Key Takeaways
- European banks will redouble their efforts to limit the earnings decline from falling interest rates.
- Banks' deposit pricing power, interest rate hedging approach, and control over operational costs will make a meaningful difference to their operating performance in 2025-2026.
- The impact on banks' credit profiles from declining earnings will depend on their capacity to pull these levers and keep the associated risks under control.
- In the longer run, diversifying the revenue base and executing an effective digital strategy will stay at the top of banks' agendas.
S&P Global Ratings believes that a moderate decline in pre-provision income is inevitable for most rated European banks in 2025 and 2026, mainly due to lower deposit margins as short-term interest rates decline. That said, a steepening of the yield curve and a return to modest loan growth could partly offset this headwind.
The moderate decline in operating performance will come after two years of significant earnings growth for most European banks. While shareholders may already expect inevitable earnings pressure from lower rates, we expect European banks to redouble their efforts to mitigate this pressure as much as possible. To do so, banks have several tactical and strategic levers at their disposal, but not an equal ability to pull them. This means that differences across banks and systems will persist.
There are three tactical moves that European banks can make. First, although banks have, on the whole, managed their deposit bases successfully, some have much stronger deposit pricing power than others. In our view, this is largely due to the scale of banks' excess liquidity buffers, as well as supply and demand dynamics for bank deposits. These dynamics remain very much drawn along national lines in the absence of a true European market for bank deposits.
Second, proactive and effective interest rate hedging can help reduce the impact of lower rates on revenues, at least in the short term. Our review of banks' disclosures indicates that many banks acted to protect their revenues from lower rates in the first half of this year, while avoiding overly exposing themselves to a potential interest rate shock in the other direction.
Third, while most European banks have seen an improvement in their cost-efficiency metrics in the past two years, this was mainly due to revenues increasing, whereas we now expect this trend to largely reverse. Relative differences in cost efficiency remain significant, and we expect that only about one-third of rated banks will manage to keep the growth in operational costs below inflation in the next two years.
Beyond the tactical actions that banks could take to protect operating income, we expect them to continue to execute broader and bolder strategic moves. A key focus will likely be on building scale, either through in-market consolidation, or by adding new verticals such as asset management to their business models, partly leveraging regulatory capital incentives. Another key focus will be on using technology to enhance operational efficiency and the quality of their services, with generative AI (GenAI) the next technological frontier.
Overall, we believe that these tactical and strategic actions should enhance banks' returns and limit earnings volatility as interest rates normalize. That said, banks with efficient cost bases, strong deposit franchises and liquidity, and large capital surpluses are likely to reap the most benefits. We will also assess whether these actions reflect a step change in banks' risk appetite and whether banks can adequately manage the associated risks.
We Expect Operating Performance To Decline Moderately In 2025-2026, With Persistent Differences Across Banks
Our economists expect that economic growth will strengthen in the eurozone, with GDP growth reaching 1.2% in 2025, while inflation will moderate to 2.1%. In that context, the ECB, alongside other European central banks, should gradually lower its main policy rate, the deposit facility rate, to 2.5% by mid-2025. At the same time, we expect long-term yields to stay close to their current levels, indicating a steepening of the yield curve (see chart 1).
Chart 1
The decrease in the deposit facility rate will drag directly on eurozone banks' revenues due to the material amount of excess reserves that they hold at the ECB's deposit facility. We estimate that a 100 basis-point reduction in the deposit facility rate represents an interest income loss of about €30 billion for large eurozone banks, around 5% of their 2023 operating income, assuming no mitigating management actions.
In other European countries such as the Czech Republic and Switzerland, central banks have opted to raise their requirements for minimum reserves, which banks do not receive interest on. All these measures and their effects on short-term rates point to a decline in banks' deposit margins (see box below).
NIM Drivers – What Banks Control And What They Don't
The net interest margin (net interest income divided by average earnings assets; NIM) is a key starting point in assessing a bank's profitability, as it reflects the revenues that the bank derives from its main lending and investing activities, net of financing costs.
From an analytical perspective, both the NIM level and NIM volatility speak to a bank's capacity to deliver revenues on a sustainable basis. Importantly, the NIM is not a risk-adjusted metric, making it necessary to analyze NIM levels and volatility in conjunction with the degree of risk that a bank takes, including credit, interest rate, and operational risk. In addition, several NIM drivers are outside a bank's control, such as the evolution of market interest rates, which will affect gross revenues in both the lending and the investment books.
