Executive summary

Europe's macroeconomic landscape is marked by gradual, albeit slow economic growth and low unemployment rate. Inflation rates have retreated across the EU, yet in many jurisdictions they are still above their central banks’ targets. Nevertheless, the region continues to be exposed to possible setbacks due to growing uncertainties from geopolitical tensions and worries about persistently slow economic growth and increasing market volatility. The recent stabilisation in real estate market prices has sustained valuations, although potential downside risks for the sector remain.

Geopolitical risks can negatively impact both financial markets and the real economy. EU/EEA banks’ direct exposures to geopolitically high-risk countries exceeded EUR 500bn as of June 2024, representing around 2.5% of their total exposures. They may also be exposed to second-round effects through their exposures towards those sectors affected by geopolitical risks. Beyond the potential impact on credit risk, geopolitical risks can also manifest for banks in the forms of market, liquidity, operational and other risks. These risks can be exacerbated by political developments which can also create a risk-averse environment. This can lead to decreased growth potentials, lower investment and market volatility, and ultimately affect banks’ asset quality, capital, liquidity and profitability.

The linkages between banks and NBFIs can present vulnerabilities during periods of financial instability. As of June 2024, EU/EEA banks' exposures to NBFIs represented 9.8% of their total assets, predominantly concentrated in larger banks. The tendency of NBFIs to participate in higher-risk lending and adopt more relaxed underwriting standards may result in greater fluctuations in asset quality. Additionally, all financial intermediation channels can be exposed to unforeseen linkages and shared asset holdings. Should banks' liquidity facilities for NBFIs be abruptly activated, or if banks were required to bring failing off-balance sheet entities onto their own balance sheets, it could adversely impact the banks' capital and liquidity ratios.

Banks within the EU/EEA expanded their asset base on a yearly basis, reporting total assets amounting to EUR 27.9 tn, which corresponds to a 1.2% growth for the year leading up to June 2024. This growth was primarily driven by a 2.4% increase in loans and advances, a 9.3% rise in debt securities, and a significant 37.6% surge in equity holdings. The change in equity holdings was driven by a small number of banks. These increases were partially offset by a decline in cash balances due to further repayments of the ECB’s TLTRO facilities and lower derivative exposures. Despite the reduction in cash balances, banks still reported EUR 3.3 tn in cash balances, contributing to robust liquidity ratios.

Lending to NFCs showed a modest recovery, with loans to SMEs and CREs increasing by 0.6% and 1.9% YoY, respectively. Growth of loans to NFCs is still affected by the level of interest rates and weak fixed investment. The CRE sector saw a notable increase in loans, driven by restructuring support for existing customers rather than new lending. Loans to households also showed slight growth, with a 0.9% YoY increase, largely due to improved conditions in the housing market and consumer confidence.

Asset quality showed a slight decline. NPLs increased by 3.4% to EUR 373 bn, accounting for 1.9% of total loans. Inflows of NPLs were primarily driven by defaults in the NFC sector, particularly among SMEs and loans collateralised by CREs. NPLs from credit for consumption increased to 5.4% from 5.2%, and NPLs collateralised by residential real estate remained stable at 1.5%. Banks anticipate a general decline in asset quality over the next 6 to 12 months, particularly in the consumer credit, SME, and CRE sectors.

Banks' liabilities rose by 1%, mainly due to increased debt issuances and customer deposits. Despite market volatility, banks remained active in primary funding markets, although issuance volumes were lower for the first three quarters of 2024 compared to same period last year. Customer deposits remain the primary funding source for EU/EEA banks, while central bank funding has decreased substantially, lowering the asset encumbrance ratio. Most banks target retail deposits as main funding source for the next quarters. A large share of banks also expects stable spreads for most market-based funding instruments and anticipates lower funding costs due to interest rate cuts. The ‘greenium’ on specific bank-issued debt differed across various debt types, with covered bonds having a rather small but stable ‘greenium’ whereas senior-preferred bonds show a higher but more volatile behaviour.

Majority of resolution banks meet their MREL, roll-over needs appear manageable. These banks must issue eligible instruments to meet MREL requirements. As of 30 June 2024, all banks met these requirements, however, 24 banks with longer transition period had a combined shortfall of EUR 6.1bn. In addition to this outstanding shortfall, there is upcoming funding need, as in order for banks to sustain their current MREL levels, they will need to roll-over around EUR 220 bn in MREL instruments by June 2025 – which appear manageable.

As of June 2024, EU banks maintained high liquidity levels, although liquidity positions have decreased since the beginning of the year. The decline was partly due to repayments of the ECB’s TLTRO in the first half of 2024, as well as higher market volatility which drove LCRs lower. Despite these challenges, banks managed to maintain their liquidity buffers by increasing their holdings of government assets and Level 1 covered bonds which compensated for the reduction in cash and central bank balances. As a result, key liquidity indicators were reported at robust levels. The LCR stood at 163.2% (down from 168.3% in December 2023) and the NSFR at 127.6% (127.1% in December 2023).

