The credit quality of Western European banks could come under pressure in 2020, due to low or negative rates, flat yield curves and low GDP growth. Banks are also dealing with a list of additional challenges that will weigh on ratings if left unresolved. Among the key challenges for the year ahead lie climate transition and conduct risk, digitalization and how to sustainably push up profitability, Scope Ratings GmbH notes in its 2020 Banking Outlook. Climate transition risks will intensify for banks as governments adopt new policies to combat global warming. Scope expects policymakers to step up the pressure on investors and banks to improve clarity on their current and future investments related to climate transition.
“Banks remain heavily exposed to risks resulting from a disorderly exit from carbon-intensive sectors and will need years to reposition asset portfolios,” Dierk Brandenburg, head of the financial institutions team at Scope Ratings, said, “during which time asset quality will be vulnerable to policy changes or government intervention”. In the meantime, investors will increasingly demand greater insight into banks’ downstream exposure to brown assets.
On bank performance, 2019 brought some relief for banks. Balance sheets emerged unscathed from the sharp deterioration in global financial conditions at the end of 2018, while capital levels among large banks withstood the volatility and ensuing slowdown in global GDP growth without any lasting damage.
“Strong supervision and high capital remain the key pillars of European bank ratings in this environment,” Brandenburg continued.
But if European monetary actions have to-date supported asset quality and capital gains, they dimmed prospects for profitability. Most listed European banks trade at steep discounts to book value.
“This is a damning verdict on the impact of negative rates on the banking sector. With central banks locked into low rates, this situation is unlikely to change in 2020,” Brandenburg noted.
Yet more headwinds are emerging: there are signs that the significant decline in the cost of risk in Europe may have bottomed out. And, faced with slowing growth, trade wars and Brexit, banks are anticipating deteriorating asset quality for most of their loan portfolios. To counter margin pressures, many banks are planning to increase SME and consumer lending, which may cause problems down the line.
One large obstacle to a more profitable banking sector in Europe is fragmentation and a lack of consolidation in major markets such as Italy or Germany. There was no material progress in 2019 and no indication that 2020 will be any different.
“This leaves euro area banks with outsized operations and insufficient digital inter-connectedness. Restructuring delays could prove costly, as banks are faced not only with mounting costs for inefficient legacy operations but also the need to invest in new technology to defend market shares against technology firms and shadow banks,” Brandenburg said.
Digitalization continues to reshape banking markets in Europe, spurred by regulatory changes such as PSD2 and by new market entrants with cheaper and more effective technologies. Scope expects the arms race between banks and technology providers to intensify during 2020, widening the competitive gap for small banks and those with expensive legacy operations. A second, already well-advanced race with criminals and rogue states is underway in the area of cyber security.
Finally, conduct risk remains a key a source of irritation for investors and regulators.
“With several large cases related to money laundering and tax fraud pending, we expect conduct risk once again to prove expensive for banks in 2020,” Brandenburg said.