Credit Conditions:

EMEA Sector Roundup: Emerging

Risks And Trends, October 2017
Primary Credit Analyst:
Paul Watters, CFA, London (44) 20-7176-3542; paul.watters@spglobal.com

Table Of Contents

European Banks

IFRS 9 To Increase Provisioning From January 2018

Nonfinancial Corporates

Insurance

International Public Finance

Structured Finance

Related Research

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Credit Conditions:
EMEA Sector Roundup: Emerging Risks And
Trends, October 2017
Here, in a companion report to "As The Political Fog Shifts To The U.K., Prospects Are Improving In The Rest Of
EMEA," our latest credit conditions report also published on Oct. 2, 2017, we explore sector credit conditions and
emerging risks for financial institutions, corporates, insurance, public finance and structured finance in Europe, the
Middle East, and Africa (EMEA).

Overview

• European banks: While stronger balance sheets and an improving loan environment auger well for dividend
prospects, raising profitability to adequate levels remains a multiyear task. The imminent advent of IFRS 9 is
expected to lead to greater volatility in provisioning and may affect bank's commercial behavior.
• Russian banks: The operating environment in Russia remains challenging, banking supervision remains weak,
and recently re-emerged funding volatility is further strengthening the market positions of state-owned banks
and is increasing pressures on small and midsize private banks.
• European nonfinancial corporates: While credit prospects are broadly stable in the majority of sectors because
of better macroeconomic conditions, our key concerns relate to Brexit uncertainty as well as the risk of more
aggressive financial policies at this stage of the cycle.
• European insurance: Persisting low interest rates remain the top risk for life insurers, while property & casualty
reinsurers struggle with excess capital that is exerting downward pressure on rates, even accounting for the
scale of recent natural disasters.
• International public finance: Brexit-related uncertainty is creating challenges for social housing and universities
in the U.K., while the escalating tension between Catalonia and Spain's central government is of increasing
concern.
• European structured finance: The evolution of car financing in the U.K. has contributed to the strong growth in
consumer credit since 2012, of which about 20% is car dealership financing that has been securitized. Lenders,
not consumers, bear the explicit residual value risk.

European Banks
A stronger economic recovery than previously expected; a clearer postelection political landscape in France,
Germany, and The Netherlands; and rising consumer confidence should support European banks on their path toward
normalization. Lending growth may accelerate, and we could also see consolidation moves, which so far have been
scarce and largely domestic, gaining further backing. Rescued banks, particularly those well advanced in their
restructuring, are also likely to gradually return to private hands. Indeed, we already saw the Irish government
divesting a 29% interest in Allied Irish Banks PLC and the Dutch government divesting an additional 7% interest in
ABN AMRO Bank N.V. in June this year.

Banks have generally strengthened capital to the point where they are now considering more generous payouts to

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shareholders, albeit typically well below those of U.S. banks. Improving profitability to more adequate levels, however,
remains a multiyear task.

Unlike in the U.S., where meaningful changes to the orderly liquidation authority framework are under discussion, in
Europe resolution frameworks are likely to be enhanced, gaining credibility and effectiveness over time. Indeed, we
continue seeing steps toward the creation of a broader and more harmonized market of senior subordinated (Tier III)
instruments in Europe, which would facilitate banks' build-up of MREL (minimum requirement for own funds and
eligible liabilities) cushions in a more cost-efficient way. While European-wide legislation is still to be discussed and
approved by the European Parliament, some countries, in particular Spain and Belgium, have already followed the
French initiative and passed legislative reforms to incorporate senior nonpreferred debt as a new debt class in the
hierarchy of banks' liabilities. Banks in both countries (Banco Bilbao Vizcaya Argentaria S.A., CaixaBank S.A. and
Belfius Bank SA/NV) tapped the market for the first time shortly thereafter.

The announcement early this month of pan-Nordic Nordea Bank AB's decision to relocate its headquarters to Finland
(from Sweden) is the first of this kind. While we do not necessarily see others following, we believe the move is
indicative of not only Nordea's but generally banks' desire to operate on a level playing field. This remains a priority for
policymakers too, not least as they continue their push to complete the EU's banking union. Interestingly too, the
Nordea process and outcome have led Danish and Swedish authorities to discuss whether they would be better off
inside the banking union.

