08 November 2023

SSM note to Eurogroup: Banking sector is resilient

Banks have proven resilient in the face of external shocks, says Supervisory Board Chair Andrea Enria. Their improved capital base, asset quality and profitability make them well prepared to weather possible economic downturns amid the current macro-financial uncertainty.

Current state of the European banking sector
In the last few years, significant institutions in the banking union have
strengthened their financial position and proved to be resilient to a
succession of exogenous shocks, including the COVID-19 pandemic,
Russia’s invasion of Ukraine and the turmoil that followed the failure of
some US regional banks and the takeover of Credit Suisse in the spring of
2023. While the pandemic delayed the exit from the low interest rate environment,
the fallout from Russia’s invasion of Ukraine hastened it. Banks have therefore
had to adjust to these shocks emanating from the rapidly changing economic
environment, characterised in particular by a rapid tightening of interest rates. The
exit from the “low-for-long” interest rate environment bolstered bank profitability,
but the financial market turmoil unleashed by the failure of Silicon Valley Bank
(SVB) showed that the path can be bumpy if banks do not rapidly adjust their asset
and liability management and their risk management focus.
The banking sector has strengthened its balance sheet and proven to be
resilient. The Common Equity Tier 1 capital ratio of the banks under our direct
supervision stood at 15.7%, while the leverage ratio stood at 5.4% in the second
quarter of 2023. Notwithstanding the gradual reimbursement of extraordinary ECB
financing, banks’ liquidity remained strong, with an average liquidity coverage ratio
of 158% and net stable funding ratio of 126% in the same period, both well above
regulatory requirements and pre-pandemic levels. In addition, profitability
continued to improve, with the annualised return on equity reaching 10% in the
first half of 2023. Asset quality has improved over time across the banking union,
with the aggregate volume of non-performing loans (NPLs) down from nearly €1
trillion in 2015 to around €340 billion today, with an NPL ratio of 1.8%.
Exchange of views of the Chair of the Supervisory Board of the ECB with the Eurogroup on 8
November 2023 2
The 2023 stress test results confirmed that the banking sector could overall withstand a very severe economic downturn. The adverse scenario was much more severe than in previous rounds and included sharp interest rate hikes, high inflation and a significant decline in asset prices. The marked improvement in banks’ starting position in terms of capital, asset quality and profitability means that the sector would be able to weather the severity of this scenario. The exercise also helped to highlight pockets of vulnerability which call for improvements in risk management and additional capital buffers. Furthermore, an ad hoc data collection focused on unrealised losses, reflecting the depreciation of securities holdings held at book value. As one of the root causes behind the recent demise of some US banks, this issue has attracted a considerable amount of market attention. The overall amount of unrealised losses net of hedges in the banking union is contained (€73 billion). This is especially true when compared with the figures disclosed by US banks (over USD 600 billion). Under the adverse market risk scenario, these losses could increase to around €150 billion, which looks manageable given the significant cash holdings and excess central bank reserves that can be tapped in a liquidity stress situation. In contrast to SVB-like business models, which are characterised by extreme interest rate risk and a strong reliance on a concentrated, uninsured deposit base, European banks also tend to have well-diversified funding sources and customer bases.
Despite this largely positive assessment, banking union valuations remain depressed, with the latest price-to-book ratio standing at 0.7. Investors want to understand whether the current higher level of profits is sustainable given the gradually deteriorating macroeconomic outlook, an expected increase in funding costs and greater uncertainty surrounding governments’ taxation of banks’ interest income. In this context, the cost of equity remains very high and is still above the average return on equity....

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