European Banking System Health Assessment
Analysis of vulnerabilities, capital adequacy, and stress test results
Executive Summary
This report examines the current state of the European banking system, assessing its resilience to economic shocks, reviewing capital and liquidity positions, and analyzing the results of recent stress tests. While overall stability has improved since the global financial crisis, pockets of vulnerability remain, particularly in southern European countries and among smaller regional banks.
Key Finding #1
European banks have maintained capital levels well above regulatory minimums, but profitability remains challenged
Key Finding #2
Stress tests reveal significant disparities in resilience between northern and southern European banks
Key Finding #3
Rising interest rates have improved net interest margins but increased credit risk in vulnerable sectors
Capital Adequacy Analysis
European banks have significantly strengthened their capital positions since the 2008 financial crisis and subsequent European sovereign debt crisis. Common Equity Tier 1 (CET1) ratios across major European banks now average 15.3%, well above regulatory minimums.
However, our analysis reveals considerable variation across countries and banking groups. Nordic and Swiss banks maintain the strongest capital positions, while some southern European banks, although improved, still lag their northern counterparts.
The quality of capital has improved substantially, with most institutions now relying predominantly on CET1 capital rather than hybrid instruments, enhancing their ability to absorb losses in stress scenarios.
Capital Adequacy by Country Group
Asset Quality Assessment
Non-Performing Loan Ratio Trends
Non-Performing Loan Trends
Non-performing loan (NPL) ratios have declined consistently across the European banking sector, falling from a post-crisis peak of 7.5% to 2.1% in 2024. This improvement reflects both economic recovery and active NPL management strategies, including portfolio sales and write-offs.
Despite this positive trend, NPL ratios remain elevated in several southern European countries, particularly Greece (5.8%), Italy (3.9%), and Portugal (3.2%). These countries also show higher ratios of forborne exposures, indicating potential hidden asset quality issues.
Sectoral Credit Risk
Commercial real estate (CRE) exposures present the highest sectoral risk in the current environment, with rising interest rates and changing work patterns putting pressure on property valuations. Banks with heavy CRE exposures, particularly in office and retail segments, face elevated risks.
Consumer credit quality has also begun deteriorating in several countries as households adjust to higher interest rates. This is particularly evident in countries with high household debt levels, such as Denmark, the Netherlands, and Sweden.
Stress Test Results Analysis
The latest European Banking Authority (EBA) stress tests subjected 50 European banks to a severe macroeconomic scenario, including a GDP decline of 6.3%, a stock market crash of 45%, and a commercial real estate price decline of 32%. The results provide key insights into the resilience of the European banking system under extreme conditions.
Stress Test CET1 Ratio Impacts by Country Group
Capital Depletion
Under stress, the average CET1 ratio declined from 15.3% to 10.2%, still above regulatory minimums. However, seven banks fell below 8% CET1.
Loss Absorbing Capacity
Credit losses accounted for 70% of capital depletion, with corporate exposures contributing most significantly to losses.
Liquidity Impacts
All major banks maintained liquidity coverage ratios above 100% even in the adverse scenario, indicating strong liquidity positions.
Liquidity Position Assessment
Liquidity Metrics by Bank Type
Liquidity positions across European banks remain strong, with the average Liquidity Coverage Ratio (LCR) at 156%, well above the 100% regulatory minimum. Net Stable Funding Ratios (NSFR) are similarly robust, averaging 124%.
The end of the European Central Bank's Targeted Longer-Term Refinancing Operations (TLTRO) program has been managed without significant market disruption, though it has increased funding costs for some banks, particularly in southern Europe.
Deposit stability has become a greater focus following recent bank failures in the United States. Our analysis indicates that European banks generally have more stable and diversified deposit bases, though digital banking has increased the risk of rapid deposit outflows during periods of stress.
Profitability Analysis
European Banking Profitability Trends
After years of compressed margins in a low interest rate environment, European banks have seen profitability improve with rising interest rates. The average Return on Equity (ROE) for major European banks reached 7.9% in 2024, up from 5.2% in 2022, but still below the average cost of equity estimated at 10-12%.
Cost efficiency remains a challenge, with the average cost-to-income ratio at 62%. Digital transformation efforts have begun to yield cost benefits, but legacy IT infrastructure continues to weigh on many established banks, while fintechs and digital challengers operate with more efficient cost structures.
Income diversification varies significantly across the sector. Universal banks with strong wealth management and investment banking operations show more resilient earnings, while retail-focused banks remain highly dependent on net interest income.
Country Risk Assessment
European Banking System Risk Assessment by Country
Geographic Risk Concentration
Our assessment identifies significant disparities in banking system health across European countries. Nordic and Benelux banking systems demonstrate the strongest overall health, with high capitalization, good asset quality, and solid profitability.
Southern European banking systems have improved considerably but continue to face challenges including higher NPL ratios, greater sovereign debt exposure, and more limited profitability. The potential for sovereign-banking nexus risk remains elevated in countries with high public debt levels, particularly Italy and Greece.
Eastern European banking systems show mixed performance. While Czech and Polish banks demonstrate strong profitability and capital positions, some southeastern European countries face challenges with dollarization, higher NPLs, and governance issues.
Emerging Risks
Short-term Risks
- Credit quality deterioration as higher interest rates impact borrowers' debt servicing capacity
- Commercial real estate corrections affecting loan collateral values and specialized lenders
- Liquidity risk from increased competition for deposits and changing customer behavior
- Market risk from potential asset price corrections and volatility in fixed income markets
- Operational disruptions from elevated geopolitical tensions and potential cyber threats
Long-term Challenges
- Digital disruption from fintech competitors and big tech entrants into financial services
- Climate risk exposure through lending portfolios and transition risks
- Demographic challenges affecting long-term growth prospects in many European markets
- Regulatory fragmentation despite progress on Banking Union and Capital Markets Union
- Profitability sustainability in a potentially lower growth economic environment
Policy Recommendations
For Regulators and Supervisors
- Maintain vigilant supervision of commercial real estate exposures and related concentration risks
- Accelerate progress on Banking Union completion, including European Deposit Insurance Scheme
- Enhance climate risk supervision and scenario analysis requirements
- Review liquidity regulations to address potential vulnerabilities from digital banking
- Strengthen cross-border cooperation on resolution planning and crisis management
For Banking Institutions
- Accelerate digital transformation while addressing legacy IT infrastructure
- Review business models and pursue sustainable profitability through diversification
- Enhance early warning systems for credit risk detection and management
- Develop robust climate risk assessment capabilities and transition strategies
- Invest in cybersecurity and operational resilience measures
Conclusion
The European banking system has demonstrated considerable resilience, with strengthened capital positions, improved asset quality, and robust liquidity buffers. These improvements position the sector to better withstand potential economic shocks than during previous crisis periods.
However, significant challenges remain. Profitability continues to lag behind global peers and falls short of sustainable levels at many institutions. Geographic disparities persist, with southern European banks facing greater asset quality and sovereign risk challenges. The changing interest rate environment has improved margins but also introduced new risks that require careful monitoring.
"European banks are better capitalized and more resilient than before previous crises, but structural challenges to profitability and emerging risks require continued vigilance from both supervisors and bank management."
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Sources
- European Banking Authority. (2025). EU-Wide Stress Test Results.
- European Central Bank. (2024). Financial Stability Review, November 2024.
- European Systemic Risk Board. (2025). Risk Dashboard, Q1 2025.
- Bank for International Settlements. (2024). Quarterly Banking Statistics.