Europe appears to be heading towards a recession and a “winter of discontent”. Inflation is climbing at its fastest pace for decades. Interest rates are rising in response. Economic activity is slowing, the euro is declining against the US dollar, and investors are holding record levels of cash.
Soaring energy prices pose a particular challenge. Here in Germany, anecdotal evidence suggests that the monthly energy bill for a four-person household could soon exceed €1,000, a four-fold increase. That could take the average household energy bill from 7% of net income to 25% or 30% pre government support measures. Unless households and firms sufficiently reduce energy consumption, we might even see gas rationing early next year – something that could reduce GDP by 7.9%1. Luckily, recent figures and mild temperatures look promising that we would achieve the targets.
So, while it’s too early to forecast the winter’s economic weather accurately, the climate is certainly looking harsher than it has been in years. The implications for banks are clear, with falling disposable incomes and business profitability pushing up credit risks.
Geopolitical risks are rising too. In addition to Russia’s invasion of Ukraine, international rivalry is increasing in many regions. These tensions, together with the megatrends labelled as “Digitalisation, Decarbonisation and Demographics” by the Economist2, are rapidly disrupting the world. I wouldn’t be surprised to see interdependencies between these economic, political and structural trends create self-reinforcing spirals over the months ahead.
In short, European banks are expected to face an increasingly volatile operating environment. This is not entirely negative for the industry; rising interest rates should allow banks to expand their net interest margins, and market volatility could provide a short-term boost to non-interest income for investment banks.
However, higher market and credit risks – probably with stronger correlations and concentrations than seen before – can affect a range of lending and trading portfolios. These risks could easily outweigh the benefits of higher rates. Falling stock markets might also leave banks facing new legal risks from claims of greenwashing.
The scale of potential tail risks is illustrated by the Bank of England’s downside stress test scenario. This assumes UK inflation peaking at 17% in 2023, a global GDP contraction of 2.5%, UK house prices falling 31%, equity prices dropping 45% and short-term interest rates peaking at 6%3. That may be unlikely, but it is sobering. It remains to be seen if the European Banking Authority (EBA) and the European Central Bank (ECB) take a similar stance in their 2023 test.
Faced with these potential threats, banks should not only safeguard their individual positions, but also respond collectively in partnership with a range of stakeholders. I would make three suggestions:
- To state the obvious, perform appropriate risk management actions, develop and implement scenario analyses that take unprecedented risk correlations into account, ensure agility.
- Using risk data, risk insights and risk management skills to inform the policy debate by sharing data with peers, politicians and supervisors.
- Engaging with regulators and supervisors to share practical insights into current experience and foster appropriate supervisory flexibility.
- Communicating with investors, supervisors, clients, staff and the public to explain why banking profits may be rising during the early phase of the economic downturn.
Turbulent times are likely ahead. For banks, the best defence lies in doing whatever they can to help society as a whole. Being part of the solution will not only help Europe to prepare for an uncertain future. It will also allow the industry to strengthen its long-term position.
That way, to complete Shakespeare’s famous couplet, perhaps European banks can help the “winter of discontent” to be “made glorious summer”.
This blog is adapted from a speech given by the author, Henning Dankenbring in October 2022.
For further insights on banking supervision, visit KPMG’s ECB Office webpage.
1 Source: Bloomberg, 2022
2 Source: The Economist, 2022
3 Source: Bank of England, 2022