European banks have cut their holdings of sovereign bonds, reducing risks both to the companies themselves and the governments whose debt they hold.
In its latest risk assessment report, the European Banking Authority said the total exposure of the EU banking sector to sovereign bonds stood at €3 trillion in June, a 10% decrease from two years ago.
However, large banks remain heavily exposed to their home country's sovereign bonds. Of all French government debt held by banks of all nations in the EBA sample, 82% was held by French banks, for example. Dutch banks held 84% of the Netherlands' debt, and Greek banks held the same proportion of Greece's debt.
The equivalent figure for U.K. banks was 58% and for Germany 57%.
'Doom loop' risk
Cutting sovereign exposure reduces the risks of banks and governments being caught in a "doom loop," which occurs when weak banks holding a high proportion of sovereign bonds destabilize their country’s governments, while at the same time over-indebted governments risk pushing banks that hold their bonds over the edge.
It was the phenomenon at the heart of the eurozone sovereign debt crisis that unfolded after the global financial crisis. It was also key to concerns about the stability of Italian banks during Italy's financial crisis earlier in 2018, which was punctuated by the government's controversial budget plans.
The EBA's figures also reveal how exposed major European banks are to Italian sovereign bonds. Italy's banks hold €204 billion, while France's banks hold €52 billion, Spanish banks hold €38 billion, German banks €25 billion and Belgian banks €24 billion.
The EBA said banks and analysts share the expectation that lenders' exposure to sovereign bonds might decrease further.
"This might in future further reduce the link between banks and sovereigns, and also banks' vulnerabilities to volatility in these markets for exposures recognized at fair value," the EBA said.
The regulator is clear in its report that the consequences of banks' exposure to sovereign bonds can be onerous.
"Sovereign bond market conditions remained volatile over 2018 with, in particular, spreads of Italian sovereign bonds rising amid renewed political tensions. Government bond markets in other EU countries have also been affected, albeit to a lesser extent," it said.
Meanwhile, banks have become better capitalized over the year, the EBA said, with the aggregate fully loaded common equity Tier 1 ratio increasing to 14.3% in June from 14.0% a year earlier.
Asset quality has improved, too, with the average nonperforming loan ratio of EU banks reaching its lowest level since the definition for such loans was agreed across the bloc in 2014, when it stood at 6.5%. The EBA said banks' NPL ratios had decreased to 3.6% in June from 4.4% in June, 2017.
It warned, however, that banks' efforts to reduce such ratios still further might be jeopardized by poor economic prospects combined with a revival of protectionism and greater political risk.
The EBA said European banks' profitability had not improved, however, with an average return on equity of 7.2% as of June. Net interest income showed a small decrease since June, 2017, despite growing lending volumes.
Margins decreased, said the EBA, as new loans were priced at lower interest rates. However, there was also increased competition from fintech firms while banks themselves were held back by IT failures.
"Efficiency in the EU banking sector has not improved. Costs related to replacements as well as outages and failures of old legacy information and communication technology systems, including costs related to IT migrations, and investments in new financial technology are further drags on profitability," the regulator said.
Operational risks for banks are expected to increase, said the EBA, in particular in relation to IT systems, but conduct and legal risks have also risen during 2018, including anti-money laundering failures.
The EBA also looks at Brexit and considers the implications of a "cliff-edge" scenario which could lead to the U.K. leaving the EU without a withdrawal agreement. It warned in June of a lack of contingency planning by financial institutions and the need to speed up preparations for a no-deal Brexit — something that led the Bank of England to respond that its own preparations were well-advanced. The situation has improved subsequently, said the EBA.
"Financial institutions have made progress in some areas. More institutions are implementing contingency plans and the contingency plans themselves have advanced," said the bank.
It said more institutions are getting the necessary licences and relocating their businesses but said there are still concerns over the cross-border derivatives market. The Bank of England has previously said £41 trillion of derivatives contracts are at risk since no long-term agreement has been reached with the EU over the issue.
On Dec. 19 the European Commission said it was preparing for a cliff-edge Brexit by granting temporary and conditional equivalence to U.K. clearing houses and depositories for one year and two years, respectively.
The EBA said it is also worried about the Brexit preparations of payment and e-money institutions. The latter are of particular importance from the perspective of the rest of the EU because of the scale of the payments businesses offered by British institutions using their cross-border passporting arrangements.
To view detailed bank-by-bank capital, asset quality, leverage and profitability metrics, click here to download S&P Global Market Intelligence’s 2018 EBA transparency exercise template.
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