On the other hand, several drivers reflect a bank's strategic choices--for example, its lending and funding mix--or its risk appetite, such as its interest rate hedging policy and the credit risk that it takes. To understand which drivers are at play in a bank's NIM trend, we typically separate its NIM into deposit and lending margins. For each of these margins, we identify the drivers that are outside the bank's control, and those that it can influence (see graphic below).
For many European banks in 2021-2023, a powerful NIM driver was the increase in short-term rates, driven by the central banks' policy rates, which yielded significant revenue gains on banks' investment portfolios. This means that both NIMs and NIM volatility have risen recently, and that NIM declines are inevitable as short-term rates come down. That said, we believe that many European banks have meaningfully and structurally improved their deposit management, and that they run active interest rate hedging programs to help limit NIM volatility.
Beyond these short-term fluctuations, our economists' base-case expectations of a steepening yield curve bode relatively well for eurozone banks' lending margins. The predominant business model in Europe remains maturity transformation, and a steeper yield curve would be a broadly favorable environment for that.
Additionally, a return closer to the economic growth potential and lower inflation would support steady loan origination after two years of depressed lending growth (see chart 2). Recent results from the ECB's euro area bank lending surveys point to a surge in loan demand from mid-2024, both on the corporate and household sides. This could result in higher lending origination from 2025 (see chart 3).
Chart 2
Chart 3
In this context, we expect a moderate decline in banks' operating performance in 2025-2026, with pre-provision income to S&P Global Ratings risk-weighted assets declining to 1.8%-1.9% for the median rated bank by 2026, down from 2.0%-2.1% in 2024. We expect this trend to be broad-based and forecast that about 75% of rated banks will report a decline over 2024-2026 (see chart 4).
Chart 4
Overall, we don't expect the change in interest rates to materially alter the distribution and relative ranking of operating performance across banks. We will see some mean reversion as deposit margins come down and lending margins and volumes potentially increase, but the main drivers of relative operating performance will remain in play, namely, deposit management, hedging practices, and operational cost management.
Stable And Rate-Insensitive Deposits Explain Some Banks' Operating Overperformance
Customer deposits remain European banks' primary source of funding, accounting for around half of their total liabilities as of June 2024. Volumes have proved fairly stable in the past few years, despite the increase in interest rates and the start of the central banks' quantitative tightening (see chart 5).
Chart 5
Importantly, the competition from nonbank deposit-like products such as money market funds (MMFs) remains modest. Taking the eurozone as an example, bank deposits have grown by a compound average of 5.5% since 2015, while MMFs have grown by 6.7%. When interest rates surged in 2023, this gap widened to annual growth of 0.0% and 12.5%, respectively. That said, MMFs remain small relative to bank deposits, with total assets approaching €1.8 trillion in June 2024, versus €12.5 trillion of bank deposits.
We see wide differences in deposit pricing power across banks and banking systems, as measured by the deposit beta, that is, the share of policy rate increases that banks have passed through to their deposits (see chart 6). Overall, these deposit betas are significantly lower now than in the rate hike cycles in 2005-2007, pointing to European banks' increased deposit pricing power.
Chart 6
In a recent report analyzing deposit stability, the Financial Stability Board estimated the average deposit beta at around 50% globally. While the eurozone deposit beta was close to this global average in the 2005-2007 cycle, at 52%, it has been much lower in this cycle, at only 27%.
Differences in deposit betas partly result from drivers outside banks' control. For instance, the level of competition between nonbanks and banks for deposits varies, and a few banks' market dominance and/or excess liquidity has helped them exert pricing power in some countries, including Ireland and Spain, for instance.
Similarly, customers' preferences to hold overnight or unremunerated deposits differ materially across countries and customer types, with corporate and private-banking customers much quicker to reprice deposits than typical retail customers. Although on the whole, deposit migration toward remunerated and fixed-term deposits did occur in 2022-2023, this largely stopped in the first half of 2024, and it has not returned to the levels we saw before the period of quantitative easing (see chart 7).
Chart 7
In the long run, an increase in deposit competition could challenge some banks' deposit pricing power. This would either be due to a further deepening of the European capital markets, giving savers more opportunities to invest in nonbank deposit-like products, or to a more integrated European banking market, leading banking groups to compete for deposits across borders. However, in the near term, we don't expect material progress in these respects in the EU.
