European banks could face an increase in nonperforming loans and a decline in profits over the next few quarters amid continued economic slowdown in their home markets, the European Banking Authority said Dec. 9.
Both asset quality and profitability of banks in the European Economic Area improved in the 12 months to June, yet there are early signs of stress that are a cause for concern, the EBA said in its latest risk assessment report. Higher volumes of loans with weaker credit quality could drive a rise in nonperforming loans, or NPLs, in the future, while the economic slowdown and some negative effects from rising interest rates could hit bank profits.
The average NPL ratio of the sampled banks improved to 1.8% as of June, from 2.3% a year prior. In the same period, overall NPL volumes declined to about €370 billion from roughly €445 billion, the EBA data shows.
Yet, the worsening macroeconomic environment is starting to take its toll on the sector, the EBA said. NPL inflows surged 30% in the first six months of 2022, driven by the impact of the war in Ukraine and slowing GDP growth, according to the report.
Furthermore, the share of Stage 2 loans in bank portfolios hit 9.5% in the second quarter of 2022, the highest level since the accounting standard was introduced in 2018, the data shows. Loans are categorized as Stage 2 when their credit quality has deteriorated significantly since initial recognition in the bank’s portfolio.
These developments indicate an upcoming rise in NPLs, especially given the gloomy outlook for the EU economy this winter, the EBA said. “[T]he abrupt rise in inflation, increasing interest rates and the energy crisis coupled with heightened geopolitical uncertainty have amplified downside risks for economic growth,” it said.
More than half of the banks in the EBA sample expect asset quality to weaken across their corporate and consumer credit portfolios, the data shows.
The average return on equity for the sampled banks grew to 7.8% as of June from 7.4% a year ago. The key driver of the increase was higher net interest income, or NII, which grew thanks to interest rate hikes by central banks.
While rising rates will continue to support bank profits, some lenders will likely feel the negative impact of elevated rates too, the EBA noted. The higher rates coupled with lower GDP growth could lead to a drop in fee income from asset management and payment services, affecting bank profitability. Banks that are more reliant on wholesale funding would also have to cope with a surge in funding costs, the EBA said.
The expected macroeconomic slowdown could lead to slower lending growth and rising impairments, while higher inflation may boost operating costs, it said.
Against this background, it remains uncertain how bank profitability will evolve in the coming months and quarters, according to the EBA.
The report tracked the performance of 122 European Economic Area-based banks over the second half of 2021 and the first half of 2022, gauging potential risks banks could experience over the next 12 months.