25 June 2014
The European Banking Authority (EBA) published today its fifth semi-annual report on risks and vulnerabilities of the EU banking sector. The report shows improvements in market sentiment and confidence which has allowed banks to increase their capital levels ahead of the 2014 EU-wide stress test and to continue the repair of their balance sheets. However, the report cautions about ongoing uncertainties on asset valuations and future profitability in an environment where the signs of recovery remain modest and fragile. The report also draws attention to looming redress costs related to conduct issues as well as to geo-political concerns in emerging markets, which could lead to risk aversion and to an impact on capital flows.
Throughout the first half of 2014, the EU banking sector continued to observe improvements in market sentiment, both on the debt and equity side. European banks have been taking advantage of favourable market conditions by continuing to raise equity ahead of the 2014 EU-wide stress test. The capital raised is allowing banks to continue the repair of their balance sheets through front-loading impairments and additional provisioning without deteriorating the absolute levels of tier 1 capital.
The improvements on the banks' asset side were coupled with a deleveraging process, which so far continues in an orderly fashion and has led to a marked decrease of risk weighted assets, a shedding of risky assets and to a shrinking of balance sheets by EUR 3.4 trillion since 2011. The de-risking process is also helping banks to improve their capital ratios.
However, the quality of some banks' loan portfolios has continued to decline and remains a concern, pointing to the need for rigorous asset quality reviews (AQR) with consistent definitions across the EU, as developed by the EBA. The ratio of impaired and past due (> 90 days) loans to total loans has increased and remains worryingly high. In some cases provisioning has not increased in conformity and an increasing dispersion is now being observed, with some banks decreasing their respective coverage ratio levels.
In addition, the heavy debt overhang in the public and private sectors and the necessary restructuring of the debt-burned corporate and households sectors may also pose significant challenges in maintaining adequate capital levels within the EU banking sector. Therefore, the ongoing repair of individual banks' balance sheets and sector restructuring should remain a key priority in the medium term.
Finally, EU banks' income and profitability has continued to face significant headwinds and the looming redress costs related to conduct issues are a key concern. The deterioration in asset quality not only influences earnings and capital strength of the EU banks but also raises questions over near future economic performance. In addition, a number of detrimental business practices of some EU banks have crystallised and costs have increased markedly. Banks with a return on equity (RoE) of less than 4 % represented 39 % of total assets of the sample in December 2013. This, combined with the new regulatory environment, modest growth outlook and a low rate environment, will continue to present a challenge in terms of the sustainability of some banks' business models.