The prospects for European banks' profits and capital in 2019 remain rather positive, but growing downside risks related to Brexit and Italy's new budget policy suggest a more mixed picture for credit ratings, S&P Global Ratings said Nov. 29.
Uncertainty around the final outcome of the negotiations on the U.K.'s departure from the EU and the spat between the European Commission and the Italian government about the country's expansionary budget policy are the key downside risks to bank ratings, according to the agency. The share of negative rating outlooks in the sector has already increased, which suggests an end of the positive trend in recent years, the rating agency said in its latest report on credit conditions in Europe, the Middle East, and Africa.
Most European banks are expected to keep their balance sheets and capitalization fairly stable, and profitability is even expected to increase slightly in 2019, albeit not beyond the cost of equity for many banks, it said.
Brexit deal
A disorderly Brexit in which Britain leaves the EU without a withdrawal agreement and with no transition period to a new status quo for financial companies would be highly detrimental to the U.K. economy and harmful especially to small banks in the country, S&P Global Ratings said. The economy could contract by 5.5% over three years in such a no-deal Brexit scenario, according to the agency.
The Bank of England on Nov. 28 projected an even stronger economic deterioration, saying there could be a 10.5% loss of GDP in the U.K. over five years after a no-deal Brexit.
Although S&P Global Ratings is sticking to an orderly Brexit as its base-case scenario, the likelihood of an adverse outcome is considerable "given the current lack of consensus in the U.K. Parliament for the withdrawal agreement or an alternative plan", the rating agency said.
Earlier in November, U.K. Prime Minister Theresa May presented a draft treaty setting out the terms of the country's withdrawal from the EU along with a draft political declaration outlining the future relationship between the two sides. The EU has approved both documents, but May faces strong opposition against the deal at home.
Approval by the House of Commons in a scheduled Dec. 11 vote is "most unlikely," and "it is very difficult to see a viable alternative that really commands the support of Parliament," Paul Watters, chair of the rating agency's EMEA credit conditions committee, said during an online presentation of the report Nov. 29. However, it is still possible that Parliament would approve the deal on a second vote that would have to be held later, he noted.
Once the Dec. 11 vote has passed, there may be some scope to renegotiate certain elements of the withdrawal agreement, Watters said. "I think that is going to be important to get all [members of parliament] back on one side."
Italy's budget
Meanwhile, the Italian government's plan to raise the country's budget deficit to 2.4% of GDP in 2019 has sparked a conflict with the EC, which wants to launch an excessive deficit procedure against Italy. The spat has led to a strong widening of Italian government bond spreads and continues to cause turbulence on the capital markets.
"Higher sovereign funding costs could result in higher funding costs for banks, limited access to foreign funding, and pressures on profitability and capital," S&P Global Ratings warned, noting that it forecasts a 2019 budget deficit of 2.7%. A more negative economic outlook could also prevent Italian banks, which are sitting on the largest pile of bad loans in the EU, from successfully concluding their ongoing restructuring, the agency said.
The reduction of nonperforming loans has been a driver for the improvement of bank profitability so far in 2018, the European Central Bank said in its latest financial stability report Nov. 29.
Financial market tensions in Italy coupled with the prolonged budgetary negotiations have affected credit ratings but have not had "a meaningful spillover" of financial stability risks to other eurozone countries, the ECB said.
Nevertheless, "the stress in the Italian sovereign debt markets [...] serves as a reminder of how quickly policy uncertainties can lead to shifts in market sentiment and a repricing of risk," it added.
The ECB also warned that the uncertainty triggered by a disorderly Brexit "could have the potential to pose a more significant downside risk to financial stability" in the euro area. The ECB once again urged banks to step up their contingency planning for a no-deal Brexit scenario.
This S&P Global Market Intelligence news article may contain information about statements issued by S&P Global Ratings, a separately managed division of S&P Global. Descriptions in this news article were not prepared by S&P Global Ratings. The original S&P Global Ratings documents referred to in this news brief can be found here.