In our view, the relatively low deposit betas at European banks also derive from the banks' improved funding profiles, as measured, for instance, by their declining loan-to-deposit ratios (see chart 8). After reducing their funding risks, many European banks were in a good position to benefit from rising rates, and they are now in a good position to pass through lower market rates to their depositors.
Chart 8
The quality of banks' funding franchises also depends on their broader strategic positions and the quality of their customer relationships. By refocusing their operations on their domestic markets and/or specific sectors, many banks have effectively improved the quality of their deposit franchises.
Interest Rate Hedging Will Help Mitigate The Negative Impact Of Lower Rates On Revenues
By hedging their exposures to interest rate risk, banks can dampen the effect of rate movements on their revenues and/or the economic value of their capital. The extent to which they do that largely depends on their appetite for interest rate risks, and the costs of the hedging transactions, typically via interest rate swaps (see "Credit FAQ: How Our Bank Ratings Consider Interest Rate Risk In The Banking Book," published on March 14, 2024).
Some European banks, including those in U.K. or Ireland, follow structural hedging policies, meaning that they consistently hedge the amount of non-maturing deposits and equity that they hold. However, most eurozone banks follow a more tactical hedging approach. They take a view on the likely direction of interest rates, assess the natural interest rate offsets from their asset and liability positions, and only actively hedge the remaining interest rate risks, and to a varying extent.
This tactical approach typically works well as long as interest rates broadly follow a predictable pattern. Between the end of 2021 and June 2022, the ECB communicated its intention to gradually lift its main policy rates before acting, allowing many banks to reposition their hedging strategies to benefit from rising rates.
Similarly, the ECB has recently communicated its intention to gradually bring down policy rates, and so far, has done this in an orderly manner. Hence we have seen many eurozone banks actively preparing for a decline in interest rates in the first half of this year (see chart 9). These actions should pay off and limit the revenue drag from decreasing rates to some extent.
Chart 9
That said, this tactical approach to interest rate risk management is not without its drawbacks. For instance, the ECB's surprise decision in 2022 to change the terms of its targeted longer-term refinancing operations (TLTROs) almost overnight caught a few banks off guard. These banks had hedged their TLTRO drawings assuming fixed rates and faced hefty costs to unwind their trades after the ECB made its announcement. In addition, banks' actions to smooth the impact on revenues could lead some to overexpose themselves to a potential rise in interest rates. In other words, hedging interest rate risk could gradually turn into betting on a specific interest rate trajectory.
As a backstop to this, European regulators have implemented the Basel standards for interest rate risks in the banking book. This requires banks to assess the sensitivity of their earnings and economic value of equity to various severe interest rate shocks. Supervisors regularly challenge banks on the models they use to conduct these sensitivity analyses and may take action if the banks exceed certain thresholds under any of the simulated rate shocks.
To assess this risk, we surveyed the disclosures of large European banks and compared their NII sensitivity to lower interest rates. We also looked at the impact of an increase in interest rates on the economic value of their equity. We found that the majority of banks are operating well within the regulatory boundaries (see chart 10).
Chart 10
Cost Efficiency Remains A Key Performance Differentiator
We expect significant differences in cost efficiency across rated European banks to persist in 2025-2026 (see chart 11). Between 2021 and 2023, most rated European banks managed to reduce their cost-to-income ratios, indicating an increase in operational efficiency. That said, this improvement was mainly due to increasing revenues and we expect it to partly reverse as revenues decline.
Chart 11
Despite this apparent improvement in efficiency, most European banks saw their operational costs increase by more than 4% annually between 2021 and 2023--the average level of service cost inflation in that period (see chart 12). Only 24 rated banks managed to reduce their operating expenses in nominal terms over the period, and a further 37 in real terms.
Chart 12
Looking ahead, we expect that only 10 banks will manage to reduce their operating expenses in nominal terms in 2024-2026, and a further 43 will keep the cost increase below 2%, the expected level of inflation. This is despite most banks' discontinuation of contributions to resolution funds from 2024. As revenues decline, controlling operating costs will remain a top priority for banks. Banks are likely to take actions on costs in conjunction with broader strategic moves to increase business scale and/or efficiency through investments in technology.
