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European banks: Key trends to watch in 2017

Major political events look set to dominate the prospects of European banks in 2017. But other issues are weighing on the minds of observers regarding the year ahead: the impact of rising inflation on interest rates in the U.K., an economic recovery in Russia and further fragmentation in global regulation.

S&P Global Market Intelligence assembled some of the key predictions from rating agencies and other observers about the year ahead.

The US factor

Moody's expects modestly stronger global growth and increases in U.S. rates to help investment banks generally, but said this could be offset by "elevated policy uncertainty." The agency also worries that global growth could weaken further and that a combination of shareholder pressure along with a substantial loosening of regulations could lead to greater risk-taking.

In general, the big investment banks have "significantly" improved their capital and liquidity profiles, Moody's said. But "profitability will remain a challenge even as returns on equity will improve modestly; many global investment banks will still struggle to earn [the] cost of capital."

Another risk to profitability stems from the investment required in technology to enhance long-term efficiency and compete with fintech specialists, while "more nimble and technologically advanced specialists" are seen as a risk to the market share of established players.

Monica Lichtner at Deutsche Bank warns of "increasing signs of fragmentation" in global regulation, pointing to the divergence of the U.S. and European banks over the final Basel IV package, which has prompted concerns of unfairness among European policymakers. "The 'balkanization' of global banking remains a key concern not least given the U.S. regulation of foreign banks," Lichtner said.

Fiscal loosening in Europe

Fitch Ratings sees government debt in the EU as a key trend to watch. In particular, it expects continued fiscal loosening in 2017 — attributable partly to political pressures — to support short-term economic growth at the expense of a reduction in the scope for lowering public debt and an undermining of the credibility of EU fiscal rules.

Moody's expects the profitability of European banks to weaken in 2017 because of a more visible decline in net interest margins and increasing costs as many banks invest in digital revamps.

The ECB will keep monetary policy ultraloose against the backdrop of sharply lower growth and it may finally implement its Outright Monetary Transaction program to buy up sovereign debt, predicts Capital Economics, which sees the euro falling to as little as 95 U.S. cents in 2017.

More tie-ups in Spain, Austria and Germany?

"Our view has been that we are likely to see more consolidation in the banking sector," Jefferies banks analyst Benjie Creelan-Sandford told S&P Global Market Intelligence, commenting on a potential sale of Banco Popular Español SA, the sixth-biggest bank in Spain, where the number of banking groups has shrunk to 14 from 55 less than a decade ago.

Carola Schuler, a managing director at Moody's, predicts more consolidation in the year ahead.

"We expect more bank mergers in fragmented systems, like Austria and Germany, and particularly within these countries' cooperative banking sectors," she said.

Southern Europe, Ireland improve

"Despite still large stockpiles of nonperforming loans in Italy, Portugal and Greece, banks' asset quality is stable or improving in most European countries," Schuler said in a report written before the enforced bailout of Italy's Banca Monte dei Paschi di Siena SpA by the government in late December.

"Levels of nonperforming loans, for example, have significantly improved in Ireland and Spain, supported by low interest rates, problem-loan sales and write-offs."

Russia back from the cold

With an economic recovery underway in Russia and the possibility of a thaw in Russo-American relations under a Trump administration, Moody's senior credit officer Irakli Pipia expects improvements in sanctions-hit banks' profitability and capital retention.

Growth in emerging Europe as a whole will strengthen in 2017 as Russia pulls out of recession, Capital Economics believes.

"We think that inflation there will fall by more than most expect and, while the central bank has struck a hawkish tone in recent months, we think that interest rates will be lowered further in 2017 … ultimately, we think the policy rate will be lowered by more than the markets are pricing in over 2017."

Société Générale, similarly, predicts a first rate cut in the second quarter of 2017, with a target rate of 9% by year-end.

For the Commonwealth of Independent States, or CIS, more broadly, Moody's sees NPLs at banks leveling off in 2017 amid a sluggish recovery, and stable loan quality despite a rise in problem loans in Kazakhstan and Azerbaijan following local currency depreciation there.

"Bank capital is also stabilizing across much of the CIS region," said Moody's managing director Nick Hill.

Brexit dominates the UK outlook

Moody's expects the uncertainty around the future relationship between Brussels and London to weigh on banks' revenues and cause asset quality to come under pressure. But it expects the stronger balance sheets of U.K. banks to help them weather the possible loss of passporting rights into Europe.

Fitch expects the uncertain path to Brexit for the U.K. to dominate the outlook for the EU, and to be "a substantial negative shock to the U.K. economy and public finances." The rating agency said it believes "it is unlikely the U.K. will remain in the EU single market, given its apparent prioritization of sovereignty and controlling immigration."

Although Capital Economics sees U.K. inflation rising above the 2% target in spring 2017 and peaking around 3% within 12 months, it thinks that the Bank of England's monetary policy committee will "look through this period of above-target inflation ... given the uncertainty about the economic outlook."

"However," it added, "as greater clarity emerges about the U.K.'s future relationship with the EU, which we expect to reveal a soft(ish) form of Brexit, we think GDP growth will pick up again in 2018 and talk of interest rate hikes will come back on the table."

House price worries in the Nordics

Nordic banks are well-positioned going into 2017, with resilient capital, robust profitability and favorable macroeconomic conditions, Moody's said. But surging house prices are a concern for most credit agencies.

"Net profitability for large Nordic banks will remain stronger than most European peers in 2017 despite the very low interest rate environment," the agency added.

Fitch said good cost efficiency, strong pricing discipline and cheap wholesale funding underpin banks' profitability, adding that margins will "likely strengthen somewhat in 2017."

It pointed to household debt and residential property inflation in Sweden and Norway as "key sensitivities" for the banks, and although it doesn't expect a major house price correction, it worries that such an event could weaken banks' operating environments as consumers pull back.