IFRS 9 To Increase Provisioning From January 2018

IFRS 9, the International Financial Reporting Standard that includes requirements for recognition and measurement,
impairment, and general hedge accounting, comes into force from Jan. 1, 2018, but there is still limited disclosure from
banks (in Europe and elsewhere) about the quantitative impact on their financials. It may not be until early 2018, at the
time of banks' publication of their 2017 annual reports, before we start to see such information disclosed.

One of the purposes of IFRS 9 is the earlier recognition of expected credit losses in banks' financial reporting, through
a requirement for both a 12-month expected loss provision on all performing loans and a lifetime expected loss
provision on underperforming and nonperforming loans. There will thus be a hit to equity as opening balance sheets
are restated and higher provisioning requirements become effective on day one, but given a broadly benign asset
quality backdrop, we expect the impact to be manageable for most European banks.

There will also likely be greater volatility in provisioning charges. The regulatory capital impact of IFRS 9 should be
limited in the EU, as plans are underway to set up transitional arrangements to phase in the impact to CET1 (common
equity tier 1) over five years. Banks could still opt to fully load the impact of IFRS 9 on regulatory capital, but that
would mean placing the bank in a comparatively weaker position ahead of future stress test exercises.

At present we do not expect the implementation of IFRS 9 to affect bank ratings in EMEA, as changes in accounting
rules by themselves do not denote an altered situation, just affect the way a situation is reported. Only in the event
application of IFRS 9 reveals fragilities not previously considered could ratings be affected.

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Over time, IFRS 9 could also affect banks' commercial behavior. There may be a shift toward shorter-duration loan
products, or a move toward higher pricing on certain products such as corporate loans and mortgages.

The Russian Banking System: Central Bank Support Has Been Important For The Sector

Support from the central bank has been important this year for maintaining the stability of the banking sector,
given several recent cases of failures of privately owned banks large enough to have a significant negative impact
on the sector.
A significant amount of accumulated problem assets as well as banks adjusting their business models to a low
growth and low margin environment continue to pressure the Russian banking sector.
Although we think that asset quality deterioration peaked in 2015-2016 (we estimate that nonperforming loans
and restructured loans together account for about 20%-24% of total loans), and the situation has been gradually
stabilizing, the amount is significant and is pressuring sector profitability. Moreover, capitalization in the banking
sector is moderate in our view and capital buffers are scarce to cover potential future losses. The growth in the
banking sector is expected to remain weak over the next two years.
Over the past few months, three private Russian banks failed, Bank Jugra, Otkritie Bank (the largest privately
owned bank in Russia as of May 2017), and B&N Bank, which accounted together for more than 12% of assets of
private banks in Russia and over 5% of total assets of the banking sector. Bank Jugra's license was revoked by the
regulator while Otkritie Bank and B&N Bank were bailed out by the central bank, which became the majority
owner and placed them under temporary administration. The actions of the central bank to step in and provide
support have been positive for the stability of the banking sector.
These and a few other bank failures observed in the past few years illustrate the weakness of banking supervision
in Russia. In our view, regulators have been more reactive than proactive, as evidenced by repeated cases where
intervention was not efficient or early enough to prevent banks from excessive risk taking or other activities that
resulted in bank failures. This caused the re-emergence of funding volatility in the sector, making private banks
particularly vulnerable to panic-driven deposit outflows moving to state-owned banks. This increases pressure on
privately owned banks, which already face a tough operating environment due to the dominance of state-owned
banks.

Nonfinancial Corporates
Corporate credit prospects in Europe are broadly stable with little evident change over the past three months.
However, shifts in the underlying political and economic environment continue to favor the eurozone more than the
U.K. In the eurozone we see a more settled political landscape after recent elections, improved business and consumer
confidence, and falling unemployment supported by easy credit conditions. The situation in the U.K. currently appears
more challenging due to Brexit uncertainty and the short time remaining before March 2019 to clarify how the U.K.
will depart the E.U., and what its future relationship with the EU will look like.

