Reduced interest rates have bolstered economic activity and supported the real estate markets. The European Union’s (EU) unemployment rate has continued its downward trend, indicative of a robust labour market that has positively impacted consumer spending. Nevertheless, geopolitical tensions and policy uncertainties remain significant risks to economic and financial stability, including a slowdown in economic growth.

Geopolitical tensions are high. This development has triggered an increase in defence spending. While such fiscal expansion may bolster economic growth, it also elevates pressure on fiscal resources, especially in countries with already high debt levels. The nexus between sovereigns and banks has weakened compared to a decade ago, due to a diversification of assets, the increasing strength of the EU/European Economic Area’s (EEA) banking sector, as well as broad fiscal discipline by EU/EEA countries. The growing financing requirements of sovereigns could potentially act as a trigger for the resurrection of this nexus. The feedback loop during times of financial stress can still be a source of risk for banks. Geopolitical risk has also been one of the major drivers of financial markets in recent quarters, inducing volatility.

In an environment of rising tariffs, EU economies might be particularly negatively affected due to their openness and dependence on international trade flows. The introduction of tariffs might particularly affect sectors with significant export flows to the United States (US). These sectors include manufacturing, such as automotive and pharmaceuticals, as well as industries related to steel and aluminium, mining and quarrying, as well as agriculture. Several banks have notable exposures to the manufacturing sectors, and exposures to US counterparties, including US sovereign debt, are not immaterial.

These developments might significantly affect financing needs and lending dynamics. This comes in addition to the rising financing needs to address technology and climate risk-related challenges. The plan to rearm Europe is expected to boost defence spending across the EU, channelling substantial investment towards various sectors, including manufacturing and technology.

EU/EEA banks’ profits grew by approximately 9% in 2024, outpacing the rise in equity and resulting in return on equity (RoE) of 10.5% in 2024, slightly higher than in the previous year (10.4%). A key challenge has been rising pressure on net interest margins (NIMs) and accordingly on net interest income (NII). However, banks have managed to improve their fee and trading income to partially offset this impact. The cost of equity (CoE) has remained high, with around 60% of banks estimating it to exceed 10%, although the proportion of banks estimating a CoE above 12% has decreased.

Indications from banks’ Q1 results are that EU/EEA banks’ results have held up well, and with no major impact from geopolitical developments. EU/EEA banks’ profitability remained roughly stable compared to end-of-year results, and there have not been signs of a significant deterioration in asset quality. However, there was an uptick in the cost of risk, which might signal that banks have started to increase their provisioning amid the deterioration in the geopolitical situation. Anecdotal evidence suggests that this might also be supported by a further build-up of overlays.

The Common Equity Tier 1 (CET1) ratio stood at 16.1%, with CET1 capital matching the 5% increase in Risk-Weighted Asset (RWA) in 2024. The volume of CET1 capital rose by around EUR 70 bn, primarily due to rising retained earnings and other reserves, helping the banking sector to be better prepared to absorb shocks and continue operations during periods of financial distress, enhancing financial stability. Due to consistently robust capital buffers and high profitability, banks’ dividend distributions and share repurchases continued to rise, reaching EUR 92 billion in 2024. This represents a payout ratio of 51% of year-end (YE) 2023 profits. Banks anticipate a further rise in the planned dividends for 2025. Significant Risk Transfers (SRTs) have an increasing use as a capital management instrument among EU/EEA banks, helping them to release capital and increase their lending capacity. More banks aim to make use of them going forward.

Banks boosted their assets by 3.2%, reaching a total of EUR 28.2 tn, primarily driven by a significant increase in outstanding loans and advances, debt securities and equity holdings. Despite a notable reduction in cash balances, banks maintained a substantial amount of cash reserves, accounting for around 11% of total assets. Lower interest rates supported client lending, with outstanding loans towards non-financial corporations (NFCs) and households growing by 1.8% to nearly EUR 13.5 tn. Related to climate risk, EU/EEA banks’ disclosure data indicate that substantial shares of their exposures might face transitional and physical risks, even though there is wide dispersion among banks and countries. Furthermore, the interconnectedness of EU/EEA banks with non-bank financial intermediaries (NBFIs) remains a possible major channel of contagion during market turmoil, with exposures amounting to 10.1% of total consolidated bank assets.

