European banks: strong profits, capital buffers protect creditors from softening macro outlook


At times of great uncertainty, it is useful to step back from the ambitious and often near-impossible goal of forecasting financial impacts with precision, and to focus instead on the availability of buffers for risk protection. In this report, we offer a simple, transparent framework for assessing the vulnerability of European banks to unanticipated shocks.

Since Russia’s invasion of Ukraine, we have highlighted how direct exposures to both countries look manageable for European banks in our rated universe. At the same time, we have stressed great uncertainty around the macro outlook and the risk that the V- shaped rebound in the European economy could come to a halt. Forecasters have started adjusting their estimates downwards, but this process may only have started. While expectations still point to growth in positive territory in 2022, it is too early to conclude that banks will escape unscathed.

We have noted that the war and the sanctions on Russia expose European banks to a number of risks which are, by their own nature, impossible to quantify ex ante. These include the risk of losses related to cyberattacks, regulatory fines related to non- compliance with sanctions, and customer losses associated with mis-management of the newly-found ESG dimension of doing business in Russia.

High inflation readings have already triggered aggressive monetary tightening in the US and UK, with the ECB expected to follow suit. So far, rate hikes have been contained, but market expectations are for significant further tightening in all major currency areas.

Banks have been spreading a cautiously optimistic message. The lifting of policy rates (and expectations of further rate hikes) is a key support to interest revenues, while worst- case scenario impacts from full write-downs of Russian and Ukrainian businesses look manageable. Rising yields are hitting the value of securities portfolios, which is a drag on capital ratios for banks which still mark them to market, but these are few and far between.

We expect the environment to remain supportive for bank credit, with the better interest- rate environment more than offsetting a mild deterioration in credit quality as growth softens. However, we are cautious of downside risks. We believe that central banks are walking a tightrope, with significant risks of policy mistakes in both directions. If they hike too fast or too far, they risk killing the post Covid recovery.

If they are seen as too complacent against the inflation threat, they risk de-anchoring expectations and having to hit the brake harder later on. Asset quality has proven very resilient to the Covid shock, though this was the result of very significant public-sector support and extremely loose monetary policies. Whether this continues to be the case as central banks try to put a leash on inflation remains to be seen.

This report focuses on a sample of 50 large banks rated by Scope. European banks entered 2022 with strong balance sheets, including high capital, low levels of legacy NPLs, and decent profitability, largely the result of a cautious management of the Covid- 19 shock in 2020. We measure their buffers in terms of capital and ordinary profitability and find that, with few exceptions, banks are well placed to withstand a deterioration in credit quality should this occur in the coming quarters.

We calculate that the majority of the banks sampled could withstand a trebling of credit provisions and still remain profitable. Nordic banks stand out as the most resilient to an asset-quality shock, thanks to their high pre-provision profitability coupled with a very low level of credit risk.

Rapidly deteriorating growth outlook, with risks skewed to the downside

In our first reaction to Russia’s invasion of Ukraine on February 21, we flagged the risk that the war could dampen prospects for economic growth throughout Europe (see European bank exposure to Ukraine manageable but second-round effects could be material).

Scope expects 2022 and 2023 growth momentum to slow from the very high recovery rates of 2021 but to remain generally above potential.

Under Scope’s baseline scenario, the recovery will slow, especially in Europe, hit by rising energy and commodity prices, negative confidence channels and a slowdown in international trade, including in relation to economic sanctions on Russia. Nevertheless, output is supported by a simultaneously easing of headwinds from the pandemic crisis and from a degree of extended fiscal policy accommodation. Annual output in 2022 remains consistent with an economic baseline of robust although uneven economic growth, with risks skewed to the downside.

Further escalation of geopolitical tensions and of the associated sanctions regimes could weigh on asset prices and risk sentiment, while a more substantive energy shock cannot be ruled out at this stage. Continued disruptions to supply chains from pandemic -related lockdowns in China and other emerging markets could raise the risk of stagflation and influence monetary policy outcomes.