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Chart 1

Diverging fortunes favor regional industries on the Continent

It is notable that business confidence in the eurozone is not only at a six-and-a-half-year high but also that the
improvement is more uniformly apparent across the region. This is benefiting those regional sectors particularly where
operations have been streamlined and capacity cut back. In construction, for instance, we are seeing clear signs of
recovery in France and southern Europe, long after the rebound in Germany and northern Europe and well behind the
U.S. where the sector has been growing since 2011.

The European steel industry is similarly benefiting. Our rating outlook for the sector remains at positive to stable,
reflecting some regional demand growth, higher tariffs on imported steel, and supply cuts in China. As a consequence,
operating margins are proving resilient, also benefitting from the cost saving programs of recent years.

Global tailwinds are generally supportive

The recovery in the global economy has been providing support to international companies operating out of EMEA
We're seeing this, most obviously, in the modest recovery in industrial commodity prices and shipping freight rates
that have been weak in recent years. Our outlook for the mining sector is positive to stable as metal prices at current
levels are enabling efficient and large producers to generate significant free cash flow--and are even allowing for a
modest catch-up in necessary capital expenditure (capex) to just above 2016 levels (for instance for mine stripping

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activities).

Similarly, we see a more stable outlook for the shipping industry overall as diminished industry overcapacity and the
low single-digit percent growth in transported volumes has caused container and dry bulk shipping freight rates to rise
to more sustainable levels. We anticipate these companies will be operating at above operating expenses (opex)
breakeven levels in 2017-2018. Tanker shipping rates are likely to be softer in 2017 (but still above opex breakeven
rates) due to oversupply of ships, but recover in 2018 as tanker deliveries slow.

We view operating conditions in the airline industry as satisfactory on the back of a more synchronized global
recovery. Passenger volumes in the region are growing at a mid-to-high-single-digit rate; load factors are close to an
all-time high and revenue per passenger kilometer has increased by over 7% year to date in 2017, according to the
International Air Transport Association.

One key risk points to Brexit

Brexit negotiations are only just starting to show signs of any real progress, although no safeguard agreement has yet
been announced to extend the status quo beyond March 2019 (that we expect). This is of increasing concern to
corporates with material U.K. activities. Most of them have contingency plans they will need to start implementing
soon if they are to mitigate the growing risks attached to a disruptive Brexit in March 2019.

This is particularly pressing for companies that have sophisticated supply chains that weave between the U.K. and the
rest of the EU. Inevitably, a disruptive Brexit would result in higher inventories and working capital to protect against
border delays where alternative domestic suppliers are unavailable. The associated short-term cost and certain
disruption, not helped by the lack of guidance from the U.K. government, is likely to negatively affect near-term
profitability and cash flow.

High value-added manufacturing sectors that are directly exposed to Brexit disruption include auto original equipment
manufacturers (OEMs), aerospace and defense, and pharmaceuticals. Less directly, we would expect other U.K.
corporate sectors to be negatively affected by factors such as currency weakness (retail importers); constraints on
public-sector procurement/spending (aerospace and defense, telecoms, business services); weak consumer demand
(retail, consumer goods, leisure); material relocations of foreign banks (telecoms, real estate, business services);
reduced foreign investment (autos, real estate); and immigration (construction, health care, agriculture).

Of more immediate concern in the U.K. is the sustainability of the pace of growth in consumer credit. Consumer credit
growth, while slipping to 9.8% year on year in July, remains high in an historical context. Motor car financing has
experienced the most rapid expansion among the various credit components, contributing about one-third of growth.
The heavy utilization of personal contract purchases (PCP) for car purchases and associated underwriting standards is
under review by the Prudential Regulatory Authority to ensure appropriate risk management and stress testing is being
undertaken. We would expect some tightening in financing terms and conditions that, combined with some
Brexit-induced reduction in consumer confidence, could depress U.K. car sales over the next year or two.

