European banks have been resilient during the Covid crisis, but still face 2 major challenges

LONDON — European banks have seemingly weathered the coronavirus crisis well, but there are still some major challenges ahead that have the potential to rattle the sector.

There’s been a noticeable difference between the pandemic and the global financial crisis of 2008: European banks have a much stronger capital position now than they did before. This is in part thanks to much tougher requirements imposed by regulators in the wake of the 2008 shock — and it looks to be paying off.

European banks are so confident about their capital positions that some are even ready to resume dividend payouts this year, despite regulators asking for caution.

“The most important takeaway is that we have not seen a deterioration in asset quality yet since the onset of the crisis,” Arnaud Journois, vice president at DBRS Morningstar, said about the latest set of quarterly results from European banks.

Fahed Kunwar, head of European banks equity research at Redburn, also said the latest quarterly results have been “strong” with three-quarters of banks beating on revenue, and closer to 90% beating on capital and provisions.

Major lenders in Europe have benefited from stimulus measures introduced by governments, but also from policies from the European Central Bank and Bank of England. Their steps have contained the number of business failures and have boosted lending.

But the situation could change over the next year as these fiscal and monetary interventions are potentially scaled back.

“Bad loans will start to appear over the next year or so. That’s when we will get a clearer picture of how bad the situation is in the corporate sector,” Nick Andrews, Europe analyst at investment research firm Gavekal, told CNBC over the phone.

Elisabeth Rudman, head of European financial institutions at DBRS Morningstar, also said that “the full level of non-performing loans is still to materialize.”

Governments haven’t announced that they are lifting financial support, but as the health crisis slows down and economies reopen they will likely pull back on their contributions. That will put pressure on certain firms, which might end up missing their debt repayments and file for insolvency.

“When these measures are withdrawn, we expect to see an increase in defaults and non-performing loans at banks,” Rudman added.

The second challenge is interest rates.

“One risk given the level of government spending is if interest rates do start to move up markedly, that will increase the cost of trying to respond to the pandemic,” Jes Staley, CEO of Barclays, told CNBC on Thursday.

Interest rates were cut to record low levels in the wake of the pandemic, but central banks could consider raising them back up if prices rise significantly in the near future.

This is a smaller risk in the euro zone, according to Andrews from Gavekal, where recent increases in inflation were associated with one-off events, such as new consumer tax rules in Germany.

However in the U.K., economists have predicted that prices could overshoot the Bank of England’s inflation target later this year, which would likely lead to the central bank increasing rates.

“It will be tougher for the overall economy,” Staley said if that plays out. Higher rates will mean that business owners and property buyers will find it more expensive to take on new debt.

However, there is one bright spot that could help European banks in the recovery phase. Economists believe that consumers will return to the shops and restaurants, and start to make the economy move again the moment that social restrictions are eased.

“We could see a stronger rebound on the back of pent-up demand,” Andrews from Gavekal said. This could lead to more business investment and end up supporting banks’ balance sheets too.