The balance sheets of euro zone banks are showing “early signs of stress” after a rise in loan defaults and late repayments from historic lows, the European Central Bank (ECB) has warned.
Officials urged lenders to increase provisions to cover rising loan losses and predicted their profits would be hit by a drop in lending volumes and increased funding costs. The ECB has increased interest rates by an unprecedented 4.5 percentage points in the past year.
“A longer period of high interest rates is likely to lead to higher provisions, which in turn will be a drag on profitability further down the line,” the central bank said at its twice-yearly financial stability review.
The ECB said the banking system was “well placed” to cope with a deterioration in asset quality due to its “strong capital and liquidity” levels and surging profitability, which recently hit its highest level for more than a decade.
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The system remained resilient during turmoil in the sector earlier this year, when lenders including Silicon Valley Bank and Credit Suisse collapsed or had to be rescued.
ECB vice-president Luis de Guindos said that while “risks to financial stability may appear less acute, they remain elevated”, pointing to the impact of weaker economic growth, tighter financing conditions, rising loan defaults and a downturn in property markets.
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He also said an “escalation of the conflict in the Middle East could trigger a sharp increase in risk aversion in financial markets, unravelling the prevailing vulnerabilities”, by disrupting energy markets, undermining confidence, slowing growth and pushing up inflation.
The ECB outlined three main “headwinds” for banks’ profitability: increased funding costs as they pass on higher rates to depositors; an increase in loan defaults as the economy weakens and debt-service costs rise; and “a substantial drop in lending volumes”.
“Default rates on both corporate and retail exposures have started to increase and the share of loans which are less than 90 days past due but still performing has also picked up and stands above the historically low levels seen in 2022,” it said.
The central bank also warned that household incomes, corporate revenues and public finances could feel an additional squeeze if the economy continues to disappoint and as the impact of the ECB’s historic monetary-tightening campaign continues to unfold.
“The weak economic outlook, along with the consequences of high inflation, are straining the ability of people, firms and governments to service their debt,” ECB vice-president Luis de Guindos said in Frankfurt.
“It is critical that we remain vigilant as the economy transitions to an environment of higher interest rates coupled with growing uncertainties and geopolitical tensions.”
The outlook for the 20-nation euro area has worsened of late, and a recession is possible after output shrank 0.1 per cent in the third quarter. Activity is only expected to pick up slightly next year, while downside risks such as the uncertain impact of rate hikes and geopolitics were seen dominating when policymakers met in October.
Still, financial markets currently expect a “soft landing”, where inflation moderates without a significant hit to growth, according to the report. Historical evidence suggests such a scenario is “difficult – although not impossible – to achieve in practice, especially given the magnitude of rate increases in a short period of time”, the bank said, adding that negative surprises to growth risk a “disorderly correction”. – Copyright The Financial Times Limited 2023/Bloomberg