Chart 2

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The other risk is more aggressive financial policies

Another growing concern is a clear increase in appetite for mergers and acquisitions in Europe, especially in the
eurozone. This is largely due to renewed confidence in business prospects, improving cash flow, and the strength of
balance sheets, often combined with a desire to improve geographical reach and competitive position within the
industry. However, companies are also tempted by the prevailing benign credit environment where debt financing is
readily available and cheap. The credit risk arises where companies make sizable acquisitions at expensive valuations

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funded by debt.

To date the negative rating impact has been largely limited to higher-rated investment-grade companies acquiring less
highly rated companies. Some sectors such as the forest products, capital goods, and mining sectors remain disciplined
for now, but, as credit metrics improve, momentum will likely build. Other sectors remain more focused on disposals
of noncore assets, partly to create headroom to lead consolidation within their industry over time (for example,
unregulated utilities and shipping).

Insurance
Table 1
European Insurers Credit Conditions Survey
Sector outlook (12
Business conditions (current) Business outlook (12 months) months)
Western Europe primary life insurers Weak No change Stable to negative
Western Europe primary non-life insurers Satisfactory No change Stable
Reinsurers Weak Somewhat weaker Stable
EMEA Developing Markets Primary Weak No change Stable to negative
insurers

Source: S&P Global Ratings

The persisting low interest rate environment continues to be the top risk facing life insurers, and one of the primary
drivers for asset allocation and product offering moves. Gradually declining investment returns and tight solvency
ratios are leading life insurers in multiple markets in Europe to adapt their product offerings to less capital-consuming
lines and to cede more of certain risks to reinsurance. At the same time, insurer investment policies tend to onboard
more credit risk, on a monitored and phased basis, given that most insurers aim at limiting the incremental capital
charges related to credit risk on their balance sheets. Insurers, such as annuity writers, are taking more credit and
liquidity risks through prominent investments in loans, generally aiming to offset such increased risk by the resulting
tighter asset-liability mismatch. The majority of stable outlooks on our ratings in the sector denote our expectation of
maintained sound capital management and successful execution, on the measures undertaken to counter the low
interest rate environment.

Western European P/C insurers

Our satisfactory opinion the Western European non-life sector indicates our view of maintained underwriting discipline
over the past few years. We expect positive underwriting results over the next two years across Western European
property/casualty markets, backed by controlled pricing to counter the low yield environment. We expect most
markets to post combined ratios (claims and costs on premiums) below 100%, with a mid-90s expected average in
Western Europe. In a few markets, particularly France, the Netherlands, and the U.K., tough competitive dynamics
could weigh on insurers' abilities to improve underwriting results, leading to average market combined ratios of above
100%.

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Global reinsurers
Low growth, low interest rates, and an abundance of competing capital from traditional players and alternative capital
providers are exacerbating weak business conditions for the global P/C reinsurance sector. Moreover, the current
hurricane season and other large natural catastrophes such as earthquakes in Mexico are putting pressure on 2017
earnings, which may help slow rate declines in 2018 and may lead to rate increases in loss-affected lines depending on
the magnitude of the natural catastrophe losses.

We believe competitive pressures in the industry are likely to persist, and the recent trend toward greater scale and
diversification through consolidation rather than organic growth highlights how difficult it will be for management
teams to defend their market positions. On the other hand, as of year-end 2016 the reinsurance sector continued to
benefit from robust capital adequacy with capital levels at record highs and strong enterprise risk management
capabilities, which should help reinsurers navigate some of the difficult market conditions during the next 12 months
and the impact of recent natural catastrophe losses.

Developing markets primary insurers

Our rated universe in EMEA developing countries--namely South Africa, Gulf Cooperation Council (GCC) countries,
Russia, Kazakhstan, Poland, the Czech Republic, Israel, and Slovenia--show a large rating spectrum spanning from the
'A' to 'B' categories. This primarily reflects wide differences in our views on country risks in these markets, the higher
earnings volatility inherent to emerging insurance industries, weaker economic prospects, geopolitical risks, and
political uncertainties. Such risks have recently translated into negative rating actions on insurers in South Africa and
to a lesser extent, Qatar. The lack of investment market depth in most of these countries, and insurers' generally
smaller, less diversified balance sheets versus those of insurers in Western Europe add to potential rating volatility.
These higher risks translate into a greater proportion of insurers with a negative outlook, which currently one-third of
our rated insurers carry. Less sophisticated risk management practices and relatively high investment concentrations
also weigh on our view of these insurers' creditworthiness.

