Box 1: Geopolitical landscape increases risks for the banking sector

Banks within the EU/EEA have reported nearly EUR 5 tn^[2] in exposures to counterparties located outside the EEA, which is 23.4% of their total exposures. Over the past year, these exposures increased significantly by more than EUR 350 bn (7.9%). A substantial portion of this growth was driven by increased exposures to counterparties based in the United States (EUR 1.3 tn in June 2024, an 11.8% YoY increase). The United States remains the largest non-EEA counterparty for the EU banking sector, followed by the United Kingdom (EUR 900 bn). Exposures to emerging markets also rose and equalled those of the UK.

Geopolitical tensions have intensified globally over the past few years amid deteriorating diplomatic relations between the United States and China, Russia’s invasion of Ukraine and war in the Middle East, and further conflicts around the globe. Although exposures to these regions are not negligible, they only account for a fraction of total exposures of the EU/EEA banking sector. Banks have almost EUR 225 bn in exposures to Middle Eastern countries, with Turkey and the UAE alone representing nearly EUR 100 bn and over EUR 45 bn, respectively. Exposures to nations directly affected by the conflict in the Middle East are limited to under EUR 10 bn, mostly towards Israeli counterparties (EUR 7 bn). Chinese counterparties account for about EUR 80 bn, while Taiwanese exposures are around EUR 18 bn. Exposures to entities in Russia, Ukraine, and Belarus are below EUR 45 bn.

Threat from terrorism is also widely elevated level, and there are increasing risks of rising trade barriers and the introduction of new tariffs. Geopolitical risks can adversely affect both the financial markets and the real economy, as well as the linkages between the two, representing a threat to financial stability. On the financial side, an increase in geopolitical risks can lead to restrictions on capital flows and payments or increased investors’ risk aversion, thereby affecting cross-border capital allocation and asset prices. This can result in heightened volatility in financial markets. On the real economy side, an increase in geopolitical risks can lead to restrictions on the import/export of goods and services or disruptions to supply chains, thereby affecting international trade and economic growth, and generating inflationary pressures. The interconnections between the two channels can potentially give rise to a detrimental feedback loop between the real economy and the financial channel, thus amplifying the overall impact of geopolitical risk on financial stability^[3].

Geopolitical risks may also amplify existing vulnerabilities leading to situations of severe distress. These risks may have a direct and indirect impact on the EU/EEA banking sector, as counterparties of EU/EEA banks are spread across over 220 countries and have exposures to sectors potentially vulnerable to geopolitical risks. The direct impact could result from heightened credit risk associated with exposures to counterparties located in countries experiencing increased geopolitical risk. Additionally, there may be indirect effects arising from supply chain disruptions caused by geopolitical tensions and reduced demand for European products due to imposed tariffs.

The latter can be a result of political developments regarding trade policies, including tariffs, trade agreements and import/export regulations. Protectionist policies might affect international trade flows, corporate earnings and overall market sentiment. In broad, political uncertainty can create a risk-averse environment, leading to decreased investment and market activity, potentially prompting investors to seek ‘safer assets’, leading to capital flight and reduced market liquidity. Prolonged political instability can hamper economic growth, affecting not only corporate profits, but market performance too. Political uncertainty can manifest itself through governmental instability, for instance where frequent elections resulting from hung parliaments might lead to significant policy changes, or rising threat from so-called populist parties and / or politicians. These shifts can impact market expectations and investor-behavior.

These factors could negatively influence the performance of the banking sector, affecting lending volumes and practices, risk management and capital requirements. They can also increase operational costs for banks, potentially reducing profitability. Market, liquidity, and operational risks can also be impacted, for instance, during financial market turmoil, increasing margin call demands, and interconnectedness between banks and sovereigns. Potential impacts may also involve employers, offices, branches, and systems being affected by an escalating conflict or terrorist attack. Other associated risks encompass increasing ICT and cyber^[4] threats, which may involve potential complications with third-party providers, for example. The emergence of geopolitical risks can lead banks to face increasing legal and AML risks, alongside dealing with fresh sanctions and related measures that increase operational risks. These challenges also extend to correspondent banking and impact internal frameworks and processes such as prudential and accounting models, as well as valuation procedures. Banks must be adequately prepared to manage these risks.

