European banks braced for €800bn of loan losses if pandemic worsens

European banks are facing as much as €800bn in loan losses and a €30bn hit to their revenue over the next three years as a result of the coronavirus crisis, according to a report from Oliver Wyman.

In the consultancy’s base or expected scenario — a slow economic recovery with most countries avoiding a second lockdown — it estimates bad debts would surge to €400bn, about 2.5 times the level in the prior three years.

In the adverse or worst-case scenario — a severe second wave of the virus — that figure doubles and banks’ non-performing loan ratios rise to 10 per cent of their total lending.

“The pandemic is unlikely to cripple the sector, however many banks will be pushed into a limbo state with very weak returns,” said Christian Edelmann, co-head of European financial services at Oliver Wyman. “They will be highly susceptible to further shocks, tend to be risk averse in lending and will struggle to fund transformation efforts.”

Continental European and British banks have struggled to recover from the 2008 financial crisis, suffering for more than a decade from dwindling earnings in an over-competitive and fragmented landscape. They are, on average, half as profitable as their US peers and many in the south such as Italy and Greece are still running down piles of pre-existing bad debts.

The five largest US banks have already reserved $55bn for potential loan-losses in the first half of the year. That was partially offset by the highest trading income in a decade, but executives warned that trend would dissipate in the second half. 

European lenders start reporting their second-quarter results this week and some of the largest such as Deutsche Bank have already warned that the level of provisions will increase from the more than $50bn they made in the first quarter.

Covid-19 will also hit earnings, primarily through long-term, ultra-low interest rates. Revenue, after expected credit losses, could fall by €180bn this year to €385bn, even if a second quarantine is avoided. It will still not have recovered to 2019 levels by 2022, remaining about €30bn lower that year at €535bn, Oliver Wyman estimates.

Net interest income, the difference between deposit and lending rates, is forecast to finish 8 per cent lower in 2021 than it was in 2019. This will disproportionately affect banks that rely on consumer and commercial lending and do not have less rate-dependent investment banking or wealth management arms.

Business lines such as payments, trade finance and credit cards are already showing evidence of being on a downward trend as activity stalls. A spike is also looming in small-business defaults after government support schemes end this autumn, the report said.

The increase in bad loans and revenue losses will drive down European banks’ average common equity tier 1 ratio — a measurement of core financial strength — from 15 per cent to 13.8 per cent in the next three years. Many will end up far lower than that.

Their already poor 6 per cent average return on equity will fall to zero this year and only recover to 5.3 per cent by 2022.

“Low profitability is not just a problem for shareholders. A subsequent crisis, potentially a second pandemic wave, or another shock, would cause losses to flow straight through into the capital bases of these banks,” raising the spectre of emergency capital raises or government interventions, the report added.

The report cautions that things could have been worse. The sector has been shielded from about a third of possible corporate defaults because of government support schemes. Investment banks have also benefited from helping companies raise about half a trillion euros of debt during the crisis so far.

To survive, the industry must embark on significant cost-cutting, balance sheet reduction and deploy teams to deal with customers in distress. Mr Edelmann said banks could not do this alone and would require top-down political and regulatory support, such as smoothing the path for mergers to create economies of scale and creating a European banking union.