EU banks have maintained strong capital positions. The CET1 capital ratio rose by 12 basis points to an all-time high of 16.1%, driven by accumulation of CET1 capital, which outpaced the growth inRWAs. The growth in CET1 capital, which now stands at EUR 1.57 tn, was supported by rising retained earnings, while RWAs increased by 3% over the last year to EUR 9.8 tn. Additionally, the leverage ratio was reported higher by 11 basis points to 5.8%, reflecting capital generation outpacing asset growth. Despite these positive trends, the CET1 headroom above overall capital requirements and P2G declined slightly by 26 basis points, standing at a still comfortable level of 466 basis points as of Q2 2024.

This increase in RWAs was mainly due to credit risk, which rose by EUR 240 bn or 3%, while operational risk and market risk also saw increases of 8% and 1%, respectively. The rise in credit risk RWAs was driven by higher exposures to corporates and institutions, and a shift towards higher risk profiles for the corporate and retail exposure classes. The average risk weight density for banks' total credit risk portfolio increased by 67 basis points to 28.1% in June 2024. Despite these challenges, EU banks have managed to maintain strong capital buffers and high profitability, enabling them to distribute record dividend payouts and share buybacks.

EU/EEA banks’ net profits remained close to their all-time highs, with RoE reaching 10.9% as of Q2 2024. The growth of NII decelerated due to the stabilisation in the interest rate environment, which is now followed by central banks’ interest rate cuts. Although banks' expenses rose, they did so at a pace slower than the average inflation rate. Despite maintaining double-digit RoE levels, a substantial number of EU/EEA banks currently fail to cover their CoE, and their market valuations remain below their book values.

Bank sector M&A activity has remained subdued. Data also indicates that cross-border transactions are less attractive than domestic ones. This might to a certain degree also be affected by the fact that cross-border universal banks tend to have the highest cost levels compared to banks with other business models. The profitability, and similarly valuation of EU/EEA banks lags behind that of their US counterparts. An analysis of the differences in profitability between EU and US banks indicates differences in their revenues as a main driver. Among various contributing factors, one reason for the higher valuation of US banks could be their generally higher profitability.

The transition to a more sustainable economy has led to an elevated demand and supply of sustainable products. The picture, however, on banks' green exposures is mixed and incomplete. Insights from Pillar 3 ESG data reveal that the taxonomy alignment of EU banks’ overall banking book remains modest as of December 2023. Both single asset classes, such as NFC and household GAR, and total GARs are low, with most banks reporting total GARs below 2%. The EU average weighted total GAR was below 3% at the end of 2023.

This shift to more use of sustainable products has also increased the risk of greenwashing. This can undermine investor confidence and necessary investments. Greenwashing can generate reputational and financial risks for institutions, including through litigation processes, and can affect the overall credibility of sustainable finance markets. Greenwashing risk materialises mostly through reputational and operational risks.

Analysing the effects of climate risk on financial entities is crucial. With increasing frequency and severity of climate events, financial institutions must anticipate, prepare for, and mitigate these risks to ensure long-term viability. The results of the ‘Fit-For-55’ climate scenario analysis, run jointly by the EBA, the ECB and other ESAs, show that in the near term, transition risks alone, modelled as a ‘run on brown’, are unlikely to threaten financial stability. Yet, if such a scenario is coupled with unfavourable economic conditions, losses for the financial system increase significantly and could potentially hamper the financing of the green transition.

The EU banking sector is facing a significant rise in operational risk. This is not least reflected in operational risk capital requirements which now account for 10.2% of total requirements, up from 9.7% in June 2023. The scope of operational risk includes conduct-related risks such as business conduct risk and financial crime, including AML and TF wealth. Technological advancements and digitalisation have heightened the importance of operational resilience. Cyber and ICT risks have grown further with a notable escalation in cyber threats and attacks in the latter part of 2023 and the first half of 2024 during a time of rising geopolitical tensions. Cyber incidents have set new benchmarks in both the variety and number, as well as their consequences. A surge in mobile banking trojans was observed in 2024, and the banking sector was among most targeted sectors for DDoS attacks.

Fraud risk has become a major operational risk driver, nearly as significant as conduct and legal risks. The growing use of digitalisation and technological innovation, including AI, has contributed to the increasing risk of fraud. Payment fraud and fraud involving theft or breach of customer credentials are the main drivers of this risk, though the proportion of such fraudulent activities differs significantly across Member States. Additionally, outsourcing risks have risen as banks increased their reliance on third-party services. The number of operational risk loss events reported by EU banks in 2023 was high, with total materialised losses from new operational risk events reaching EUR 17.5 bn, a 27% increase compared to the previous year. This highlights the need for banks to continue strengthening their operational risk management and resilience capabilities.

AI integration in the EU banking industry is advancing, enhancing efficiency in areas such as customer segmentation and the detection of illicit activities. The adoption of AI and GPAI in banking brings risks that require careful management. GPAI models are complex and opaque, often generating misleading ’hallucinations’ and introducing ICT risks, including data privacy and cybersecurity concerns due to reliance on third-party models. GPAI also relies on extensive datasets that may lack quality, while unclear data collection practices by GPAI model developers can complicate data governance by banks.