By Marco Troiano, Head of Financial Institutions, Scope Ratings

With the daily escalation of the conflict and related sanctions, pinpointing the full impact of the war on the European economy and on its banks is a daunting task.

The latest sanctions announcements, including limitations to the Russian central bank’s ability to mobilise its FX reserves, add an element of fragility to a financial system that had already been targeted by harsh measures last week. The ECB’s decision to declare Sberbank’s European subsidiaries “failing or likely to fail” due to rapidly a deteriorating liquidity situation shows the extent of the pressure Russian banks are under to secure finance. The Russian Central bank’s decision to raise interest rates to 20% from 9.5% also shows the authorities’ resolve to stop capital flight and stabilise the value of the rouble.

The direct exposures of European banks to Ukraine and Russia are, by and large, manageable (see our comment of last week European bank exposure to Ukraine manageable but second-round effects could be material.) For banks with local subsidiaries, the crisis could result in structurally lower profitability, as both Russian and Ukrainian subsidiaries had been contributing positively to their bottom lines.

Local asset quality and profitability in both countries are likely to suffer as a result of the economic impact of the conflict in Ukraine and of the sanctions in Russia. Even under a relatively benign scenario, the euro value of these profits would be diminished due to the devaluation of the rouble. Under a worse-case but no longer unthinkable scenario, local subsidiaries could at some point run out of liquidity, and European parent banks would then face some very hard choices about whether to recapitalise or let go of a subsidiary.

More broadly, the growth spillover effects from a prolonged conflict are hard to estimate, especially as uncertainty remains as to the extent of a possible energy crisis. We take comfort from the ECB’s early assessment that the crisis could shave decimals off GDP growth under a base-case scenario, and up to 1% under a severe scenario. Judging by the statements of political leaders, Europe seems ready to accept the economic cost of a tough stance on Russia, including potentially through higher energy prices.

Economic impacts would be unevenly distributed. Energy dependence on Russian gas imports will be a factor determining the severity of impacts, with Germany and Italy most exposed among large European countries. European economies could also suffer from lower exports to Russia, which is an important trade partner for many Eastern European countries. A weaker growth outlook could impact local asset quality of European banks exposed to Eastern Europe.

None of this will comes as a surprise; we see macro volatility as a structural feature of banks exposed to growth markets. In fact, we look at geographic diversification into emerging markets as a positive feature of banks’ business models, as long as risks are well understood and managed. Exposure to emerging markets offers banks the optionality to deploy capital in countries with growth potential and with a more favourable interest-rate outlook, supporting profitability.

We highlight two further risks which may be more difficult to measure. First, the breadth and speed at which sanctions have been imposed raises the risk that some banks may not be fully prepared to implement them. Sanctions violations have been source of fines and embarrassment in the past. With investors increasingly focused on ESG topics, we think the consequences of non-compliance could be severe. Secondly, while we assume that military conflict will not extend to the rest of Europe, the risk of cyber-attacks on European institutions, including banks, cannot be discounted.

European banks enter this crisis from a position of strength. Financial fundamentals are solid, including capital, asset quality and liquidity, while profitability has rebounded from the depths of the Covid-19 crisis. In fact, just before the escalation of the Ukraine crisis, large European banks had been distributing excess capital, via dividends and buybacks. Given the renewed uncertainty, we would not be surprised if supervisors recommend that banks to hold back on extraordinary distributions to preserve capital buffers.