EU/EEA banks’ three-year funding plans project a 1.7% increase in total assets for 2025, with higher growth rates expected in 2026 and 2027. Lending to NFCs is anticipated to rebound, growing at 4.3% in 2025 and maintaining close to 4% yearly growth through 2027. Household loans are forecasted to increase more modestly by 2.0% in 2025, before picking up pace in the following years. Banks plan to increase their liquid assets, reversing the decline in cash balances, while the growth of debt securities is expected to slow down, due to the declining interest rate environment.

The materialisation of credit risk has been evidenced by a slight increase in non-performing loans (NPLs) and a significant rise in the allocation of loans under International Financial Reporting Standard (IFRS) 9 Stage 2. By the end of 2024, EU/EEA banks reported an increase in NPLs to EUR 375 billion, with the NPL ratio rising slightly to 1.88%. Loans classified under Stage 2 surged to historically high levels, making up 9.7% of total loans, primarily driven by an increase in Stage 2 household loans. Despite the deterioration in asset quality metrics, the outlook has improved due to a lower interest rate environment and the stabilisation of real estate markets. However, given the heightened geopolitical and macroeconomic uncertainty, particularly related to tariffs, downside credit risks remain elevated.

Key liquidity and funding indicators demonstrated a robust position among EU/EEA banks, with the Liquidity Coverage Ratio (LCR) at 163.4% and the Net Stable Funding Ratio (NSFR) at 127.1% as of December 2024. Banks’ liquidity remained high, despite previous targeted long-term refinancing operations (TLTRO) repayments and the drop in excess liquidity in the system. However, banks’ LCR has shown a decreasing trend since December 2023, due to the drop in High-Quality Liquid Assets (HQLA). Changes in LCR were underscored by changes in the interest rate environment and deposit behaviour. During 2024, banks continued with the adjustments of their liquidity buffers by replacing central banks’ reserves with sovereign debt, covered bonds and Level 2 assets. The asset encumbrance ratio further decreased by 60 basis points (bps) year-on-year (YoY) to 24.1% in December 2024.

EU/EEA banks grew their liabilities by around 3% in 2024, reaching EUR 26.2 tn as of YE 2024. Debt securities issued increased the most, reaching a share of 20.3% of total liabilities in Q4 2024. Household deposit volume reached nearly one third of total liabilities, increasing by 1.3% in 2024 to a share of 31.1%, while the share of NFC deposits increased to 17.2%. There is, however, strong heterogeneity in the liability mix across institutions. Market data indicate that EU/EEA banks remained active in primary funding markets in 2024, except for periods of significant volatility. Issuance data shows that volumes of bank debt instruments were lower in the first five months of 2025 compared to the same period in previous years. The importance and volume of central bank funding continued to decrease in 2024, driven by final repayments of TLTRO funding.

Looking forward, the fastest growing liability segments in EU/EEA banks’ funding plans are repos, long-term unsecured debt securities and client deposits. EU/EEA banks’ yearly issuance volumes are expected to rise significantly over the next three years. Banks also plan to increase secured debt issuances sharply this year after comparatively low volumes in 2024. However, rather optimistic plans for this year might face challenges amid elevated market volatility that could be seen during parts of the first half of the year, and which might also similarly happen during the remainder of the year.

The increasing complexity and systemic nature of operational risks in the banking sector, driven by digitalisation, technological advances, and heightened geopolitical tensions, have put these risks even further to the forefront. Digitalisation and technological advances, with related cyber risk, are a key driver of operational risk besides fraud, reputational challenges and the risk of financial crime, including anti-money laundering (AML) risk, and further conduct-related and legal risk. RWAs of operational risk have grown, reflecting its significance in the overall risk profile of banks.

Technological progress also relates to crypto assets and possible implications for the banking sector. The rapid evolution of the crypto-currency markets and the emergence of distributed ledger technology is a potential opportunity for financial institutions. Some banks in the EU/EEA have further progressed their engagement with digital assets, including direct exposures, as well as offering consumer-facing services, such as custodial wallets and facilitating transactions through blockchain platforms. This shift presents opportunities for banks to provide clients with access to the digital assets market, but it also entails risks, including infrastructure risks such as blockchain failures, and cybersecurity threats such as hacks and data breaches.