With persistently high inflation requiring interest rates to remain in restrictive territory (potentially for about two years), financing conditions have clearly deteriorated for retail and corporate borrowers in Europe. Tighter financial conditions have also exposed vulnerable financial actors, shaking the market's confidence in banks. Looking ahead, our economists expect that real interest rates will turn positive in 2024, which is usually associated with weaker investment and economic growth. Against this backdrop, we expect that banks across Europe, the Middle East, and Africa (EMEA) will remain broadly resilient in 2023. Indeed, the solid capital buffers they have built up over the past few years, as well as their ample liquidity position and generally diversified funding profiles will support their creditworthiness. That said, we will likely see divergences among EMEA banks, with the strength of deposit franchises and credit risk management practices as key sources of differentiation.

Rising rates continue to support most EMEA banks' profitability, even if operating and credit costs are set to increase while lending growth will continue to decelerate. S&P Global Ratings expects that many banks in EMEA will be able to improve their returns in both 2023 and 2024. Provided that the authorities carefully balance tightening monetary policy with the risks to financial stability, banks should be able to preserve their solid capitalization and funding profiles.

At the same time, tighter financing conditions could uncover pockets of greater risk for banks. Vulnerable segments could include small-to-midsize enterprise (SME), consumer, and commercial real estate (CRE) lending. We therefore expect banks to face weakening asset quality over the next year, although the impact should be manageable, with provisions normalizing rather than spiking. While we consider that EMEA banks will perform resiliently over the coming quarters, we see three main downside risks to our baseline assumptions:

• Persistently high core inflation: This would add to the pressure on banks' operational costs and returns, as well as on the financial condition of corporates and households. In this scenario, monetary policy--and, potentially, fiscal policy--may need to be tightened further, taking a toll on economic growth and employment, and leading to weaker asset quality and business prospects for banks.

• Market volatility and restrictive financing conditions: Weaker borrowers could face excessively high funding costs and limited access to financing, ultimately triggering higher credit losses for banks. Emerging market banks--especially those with a high reliance on external debt--are the most vulnerable. Nonbank players could also suffer in that situation and spread the risk to the broader financial system.

• Banks' failure to deliver commercially and operationally resilient business models: This could occur if they fail to tackle inefficiencies, digitalize their businesses, and improve protection against cyber risks.

Potentially severe tail risks relating to the Russia-Ukraine conflict also remain a concern, as well as a heightened risk of disruption due to climate change and the energy transition.

Rating actions among EMEA banks remain fairly well balanced so far in 2023, with a positive net rating action bias and a persistent stable outlook bias, reflecting our view of a likely resilient performance throughout 2023.

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EMEA Banks Are Well Placed To Withstand The Ongoing Confidence Test

Market confidence in banks has been fragile since the recent string of regional bank failures in the U.S., and, in March 2023, the takeover of Credit Suisse by UBS. Weaker banks and nonbank financial institutions will likely experience greater pressure from weaker investor sentiment toward the financial sector and might find it difficult to meet their refinancing needs. The wholesale funding market will remain choppy for a while, especially for capital instruments.

However, we don't see EMEA banks as having the key funding vulnerabilities and sensitivities to interest rates that stressed some U.S. regional banks, for three reasons. First, we consider that the majority of EMEA banks have diversified funding profiles with strong domestic deposit franchises and limited reliance on wholesale deposits. Second, while the shift in monetary policy has led to unrealized losses in banks' securities portfolios, banks have recognized most of the losses through either the profit and loss statement or capital accounts, and the increase in unrealized losses has had a limited impact on the common equity tier 1 capital ratio. In addition, while the size of the securities portfolios that banks carry at amortized cost varies, in our view, it would take an acute liquidity crisis to force the materialization of such unrealized losses, as we consider that the majority of EMEA banks have solid liquidity buffers. Finally, we view the exposure of the majority of EMEA banks to the U.S. as limited, which limits contagion risk.

