Eurozone banks have decreased their risk tolerance, partly due to the high risk perception resulting from the increasing key banking rates and the tightening of their balance sheets, which suggests dampening economic conditions. Photo: Shutterstock

Eurozone banks have decreased their risk tolerance, partly due to the high risk perception resulting from the increasing key banking rates and the tightening of their balance sheets, which suggests dampening economic conditions. Photo: Shutterstock

Eurozone banks tightened their lending standards in Q1 2023 despite a drop in loan demand, stemming from lower risk tolerance and tougher balance sheet conditions, the ECB’s most recent quarterly survey shows. These developments suggest that economic growth may be further stunted in the coming months.

On Tuesday 2 May, the European Central Bank significant macroeconomic changes in the bank lending business, as well as in central bank balance sheets on net liquidity in the euro area. Together with a larger than expected drop in loan demand in Q1 2023--while banks’ risk perceptions remained substantially higher--and a looming interest rate hike this Thursday, the markets are preparing for slower economic growth in the next quarter, if any.

ECB saps liquidity

The ECB announced in June 2022 that it would discontinue net asset purchases under the Asset Purchase Programme from 1 July 2022, which had injected over €3.2trn in liquidity since 2015, but would continue to reinvest the principal payments in full. However, to combat high inflation through interest rate hikes, the bank’s governing council decided on 15 December 2022 that the APP portfolio would start declining from the beginning of March 2023, and not all of the principal payments would be reinvested, thereby gradually removing liquidity.

The decline will average €15bn per month until the end of the second quarter of 2023.

This change in monetary policy resulted in balance sheets tightening of the banks, which in turn, according to the banks surveyed, led to strengthening the terms and conditions for loan contracts to businesses and households in Q1 2023.

Lending down on perceived credit risk

The tightening of credit standards was mainly driven by the widening of margins on riskier loans, which increased risk perceptions, and more generally, the rise in ECB key interest rates. Notably, the pace of net tightening in credit standards was at its highest level since the EU sovereign debt crisis in 2011. According to the current survey, euro area banks anticipate a further, albeit more moderate, tightening of credit standards for loans to firms and home purchases in the second quarter of 2023.

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Loan demand dampens

The banks reported a larger-than-expected decrease in demand from firms for loans or credit lines in Q1 2023, the strongest decline since the global financial crisis in 2008. In the second quarter of 2023, banks anticipate a further, albeit smaller, net decline in demand for loans to firms.

Additionally, demand for housing loans remained strongly negative (-72%), close to the sharp decrease reported in the previous quarter (-74%), which was the highest on record since the survey began in 2003.

The increasing mortgage rates and weakening prospects in the real estate market negatively impacted the demand for loans to households. In the second quarter of 2023, banks expect a further strong net decrease in demand for housing loans.

Overall, loans to firms and households have a negative impact on bank lending volumes across all categories of lending and will continue a negative trajectory over the next six months, the survey participants expected.

Looking at the bright side, eurozone banks reported a positive impact on their net interest margins in the past six months due to the ECB’s key interest rate decisions. While this has had an overall positive impact on bank profitability, the increase in interest margins has been partially offset by a decrease in volume of net interest income.

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