European banks: recession risks flash red

Europe faces severe risks to its financial stability, regulators warned this week. The post-financial crisis drive to build resilience in the financial sector is set to be put to the test.

The European Systemic Risk Board’s first-of-a-kind alert was largely based on the war in Ukraine. It was drafted the week before the “mini” Budget triggered turmoil in UK markets, forcing the Bank of England to intervene by buying bonds.

Pension funds, not banks, have been at the heart of the UK market tumult. The former have been forced to sell assets to meet margin calls. But the prospect of sharp rises in interest rates have forced banks to withdraw mortgage products. That has dragged down share prices, though signs of wider financial contagion are not apparent.

The investment case for banks is weak, even though their forward earnings valuations are now close to record lows. The shares could prove a value trap, as recession worries worsen.

European bank shares, down 23 per cent this year, are sending the message that recession is here. But earnings estimates for EU and UK banks are close to decade highs thanks to rising interest rates. These will continue to push net interest margins higher.

On the other side of the earnings equation are bad loans. Cost of risk in Europe — provisions as a share of loans — is only expected to be 37 basis points this year, rising to 42bp in 2023 and 2024.

That equates to about a 1 per cent contraction in GDP or a mild recession next year, says Andrea Filtri of Mediobanca. By way of comparison, Europe’s economy contracted 4 per cent during the financial crisis and 6 per cent during the pandemic. Provisions soared to some 120bp during the former.

Provisions will rise with the severity of the recession. Stronger lenders might begin booking higher provisions as soon as the fourth quarter. This will smooth out losses and should keep capital buffers relatively intact. It might also discourage governments from taxing the windfall profits generated by rising interest rates.