Solid Capitalization Remains An Important Stabilizing Factor In Banks' Creditworthiness

Many EMEA banks' regulatory capital ratios declined slightly in 2022, reflecting strong lending activity and higher distributions to shareholders than during the COVID-19 pandemic. We estimate that dividend payouts and share buybacks increased to 50% of banks' net profits in the eurozone, from 35% the year before, and we expect them to remain at that level this year. At the same time, we expect many banks to reduce their appetite for lending growth over the next year. As a result, the stable outlook bias on banks in EMEA largely indicates, among other things, our expectation of stable capitalization over the next year, despite higher shareholder distributions.

Asset Quality Should Deteriorate Only Moderately, While Credit Costs Should Normalize

We think that the generally resilient job market will support the performance of EMEA banking sectors' lending portfolios despite the pressures of economic stagnation. Banks weathered the two macroeconomic shocks in 2020 and 2022 well, and built substantial provisions while strengthening their balance sheets over the past six years, supporting their creditworthiness. This stands them in good stead to withstand what our economists see as a complicated but not dire economic outlook for 2023-2024 (see "Economic Outlook Eurozone Q2 2023: Rate Rises Weigh On Return To Growth," published March 27, 2023).

While so far, we have only seen muted growth in loan delinquencies, weaker economic conditions and tighter funding will inevitably exacerbate stresses for some household and corporate borrowers due to cost-of-living pressures and rising real interest rates. We expect that the consumer, SME, and CRE portfolios will be the most vulnerable to these pressures. At the same time, we expect provisions to normalize rather than spike over the next two years. Banks' risk appetite for new lending and the extent to which they can proactively manage and provision for weakening loan quality will differentiate their performance and could influence the ratings.

Tighter International Financing Conditions Pile Pressure On Emerging Market Banking Sectors

We consider that banking sectors with substantial levels of net external debt and markets with corporate or sovereign weaknesses linked to net external debt are the most vulnerable to the tough international funding conditions that we expect to continue through 2023. In our view, Turkiye and Tunisia appear among the most at risk among the EMEA emerging banking sectors.

Turkish banks are particularly vulnerable to negative market sentiment, increased risk aversion, reductions in global liquidity, and higher financing costs. This is due to their high external debt, which we estimate at about $144.2 billion at the end of 2022. At the same time, we expect that Turkish banks will retain access to external funding despite a moderate decline in rollover rates, so long as the government can contain balance-of-payment risks and their external debt continues falling gradually over the next two-to-three years.

Tunisian banks continue to navigate significant macroeconomic pressure, at least some of which is still linked to the revolution in the country 12 years ago. Those issues, coupled with a lack of economic reform, have weighed on economic activity, resulting in economic growth of 1.3% in 2023, according to the International Monetary Fund (IMF), and fiscal and external deficits likely totaling a cumulative 11.3% of GDP. In our view, if Tunisia is unable to make progress in talks with IMF to secure a program that would support economic reform, or at least attract bilateral or multilateral support from other parties, it will likely experience major balance-of-payment, fiscal, and currency instability, which would have a materially negative impact on the banking sector.

Some Emerging Market Banking Sectors Buck The Trend

Bucking the global trend of tightening funding conditions, the emerging banking sectors of Armenia, Azerbaijan, Georgia, Kazakhstan, and Uzbekistan got a boost from a substantial inflow of nonresident deposits in 2022 due to the war in Ukraine and the increased instability in the region as a result. This strengthened banks' funding bases and had either a neutral or positive impact on their funding costs. Although the impact is likely to be temporary and we do not expect the same strong inflows this year, we do not think that the nonresident deposits will leave the banking sectors abruptly. We therefore consider the related risk to be manageable.

Key Banking Sector Risks In EMEA

The table below presents S&P Global Ratings' views about the key risks and risk trends affecting the banking sectors in EMEA where we rate banks. For more detailed information, please refer to the latest Banking Industry Country Risk Assessment (BICRA) on a given country. According to our methodology, BICRAs fall into groups from '1' to '10', ranging from what we view as the lowest-risk banking systems (group '1') to the highest-risk (group '10').

