Evidently, 2020 was a disastrous year for banks, with banking stocks, at a point in time trading at all-time lows. Nonetheless, European banks are heading into 2021 in a better position than many would have expected just a few months ago.

This recession is clearly different in comparison to previous recessions as it was driven by a health crisis rather than a financial crisis, with banks supporting the economy and governments’ support packages. In fact, banks’ capital ratios remained resilient, even though significant provisions for expected credit losses (ECLs) were booked during 2020.

The European economy, similarly to Malta, is expected to start recovering as from the second quarter of 2021. This recovery is supported by the continued monetary and fiscal support of various governments throughout Europe, which also includes the €750bn EU Recovery Fund that began supporting governments and central banks on 1 January 2021. Another key aspect of this recovery will be the speed at which COVID-19 vaccines are administered and the effectiveness of vaccines against new variants and mutations of the virus.

The strong efforts taken by governments to support households’ balance sheets have been an important aspect of this recovery. In fact, a sizeable portion of governments’ support packages has been aimed at people whose jobs would otherwise have been made redundant.

As noted earlier, capital ratios remained strong throughout 2020. As published by the European Central Bank (ECB), the aggregate Common Equity Tier 1 (CET1) ratio for significant banks (i.e. banks that are supervised directly by the ECB) as at the third quarter of 2020, stood at 15.2%, while the aggregate capital ratio stood at 19.1%. By comparison, the median CET1 ratio of large EU banks before 2009 stood at around 7.5%.

In view of the various governments’ support packages and the monetary support given by the ECB, the economic impact as a consequence of the pandemic has been much less than that previously expected in the second quarter, as Europe was dealing with the first wave of COVID-19. As published by the ECB, the stock of non-performing loans (NPL) fell to €485 billion in the third quarter of 2020 from €503 billion in the second quarter, reflecting a decline of 3.6%. Similarly, the NPL ratio fell to 2.82% from 2.94% in the third quarter of 2020.

In fact, such improved economic sentiment has been reflected in the relatively low default rates across Europe. Fitch Ratings has lowered their forecasted European high-yield bond default rate to 3.6% in 2020 and 5.0% in 2021, compared to their initial expectations of 4.5% and 7.9%, respectively. As noted by Fitch, many issuers have addressed their liquidity risks in 2020 and refinanced their maturities once secondary-market prices recovered following government stimulus packages and the post-lockdown economic recovery. This improvement in the macroeconomic environment has led to several European banks reversing a portion of ECLs in Q4 2020, which naturally improved the banks’ profitability and capital ratios.

Another positive note for banks, has been the lifting up of the recommendation made by the ECB in March 2020 for EU banks to suspend capital returns. Even though the ECB still calls on banks to refrain or limit dividends until 30 September 2021, we see this a positive development and a stepping stone towards normalisation. According to latest guidelines, dividends are to remain below 15% of cumulated 2019-20 profits and not higher than 20 basis points of CET1 ratio.

Despite the positive traits noted above, the banking industry still faces several downside risks. The various government support packages throughout Europe came at a hefty price of increased debt levels, with the debt-to-GDP ratios reaching unprecedented levels in some countries. At the end of the third quarter of 2020, the government debt-to-GDP ratio in the euro area increased to 97.3%, which is well above the 60% debt-to-GDP limit. In fact, in July 2020 the European Fiscal Board recommended to get rid of this debt threshold and instead adopt realistic debt targets specific to the bloc’s national economies.

Additionally, the EU expects inflation to only rebound to 1.0% in 2021 (2020: 1.1% and 2023: 1.4%), therefore still under the ECB’s inflation target of 2%. Consequently, it will be very difficult for the ECB to increase interest rates in such an environment, especially in the short to medium term. This will in turn, continue to put pressure on the banks’ profitably margins.

Furthermore banks face two other key challenges, increasing investment in technology and IT infrastructure, and the fact that most European banks are faced with a combination of weak profitability but significant excess liquidity, which in most cases attracts negative returns. Such environment has led to banks adopting significant transformation programmes to drive down costs and improve profitability margins.

However, such policy will naturally run its course and will not be enough, especially for small banks that lack economies of scale to compete effectively while maintaining profitability and making the necessary investments in technology. This will most probably lead to consolidation between banks and therefore, result in a number of mergers, especially when considering that the European banking sector is still fragmented, with a large number of small banks.

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