Four Threats to European Banks in 2023

The most extreme threat European banks face in the current geopolitical and economic context, is posed by the growing risk of armed conflicts in areas like Kosovo, Taiwan or Korea, as the war in Ukraine provides a "distraction" that other powers may try to exploit. This is one of the conclusions outlined by Andrea Resti of Bocconi's Department of Finance and member of a panel of independent advisors to the European Parliament's Committee on Economic and Monetary Affairs in an in-depth analysis recently published. Moreover, there are concerns that EU banks may not be fully appreciating the challenges originating from a deteriorating macroeconomic context.

Resti's analysis describes three other factors that make the European banking sector more vulnerable. The first is a higher credit risk, originating from rising interest rates that make corporate debt less sustainable, higher energy and food prices putting pressure on corporate margins, lower disposable income leading to a drop in demand from consumers. This risk is going to become stronger once the short-term effect of a sharp rise in inflation rates on nominal loans has abated.

Secondly, banks have acquired in the past few years a huge quantity of sovereign bonds issued at the very low interest rates available until recently. These bonds are now worth considerably less as interest rates rise, deteriorating many banks' asset base. This problem is especially severe for bonds issued by heavily indebted countries like Italy as growing interest rates makes servicing their debt more expensive and raise the risk premium investors require.

Another threat comes from the European Central Bank's decision to tighten liquidity after the long period of very low inflation has effectively ended. Indicators show that banks do not see affordable alternatives to ECB funding, putting a potentially high pressure on some banks' net margins as the cost of liquidity goes up.

"Banks and supervisors seem to disagree on the severity of the dangers that lie ahead," Resti explains. "Banks feel that growth will pick up again in 2023, and that regulators have a much too pessimistic view of the general situation. But if supervisors are right in believing that Euro-area lenders are vulnerable to second-round effects, then the lenders' unwillingness to fully share such concerns might impair their capacity to prepare for, and react to, an unfavorable context."