Financial stability is improving in most European banking systems, but rising bail-in risks and weak profits pose challenges, according to Moody's Investors Service.
The rating agency said that new EU-wide regulation has enforced higher capital levels, which, through de-risking and better asset-liability matching will improve bank performance, longer term. However, weak macroeconomic conditions weigh on Europe's banking sector, and low overall bottom lines implies that the European banking industry remains structurally vulnerable.
“We may see banks making further adjustments to their costs and possibly changes to their business models. European banks' bottom lines should benefit from declining provisioning costs in 2015, but conduct and litigation charges will remain high," said Carola Schuler, a Managing Director in Moody's EMEA Financial Institutions Group.
Also, given the pending EU bail-in regime, benign funding costs are likely to rise. It remains to be seen whether banks will be able to pass on to their customers the higher cost of regulation and in particular, any bail-in costs.
"What we will likely see in terms of asset quality is a split between broadly stable conditions for banks in core euro area countries, with notable exceptions being German banks' ship financings and Dutch banks that are impacted by the challenged real estate and SME sectors, and a slowing of pressures in the periphery," continued Schuler. "In the periphery, new problem loan formation has slowed, but, the degree to which we will see a bottoming-out of this trend will depend on a more sustained improvement in still-difficult economic conditions," explained Schuler.
Moody's also said that ECB funding dependence for banks in periphery countries has fallen significantly. Gradual improvement in investor sentiment towards periphery banks has widened market access also for medium-sized or smaller firms and the cost of funding has decreased; but, with the recovery still fragile, these improvements could be subject to sudden change.
Moody's noted that of the non-euro area EU countries, the UK's banks are benefitting from economic recovery and prudential regulatory measures and improving bank fundamentals shield against remaining housing market risks. However, creditors face headwinds from the finalisation of the UK resolution and bail-in regime. Furthermore, low interest rates and economic growth support the performance of the Nordic banking systems, whose banks rank among the highest-rated in Europe. Although Moody's says that banks in these sectors are exposed to the risk of corrections to currently high house prices, particularly in Norway and Sweden which may pressure bank performance.
Central and eastern European (CEE) economies and banking systems are on a recovery trend, despite the key downside risk posed by CEE's significant trade linkages with the core EU countries which are facing weak macroeconomic conditions. CEE banking systems with a high share of foreign currency lending (Hungary and Romania) are likely to be more exposed to FX volatility in 2015, exacerbated by reduced funding levels from parent banks since the financial crisis.
CIS banks face strong headwinds in 2015 owing to the Ukraine crisis and geopolitical risks, which will result in CIS banks' asset quality and capital remaining under pressure in 2015. For example, in Ukraine, massive loan restructurings understate the level of problem loans, and Moody's expects total problem loans to rise to 55% of gross loans into 2015 (YE 2013: 35%).
Furthermore, in Russia, banks' problem loan ratio will likely deteriorate to 9.5% (YE 2013: 7%).
