Increase in credit risk among banks: a gateway for private debt

Traditional banking is hitting a roadblock as increasing credit risk and interest rates are hindering loan production, leading to a surge in private debt investment in the global and European markets and paving the way for a new era of corporate lending. In this article, we will explore the impacts of these emerging trends at the Luxembourg market level.

It comes as no surprise that the latest EY European Bank Lending Economic Forecast issued in Q2 2023 predicted that bank lending growth across the Eurozone will slow from a high of 5% in 2022 to 2.1% in 2023, due to high inflation and increasing interest rates. Non-performing loans are forecast to rise marginally, with Italy and Spain predicted to record the highest ratios due to their volume of variable-rate mortgages.1 Central banks worldwide are fine-tuning their policies, with the Federal Reserve expected to maintain elevated rates while the European Central Bank is expected to slightly decrease rates.

What does this actually mean for the traditional banking market in Luxembourg?

When we zoom in on the local market, the volume of loan production among banks in Luxembourg decreased by 30% during the first eight months of 2023 when compared to the same period in 2022, as shown in the statistics of the Central Bank of Luxembourg.2 This decrease has also been driven by the increase of close to 300 basis points in variable interest rates and more than 200 basis points for fixed interest rates compared to those before the Russo-Ukrainian war. Upon closer examination of the sharp decrease in loan volume, it becomes evident that two main areas govern this decline: mortgage loans, which have experienced a decrease of over 30%, and loans to non-financial corporations (NFC), which have seen a staggering drop of over 40%. While this decrease seems correlated with the increase in interest rates especially for the mortgage loans, there is more to it than meets the eye. The decrease in mortgage loan volume is dominated by a decline in housing demand due to high prices, high costs of construction and high borrowing costs, as shown by STATEC figures for H1 2023, with a 50% decline in real estate transactions over the same period in 2022.3 For the decline in NFC loan granting volume, while the high borrowing costs factor exists, another significant factor is dominating this decrease: the increase in credit risk. The latter is stemming from the difficulties some of these NFCs are facing to repay their existing exposures on one side and the banks’ reduced risk appetite to manage the impact on their risk weighted assets as well as their wish to maintain a stable ratio of non-performing loans (NPL) on the other side.

In order to further understand the impact of the above, a benchmarking exercise of the main credit risk indicators with similar European markets seems necessary. A quick look at the European Banking Authority (EBA) risk dashboard for the second quarter of 2023 shows us the following:4

• Weighted average NPL ratio has remained stable at 1.8% since the start of the economic downturn at the end of the second quarter of 2022
• Forbearance ratio maintained its downward trend and decreased by 20 basis points to 1.5% in comparison to June 2022
• Cost of risk (i.e., the ratio of risky assets under the total of provision hitting the profit and loss in the current year) surprisingly remained stable at 0.45% versus June 2022
• NPL coverage decreased by 9 basis points to 42.9% versus June 2022

Upon closer examination of the local economy and specifically some of the main banking groups in Luxembourg, a preliminary analysis of the publicly available financial statements as of 31 December 2021 and 2022 reveals varying data. The weighted average NPL ratio increased from 1.85% in 2021 to 1.93% in 2022 and the weighted average cost of risk, standing at 0.55%, remained within close range of the European average, even surpassing it by a few basis points which is in line with the current macro-economic environment. This has not been the case for the NPL coverage ratio, as the latter standing at 35% is lower than the European average of 42.9%. 

This poses the question: are banks in Luxembourg overestimating their recoverable amounts from their non-performing customers?

The above information sheds light on the heightened focus of regulators on early warning indicators and the forward-looking aspects of the banks’ credit risk assessments. A proper implementation of forward-looking aspects and early warning indicators would have an impact on the above risk indicators given the increasing concerns about a recession and rising default rates in the European economy with S&P expecting the European trailing-12-months-speculative-grade default rates to reach 3.75% by Q2 2024 versus 3.1% in Q3 2023.5

One of the aspects slowing down the volume of lending of banks in Luxembourg may be attributed to the approach applied by their credit risk models generally inherited by their parent entities with little room to adapt to local specificities or built years ago for the initial implementation of IFRS9. These limitations could hinder the banks’ ability to evaluate and assess emerging (novel) risks through their existing models, e.g., the supply of energy, supply chains in general, environmental risks, inflation, and geopolitical risks, due to the lack of necessary historical data with regard to these risks. This approach could lead banks to forfeit profitable lending opportunities to safer clients when their pricing mechanisms do not correctly capture the riskiness of their customers. The limitation of the banks' models to evaluate these novel risks and the early warning indicators related to them is also highly impacting their cost of risk, which explains why the latter has remained stagnant on a European level since June 2022. Instead, banks are mainly relying on overlays to bridge that gap; these overlays do not yield client-specific provisions and do not allow the active monitoring of novel risks.

Is the slowdown in traditional banking activities creating opportunities for other actors in a similar market? 

This slowdown on the level of the traditional lending activity is also giving rise to a different type of lender, mainly private debt, which is flourishing on a global level in general and in the European market in particular. The private debt actors evolving in an unregulated market highlights a shift from traditional banking to the former, with more and more inflows from institutional investors going towards private debt. As highlighted in the Pitchbook H1 2023 Global Private Debt Report, fundraising commitments on a global level are at USD 94.9 billion in the first half of 2023, which is ahead of the USD 91.4 billion figure of H1 2022, of which around USD 10 billion are originating from the European market.6 In the European market, France recently overtook the UK in terms of private debt deals according to Private Debt Investor (PEI) with the Benelux region being one of the faster growing regions for private debt in Europe. To assert this shift from traditional banking to private debt, we can see banks joining the private debt market with partnerships between major actors of both sectors to launch new funds by the end of 2023. 

Luxembourg being one of the main financial hubs for investment funds in Europe and the world, has seen its fair share of this shift towards private debt, with a growth of 51% in June 2023 versus June 2022, reaching assets under management of EUR 404 billion – the main focus being on direct lending. When compared to the 40% growth in 2021 before the economic slowdown we can see that the private debt lending market is still flourishing as opposed to the traditional banking lending market.7

Does this mean that private debt actors are taking larger risks compared to traditional banking?

Even though private debts are charging higher interest rates to their borrowers, risk management for private debt investments requires a more hands-on approach than traditional banking products, whereas in traditional banking, risk evaluation is often based on cyclical reviews or legacy systems. Therefore we can see why some NFCs are opting to contract large loans, with sometimes little to no collateral and more simplistic financial covenants via private debt. 

In the face of such significant changes to the lending landscape across the Eurozone, it is clear that traditional banking needs to adapt to the changing conditions. With interest rates on deposits on the rise, and customers expecting higher rates, banks are expected to increase focus on their commission income to shore up the shortfall from interest margin, possibly driving more NFC to private debt. Ultimately, whether private debt can play a more significant role in the lending industry in Luxembourg and beyond remains to be seen.