French banks face profitability squeeze as surprise election roils markets

French banks' profits are likely to suffer a further squeeze in the coming quarters if the country's upcoming parliamentary elections put the far-right National Rally or leftist New Popular Front in power.

Concerns over the parties' taxation and spending plans is roiling bond and equity markets, pushing up French banks' funding costs. Uncertainty about the country's economic trajectory could also hit the banks' lending activity, reducing income just as pressures that have weighed on profits over recent quarters were expected to begin easing.

French President Emmanuel Macron called snap parliamentary elections June 9 after a big victory for Marine Le Pen's far-right National Rally party in a vote for the European parliament. Ahead of the first round of parliamentary elections June 30 and a second round July 7, National Rally have a strong lead in the polls with New Popular Front second.

"This political uncertainty could put pressure on business dynamics more than we were expecting, so that improving profitability is even more of a challenge for the banks," Nicolas Hardy, deputy head, financial institutions at Scope Ratings, said in an interview. "It's also putting pressure on wholesale funding costs, which is not helping their lending margins."

Recent recovery

French banks only recently began to see a recovery in domestic net interest income (NII) — the difference between what banks earn on loans and what they pay for deposits and funding — after consecutive quarterly declines. A sharp rise in deposit costs due to regulated savings schemes such as the Livret A, largely fixed-rate mortgage books, and limits on the rate at which the banks could pass on higher interest rates known as the usury rate were among the factors weighing on domestic NII.

The uncertainty generated by Macron's election announcement prompted a massive sell-off in French banks stocks, which have yet to recover. Société Générale SA is taking the biggest hit of the country's three listed lenders, falling almost 20% since the beginning of June, S&P Global Market Intelligence data shows. BNP Paribas SA, France and the eurozone's largest lender by total assets, is down more than 12% since the start of the month as of June 24, while Crédit Agricole SA has fallen by almost 13%.

"The market is playing the banks as proxies for 'France Incorporated,'" said Johann Scholtz, bank equity analyst at Morningstar.

Sovereign risk

Fears over what a National Rally or New Popular Front government would mean for France's national debt also led investors to sell-off French sovereign bonds. The price of credit default swaps — an indicator of investor confidence in a borrower paying their debts — on French sovereign bonds rose by almost 15 basis points in the days after the election was called.

Rises in sovereign risk increase banks' funding costs through several channels due to the pervasive role of government debt in the financial system, according to a 2011 published by the Bank for International Settlements. French banks' balance sheets hold large amounts of French sovereign debt, which is now less valuable, making the banks riskier to their lenders.

The declining value of French bonds also reduces the value of the collateral French banks can offer when raising wholesale funding and central bank liquidity. A weakening of the sovereign reduces the funding benefits that banks derive from implicit and explicit government guarantees.

French banks were already weighing up potential knock-on effects from a recent downgrade of French sovereign debt by S&P Ratings to AA- from AA. Sovereign downgrades generally flow through to lower credit ratings for domestic banks, increasing wholesale funding costs and potentially impairing their market access.

"When the [bond] market turns bearish on France, the market turns bearish on French banks," said Sam Theodore, an independent European banking consultant. "Nobody says, 'France is a problem country now, but the French banks are doing fine,' — it doesn't work like that."

Overdone

Still, the slump in French sovereign debt should not pose any urgent problems for French lenders, Hardy said.

"We don't see the sovereign at the current high rating level being an immediate pressure point in terms of bond portfolios for banks," he said. "There are valuation issues that could have an impact on their earnings and market volatility may last for some time."

The extent of the sell-off in French bank stocks is also likely overdone, Scholtz said. "The sheer quantum of the moves imply massive hits to earnings," he said. "And I'm not sure that's necessarily the case."

National Rally entered the final week before the first round of votes with a strong lead in the polls at 35.2%, according to a seven-day weighted average of recent polls calculated by the Financial Times. New Popular Front, an alliance of left-wing parties, is second with 28.3%. Macron's Citizens Together coalition are third with 20.1%.

"From the market trust perspective, the left would be the worst scenario," Theodore said. "National debt levels will continue to go up in any of these three scenarios, but probably much more so on the left side. Basically, business confidence is going to get a big hit in France."

Increasing support

Le Pen's far-right party, which has never been in power, enjoyed a surge in popularity in recent years following a rebrand in 2018 that changed the party's name from National Front. Le Pen attracted enough support in the 2022 French presidential election to make it to a run-off against Macron, which she lost heavily.

National Rally released its manifesto June 24. Beyond its trademark anti-immigration policies, the party pledges to reduce taxation while increasing spending in some areas such as state pensions. The plans would still allow for a reduction in France's budget deficit, the party claims.

Unpopular economic reforms to reduce public debt and make France more business-friendly have defined Macron's presidency since he took power in 2018. Some of his policies, such as an increase in fuel taxes and an increase in the retirement age, sparked widespread protests and occasional civil unrest.

Macron's economic reforms failed to prevent the country last year from exceeding the 3% deficit spending limit the European Union sets for all its members. The failure prompted the European Commission, the EU's executive arm, to announce June 19 that it is opening an Excessive-Deficit Procedure that will force France and six other countries to set out a plan to bring spending back under the threshold.

"These developments should be a worry for the banks," Theodore said. "In terms of market perception of French banks, that's not good news."