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Selected Research

We recently published several articles highlighting our views on EMEA banking sectors:

• Banca Popolare dell'Alto Adige Outlook Revised To Positive On Reducing Economic Risks For Italian Banks, May 19, 2023
• Islamic Finance 2023-2024: Growth Beyond Core Markets Remains Elusive, May 1, 2023
• Outlooks On Egyptian Banks Revised To Negative Following Same Action On Sovereign; Ratings Affirmed, April 28, 2023
• U.K. Bank Credit Losses Will Rise Modestly To £5.2 Billion In 2023 As Marginal Borrowers Feel The Strain, April 26, 2023
• How The EU’s Bank Crisis Management Reforms Could Affect Ratings, April 25, 2023
• European Global Systematically Important Banks Are Weathering Market Volatility, April 25, 2023
• Various Positive Rating Actions Taken On Greek And Cypriot Banks, April 25, 2023
• European Banks' Asset Quality: Tougher Times Ahead Require Extra Caution, April 20, 2023
• Crisis Management Observations From Recent European And U.S. Banking Sector Volatility, April 19, 2023
• Where And How External Funding Stress Might Hit Emerging Market Banks, April 17, 2023
• How The Composition Of Swiss Banks' Gone-Concern Buffers Affects Our Rating Metrics, April 4, 2023
• Swiss Regulator's Statement On Credit Suisse AT1 Confirms Impact Of Documentation And Legislative Powers, March 23, 2023
• Cyber Risk Insights: European Banks' IT Complexity Amplifies Risk, March 23, 2023
• European Bank AT1 Hybrids In A Post-Credit Suisse World, March 21, 2023
• European Banks Can Weather The Market Turmoil, March 21, 2023
• Ratings Affirmed On Seven Kazakhstani Financial Institutions On Improving Banking System Resilience; Outlooks Stable, March 20, 2023
• South African Banking Outlook 2023: Economic Woes Won't Derail Performance, March 17, 2023
• Unrealized Losses: The Rate-Rise Risk Facing Banks, March 16, 2023
• Credit FAQ: Why Most GCC Banks Can Manage Contagion Risk From SVB, March 16, 2023
• European Banks See Limited Contagion Risk From SVB, March 14, 2023
• Outlooks On Five South African Banks Revised To Stable On Similar Sovereign Rating Action; All Bank Ratings Affirmed, March 13, 2023
• The Energy Transition: GCC Banks On Stable Ground, March 13, 2023
• Interest Income Fuels Bumper U.K. Bank Profits As Rates Near Their Peak, March 10, 2023
• Nordic Banks In 2023: Robust Fundamentals And Strong Performance Despite Economic Slowdown, March 6, 2023
• Future Of Banking: E-Krona Will Extend Sweden's Digital Lead, March 1, 2023
• Digital Bonds: The Disruption Is Underway, Feb. 27, 2023
• Bulletin: Morocco's Removal From The FATF Grey List Might Bring Few Benefits For Its Banks, Feb. 27, 2023
• German Banks In 2023: Well Placed To Withstand Economic Challenges, Feb. 21, 2023
• North Africa And Jordan Bank Outlook 2023: Uncertainty Will Test Resilience, Feb. 21, 2023
• Scenario Analysis: As Tunisia Seeks Financing, Its Banks Face Uncertain Prospects, Feb. 20, 2023
• Bulletin: Robust German Banking Industry Weathers Increased Geopolitical Economic Risk, Feb. 16, 2023
• Banking Sector Outlook 2023: Central Asia And Caucasus Remain Resilient, Feb. 9, 2023
• Outlook On 12 Nigerian Financial Institutions To Negative On Same Action To Sovereign; 7 National Scale Ratings Lowered, Feb. 8, 2023
• Israeli Banks 2023 Outlook: Rising Risks Are Well Contained, Feb. 7, 2023

