The balance sheets of eurozone banks are showing “early signs of stress” after a rise in loan defaults and late payments by customers, the European Central Bank has warned.
Higher interest rates have boosted banks’ income and profits for the time being, the ECB said, but lenders are facing pressures from higher funding costs, worsening asset quality and lower lending volumes.
The central bank also warned in its twice-yearly financial stability review that higher interest rates and slower growth were posing problems for people, companies and governments in the euro area.
Higher borrowing costs were likely to lead banks to set more money aside to cover bad debts, hitting future profitability, it said.
However, the rise in defaults and late payments has come from a historically low level, and the ECB believes the banking system should be able to cope with worsening asset quality thanks to strong capital buffers and liquidity levels.
The ECB’s vice-president, Luis de Guindos, said the turbulence seen in the spring, when several lenders in the US and Switzerland, including Silicon Valley Bank and Credit Suisse, either collapsed or had to be rescued, had now abated, but “while risks to financial stability may appear less acute, they remain elevated”.
He said that while the tight financing conditions created by the ECB’s run of interest rate increases should help bring inflation back down to target, “they can also push overextended borrowers into financial distress”.
He said people’s disposable incomes, company revenues and government finances “may suffer an additional squeeze if economic activity disappoints further or if energy prices surge over the coming winter”.
The central bank said property companies were particularly vulnerable to losses as the downturn in the eurozone’s commercial real estate markets continued. Demand for office space fell sharply in the second quarter of this year, especially outside the prime sector.
Financial markets have remained resilient, with expectations of a soft landing – a limited impact on economic growth as inflation recedes – but sentiment “could shift quickly”, Guindos said.
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Referring to the Israel-Hamas war, Guindos said: “An escalation of the conflict in the Middle East could trigger a sharp increase in risk aversion in financial markets, unravelling the prevailing vulnerabilities. In addition to the potential adverse repercussions for the supply of energy commodities, an escalation could undermine general confidence and slow down economic growth, while pushing inflation rates up in parallel.”
The central bank outlined three main risks for eurozone banks: first, the combination of higher living costs, higher debt servicing costs and worsening economies could have a negative impact on bank asset quality.
Second, higher lending rates, lower demand for loans, and tighter credit standards have led to a “substantial drop” in lending volumes, which will affect banks’ profits.
Finally, banks’ current strong profitability is also likely to come under pressure as their funding costs catch up with the interest rates paid on new business. “Profitability is projected to decline in most countries going forward,” the review said.