Inflation and higher interest rates a mixed blessing for European banks Entering 2022, inflationary trends were already evident in several key energy commodities and a consensus had formed towards a pattern of gradual increases in policy rates in major Western economies. War in Ukraine, the steep deterioration in the Russia-European relationship, and the lockdown in Shanghai in April will only exacerbate price pressures. Policy rates in the UK and the US have started going up, and the rates market is pricing in an increasingly hawkish Federal Reserve. The ECB has so far signalled a more cautious approach, but our expectation is that euro rates will also start rising this year.

This environment has many advantages for banks but is not free of pitfalls. Short rates moving from negative to zero will reduce the cost of excess liquidity held at central banks. This has been weighing on banks’ profitability for the best part of a decade, in particular in core Europe. Further increases in short-term rates will likely boost bank revenues, in particular for banks with large retail franchises, as non-remunerated current account deposit balances tend to be relatively sticky. A steeper yield curve in general will support income from traditional banking activities. Banks are, at their core, maturity transformation machines.


Partly offsetting these benefits, higher interest rates could prove a headwind to banks with a greater share of wealth management in their business mix. For the past decade, low rates on savings deposits have increased the relative attractiveness of higher-yielding investment products, boosting fee income from asset management and distribution. Higher rates could mean a reversal of this trend, especially if coupled with greater volatility in risky assets.

In an inflationary environment, banks’ management of their cost bases will be put to the test. The cost lever has been a key element supporting profitability in recent years, as banks have moved to shrink their physical distribution networks and workforces, while keeping wage inflation in check. The latter may be more difficult with CPI inflation running at high-single digit rate (if not higher).

In the short term, asset quality is likely to deteriorate. Inflation will eat into household budgets, and rising mortgage rates may put pressure on customers with variable rates mortgages.

Positively, we note that the proportion of mortgages originated with variable rates has been declining over time in many European countries. While this will also likely negate some of the benefits of rising rates in the back book, it will also limit the likely decline in credit quality.

Governments may move, at least partially, to soften the blow from higher bills on more vulnerable households, but this is unlikely to fully negate the adverse impacts on repayment capacity.


The resilience of different corporate sectors to higher inflation and rates raises question marks. A disinflationary environment has prevailed for the best part of the past 30 years in Europe, meaning that most entrepreneurs and top managers have no direct experience of managing businesses in inflationary environments. The same goes for bankers. The global financial crisis of 2007-2009 and the subsequent European sovereign and banking crisis have resulted in banks’ origination criteria putting greater weight on borrowers’ cash flows (as opposed to collateral).

This approach has resulted in recent years in better credit selection and loan performance across the board. However, in an inflationary or even stagflationary environment, corporate cash flows are likely to be more volatile. Real-estate collateral may provide rising protection for nominally fixed loan amounts. How quickly banks adjust their origination and risk management practices to the changing realities remains to be seen.

Longer term, we believe higher (but controlled) inflation should help engineer a beautiful deleveraging, in which the real value (and burden) of legacy debt declines, and incomes grow faster than debt. This may not be good news for credit investors, but it will help reduce asset-quality risks.

Solid earnings buffers provide a strong first line against credit deterioration

For the 50 banks in our sample, we calculate pre-provision profitability and cost of risk for the 2019-2021 period. This gives us a rough estimate of the room banks have to absorb additional costs through their P&Ls before capital is affected. High underlying profitability is also a key anchor determining banks’ ability to raise equity if the need were to arise due to exceptional circumstances.

Nordic banks stand out for their very high profitability coupled with a low level of credit losses. Several banks with emerging-market exposures also display high profitability, often on account of higher interest margins – although this is sometimes coupled with high cost of risk. At the other extreme, we find banks with very high reliance on interest revenues whose profitability has suffered disproportionately from the very low-rate environment, in particular in the Euro Area.


