Are European banks ready for the recession?

With war active in Europe, disease caused by SARS-CoV-2 and signs of famine emerging in many parts of the world, this is a time of immense tragedy. And it’s probably the most complex operating environment bank executives have ever experienced.

Add macroeconomics to this list of problems. Inflation is at its highest for 40 years; supply chains have proven fragile or completely blocked; stock prices have plunged (and recently recovered a bit); Commodity prices have followed a similar rollercoaster ride (with the exception of European gas, which is now trading ten times higher than its long-term average).1 To turn the tide, central banks started to raise their key rates, but the gap between inflation and these rates has not been so wide since the 1970s, both in Europe and in the United States.

The situation seems to be getting worse, not better. Europe is on the brink of recession, according to many analysts.2 Will central banks bring down inflation and keep the economy growing? Or are the forces at work so powerful and disruptive that Europe is tipping into stagflation? We see two corresponding scenarios:

  • inflationary growth, where rate hikes keep inflation under control for a few years and growth is not severely affected
  • stagflation, in which monetary policy is unable to control inflation, drivers of inflation such as energy market volatility remain active and economic growth slows significantly

What will a slowdown mean for banks?

The banking sector is heading into recession, if that’s what’s coming, from a position of strength. Over the past ten years, the industry has built up significant reserves of capital. Tier 1 capital is now between 14-15%, compared to 10-11% in 2007. Liquidity is also better, with a loan-to-deposit ratio below 85%. Capital markets were unimpressed, however: as banks took reserves in 2022 for future losses, investors sold. Bank stocks are now trading at the same level as at the end of 2020.

In both scenarios, we expect the initial phase to be positive for banks. Rising interest rates will increase net interest margins as short-term lending products (such as consumer credit) revalue faster than liabilities such as deposits. In this phase, costs and risks should remain under control, although talent costs, a major category, have increased recently, a trend that may continue. In the first half of 2022, as rates rose, banks reported an 8% rise in profits compared to the first half of 2021, mainly due to improved net interest income.

The big question is what will happen after the initial phase. Banks could see three effects, small or large depending on the scenario: slower volume growth, higher costs and higher defaults. Start with volumes: Payments and transactions will slow in a recession, and higher rates will likely discourage car loans, mortgages, new bond issues and IPOs. Costs will also increase with inflation; beyond talent, many other categories such as technology and branch operations will be affected. Finally, if the recession hits hard, bank customers will suffer. Some will default and many more will have to restructure their loans.

seize the moment

Our research found that companies that take bold action in anticipation of a potential crisis outperform others, and their lead increases in subsequent years. This is particularly true in the banking sector; for example, 60% of the gap between leaders and laggards widened in the first two years after the financial crisis of 2008 and 2009 (illustration).

We strive to provide people with disabilities equal access to our website. If you would like information on this content, we would be happy to work with you. Please email us at: [email protected]

In our experience, in the months leading up to a change in the economic cycle, large banks are more successful than others in building resilience across the business. Today, this requires three movements:

  • Take bold steps now to build financial resilience and prepare for growth. Banks can take four short-term actions that will help them absorb and mitigate losses in 2023. First, they can set the stage for repricing assets and liabilities by analyzing the potential effects on volumes and credit quality. Then banks can manage inflationary pressure on wages and other costs, by striving to win employees through requalification offers, location flexibility and ensuring that new talent is sought in the right areas. A third step: banks can rebuild the muscles needed to manage non-performing assets, including the skills to renegotiate loan terms and develop new customer care strategies. Fourth, banks can deepen balance sheet resilience doubling capital and liquidity calculations to improve accuracy.

    These bold moves should consider a granular sector-by-sector and segment-by-segment approach, as different sectors will be impacted to different degrees and at different times over the coming months. Banks can learn from the experience of handling the 2020-21 COVID-19 crisis.

  • Update stress testing and scenario planning skills. New risks appear all the time; a year ago, very few people worried about letters of credit for tanker shipments. Banks need to reassess the assumptions underlying their models; add new data, such as behavioral changes visible in social media, to their models; and accelerate the speed of their efforts. Most banks would be well served if they could run stress tests and scenarios twice a month.
  • Keep an eye on long-term resilience. The previous moves will put the leaders on a trajectory of outperformance. These banks can keep the pressure on their rivals by developing other forms of resilience that will prepare them for the longer term. Examples include operational resilience (where business continuity plans need to be refreshed), technology resilience (where many banks are not yet fully capitalizing on automation), and business model resilience (many banking businesses such as day-to-day banking, investment advice and mass wholesale are rapidly changing, so banks need to reassess their ability to succeed under the new conditions being developed and position themselves accordingly). All of this newfound resilience will allow banks to do what big business does in times of crisis: explore potential M&A opportunities, for example with fintechs, in light of the recent drop in valuations.

Every challenge brings the potential for success, and the actions of today’s banking executives will define the playing field of tomorrow. If a downturn occurs, banks will be glad they acted quickly. If it does not happen, the banks will be all the better placed for the next wave of growth.

Nuno Ferreira is a partner in McKinsey’s Lisbon office, Matthew Lemerle is a senior partner in the London office, and Marcus Sieberer is a senior partner in the Zurich office.

This article was first published as editorial in The banker September 28, 2022, and is reproduced here with permission. Copyright © 2022; The banker

1 Harry Dempsey and Polina Ivanova, “Gas Prices in Europe Soar After Russia Steps Up Supply Cuts” FinancialTimesJuly 26, 2022.

2 See, for example, Simon Kennedy, “Morgan Stanley Predicts Eurozone Recession in Last Quarter,” Bloomberg, June 29, 2022.