State of the European banking sector
During the first decade of the banking union, the resilience of European banks has strengthened. Legacy risks have been reduced, banks are better capitalised, and the new institutional framework of the banking union provides better tools for preventing and managing stress situations. These are significant achievements. At the end of 2023 their average risk-weighted Common Equity Tier 1 (CET1) ratio for banks under the direct supervision of the ECB was 15.7%, up from 13.5% in 2015. This is the highest quality of regulatory capital as it absorbs losses immediately when they occur. Banks’ fully phased-in leverage ratio has increased slightly to 5.7%, compared with 4.9% in 2016.1 Banks’ liquidity has remained well above regulatory requirements. Their average liquidity coverage ratio, which measures whether they have sufficient liquid assets to cover periods of short-term liquidity stress, stood at 164.4% at the end of 2023, while their net stable funding ratio, measuring the degree of stability of banks funding, was 126.5%. Bank profitability has also increased, largely driven by higher interest rates, with their return on equity reaching 9.3% in the last quarter of 2023. Moreover, asset quality has improved significantly over the last ten 1 This measures the ratio between Tier 1 capital and on and off-balance sheet total exposures. years. The non-performing loans (NPL) ratio, which was above 7% in 2015, fell to just 2.3% in the last quarter of 2023.
Resilient, well-capitalised banks provide benefits to society. They are better equipped to absorb potential shocks and to compete with their international peers, and they contribute to economic growth by lending to the real economy. Bank funding continues to account for around 30% of the financing of European firms, despite increasing competition from non-bank financial intermediaries. Well-capitalised banks are thus the backbone of a strong economy.
In recent years, European banks have had to demonstrate this resilience in the face of a series of external shocks. These include the COVID-19 pandemic, the energy crisis, Russia’s invasion of Ukraine and the turmoil on international banking markets in the spring of 2023, all of which have placed significant stress on European economies and societies. European banks have weathered these stress episodes well, thanks to their resilience. But they have also benefited from significant fiscal and monetary support that mitigated the impact of the shocks on their balance sheets. Unlike a typical recession, the recession caused by the pandemic did not lead to an increase in corporate insolvencies or in loan losses.
CONCLUSION
All this being said, while European banks may have coped well with yesterday’s problems, they must be able to withstand tomorrow’s challenges equally well. European banks are operating in an environment marked by new risks. Climate change, digitalisation, demographic trends and geopolitical risks require structural adjustments, both in the real economy and in the financial sector. And heightened competitive pressures are challenging banks’ profits margins, which may ultimately compromise their resilience and prompt them to take excessive risks.
There are several key dimensions to resilience. Well-capitalised and liquid banks are better able to withstand adverse shocks and continue lending in times of stress. Banks that strengthen their operational resilience and IT infrastructure will be able to confront the increase in cyber risks. And on a more general level, banks that have good governance and risk management systems in place will be resilient in the face of a broad range of challenges.
Strengthening banks’ resilience requires forward-looking risk assessments. While capital and liquidity ratios are important indicators of a bank’s soundness, they primarily take a backward-looking perspective. So these indicators must be complemented by a thorough analysis of new or emerging risks, which are not captured well by existing risk models. Banks’ risks can increase as a result of direct exposures to countries or sectors affected by geopolitical shocks, but also due to the knock-on effects of weak growth, deteriorating investment sentiment or heightened inflationary pressures. And escalating geopolitical tensions could result in greater financial market volatility and trigger asset price corrections. Banks need to reflect these risks in their capital planning and internal stress tests.
A forward-looking perspective is also required when assessing the profitability of the banking sector. Bank profitability and valuations have recently improved due to higher interest rates. But the longer-term profitability outlook may deteriorate if funding costs increase, loan growth weakens or losses materialise. So far, higher interest rates have not been fully passed through to deposit rates. However, competitive pressure for deposits may lead to a stronger pass-through and thus higher funding costs for banks. The ability to pass higher costs on to customers in the form of higher interest rates on loans may be constrained by weak loan demand.6 In this uncertain environment, taxes on bank profits or administrative interest rate measures may weaken bank profitability and resilience. However, higher current profitability provides an opportunity for banks to strengthen their resilience, both in terms of capitalisation and investment in robust IT infrastructure.
Creating a European framework for liquidity in resolution is still needed urgently. The delay in introducing the European Stability Mechanism’s common backstop to the Single Resolution Fund is another important gap that needs to be closed.
At the same time, it is crucial to establish the third pillar of the banking union, a European deposit insurance scheme (EDIS). It would allow better risk-sharing, promote further banking market integration, and further enhance the credibility of resolution. The ECB therefore welcomes the fact that the ECON Committee of the European Parliament has adopted a position on the Commission’s EDIS proposal. It is an important signal of its commitment to completing the banking union and encourages the EU co-legislators to make further progress.
Progress is also needed on the capital markets union (CMU). Banking union and capital markets union are complementary. Advancing the CMU is critical for the European economy, not least to support the private investment needed for the green transition and digital transformation. The recent statements on this topic by the Eurogroup20 and the European Council21, as well as the ECB Governing Council,22 can be important building blocks for future progress on CMU in the coming legislative term. Last, we very much welcome the upcoming single rulebook on anti-money laundering and countering the financing of terrorism and the imminent establishment of the EU Anti-Money Laundering Authority (AMLA).