Economic, Sovereign, And Other Research

• Sector And Industry Variables Published For Banking Industry Country Risk Assessment Update For April 2023, April 28, 2023
• Credit FAQ: Spotlight On Refinancing Risks In European Commercial Real Estate, April 24, 2023
• Emerging Markets Credit Ratings: Strength And Struggles Amid Global Shocks, April 17, 2023
• Banks' Capital Markets Revenue May Feel The Strain Of Economic And Industry Uncertainty In 2023, April 13, 2023
• Credit FAQ: Defining And Rating An Alternative Investment Fund, March 31, 2023
• Credit Conditions Europe Q2 2023: Costs Rising To Cure Inflation, March 28, 2023
• Sovereign Debt 2023: Emerging EMEA Cautiously Returns To The Markets, March 9, 2023
• Sovereign Debt 2023: Borrowing Will Stay Elevated Despite Rising Cost Of Debt, March 9, 2023
• German Residential REITs Face A Mixed Outlook In 2023, Feb. 20, 2023
• Global Finance Company Outlook: Testing Times Ahead, Feb. 8, 2023

BICRA Changes

Over the past quarter, we made the following changes to our BICRAs.

Armenia

We have revised our economic risk trend for Armenia to positive from stable. Since the Russia-Ukraine conflict began, Armenia has experienced positive spillover in the form of large labor and capital inflows from Russia. This, in turn, has boosted economic growth to double digits (estimated at about 12.6% in real terms in 2022) and narrowed Armenia's persistent twin deficits. We think there is unlikely to be a sharp reversal in financial and labor flows to the country in the next 12 months. Barring extreme scenarios, including a new direct military conflict with Azerbaijan, Armenia's near-term economic growth rate may slow but to a still robust 4% in 2023. The decline would likely be due to weaker external demand (particularly for tourism), restrictive global financial conditions, and dissipating financial and migrant inflows. At the same time, we expect that external and government balance sheets will remain stronger than before. This economic outlook, in our view, will help Armenian banks generate new business and improve asset quality.

Austria

We have revised our industry risk trend for Austria to stable from negative. This reflects our view that pressures on Austrian banks' profitability have moderated. Cost-optimization measures and improving revenue have contributed to the development, which we foresee will be sustainable. However, we expect only a marginal further profitability improvement in the medium term, reflecting a weakening economy, high inflationary pressure on operational costs, and increased risk costs. In our view, the sector's return on assets should remain about 0.5% in the medium term. Our base-case scenario does not take into account the tail risks from the secondary effects of the Russia-Ukraine war on Austria's and Europe's economies.

Cyprus and Greece

We have revised our industry risk trend for Cyprus to positive from stable. We have revised our BICRA for Greece to group '7' from group '8', our industry risk score to '7' from '8', and our industry risk trend to stable from positive. In our view, Cypriot and Greek banks will increasingly reap the benefit from years of balance-sheet cleanup and earnings restoration and now from interest rate hikes, significantly enhancing their loss-absorption and capital-building capacities. Banks in these countries have also made significant progress in rebalancing their funding profiles, thanks to strong deposits and sharp balance-sheet deleveraging, which now position them well to repay the large targeted longer-term refinancing operations they have undertaken.

Italy

We have revised our economic risk trend for Italy to positive from stable. The positive trend reflects our view that domestic banks in Italy have sharply reduced the high stock of problem assets accumulated in the previous downturn, and significantly reduced imbalances on their balance sheets. We also believe banks have made structural progress in managing the elevated credit risk they are exposed to in comparison with peer banking systems, including high exposures to weaker small and midsize enterprises. This progress can be summarized as better underwriting standards, more proactive management of riskier loans, and more prudent provisioning, all under the supervision and guidance of the European Central Bank. Furthermore, the weakest banks that suffered the most in past recessions are no longer operating after being either liquidated or merged into stronger banks. These factors are likely to make Italian banks' asset quality more resilient to future downturns than in the past.

Kazakhstan

We have revised our BICRA for Kazakhstan to group '8' from group '9', and our industry risk score to '8' from '9'. We believe that Kazakhstan's banking industry is demonstrating signs of recovery from a protracted correction following increased credit losses. This recovery is being supported by favorable commodity prices stimulating credit demand, alongside material improvements in asset quality. Kazakhstani banks benefit from solid margins and have demonstrated a capacity to generate earnings to buffer them against risks even as the external operating environment has remained uncertain and volatile.

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