Banks Compete Strongly As Rates Climb, June 16, 2023
• Spotlight On Refinancing Risks In European Commercial Real Estate, April 24, 2023
• European Banks' Asset Quality: Tougher Times Ahead Require Extra Caution, April 20, 2023

Regulation, recovery, and resolution

• The Resolution Story For Europe's Banks: Making The Regime Fit For Purpose, Oct. 4, 2023
• Swiss Public Liquidity Backstop Has Limited Implications For Hybrid Ratings, Sept. 18, 2023
• Credit FAQ: How Owner Support And Intent Influence European Bank Hybrids, July 27 2023
• Credit FAQ: A Closer Look At Insulated Entities In Financial Services, July 18, 2023
• Swiss Public Liquidity Backstop For Banks Comes With Strings Attached, July 17, 2023
• Economic Research: Thirty Years Of The EU Single Market: Why Cross-Border Capital Flows Remain Sluggish, Despite Positive Developments, May 25, 2023
• How The EU’s Bank Crisis Management Reforms Could Affect Ratings, April 25, 2023
• Crisis Management Observations From Recent European And U.S. Banking Sector Volatility, April 19, 2023

Stress testing

• EU Banks Resist Tough Assumptions In Latest Stress Tests, Aug. 1, 2023
• Latest BoE Stress Test Signals U.K. Banks' Resilience To A Severe Downturn, July 12, 2023

Tech disruption / Cyber risk

• Future Of Banking: AI Will Be An Incremental Game Changer, Oct. 3, 2023
• Tech Disruption In Retail Banking: Country-By-Country Analysis 2023 Leaders And Laggards Emerge, Sept. 27, 2023
• Europe's Crypto Regulation Lead Could Attract Followers, May 5, 2023
• Cyber Risk Insights: European Banks' IT Complexity Amplifies Risk, March 23, 2023
• DeFi Protocols For Securitization: A Credit Risk Perspective, Feb. 7, 2023

Appendix

Writer: Kathrin Schindler.