European NPL outlook: Germany and UK
European bank share prices whipsawed in mid-March, as instability fears within global financial markets reignited. Credit Suisse’s stock price plunged by almost 30% on Wednesday (15 March), after its largest investor, Saudi National Bank, ruled out increasing its stake on regulatory constraints. It led a sharp sell-off in global banks, sparking renewed investor fears of broader risks in the financial system, triggered by the collapse of Silicon Valley Bank (SVB), which suffered a bank run and collapsed within 48 hours in early March.
Ultimately, the Federal Reserve backstopped SVB depositors and the Swiss National Bank (SNB), Switzerland’s central bank, provided a liquidity facility of up to 50 billion francs (€50.75 billion) to Credit Suisse. It is a fast-evolving situation which we will address more fully next month. In this new article series, we provide an outlook for the European non-performing loan (NPL) market focussing on select markets. In this first article, we explore the euro area, Germany and the UK.
Euro area
European banks’ stock of non-performing loans (NPL) held modestly reduced to €348 billion in Q3 2022 (Q2: €350.9 billion), reflecting an NPL ratio (excluding cash balances) of 2.29% (Q2: 2.35%), according to the most recent data published by the European Central Bank (ECB). Nearly half of all current EU bank-held NPL exposures (43%) are held by banks classified by the ECB as medium to high risk or non-rated. By comparison, large banks in the euro area held almost €1 trillion in bad loans seven years earlier.
The growth in Stage 2 loans, characterised by increased credit risk and often a precursor to NPLs, nudged up to 9.79% in Q3 (Q2: 9.72%; Q3 2021: 8.85%), further above levels seen in Q4 2020. The growth in Stage 2 loans may signify an early warning sign of deteriorating asset quality on European banks’ balance sheets amid high energy prices, inflation, wages and borrowing costs. The European financial system remains highly vulnerable to a deterioration in the macro environment. The reversal in loose interest rates was faster than any forecasters or central banks expected, which created unexpected challenges and opportunities for banks and lenders.
In the short term, many banks were insufficiently hedged for interest rate risk, which led to losses. As bond prices came under pressure, funding costs rose faster than yields on the asset side of banks’ balance sheets. In the medium term, rising interest rates improve banks’ net interest income, but it also deteriorates banks’ funding conditions.
An economic slowdown, or recession, combined with higher-for-longer interest rates, increase the risks of defaults across the economy. Pressure on corporate margins stems from sharp increases in input prices, depressing the outlook for investment, while higher borrowing costs will weigh on debt serviceability. Increased credit risk is often the precursor to the emergence of a new generation of non-performing loans (NPLs).
The correlation between residential and commercial real estate (CRE) markets and rising interest rates exerting downward pressure on real estate values could reduce the value of loan collateral, which, in some cases, would prompt forced sales and possible losses among lenders.
SVB, a small technology-focused lender, revealed on Wednesday (March 8) that it lost $1.8 billion after selling a portfolio of securities valued at $21 billion. SVB offloaded the securities in response to a decline in customer deposits. The losses prompted the bank to announce a $2.25 billion share sale to bolster its balance sheet amid “continued high-interest rates, pressured public and private markets and elevated cash burn levels from our clients as they invest in their businesses”.
SVB securities portfolio losses sparked a widespread sell-off in the US banking sector, which spilt over into Europe, as markets digested the extent to which the tech bank’s problems represent contagion risk. This event is the clearest sign yet of how rising interest rates have put pressure on banks’ balance sheets – specifically in less liquid bond portfolios, which cannot be sold quickly without taking losses. Banks have simultaneously suffered a sharp fall in the value of bond securities as interest rates have risen and post-pandemic deposit declines, depleting banks’ capital buffers. We will examine this fast-evolving situation in more detail in the coming weeks.
