European Banking Vulnerability Analysis

The global banking sector is facing additional stress amid a macroeconomic environment characterized by excessive monetary and fiscal stimulus in the aftermath of the Global Financial Crisis. The low-for-longer era fueled by quantitative easing to reactivate the economy post-COVID-19 pandemic came to an abrupt halt due to geopolitical tensions, headline inflation, global supply chain distortions, and hikes in energy and food prices. Several central banks, including the FED, ECB, and BoE, have reversed quantitative easing and low interest rates by announcing severe rate hikes despite an initial sense of reluctance. Higher central bank interest rates could positively impact banks and institutional investors, but a stronger net interest margin (NIM) depends on the balance sheet's funding structure, hedging of duration risks, liquidity of the investment portfolio, etc. Higher rates could lead to lower yields and greater risks, including (un)realized losses in the investment portfolio and duration risks, deteriorating asset quality, as well as higher funding costs. The situation is particularly impacting EU and global SME banks due to negative Economic Spread and a lack of scale, putting additional pressure on profitability and ultimately driving up the cost of equity, leading to further challenges.