Our initial calculations allow us to stress cost-of-risk assumptions to model the banks’ ability to withstand increases in cost of risk. We estimate that the majority of the banks in our sample could withstand a trebling in cost of risk while remaining profitable. According to our calculations, Svenska Handelsbanken, Swedbank, KBC and UBS would be able to withstand a tenfold increase in credit provisions while continuing to show a positive bottom line. Similarly, we calculate that close to 80% of banks in our sample could absorb a 100bp increase in cost of risk out of ordinary profitability. Swedish banks again stand out on this account: SEB, Handelsbanken and Swedbank would still be profitable in the extremely unlikely scenario where loan-loss provisions increase by 300bp of RWAs.


Capital buffers remain sizeable despite generous distributions

Following years of high profit retention, European banks have accumulated very comfortable capital cushions relative to regulatory requirements. We calculate that the median CET1 ratio now stands well over 15%, and no bank has a CET1 ratio below 10%. This is largely the result of the great re-regulation that followed the global financial crisis. Chasing ever-higher requirements, European bank have built high capital stacks, which we have highlighted as a key source of strength for the industry. Prior to the GFC, the median CET1 ratio was 7%, and no bank had CET1 ratio of more than 15%.

As Covid-19 hit, the process of capital accumulation had another leg up. Prudently, supervisors nudged banks into retaining profits in anticipation of higher loan losses, which have – at least so far – failed to materialise. This has left European banks with significant excess capital.

Capital build went into reverse from the second half of 2021, when European banks started announcing plans for generous dividend distributions and share buybacks (see EU bank stress tests: four key takeaways for investors published in August 2021).

But buffers to capital requirements still remain large. If banks headed into the pandemic with buffers typically below 300bp, a more typical figure now is 500bp. This is well above the banks’ own targets, affording significant flexibility with respect to organic growth, M&A opportunities and distributions.


So far, banks have largely stuck to their pre-war capital distribution plans, with RBI being the most notable exception. Even banks with sizeable exposure to Russia, such as Societe Generale and UniCredit, have indicated that they are comfortable with their distributions plans, at least for now. Supervisors have ruled out imposing blanket bans on distributions, which we take as a sign that they are relatively comfortable with banks’ exposures and overall balance-sheet quality


Looking at the combination of profitability and capital buffers, we consider European banks to be reasonably equipped against a deterioration of the business cycle.

Nordic banks stand out both for their above-average post-provision profitability and high level of excess capital. Their strong efficiency metrics, underpinned by modern franchises and high digital penetration have combined with low credit losses in what has long been perceived a safe haven of European banking. Capital buffers have declined in recent years as a percentage of RWAs, although this typically reflects regulatorily-driven RWA inflation and higher buffer requirements.

Conversely, German banks look more vulnerable due to lower earnings capacity and relatively more contained capital buffers.

German banks have relatively low pre-provision profitability compared to European peers, which limits their ability to absorb increases in cost of risk in more extreme scenarios. This is driven by low net interest margins and cost/income ratios that are still far from international standards.

Even for German banks, it is useful to note that 2021 performance was stronger than it has been in the past decade, and that they would be especially positively geared to rising interest rates in the Euro Area, given their swathes of excess liquidity.


Direct exposure to Russia and Ukraine: a tangible risk, but only to a handful of banks

Ukraine’s banking market primarily comprises three State-owned systemic institutions (PrivatBank, Oschadbank and Ukreximbank). European banks are relevant players, though the size of their local balance sheets is limited to a few billion euros equivalent and is mostly funded via local deposits, leaving banks exposed primarily through their equity stakes.

RBI’s Bank Aval is the largest of the foreign-controlled banks, which also include BNP Paribas’ Ukrsibbank, PKO’s Kredobank, as well as Credit Agricole’s and OTP’s local subsidiaries. RBI’s equity in Aval, excluding minorities, was worth approximately EUR 320m-equivalent at end of 2021, and this is the largest foreign-controlled bank in the country.

Despite the war, Western banks look keen to continue operating in Ukraine to support the local financial infrastructure and what remains of the Ukrainian economy. The banks have also joined international efforts to mitigate the humanitarian crisis in the country, in particular in support of refugees. For example, PKO allows refugees to exchange cash hryvnia into zloty at its local branches.

