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Trade wars likely to weigh on European banks’ asset quality
By Marco Troiano, Financial Institutions
Investor unease is also driven by the broader uncertainty and unpredictability of US trade policy. The tariff announcements are undoubtedly unwelcome and will likely have direct impacts on Europe’s growth and interest-rate outlook, and indirect impacts on the performance of banks.
In the near term, we expect the primary driver of asset-quality deterioration to emerge on the corporate side, which could happen more quickly than anticipated as EU exporters face material pressure as they adapt to a new environment of higher trade barriers.
Banks with a greater focus on corporate and business lending are therefore most exposed. As the economic slowdown takes effect and second round effects begin to materialise, greater pressure on credit quality could spread to other segments.
Small and medium-sized enterprises could be affected by second-round effects from weakening demand, in particular in the value chain of larger companies with high export dependence on the US, as well as from fiercer competition in Europe that could result from a re-routing of trade flows from non-European markets, adding further pressure.
Depending on whether labour market conditions weaken, credit quality in consumer credit and to a lesser extent mortgages could also deteriorate.
The tariff announcements have also altered market expectations around inflation and interest rates, broadening the range of possible scenarios. At least initially, rate expectations appear to be drifting lower. Lower rates would reverse some of the gains in banks’ profitability linked to widening interest margins. This is consistent with a base-case assumption of no immediate EU retaliation against the 10% tariffs and continued open trade, which would see some overcapacity in Europe and renewed disinflationary forces.
A more benign scenario of negotiations and a gradual de-escalation of new tariffs also remains possible but is unlikely to completely restore investor confidence in the short term, given the abrupt nature produced by the shock announcement of 2 April.
On the negative side, a renewed escalation of trade tensions with retaliation by the EU and the further escalation of tariff rates from the US also remain a credible risk and would likely lead to more pronounced GDP losses across Europe and a more significant deterioration of banks’ asset quality.
Banks enter phase of uncertainty from position of strength
While some credit deterioration remains likely under any of the above scenarios, European banks enter this new phase of uncertainty from a position of relative strength. Balance sheets are broadly sound, with relatively small amounts of legacy non-performing loans (NPLs) and modest newer-vintage NPLs, in particular in commercial real estate.
More importantly, banks have built up significant capacity to absorb credit losses through their ordinary profitability, which should shield their capital positions. Nevertheless, continuous monitoring of macroeconomic conditions and early-warning asset-quality indicators will be key to identifying outlier institutions, which could see their credit ratings deteriorate.
Looking beyond the immediate impact of the tariff announcements, we continue to monitor the policy shifts of the Trump administration with respect to broader financial policy, including potential changes of bank regulation, interference in monetary policy independence and changes to the framework of international co-operation in safeguarding financial stability.
For example, limiting foreign banks’ ability to obtain dollar funding from their central banks could require significant adjustments of banks’ funding structures and business models: 17% of euro area bank funding is denominated in US dollars, .according to the ECB’s November 2024 Financial Stability Review, and is primarily wholesale. Part of this funding is short term, exposing banks to risks if dollar liquidity is disrupted. These risks, however, are mitigated by banks’ ability to obtain dollar liquidity from the ECB which in turn, relies on swap lines with the Federal Reserve.
We consider it unlikely that financial policy will be weaponised to the point of endangering global financial stability, not least because of the potential unintended consequences for the status of the dollar as the global reserve currency. The Federal Reserve’s continued independence from the political process provides some further comfort.
A co-operative attitude among global central banks during these times of market unrest is critical for financial stability. Any indication that this is at risk would raise further risks for banking sector resilience and add pressure on banks’ credit profiles.
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