EU/EEA banks show notable exposure to some vulnerable geopolitical risks sectors, but only limited direct exposures to vulnerable countries

The following analysis primarily addresses the aspect of credit risk, evaluating vulnerability via direct as well as – to the degree possible – certain indirect effects. An essential phase of this assessment involved identifying countries and the business sectors potentially most susceptible to geopolitical risk.

The identification of the most vulnerable countries was based on country risk scores^[5]. In concrete, S&P Capital IQ’s country risk scores were used. The score considers political, economic, legal, tax, operational and security risks that arise from doing business with or in a specific country. The scale ranges from '1' (very low risk) to '10' (extreme risk). For the purpose of the analysis, all countries classified at least as ’high risk’, i.e. those with an overall country risk score of 2.4 or above, were considered. This resulted in the selection of 82 countries, of which 10 were identified as severe-risk countries with an overall risk indicator of at least 4.4.

EU/EEA banks’ direct exposures to these geopolitically high-risk countries exceeded EUR 500 bn as of June 2024, representing around 2.5% of the total exposures of EU/EEA banks. A significant concentration of these exposures was found in Spanish banks through their subsidiary operations in Mexico and Turkey (around EUR 220 bn and EUR 57 bn), though notable exposures to higher geopolitical risk countries are present throughout several banks in Europe, albeit with a great degree of heterogeneity. In most EU/EEA countries, banks reported direct exposure to countries vulnerable to geopolitical risks of less than 4% of their total exposures. While countries such as Spain, Hungary and Croatia have slightly more such significant exposures, it was nevertheless less than 11% of their total exposures (Figure 3).

The identification of the most vulnerable business sectors was based on the simple correlation between the equity performance of relevant sectors, as indicated by selected Euro Stoxx sectoral equity indices, and the GPR Daily Index, considering a time horizon of 3 years, from mid-September 2021 to mid-September 2024^[6]. For the analysis, the five sectors that exhibited the highest negative correlation with the GPR Index were selected and assumed to be those facing particularly elevated vulnerabilities relating to rising geopolitical risks. The findings of the analysis showed that businesses related to accommodation and food service activities, transport and storage, information and communication, trade, and manufacturing were the most negatively correlated. Businesses concerning human health services and social work activities as well as construction showed an intermediate correlation.

On average, the proportion of banks’ exposures to business sectors susceptible to geopolitical risks was around 40% of total NFC loans for EU/EEA banks, with notable variability. For several jurisdictions, more than half of total loans to NFCs concerned businesses operating in vulnerable sectors. This percentage increased further exceeding 60% for Greece, Slovenia, Cyprus and Bulgaria (Figure 3).

Sources: Caldare and Iacoviello, Refinitiv Workspace, S&P Capital IQ, EBA supervisory data and calculations

Box 3: EU/EEA banks’ interconnections with NBFIs

Banks’ exposures to NBFIs could be a source of vulnerability in periods of turmoil, as banks are often closely intertwined with different types of NBFIs. The EBA published in early summer 2024, as part of its RAR, a detailed assessment of the risks to the banking sector stemming from these interlinkages^[10]. As of June 2024, EU/EEA banks’ exposures to NBFIs amounted to 9.8% of consolidated bank assets. Large banks are generally more connected to the non-bank sector, with exposures amounting to 10.4% of total consolidated assets, followed by medium-sized banks (5.0%) and small banks (5.3%)^[11].

Exposures towards NBFIs are highly concentrated in a few countries, as 80% of the total exposures of EU/EEA banks, are reported by only five countries, (i.e. France, Germany, Italy, Spain, and the Netherlands). Of these, with the exception of Spain, all countries reported relative total exposures towards NBFI counterparties as a percentage of total consolidated assets above the EU/EEA average. In most countries, the main links to banks on the asset side are in common non-trading loans, followed by debt securities and reverse repos (Figure 10).

