Are Europe’s banks ready for recession?

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

Add the macroeconomy to that list of problems. Inflation is at 40-year highs; supply chains have proved brittle or seized up altogether; share prices have plunged (and recently recovered a bit); commodity prices have gone on a similar roller-coaster ride (except European gas, which is now trading ten times higher than its long-term average).1 To turn the tide, central banks have begun to raise key lending rates, but the differential between inflation and these rates has not been this wide since the 1970s, in both Europe and the United States.

The situation looks to get worse, not better. Europe is on the verge of a recession, according to many analysts.2 Will central banks beat back inflation and keep the economy growing? Or are the forces at work so strong and disruptive that Europe tilts into stagflation? We see two corresponding scenarios:

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

What will a downturn mean for banks?

The banking sector heads into the downturn, if that’s what’s coming, in a strong position. Over the past ten years, the industry has built substantial capital reserves. Tier 1 capital sits at 14 to 15 percent today, versus 10 to 11 percent in 2007. Liquidity also is better, with a loan-to-deposit ratio below 85 percent. Capital markets have not been impressed, however: as banks have taken reserves in 2022 for future losses, investors have sold. Banking shares are now trading at the same level as at year-end 2020.

In either scenario, we expect the initial stage to be positive for banks. Rising interest rates will lift net interest margins, as short-term lending products (such as consumer finance) are repriced faster than liabilities such as deposits. In this phase, costs and risks are likely to remain under control, though talent costs—a major category—have been rising recently, a trend that could continue. In the first half of 2022, as rates have risen, banks have reported an 8 percent gain in earnings versus the first half of 2021, mostly attributable to improvement in net interest income.

The big question is what will happen after the initial stage. Banks could see three effects, small or large depending on the scenario: a slowdown in volume growth, higher costs, and greater delinquencies. Start with volumes: payments and transactions will slow in a recession, and higher rates will likely deter auto loans, mortgages, new bond issuances, and IPOs. Costs also will rise with inflation; beyond talent, many other categories such as technology and branch operations will be affected. Finally, if recession bites hard, banks’ customers will suffer. Some will default, and many others will need to restructure their loans.

Seize the moment

Our research has found that companies that take bold moves in anticipation of a potential crisis outperform others, and their lead grows in subsequent years. It’s especially true in banking; for example, 60 percent of the gap between leaders and laggards was built in the first two years after the financial crisis of 2008 and 2009 (exhibit).

In our experience, in the months leading up to a change in the business cycle, leading banks do better than others at building resilience across the enterprise. Today, that calls for three moves:

  • Take bold steps now to shore up financial resilience and prepare for growth. Banks can take four short-term steps that will help them absorb and mitigate losses in 2023. First, they can set the stage for repricing of assets and liabilities by analyzing potential effects on volumes and credit quality. Next, banks can manage inflationary pressure on salaries and other costs, working to win over employees through offers of reskilling, location flexibility, and making sure to fish for new talent in the right pools. A third step: banks can rebuild the muscles needed to manage nonperforming assets, including skills to renegotiate loan terms and craft new customer assistance strategies. Fourth, banks can go deeper on balance sheet resilience by doubling down on capital and liquidity calculations to improve accuracy.

    These bold steps should consider a granular sector-by-sector and segment-by-segment approach, as different sectors will be affected in different magnitudes and timings over the next months. Banks can use the experience of managing the 2020–21 COVID-19 crisis.

  • Bring stress-testing and scenario-planning skills up-to-date. New risks are emerging all the time; a year ago, very few people were worried about letters of credit for tanker shipments. Banks need to reassess the assumptions behind their models; add new data, such as behavioral shifts visible in social media, to their models; and ramp up 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 resilience for the long term. The preceding moves will set leaders on a trajectory for outperformance. These banks can keep the pressure on rivals by building other forms of resilience that will set them up for the longer term. Examples include operational resilience (where business continuity plans should be refreshed), technology resilience (where many banks are still not fully capitalizing on automation), and business model resilience (many banking businesses such as everyday banking, investment advisory, and mass wholesale are rapidly evolving, so banks need to reassess their ability to succeed on the new terms now being drawn up and position accordingly). All that newfound resilience will allow banks to do what leading companies do in a crisis: explore potential M&A opportunities—for example, with fintechs—in light of the recent drop in valuations.

Every challenge brings potential for success, and the actions of bank leaders today will define the playing field of tomorrow. If a downturn arrives, banks will be glad they moved quickly. If it doesn’t arrive, banks will be that much better placed for the next wave of growth.

Nuno Ferreira is a partner in McKinsey’s Lisbon office, Matthieu 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 an op-ed in The Banker on September 28, 2022, and is reprinted here by permission. Copyright © 2022; The Banker

1 Harry Dempsey and Polina Ivanova, “European gas prices soar after Russia deepens supply cuts," Financial Times, July 26, 2022.

2 See, for example, Simon Kennedy, “Morgan Stanley predicts euro area in recession in final quarter,” Bloomberg, June 29, 2022.