International Public Finance

U.K. rated social housing entities
Brexit-related uncertainty continues to burden social housing providers. Although we continue to view the sector as
low risk, elevated inflation may squeeze their financial performance. Providers with a high dependence on asset sales
may take an additional hit from a possible contraction in the U.K. residential real estate market, especially in London.
A price correction and delays in transactions may erode their liquidity positions and delay the implementation of
development projects. We have assessed how stress on a real estate market may affect ratings on U.K. social housing
entities. Although we would expect all ratings to remain investment grade, up to one-third of our public ratings in the
U.K. may be lowered by one or two notches, in case of a relatively sharp contraction in sales volumes and prices.

The Grenfell Tower tragedy may trigger a revision of the U.K.'s social housing policy. It may lead to pressure for higher
spending on social housing entities, which may be mitigated by a less strict control over revenue sources. Although we
don't expect the central government to increase development grants for new housing, we may anticipate a revision of
a current policy, which applies a nominal 1% rent cut annually over 2016-2020.

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Lower-tier U.K. universities

The credit quality of U.K. universities may suffer due to potentially higher personnel spending, lower demand, and
rising pension deficits.

The implementation of registration requirements and potentially work visas post-Brexit may deter overseas and
European students and staff from attending U.K. universities. While the share of non-U.K. EU students has remained at
a relatively low level of about 5% in recent years, universities are heavily dependent on teachers from outside the
country, primarily other EU countries. Combined with a weaker pound, Brexit may lead to a noticeable staff exodus
that would inevitably raise personnel costs and reduce demand for the services of U.K. universities.

Rising pension deficit obligations may also increase costs and affect the competitiveness of second-tier U.K.
universities. The deficit in the Universities Superannuation Scheme (USS), which is a defined benefit pension scheme
for academic staff with almost 400,000 members from 350 universities, has almost doubled last year. Although there
are concerns expressed regarding the reliability of this calculation, the deficit must have being growing. USS is a
multiemployer scheme with a "last man standing" clause. Individual universities will have to fund the entire deficit
should any members become insolvent. Hence, the whole sector may need to share the burden.

Catalan referendum and the budgetary consolidation of Spanish regions

In our base-case scenario, we expect a gradual consolidation of Spanish regional governments' finances due to more
vigorous revenue growth, fueled by ongoing economic recovery. We continue to expect the regions to post deficits,
albeit declining, during our forecasting horizon to 2019. A more dynamic revenue environment will not be enough to
restore the health of regional accounts, in our opinion, but it will allow normal status regions to stabilize or slightly
reduce their tax-supported debt ratios, which will remain very high. We understand that the changes to Spain's
regional financing system are required for the Spanish local and regional government to achieve structurally stronger
revenues and expenditure balance. The process toward a reform of the financing system has started, but we believe
political and technical complexities are likely to delay its conclusion. In particular, the ongoing political dispute
between Spain's central government and Catalonia's regional government is a roadblock to the reform of Spain's
regional financial system. The Catalan government arranged a referendum on independence on Oct. 1, 2017, which
the central government claimed was legally impermissible.

Our current ratings on Catalonia (B+/B), the lowest of any Spanish regions we rate, factor in the region's institutional
and political uncertainties, very high debt burden, and liquidity support from the central government. Our base case
assumes that Catalonia remains a part of Spain. The negative outlook on the region takes into account our view that
political tensions between Catalonia and Spain's central government may escalate further, and may jeopardize the
effectiveness of liquidity support for the region, which in our view requires smooth communication and coordination
between both governments.

Structured Finance
Evolution in car financing raises auto ABS risk considerations
The increasing use of dealership finance--often provided by manufacturers' finance arms--has recently helped fuel new
car sales. In the U.K. particularly, car financing has been a major contributor to strong growth in overall consumer

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credit since 2012, which has raised potential concerns for policymakers. In turn, much of the rise in auto-related credit
has been due to the increasing popularity of personal contract purchase (PCP) agreements.

