Ukraine conflict and the impact on the European banking landscape
The primary consideration in any conflict is the humanitarian crisis. We sincerely hope for a ceasefire and rapid diplomatic resolution. Russia’s military invasion of Ukraine led to a raft of severe international sanctions and corporate exits, which has pushed the Russian economy to the brink and thrust the eurozone economy into a stagflationary shock. A severe market sell-off caused many European banks to lose more than one-quarter of their value in a week.
Leading into the conflict, central banks were shifting from monetary stimulus (i.e., the end of covid-era stimulus) to tightening (i.e., raising interest rates); the latter of course a long-awaited tailwind for banks’ net income. However, the conflict has now caused markets to revise the outlook for already-surging inflation upwards and growth downwards. It can create a toxic environment for banks, which may now suffer from lower and slower monetary tightening, lower economic growth, and Russian-related impairments. When banks are under pressure, within the European system, it can escalate quickly as market liquidity is deeply interconnected.
In this article, we will examine the economic consequences of the conflict, the sanctions and retaliatory sanctions, on the Russian and eurozone economy. Thereafter, we will consider the impacts on European banks.
Sanctions to push Russian economy to default
Since the start of the conflict, governments and corporates around the world have implemented unprecedented sanctions designed to isolate the Russian economy. Sanctions include the EU’s exclusion of seven Russian banks from the SWIFT messaging system (to deteriorate Russia’s ability to conduct cross-border payments), and blocking Central Bank of Russia’s (CBR) access to a large proportion of its $640bn reserves (to undermine CBR’s ability to support domestic financial system and currency). As a result, the economy – and the Rouble – is in freefall.
Country-specific sanctions and corporate exits from the Russian market have ramped up the economic pressure. Germany has frozen the Nord Stream 2 gas pipeline project (cutting off future revenues to Russia), while the UK has blocked access to London’s capital markets, including the suspension of trading in 28 Russian listed securities by the London Stock Exchange (LSE). The US has also banned imports of Russian oil, liquefied natural gas and coal, while the UK will phase out oil imports by year end. Elsewhere, the FTSE and MSCI has delisted Russian listings out of its indices, effectively declaring Russia as “uninvestable”. At the current count, more than 120 international companies have pulled out from Russia – from retailers to consumer goods, oil, and gas, automakers, media and finance.
In response, Russia’s central bank more than doubled its main interest rates from 9.5% to 20%, banned foreign investors from selling Russian securities and assets, as well as certain commodity exports. The Russian economy is braced for a deep economic recession. Fitch Ratings has warned a Russian sovereign default “is imminent”. The European Central Bank (ECB) said the Russian invasion of Ukraine “is a watershed moment for Europe” which bears risk of regional spillovers that could adversely affect euro area financial markets. The ECB maintained zero percent interest rates and will accelerate the conclusion of net purchases under the asset purchase programme (APP) in the third quarter. The ECB’s accelerated taper reflects a slightly hawkish tilt which prioritises surging inflation over the negative demand shock to activity. The second-order effects of the conflict will also ripple through the European banking market.
Eight banks share €77bn in Russian exposure
The immediate reaction in the banking market was seen in share prices and ratings downgrades. Many European banks lost more than one-quarter of their market capitalisation within one week. Some suffered analyst downgrades driven by longer-term risks to loan book asset quality, liquidity, and operational risk in compliance with fast-evolving international sanctions. European banks with Russian and Ukrainian subsidiaries are also exposed to the plunging Russian Rouble.
Seven European banks share €77.2bn in combined Russian exposure, with a concentration of €55.7bn among three banks. Austria’s Raiffeisen Bank International (RBI) has the largest exposure, estimated at €22.9bn, followed by France’s Société Générale, with €18.6bn, and Italy’s UniCredit, with €14.2bn, according to Bloomberg reporting. The credit quality of large western European banks’ exposures “is likely to deteriorate sharply, particularly for the counterparties most affected by sanctions,” Fitch Ratings wrote. “This could lead to material increases in loan impairment charges at some of the banks.” In addition, any severe hit to eurozone economic growth will weaken banks’ future profitability. Capital Economics has cut its GDP growth forecast for 2022 from 3.5% to 2.8%, citing the impact of sanctions, particularly in relation to energy trade, will be felt acutely for several months.
RBI’s Russian loan book accounts for around 18% of group earnings before tax, estimates S&P Global, and is biased towards corporate customers, with some retail exposures. “We anticipate that an economic downturn and the effect of sanctions in Russia will lead to rising non-performing loans and weaker profitability,” S&P Global wrote in a ratings note. The bulk of Société Générale €18.6bn Russian exposure, approximately €15.4bn, is through its subsidiary, Rosbank, the bank confirmed in a statement. Rosbank’s exposure includes 41% retail loans (i.e., mortgage and auto) and 31% corporate loans. The balance of Société Générale’s €3.2bn exposure is offshore loans, of which €2.6bn are held on balance sheet. The bank also confirmed €80m in exposure to Ukraine, concentrated on international corporate clients. UniCredit’s Russian exposure is split €7.8bn to customers of its Russian subsidiary and €4.5bn in cross-border exposure to Russian customers. In the extreme scenario, where UniCredit’s exposure was entirely non-recoverable, UniCredit would take a 200 basis point hit to its capital buffers, the bank confirmed in a statement. Separately, the Financial Times reported this would represent losses of around €7bn. However, this is not the bank’s base case and still plans to pay its 2021 dividend. UniCredit’s CEO Andrea Orcel said on Tuesday (March 15) that the bank was considering exiting its Russian operations, according to Bloomberg, following a similar decision by Deutsche Bank.
The next European bank largest exposures are the Netherlands’ ING (€6.7bn), Italy’s Intesa Sanpaolo (€5.6bn), France’s Credit Agricole (€4.9bn) and BNP Paribas (€3bn), and Germany’s Commerzbank (€1.3bn). Deutsche Bank reported gross loan exposure to Russian of €1.4bn, which comprised €1.1bn to Russian companies with material operations and cashflow outside Russia and €0.3bn from loans to subsidiaries of large multinational companies. In addition, gross loan exposure to Ukraine is €42m. By contrast, US banks’ exposure to Russia is limited – $14.7 bn in a sector worth $22.6 trillion, according to data from the Bank of International Settlements. Citigroup is the most exposed US bank with $9.8bn exposure to Russia. The bank risks losing $4bn as a result of the war and sanctions, according to the Financial Times.
Russian banks exit Europe
Sanctions imposed by the US and the EU undermined Russian banks’ ability to support European subsidiaries. Fitch Ratings downgraded the ratings of 32 Russian banks and their international subsidiaries. Sberbank Europe, the European subsidiary of Russia’s largest bank headquartered in Austria, was the first Russian banking failure after the invasion. The Austrian unit collapsed after sanctions prevented the Russian parent from providing vital liquidity in response to “significant deposit outflows”, according to the European Central Bank (ECB).
Sberbank Europe has about 800,000 retail and corporate exposures across the CEE region with €13.6bn in assets at year-end 2021, with subsidiaries in Croatia, Slovenia, the Czech Republic, Hungary, and Serbia. Sberbank Europe is a fully owned subsidiary of Sberbank of Russia, which is majority-owned by the Russian Federation. Elsewhere, VTB Bank, Russia’s second-biggest bank, is also preparing to wind down its European subsidiary, due to western sanctions, according to the Financial Times. VTB Europe holds more than €4bn in deposits for mostly German retail customers. The bank also has an investment banking operation in London.