The considerable increase in NBFI activity over the last 10 years is partly due to banks refining their business strategies to adapt to regulatory changes, such as CRR3/CRD6. Therefore, in some cases, these providers of ‘private credit’ could have become alternatives for bank lending. Results of a recent EBA survey with competent authorities performed as part of the regular work to monitor banking sector risks, suggests that NBFIs (particularly other financial intermediaries^[12]) in the EU/EEA largely tend to cover more niche markets that may have limited opportunities to access traditional bank financing. This includes, but is not limited to, low credit score consumer loans, specialised consumer credits (e.g. payday loans), leasing, factoring, real estate, or microfinance including SMEs.

NBFIs seem to be playing a particularly important role in the CRE market, especially as part of development and investment strategies (i.e. strategies to invest in illiquid assets). While the European CRE debt market is still dominated by traditional banks, the sharp rise in interest rates combined with lower valuations and the tightening of regulation have led to a significant reduction in banks’ overall appetite for financing in this market. In addition, the CRE market is facing secular trends, such as Europe’s focus on sustainable urban development and renewable energy, which often require specific financing requirements that are less suited to traditional bank loans and may be more suited to providers of alternative financing with more tailored arrangements, creating market opportunities for NBFIs.

NBFIs are also important for corporate lending, especially for SME financing amid rising interest rates and tightened SME lending standards by banks. Despite the continuing application of the SME supporting factor, banks face relatively strict capital requirements that limit their SME lending. Therefore, SMEs – which are responsible for a large share of employment in the EU – often face financing challenges because their access to external financing is limited for various reasons, including insufficient credit and rating history, opaque corporate structures and higher risk profiles. As far as NBFI lending is originated at fair prices and otherwise adequate standards, NBFIs which offer customised financing solutions tailored to the specific stage of SME financing could be an important complement to traditional bank financing in closing the financing constraints experienced by SMEs.

Consumer lending can be considered a more niche market in many jurisdictions, and NFBIs are in particular complementary to banks in providing services to segments of the population that have limited access to traditional bank lending for reasons such as irregular income or insufficient credit history.

Nevertheless, the results of the survey also indicate that, depending on the country, activities of NBFIs may largely overlap with those of the banking sector. Hence, banks and NBFIs are often seen as complementary to each other.

While improved access to credit as such undoubtedly improves welfare, and new types of lenders may cover parts of the market that are no longer attractive to banks, concerns have been raised. These include that lending standards may not always be as prudent as those applied by regulated financial institutions. The EBA survey also looks at how credit standards and asset quality at NBFIs compare to the banking sector. Responses suggest that NBFIs often charge higher fees and interest rates on credit products compared to banks, which could ultimately affect investment and economic growth. Main reasons for this might be NBFIs’ increased preparedness to engage in higher-risk lending, or looser and more flexible underwriting standards, with products often not meeting the standards required by regulated financial entities. As a result, this may lead to greater variability in asset quality, particularly among non-bank lenders that are not owned by banks. The potentially reduced capacity of less-regulated lenders to absorb credit losses and/or their unwillingness or inability to remain in the market during economic downturns could pose risks of a credit crunch for affected borrowers with limited access to other sources of financing. Even if in the EU the volume of NBFI lending remains moderate and is as such unlikely to be of direct systemic relevance, hidden risks may have been created which need to be carefully identified.

Although the risks related to liabilities, such as deposits from NBFIs or repurchase agreements with these entities, are significant, the larger financial intermediation system might be exposed to hidden connections and shared asset holdings, which are viewed as crucial sources of risk to their asset side. For instance, if banks’ liquidity lines to NBFIs were suddenly triggered or banks had to absorb failing off-balance sheet vehicles onto their balance sheets, banks’ own capital ratios could be compromised. In addition, asset losses triggered by NBFI fire-sales could generate mark-to-market losses to banks, thus limiting their capacity to provide funding and liquidity support to their clients, including NBFIs.