RISK ASSESSMENT OF THE EUROPEAN BANKING SYSTEM

Despite the robust economic recovery in the last quarters and the progress in COVID-19 vaccination, vulnerabilities remain. Increasing vaccination rates have allowed social distancing and mobility restrictions to be eased, hence fuelling economic growth. Yet supply bottlenecks and rising energy prices have driven inflation to levels not seen since before the Global Financial Crisis (GFC). Public and private debt levels have further risen during the pandemic. Overly stretched valuations in financial and housing markets might prompt abrupt corrections.

Banks have increased lending to small and medium enterprises (SMEs) and grown their mortgage exposures. Banks’ total assets have increased slightly, driven by a further increase in cash balances. Despite the overall decrease in loans and advances, lending to SMEs and households has risen. The increase in the latter is mostly explained by the rise in mortgage lending. By contrast, outstanding loans to large corporates have declined on the back of increasing non-financial corporations (NFC) debt issuance. The volume of publicly guaranteed loans has stabilised while exposures under European Banking Authority (EBA)-compliant moratoria expired for approx. 85% of the loans to which this measure has been applied.

Asset quality has improved overall but concerns remain for loans to specific sectors and those that have benefited from support measures. The non-performing loan (NPL) ratio has further decreased this year, which was not least supported by several large NPL securitisations. However, the NPL ratio of the exposures to the sectors most affected by the pandemic is on an upward trend. The share of loans classified under stage 2 under the International Financial Reporting Standard (IFRS 9) has started to decline, but remains above pre-pandemic levels. The volume of forborne loans has seen an uninterrupted upward trend since the start of the pandemic. The asset quality of loans under public guarantee schemes (PGS) and under moratoria is a source of concern, as an increasing share of these loans are being classified under stage 2 or as NPL. An analysis of new default rates shows that they tend to be higher for exposures from emerging market economies (EME). Whereas new default rates are slightly lower in the European Union (EU) / European Economic Area (EEA) region compared to one year ago, they have edged higher in EMEs, raising concerns for the banks exposed to these markets. The positive mood in funding markets and the availability of central bank funding allow banks to maintain comfortable liquidity positions. Despite recent rises in yields and some bouts of volatility, banks’ debt spreads have remained at relatively contracted levels, allowing issuers to make progress in building up their minimum requirements of eligible liabilities (MREL) buffers. Even though an increasing share of banks report the application of negative rates to depositors, customer deposits have further increased. Banks have continued to increase their take-up of central bank funding and more than half of central bank-eligible assets and collateral are now encumbered. Banks’ main liquidity indicators show strong positions across the EU/EEA. However, a change in the share of central bank funding and the impact of changes in interest rates might affect the stable funding structures of banks. Assuming that central bank funding is excluded from the numerator and that no counterbalancing measures are applied, the net stable funding ratio (NSFR) would fall by around 15 p.p. to about 115%.

Banks have made some progress related to environmental, social and governance (ESG) risk considerations. The share of ESG bonds of total bank isurances has increased substantially over the past few years.

Banks have started recognising ESG risks as drivers for traditional financial risk categories, e.g. credit risk, and integrating ESG risk considerations into their risk management. However, there is significant progress to be made, including in areas such as business strategies, governance arrangements, risk assessments and monitoring. In addition, data gaps continue to challenge the incorporation of ESG considerations into banks’ risk management. The lack of data often constrains banks’ efforts to develop methodologies to identify, assess and monitor ESG risks. Public disclosures as well as bilateral engagement with counterparties and external data providers currently seem the main sources for ESG risk assessment and monitoring.

The average Common Equity Tier 1 (CET1) ratio has increased this year on the back of retained earnings and reserves. Strong results in the first half of 2021 have boosted capital levels while factors like the increasing share of cash balances and central bank reserves over total assets, PGS, or the SME and the infrastructure-supporting factors have helped to keep risk weighted-assets (RWA) almost flat. The leverage ratio has gone up mainly because of the European Central Bank (ECB) decision to allow banks to exclude certain central bank exposures from the computation. The vast majority of banks adhered to supervisory recommendations and refrained from distributing 2019 profits, yet catch-up dividends or share buybacks will presumably be exercised in the last quarter of 2021 or in 2022.

Lower impairment costs have increased profitability, but structural challenges remain. The average return on equity (RoE) of EU/EEA banks is still below the estimated cost of equity (CoE). Banks’ net operating income (NOI) has not recovered to pre-pandemic levels. The low and negative interest rate environment is still weighing on lending margins. In contrast, net fee and commission income (NFCI) has grown, substantially boosted by asset management activities. Despite the acceleration in branch closures during the pandemic, operating expenses have stabilised in the past year as pre-existing working arrangements have gradually resumed. Staff productivity – measured as net operating income minus provisions and impairments generated by each euro of staff expenses – has improved on the back of lower impairments. Supervisory data shows that this indicator also depends on external factors such as the interest rate environment as well as on internal ones like the level of digitalisation.

Operational risk losses increased during the pandemic. The number of operational loss events has reached its highest level since data has been available. Though the annual materialised losses from these events is lower than in the 2014-2018 period, it strongly increased last year. The growing usage of and reliance on technology has been accompanied by a rising number of information and communication technologies (ICT) and security-related incidents. Money laundering and terrorist financing (ML/TF) risks may rise not least due to factors such as reliance on remote onboarding solutions.