Germany
In 2022, German banks continued to assess their credit risks as low, supporting historically low provisioning, according to the Bundesbank, Germany’s central bank. German banks held €31.1 billion in NPLs (excluding cash balances) as of the third quarter of 2022, reflecting a 1.26% NPL ratio, according to the most recent data published by the ECB. There has been a slight uptick in Stage 2 loans in this period.
NPLs in German banks are forecast to increase by 24% to €38.1 billion by the end of 2024, according to , an influential survey of risk managers in leading German credit institutions.
The anticipated pick-up in NPLs in Germany reflects a delayed pace of defaults in 2023. By the end of 2023, NPL stocks are now forecast to climb 15% to €35.3 billion, compared to a forecast of €37.6 billion in the summer 2022 survey. These forecasts are anchored to reported NPL stocks of €30.7 billion in September 2022 by the EBA.
Overall, the delayed defaults culminate in the highest forward expectation for German NPL activity in the NPL Barometer’s eight-year history – including compared to expectations after the Covid-19 pandemic broke out and before stimulus measures were introduced.
Over the next 12 months, six out of 10 (58%) survey participants expect consumer NPL stocks to increase. High inflation erodes real incomes, which weighs on the sustainability of household debt, impacting consumer loans and residential mortgages. The consequences impact financial behaviour. Payment practices of German companies and consumers have deteriorated significantly. Late payment of invoices by German companies has increased to the highest level in seven years, of four million invoices. “This is ringing the alarm bells for lenders and creditors,” said Patrik-Ludwig Hantzsch, head of economic research at Creditreform. Large companies with more than 250 employees were responsible for the lion’s share of outstanding debts with suppliers and lenders, accounting for 58.8% of overdue receivables. German low to mid-earning consumers are also postponing purchases, and invoice payments while small purchases are increasingly loan financed. A survey by Schufa, the German credit agency, found that payment disruptions have increased by 30% year-on-year. “We are watching inflation with concern,” says Tanja Birkholz, chairwoman of Schufa.
In the SME sector, almost half (49%) expect NPLs to increase, while just under half (46%) expect the same in the commercial real estate (CRE) sector. Only one in five participants (21%) expect NPL stock to increase in the residential industry.
The survey, published in January by the Bundesvereinigung Kreditankauf und Servicing (BKS) and the Frankfurt School of Finance & Management, indicates ambivalence beneath the headline of a more active German NPL market. On the one hand, participants forecast higher NPL stocks to come and a more active NPL market, while on the other hand, respondents remain cautious about predicting NPL volumes and NPL ratios in the next two years. Risk managers’ reluctance on the latter may reflect silent hope government aid measures may yet ease the flow of NPLs to come, suggests BKS President Jürgen Sonder, although there is no indication political will exists to support more stimulus.
Since this survey, however, the outlook for the German economy has improved slightly. According to the European Commission, real GDP is expected to increase slightly by 0.2% in 2023. This represents an upward revision from the -0.6% projected in the Autumn Forecast, driven by easing energy prices and policy support to households and firms. However, weak foreign demand will weigh on exports. In 2024, growth is expected to rebound to 1.3%.
Applications for insolvency proceedings fell 3.2% in January, reversing the 3.1% rise in December, according to provisional data by the Federal Statistical Office (FSO). The number of insolvencies and corporations in January was 775, according to the Leibniz Institute for Economic Research Halle (IWH). However, the institute warns of trouble ahead, citing high energy prices, wages and borrowing costs. “We expect higher insolvency figures for the next few months,” says Steffen Müller, head of the IWH department for structural change, productivity, and insolvency research. “The number of insolvencies could reach the long-term average again in the spring of 2023.”
The insolvency of weak companies is painful, but it frees up workers in tight labour markets to work at future-oriented companies. “The market exit of uncompetitive companies is essential for the competitiveness of the German economy as a whole,” says Steffen Müller.
