COVID-19: the impact on Europe’s smaller banks

18 November 2020

The more than 2,000 small and medium-sized banks that are directly supervised by national authorities – also referred to as less significant institutions – play an important role in the European economy. They account for nearly 20% of the European banking sector by assets and are a key source of funding for smaller businesses. Their financial health is therefore a vital factor in their ability to support the European economy in the wake of the coronavirus (COVID-19) pandemic.

Overall, these banks entered the pandemic crisis with relatively few bad loans on average (non-performing loans made up only 2.3% of total loans), ample liquidity buffers (the average liquidity coverage ratio was above 200%, more than double the required minimum) and a good solvency position (with Common Equity Tier 1 capital standing at 17%, comfortably above minimum requirements). However, these banks are now confronted with a deep pandemic-induced economic recession that is continuing to unfold. While governments, central banks and supervisors across Europe responded swiftly to the pandemic by taking emergency measures to stave off the worst of the crisis, the true extent of the economic damage will only become clear as these measures are scaled back. What is already clear is that many businesses are struggling, and this has spillover effects on banks. The impact on smaller banks is likely to be in areas such as asset quality and solvency. What’s more, this is all coming at a time when these banks are still addressing a number of long-standing issues, including shrinking interest margins and poor efficiency.

In terms of asset quality, the banks most affected by the crisis are those with a significant concentration of exposures to economic sectors that have been severely hit by the pandemic. These include the hospitality, retail trade and transport sectors as well as some manufacturing subsectors. But banks exposed to less vulnerable sectors may also be challenged by the fallout from COVID-19, especially if they entered the crisis with high levels of non-performing loans (for example, bad loans to the construction sector already represented 10% of total loans to this sector at the end of 2019).

Looking at concentration of exposures, the COVID-19 pandemic could cause banks to become excessively exposed to the domestic government sector. For some 50 banks, sovereign exposures already represented more than one-third of their total assets at the end of 2019. Such poor diversification may indicate that these banks lack alternative business opportunities, which points to an unprofitable business model, or that they are behaving opportunistically, by investing in these bonds as part of a carry trade strategy, for example. In any case, the banks in this position are leaving themselves vulnerable to potential stress in their domestic sovereign bond market.

In terms of liquidity, the picture is mixed. The ECB has recently taken measures to drastically mitigate banks’ funding risk, including by providing new long-term central bank funding and making it easier to access this funding. Nevertheless, a large number of small and medium-sized banks remain exposed to liquidity risks. For example, many banks have very high levels of committed credit lines relative to their available high-quality liquid assets, making them vulnerable in the event of a corporate rush for liquidity similar to the one seen during the first phase of the COVID-19 crisis. Another liquidity issue concerns small and medium-sized banks that rely heavily – or excessively, in some cases – on wholesale funding. This reliance could leave them exposed to volatility in wholesale markets. This type of institution includes the subsidiaries of banks from emerging markets and the captive banks of corporate groups, for example in the automotive and aviation sectors. Such captive banks are vulnerable given that their parent companies are not immune to the crisis. In fact, some manufacturing companies are among the hardest hit by the COVID-19 crisis and are subject to credit rating downgrades.

Finally, a deterioration in asset quality, as described above, would affect banks’ solvency because the associated credit losses would gradually eat into banks’ capital buffers. Again, some banks are more at risk than others in this area. At the end of 2019, before the introduction of the recent temporary measures in support of the banking sector, which include a substantial loosening of capital requirements, some 40 institutions had a fairly limited capital buffer over their prudential requirements. Ten banks would have fallen short of their requirements had they not made use of transitional, i.e. less strict, calculation provisions.

To conclude, some banks are more vulnerable than others to the fallout from the COVID-19 crisis. This is due to a weaker solvency position or individual business model characteristics. While the actions taken by governments and central banks have bought banks some time by temporarily alleviating the impact of the crisis on the banking system, the scaling back of these measures is likely to exacerbate vulnerabilities. That is why the authorities responsible for supervising small and medium-sized banks are stepping up their efforts to ensure that these banks continue to meet their capital and liquidity requirements and can therefore operate safely and in the interest of economic recovery.