Fitch: Risk of Eurozone deflation, peripheral banks hit first
Thursday, 23 October 2014 00:00
-
- {{hitsCtrl.values.hits}}
Deflation in the Eurozone would put further pressure on banks, dampening earnings, increasing non-performing loans and weakening collateral values. Banks in peripheral countries with already weakened banking systems and low inflation would be affected first.
Falling prices, wages and incomes reduce demand for credit and make existing debt harder to service, while falling asset prices weaken defaulted loan recoveries. But the negative knock-on effects on economic growth means there is likely to be an official sector response, which could ease banks’ pain.
The risk of deflation is increasing, but it is not Fitch’s base case for the Eurozone as a whole. Fitch expects strengthening GDP growth and a narrowing of the output gap to help avert deflation. Combined with greater banking sector transparency and increased capitalisation this is neutral to positive for bank Viability Ratings. But it is removing sovereign support from Eurozone bank ratings, which will trigger Issuer Default Rating downgrades.
Fitch has considered a “Japan-style” deflation scenario for European banks, after a similar exercise for sovereigns and corporates. Deflation would negatively affect several inputs to Fitch’s Viability Ratings assessment, including the operating environment, asset quality, capital, and earnings. The nature and extent of the impact would reflect the severity of deflation, its duration, and its variation across jurisdictions. The effect on individual banks would also depend on the creditworthiness of each bank, and any additional official sector policy responses.
Earnings and operating environment would deteriorate
Bank earnings would suffer through a combination of lower demand for credit, higher impairments, and continued low interest rates and a flat yield curve. Structurally profit-making banks would be better placed in a deflationary scenario. Conversely, banks without leading market shares or the ability to manage costs effectively are more vulnerable. The banking systems in Ireland, Belgium, the Netherlands, Portugal and Germany all suffer from relatively low profitability (as measured by pre-impairment operating profit/assets), although there is significant variation within each country.
Growing NPLs would weaken capital and asset quality
Weaker asset quality would be likely to show up through higher non-performing loan ratios as real debt burdens increase, and a reduction in the value of collateral as asset prices fall. This would put pressure on capital while banks are transitioning to Basel III with its tougher capital standards. Banking systems that already have high impairments, high unreserved NPLs, and low earnings are most vulnerable.
Some of these countries, such as Cyprus, Greece, Italy and Spain, have continued to experience post-crisis declines in residential property values (although in some cases prices have stabilised), so deflation could exacerbate this effect in the short term. It could also be much harder for countries to regain competitiveness if prices are falling, as it is usually difficult to lower nominal wages. Protracted deflation could be accompanied by significant capital reallocation across the Eurozone, or even capital flight from weaker countries.
Impact would vary by sector
Industry sectors with oversupply such as pulp and paper, shipping, and steel, and mid-size companies primarily focused on domestic markets would probably be most affected in the deflation scenario. Banks such as the north German Landesbanks, which are exposed to shipping, would be correspondingly more vulnerable. Retail lending (including residential mortgages and unsecured personal lending) could be worst affected in countries with already high personal indebtedness, such as the Netherlands, Ireland and Portugal, although in some cases this could be offset by household savings.