UK
The large UK banks’ asset quality held up well in 2022, according to Fitch Ratings, with impaired loan ratios remaining near historic lows, although loan impairment charges (LICs) started to increase in the second half of 2022. The UK’s largest banks are well capitalised, and Stage 3 loan ratio stands at 1.8%, down from 2.0% at the end of end-FY20, according to DBRS. There is a concentration of smaller lenders exposed to higher-risk lending (e.g., buy-to-let, high LTV and loan-to-income mortgage lending, and lending to lower-rated and highly leveraged corporates) that are more exposed to losses.
Increased pressure on consumers and businesses has multiple familiar sources: high energy prices and inflation, rapid interest rate increases, and the upcoming higher taxes in the March UK Budget. The Bank of England (BoE) . Fitch forecasts the BoE to raise rates to 4.75% this year before reducing them to 4.0% in 2024. The UK is expected to enter a recession this year. UK real GDP growth is now forecast to slow significantly to 4.3% in 2022 and to -1.0% in 2023, according to DBRS.
The UK banking sector has the resilience to absorb an economic downturn much worse than the one currently anticipated, which reflects the large financial buffers they have built up since the 2008 global financial crisis. UK banks are still carrying high volumes of covid-era government-backed loans and are continuing to tighten lending standards as the economy weakens, adding refinancing risk for corporates over the next two years. However, there is a risk that excessive lending restrictions restrict access to funding for creditworthy households and businesses, weakening the economy and, ultimately, the banks in the longer term.
Insolvencies
The coming UK recession is expected to trigger a surge in business insolvencies over the next two years, which will eclipse levels following the global financial crisis (GFC) and the 1990s recession, according to Capital Economics, a UK independent economist. UK business insolvencies are forecast to rise to a record high of around 8,400 per quarter by Q2 2023, and may take until early 2025 for the rate of quarterly insolvencies to normalise at about 4,000 per quarter.
Over the last two years, the number of insolvencies in England and Wales rose sharply from 2,348 in Q1 2021 to 5,995 in Q4 2022, as covid-era stimulus and government protections protected poorly capitalised businesses from failing. But a run-off in protections and a weakening economic outlook (i.e., elevated raw material costs, wages and rising interest rates) create the conditions for a “catch up” for firms that should have fallen into insolvency during the pandemic moratorium, suggests Capital Economics’ assistant economist Olivia Cross.
Capital Economics forecasts the UK economy will slip into a recession this year. It expects a peak-to-trough fall in real GDP of 2.0% in 2023, the unemployment rate will rise to a peak of 5.5%, while CPI inflation and Bank Rate will remain elevated. In this scenario, insolvencies will rise from 5,995 in Q4 2022 to a peak of 8,370 per quarter in Q2 2024, implying 26,600 “excess insolvencies” over the next two years and 32,000 from Q4 2021, higher than following the GFC and the 1990s recession.
“Of course, much depends on the behaviour of creditors,” writes Capital Economics’ Olivia Cross. “If they provide more forbearance, then the rise in the number of insolvencies may be lower. Equally, if the recession is smaller than we expect and/or interest rates are cut sooner, then there would be fewer insolvencies.”
The most vulnerable industries are food and accommodation, construction and other services sectors. Meanwhile, the transport, financial services and agricultural sectors are less vulnerable. The retail sector, which has seen the largest outright rise in insolvencies so far since Q4 2019, is towards the middle of the range. However, the sharp rise in energy costs means energy-intensive manufacturing firms may also be more at risk, while strong wage growth will put pressure on the services sector as labour makes up a large proportion of total costs. More broadly, rising interest rates will increase firms’ debt servicing costs and increase the probability of insolvency among highly-leverages companies with slim cash reserves and operating margins.
Timur Peters is the founder of Debitos GmbH. He holds a diploma in finance and law. He has more than 10 years’ experience in the range of finance.
Before Founding Debitos Timur Peters was responsible in the distribution of Software for Banks and Financial Institutions for Comarch for the D/A/CH Region. Next to this he has worked for several years as a self employed Project Consultant in the area of Financing of Litigation cases, Peer2-Peer Credit Marketplaces and other online projects for financial institutions.
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