European banks set to avoid bad loan surge in 2024

Europe's largest lenders look increasingly likely to avoid a sharp increase in bad loans that many feared when central banks began aggressively hiking interest rates in 2022.

Analysts expect only a modest increase in credit losses for Western European banks in 2024, climbing to about €79 billion from just over €71 billion in 2023, according to S&P Ratings data. Cost of risk — a measure of a bank's expected credit losses — is also expected to fall for most large European banks in the year, S&P Global Market Intelligence estimates data shows.

The relatively benign outlook for 2024 follows a small uptick in loans at risk of credit loss in the third quarter of 2023 from the end of 2022, the data shows.

"We have seen a very modest pickup in the stock of nonperforming loans despite the sharp rise in interest rates," Nicolas Hardy, deputy head of financial institutions at Scope Ratings, said in an interview. "It's relatively positive and it could also last."

Shifting rate environment

Many analysts and economists had expected a much stronger increase in bad loans among the region's banks in response to an unprecedented rise in interest rates over the past two years. The European Central Bank hiked rates by 450 basis points in the 15 months to September, while the Bank of England increased rates by 515 bps between December 2021 and August.

Increasing confidence that the eurozone and the UK will avoid deep recessions and significantly higher unemployment in 2024 is encouraging analysts to have a more positive outlook for banks' balance sheets in the coming quarters.

The ECB expects the eurozone economy to grow by 0.8% in 2024, while the Bank of England expects the UK to see flat growth. Both projections were revised slightly down from previous estimates, however.

Central banks expect unemployment in the eurozone and the UK to rise only marginally in 2024. Forecasts for eurozone unemployment in 2024 have slightly improved since September, with the latest ECB projections foreseeing an increase to 6.6% from 6.5% in 2023. The Bank of England expects UK unemployment to rise to 4.7% in 2024 from 4.3% in 2023, up from the 4.5% forecast in August.

"We're not really that concerned about household asset quality unless there's significant uplifts in unemployment, which we don't really see at the moment in most areas," said Johann Scholtz, bank equity analyst at Morningstar.

European banks experienced only a small increase in stage 2 and stage 3 nonperforming loans (NPLs) — loans at greatest risk of credit losses — in the first nine months of 2023, Market Intelligence data shows. Aggregate stage 2 and stage 3 loans at Europe's 20 largest banks by total assets increased by 1.5% to just over €1 trillion in the nine months to the end of September, after a sharp increase in 2022, according to the data.

Beyond the volume of stage 2 and stage 3 loans, analysts examine the flow of loans between the stages to look for signs of emerging problems, said Pablo Manzano, vice president of financial institutions at credit rating agency DBRS Morningstar.

"Doing that analysis, we don't see any sign of weakening or deterioration," Manzano said.

Of Europe's 15 largest banks, 11 are expected to have stable or lower cost of risk in 2024 compared with 2023, Market Intelligence data shows. Of the 11, UBS Group AG, which recently completed its takeover of crisis-hit domestic peer Credit Suisse Group AG, is expected to see the largest fall in cost of risk, to 100 bps from between 200 bps and 300 bps.

Still, some lenders could see an increase. Cost of risk at Italian banks Intesa Sanpaolo SpA and UniCredit SpA is expected to increase the most, respectively, Market Intelligence estimates data shows.

Asset quality problems are more likely for Italian banks, as well as banks in markets such as Spain and Portugal, due to the larger proportion of variable rate loans that tend to be held on their balance sheets, said Arnaud Journois, vice president of financial institutions at DBRS Morningstar.

"They get the benefit of that in their revenues, but on the other hand that might prove riskier on the asset quality side as more borrowers struggle with higher interest payments," Journois said.

Banks in Italy also tend to have a higher exposure to small and medium-sized enterprises, which are a likelier source of problem loans in the current environment, Journois added.

Lenders with significant exposure to commercial real estate and leveraged finance might also struggle, Scholtz said. The recent collapse into insolvency of Austrian property and retail group Signa, which owes billions of euros in loans across several European banks, has validated warnings about the sector as interest rates continued to rise.

"For us the concern would probably be more toward loans for property development, where there are no tenants and no cash flow," Scholtz said.

Reserves

Any increase in bad loans should be manageable for European banks. Europe's 20 largest banks had more than €87 billion in aggregate reserves covering stage 2 and stage 3 loans as of the end of September, Market Intelligence data shows. Stage 2 and stage 3 reserves as a percentage of stage 2 and stage 3 customer loans at the banks have remained relatively stable since a surge in provisioning in response to the COVID-19 pandemic.

Much stronger capitalization since the 2008 global financial crisis and a recent surge in profitability from higher interest rates will provide additional protection for the banks.

European banks entered the latest central bank hiking cycle with much healthier balance sheets than those seen over the last decade or so. Following the surge in NPLs generated by the 2008 global financial crisis and subsequent eurozone sovereign debt crisis, NPLs in the euro banking system have fallen by around two-thirds from their peak in 2015 to just over €300 billion in 2023.

"The banks are in good shape, thanks to the cleaning up of balance sheets in recent years," said Hardy. "They have the capacity to absorb a moderate increase of problem loans, which is likely since higher interest rates put pressure on the most vulnerable borrowers."