Banks Focusing On Revenue Diversification And The Digital Transition Will Fare Best
Revenue diversification is not new to European banks
In the past few years, we have seen a trend of European banks reducing their international presence and investing in their domestic markets. This takes the form of either in-market consolidation or bolt-on acquisitions to add ancillary business lines such as insurance or asset management. Given the noncompletion of the Banking and Capital Markets union, we believe that this trend is likely to continue.
In addition, a preferential regulatory capital treatment under EU law, the so-called Danish compromise, facilitates these investments via an insurance subsidiary. When a bank is the parent of a financial conglomerate that incorporates an insurance company, the bank may, subject to supervisory approval, risk-weight its investment in the insurer rather than fully deducting it from its consolidated regulatory capital. Under the new Capital Requirements Regulation applicable from Jan. 1, 2025, this risk-weight will be set at 250%, an improvement from the current 370% risk-weight that large banks (using internal ratings-based models) apply.
BNP Paribas benefitted from this preferential treatment when it announced the acquisition of AXA Investment Managers through its insurance subsidiary in August 2024 (see "BNPP's Acquisition Of AXA Investment Managers To Boost Its Asset Management Activities," published Aug. 6, 2024). More recently, Banco BPM SpA has announced its intention to acquire Anima Sgr, a leading Italian asset-management company, through its insurance subsidiary (see "Banco BPM Ratings Affirmed At 'BBB/A-2' On Anima Tender Offer And Equity Stake In Banca Monte dei Paschi; Outlook Stable," published on Nov. 15, 2024).
Under our risk-adjusted capital (RAC) framework, we fully deduct banks' investments in insurance companies from their RAC, meaning that the RAC impact from these investments is typically more negative than the regulatory capital impact. We believe that the revenue diversification resulting from these investments can offset the immediate negative capital impact to some extent, providing that the banks can adequately manage the risks from these new operations.
Neither is leveraging new technologies to improve efficiency
Our ratings already reflect banks and banking systems' capacity to exploit new technologies while managing the associated risks. A bank's ability to deploy technology at scale is a clear advantage, but tackling the complexity resulting from legacy systems is also a challenge. Several banks are launching or testing new tools based on GenAI as this technology matures, and the EU AI Act provides a framework that aims to build trust in this technology.
In the near term, banks' investment needs are likely to offset any efficiency gains, and so such gains are unlikely to be immediately visible in the banks' financial results. That said, banks that are able to invest and deploy new technologies at scale will likely reap significant benefits.
The evolution of banks' credit profiles will depend on their strategic approach and ability to control associated risks
Overall, we believe that the various tactical and strategic actions we describe above should enhance banks' performance and limit revenue volatility as interest rates normalize. That said, not all banks are equal in their capacity to take these actions. From a strategic perspective, banks with excess capital and high equity valuations appear best placed to make investments and increase the scale of their operations. From a tactical perspective, banks with most deposit pricing power and a more effective hedging strategy are best placed to navigate the lower interest rate environment.
In terms of credit profiles, it will also matter whether banks' tactical and strategic actions reflect a material step change in their risk appetite, and whether banks' risk management practices are adequate to mitigate the associated risks. For instance, several large European banks such as BNP Paribas and Société Générale have announced partnerships with private equity and/or private debt funds, as these actors have gained importance in European corporate lending. These partnerships can represent significant business opportunities, but also risks, as they may expose banks to the financial ecosystem at multiple levels--directly via portfolio companies and funds, and indirectly via fund investors. Banks' capacity to manage this exposure holistically will be key to ensuring that these partnerships deliver the risk-adjusted profits they expect.
Related Research
- Banco BPM Ratings Affirmed At 'BBB/A-2' On Anima Tender Offer And Equity Stake In Banca Monte dei Paschi; Outlook Stable, Nov. 15, 2024
- BNPP's Acquisition Of AXA Investment Managers To Boost Its Asset Management Activities, Aug. 6, 2024
- Credit FAQ: How Our Bank Ratings Consider Interest Rate Risk In The Banking Book, March 14, 2024
This report does not constitute a rating action.
| Primary Credit Analysts: | Nicolas Charnay, Paris +33623748591; nicolas.charnay@spglobal.com |
| Karim Kroll, Frankfurt +49 69 33999 169; karim.kroll@spglobal.com | |
| Secondary Contact: | Giles Edwards, London + 44 20 7176 7014; giles.edwards@spglobal.com |
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