RBI, Societe Generale, UniCredit and OTP all have sizeable local operations in Russia. The size of their Russian subsidiaries’ balance sheets varies from a few percentage points of total consolidated group assets (UniCredit and SG) to close to 10% of the total (RBI). RBI also maintains a significant profit dependency on Russia (Figure 11). OTP’s profit dependency is similarly non-negligible, especially when considering the combined contribution of Russia and Ukraine to group profits.


Several European banks also reported offshore exposures to both Russia and Ukraine (see Box B). Large French, Italian and German banks reported sizeable exposures, and they could suffer material losses under a worst-case scenario (see Box B).


While Ukraine may come back as a smaller but still-viable banking market, we believe the prospect for European banks in Russia are very grim. Several large European banks such as Deutsche Bank, Commerzbank BNP Paribas and Credit Agricole have already announced intentions to wind down existing portfolios and exit the country.

Others may have not fully committed to a full exit but are reviewing their options. Even the fate of the local subsidiaries lies in the balance. A walkaway scenario is definitely on the cards. Societe Generale announced on April 11 that it had reached an agreement to sell its Russian subsidiary Rosbank to a Russian investor, Interros Capital, subject to regulatory approvals. The transaction is expected to result in a EUR 3.1bn P&L impact and decrease the group’s CET1 ratio by approximately 20bp.

A few days before SG’s announcement, UniCredit announced it was pushing back its board meeting to approve Q1 2022 results by one week to May 4 to have more time to manage its cross-border Russian exposure. In mid-March, UniCredit’s CEO told the press the bank was evaluating an exit from Russia, though he stressed the consequences and complexity of disentangling the bank from the country.

His comments were echoed in the following days by RBI and OTP, which have begun winding down operations and are considering all strategic options up to and including a complete exit. The attitude of Western banks to local operations in both countries speaks volumes about the social dimension of the banking business.

In our view, keeping operations in either country is not in the immediate financial interest of parent companies’ shareholders. But pulling the plug on war-torn Ukraine just does not feel like the right thing to do and would likely harm banks reputations as lenders and employers globally.

Similar considerations apply to employees and customers in Russia, in large part innocent bystanders who are themselves facing grim economic circumstances. However, given the deterioration in international relationships and the broad sanctions regime, we believe banks would be happier to step away from Russia if given the opportunity to do so with limited financial and reputational damage. This could be the case if the banks are nationalised or local buyers emerge.


Lingering risk of sanction violations

Additional concerns stemming from the Russo-Ukrainian war and the related sanctions regimes affect European and global banks. As we flagged early on, a far-reaching economic sanctions regime has been imposed at warp speed.

In the space of one week at the end of February, three different EU sanctions packages were announced, on top of sanctions already in place since the annexation of Crimea in 2014. Two additional packages were adopted in March and April. A sixth package of sanctions is currently being discussed.

The regime of asset freezes and prohibitions to make funds available now applies to a total of 1,091 individuals and 80 entities, including politicians, businessmen, oligarchs and media personalities.

Internationally-active banks sit on the front line in the effective application of such sanctions and run the risk, willingly or inadvertently, of falling short of authorities’ expectations. KYC processes have proven leaky in the past, and there is no assurance that they will not be so again. Crucially, it is our understanding that EU sanctions have no extra-territorial jurisdiction hence do not directly apply to banks in Russia or other third countries (including banking subsidiaries of European banking groups).

However, EU-based parent companies could be held accountable if authorities believe non-EU subsidiaries have been used to circumvent the sanctions regime. The incentives of management team of EU banking groups and their local subsidiaries may not always be fully aligned, given the circumstances.

Sanctions violation risk is on the radar of European supervisors. In mid-March, Reuters reported that the ECB was asking supervised banks to put accounts of all Russian and Belarusian national under high scrutiny. The ECB, as bank supervisor, is not directly responsible for the enforcement of the sanctions regime but the risk that future fines could put supervised entities at risk means that it is indirectly.

Another source of risk is that prohibited transactions could be layered via correspondent banks in third countries. Should violations occur (and be discovered, even at a later stage) proving the appropriateness of due-diligence processes could be a costly legal exercise.