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Earlier this year, substantial global market tensions emerged following the failure of two mid-sized banks in the United States and the loss of confidence in Credit Suisse.
As a result, banking sector risks are now squarely back in the focus.
While market sentiment towards euro area banks had improved markedly in 2022, this reversed abruptly in March following the events I just mentioned. Market tensions led to sharp declines in euro area bank stock prices and in riskier bank bond markets, notably in the Additional Tier 1 segment.
Fortunately, turmoil in the euro area was short lived. The limited exposures of euro area banks to the sources of US and Swiss bank stress, their solid fundamentals, and the comprehensive regulatory and supervisory frameworks in place shielded them from a more severe financial unravelling.
But this shock was only the latest in a series of extraordinary events that have put Europe’s economy and banking sector to the test – the pandemic, Russia’s war against Ukraine, and the subsequent energy crisis.
It is against this background that I would like to review the last couple of months from the perspective of euro area banks. I will first highlight how they differ from their global counterparts, before turning to the complex challenges they currently face. I will then conclude by discussing how macroprudential policy and regulation can help maintain banks’ resilience.
Euro area banks’ fundamentals are solid across several key areas.
The first of these is profitability. Euro area banks’ profitability improved in 2022 and their return on equity reached almost 8%, its highest level since the start of the banking union. This improvement in earnings was followed by an increase in distributions to shareholders via dividend payouts and share buybacks. Market valuations for euro area banks also improved, with the valuation gap vis-à-vis their US peers narrowing.
The second key area is resilience. The euro area banking sector is underpinned by strong capital positions. Banks’ aggregate Common Equity Tier 1 ratio stood at 15.3% at the end of 2022, well above the minimum requirements. And the decline in non-performing loan (NPL) stocks continued last year, with banks’ aggregate NPL ratio stabilising at 2.3% in the fourth quarter.
The third area I want to highlight is liquidity and funding. Here, euro area banks differ substantially from their global counterparts. Their average liquidity coverage ratio exceeded 160% at the end of 2022, and around half of their high-quality liquid assets are held as cash and deposits with central banks. On aggregate, euro area banks are mainly funded by customer deposits, and a relatively high share of these are covered by deposit guarantee schemes.
There is no room for complacency, however.
Economic activity in the euro area has held up better than expected and a recession at the turn of the year did not materialise. But growth is still weak and inflation continues to be too high, with underlying price pressures remaining strong. Earlier this month, the Governing Council decided to raise interest rates by 25 basis points, bringing the deposit facility rate to 3.25%.
The challenging outlook heightens the uncertainties surrounding banks’ profitability and resilience.
While higher interest rates boost banks’ net interest income, the benefits could be somewhat smaller than previously anticipated given a slowdown in lending growth and the inversion of the yield curve....
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