The expected eventual drop in rates should weigh moderately on bank profitability in developed economies like Europe and the U.S. A downside scenario, where this is coupled with a material deterioration in the economic backdrop, would leave banks scrambling to bolster both their profitability and asset quality—exacerbating the divergence in credit quality between the largest lenders and their less-diversified counterparts.
What we’re watching:
The rapid stretch of monetary-policy tightening by the European Central Bank (ECB) and U.S. Federal Reserve has generally been a boon to bank profitability in both regions. Higher interest rates have boosted banks’ net interest income—resulting in higher net interest margins (NIMs) and enhanced profitability. Lenders have benefited from a widening of the spread between the interest they pay to depositors, and the income they reap on lending.
That said, for some banks, the rise in rates has led to slower loan growth, asset-quality pressure, and a weakening of funding and liquidity. For instance, European banks have already tightened lending standards, with annual loan growth for lenders in the eurozone at close to zero at the end of November. In the U.S., bank lending in 2023 was up barely 2%. This is a predictable outcome of monetary tightening. A question is whether future rate moves (or lack thereof) could lead to a further unexpected tightening in credit conditions for borrowers.
With inflation now closer to central bank targets and economic growth set to slow somewhat, policy rates’ next move is likely to be downward. Lower rates could be a mixed bag for many banks. While NIMs would likely fall, balance-sheet pressures could ease and loan growth may pick up, assuming economic growth holds up.
As it stands, our outlook for global banks remains steady. As of Feb. 7, 78% of bank rating outlooks were stable, due largely to solid capitalization, improved profitability, and sound asset quality. That said, we anticipate increasing credit divergence, with more pressure on nonbank financial institutions and entities (banks or nonbanks) with weak funding profiles or directly exposed to geopolitical risk.
What we think and why:
Banks are well-positioned to manage an orderly normalization of monetary policy, in which the ECB and the Fed gradually lower interest rates and continue to shrink their balance sheets. For most banks, a normalization of interest rates is preferable to an environment in which rates stay higher-for-longer. Lending is a key source of revenue (and risks) for banks. A tightening cycle with no end in sight would mean lenders' loan books would suffer. It is also far preferable to the era of ultra-low policy rates in many regions that squeezed bank margins and profitability.
Across the 83 banking systems S&P Global Ratings covers globally, we expect provisions for credit losses of more than $2.5 trillion in the 2023-2025 period. Losses jumped 16% last year, and we expect more modest increases of 6% this year and 4% next year. Our base-case forecasts show median credit losses of about 17% of pre-provision earnings for 2023 and 2024 for the top 200 rated banks, which represent about two-thirds of global bank lending. Credit losses would need to be more than five times higher than forecasted before depleting bank capital rather than earnings.
In a downside scenario, a sudden reversal in rates—if in response to a sharp economic slump and an associated, unpalatable jump in unemployment—would be more difficult for banks to absorb. In such a scenario, the drop in interest rates would compress lenders' NIMs while the underlying economic headwinds would buffet banks' business volumes, asset quality, and financing conditions.
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What could change:
Regulation in the wake of the Global Financial Crisis has played a role in reducing risk by raising capital requirements, particularly for the large and systemically important banks. Following turmoil in the global banking industry in March of last year, U.S. regulators have put forth additional regulatory proposals to increase the strength and resilience of the banking system. The proposed rules would result in more stringent capital requirements for many U.S. banks.
S&P Global Ratings views the proposed regulations as an incremental positive for creditors, but whether it will translate into higher ratings for any lenders is unclear and hinges on how much capital they ultimately hold. Also, it's not clear when and whether the proposal will be enacted as written.
Regarding interest rates, the "longer" for interest rate prospects has become the operative component in the outlook for higher-for-longer. If inflation proves more persistent than we expect (despite a slowdown in growth) the Fed or the ECB may be forced to keep borrowing costs high for a protracted period. This would continue to pressure bank balance sheets, including funding, liquidity, and market values. An extension of the higher-for-longer rates and a tepid economy would also limit revenues in fee-income sources such as asset and wealth management, investment banking, and mortgage banking.
Additionally, weaker economic performances could result in higher corporate insolvencies (where leverage is already extremely high), including in sectors already pressured, such as commercial real estate—thus fueling higher credit losses.
CreditWeek, Edition 16
Contributor: Alexandre Birry
Written by: Joe Maguire and Molly Mintz