In these deals, borrowers make monthly payments over a fixed term (such as three years) then have the option of
either making a final balloon payment (for example, 50% of the original loan balance) and taking outright ownership of
the vehicle, or simply returning it to the lender. These contracts have become popular with borrowers as the monthly
payments are lower than for a fully amortizing hire purchase agreement of the same term. For manufacturers, the
end-of-contract decision point presents a valuable opportunity to re-engage with the customer and potentially sell
them a new car.

However, PCP agreements expose lenders to residual value risk, given uncertainty over whether borrowers will
exercise their option to return the vehicle and future used car values. While return rates are currently low, this could
change in an economic downturn. Given the recent volume of PCP deals there is also a potential systemic risk, where
an unexpected increase in returns floods dealers with used cars, depressing prices and therefore driving return rates
higher still.

Some of this residual value risk has been passed on to investors in securitizations. Between 2012 and 2016, we
estimate that investor-placed U.K. auto asset-backed securities (ABS) issuance of £15 billion was equivalent to about
20% of overall dealership finance advances for new car purchases. Unsurprisingly, the prevalence of PCP agreements
in auto ABS collateral pools has increased, mirroring the wider market. When assigning ratings in these transactions
we therefore test whether the securities can survive without defaulting in stress scenarios that feature high return rates
and depressed used car values, and we will continue to monitor developments in this area closely.

End of central bank funding schemes could spur a return of bank-originated issuance
Investor-placed European securitization volumes have grown modestly year on year in 2017, with issuance
increasingly coming from nonbank originators (see chart 3). However, this trend could soon reverse as central banks
begin to rein in various stimulus measures.

For example, the Bank of England recently confirmed that financial institutions will no longer be able to make new
drawdowns under two of its funding schemes after February 2018. Since 2012, U.K. institutions have borrowed at
advantageous terms from the Funding for Lending Scheme (FLS) and the Term Funding Scheme (TFS), accumulating
£120 billion by mid-2017 and reducing their incentives to tap debt markets by issuing instruments such as residential
mortgage-backed securities. Indeed, bank-originated investor-placed U.K. securitization issuance has dropped sharply
since the FLS began (see chart 4). Securitization issuance from nonbank originators--such as specialist asset managers
and private equity-backed vehicles--has partially filled the gap left by banks over recent years, but some of this activity
was likely opportunistic and may not continue. Closure of the drawdown window marks the beginning of the end for
U.K. banks' use of FLS and TFS funding and, as central bank borrowings begin to mature, bank issuers may begin
returning to structured finance markets in greater volume.

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Chart 3 Chart 4

Similarly, in the eurozone, formerly substantial securitization markets such as Spain and Italy have seen little
investor-placed issuance since the ECB started offering institutions unlimited allocations of cheap funding through its
long-term refinancing operations (LTROs). Together, Spanish and Italian banks still have more than €400 billion of
such borrowing outstanding. However, drawdowns under the latest incarnation of LTROs ended in March 2017. As the
ECB begins to normalize its policies, the terms of funding that it offers to financial institutions will likely tighten and the
scale will diminish, making banks more likely to return to debt markets.

Related Research
• Credit Conditions: North America September 2017--Growing Pressures Add Uncertainty, But Favorable Conditions
Prevail, Sept. 28, 2017
• Credit Conditions: Asia-Pacific Credit Conditions September 2017: Trends Are Improving Slightly But Risks Are
Escalating, Sept. 26, 2017
• Credit Conditions: Political Risks Are Receding In Latin America, But Uncertainty Looms, Sept. 28, 2017
• Credit Conditions: Top Global Risks – September 2017, Sept. 28, 2017
• Cheap Finance Drives Record U.K. New Car Sales, But For How Long? May 31, 2016
• This Time Is Different: The Eurozone Recovery Is Alive And Kicking, Oct. 2, 2017

S&P Global Ratings' Credit Conditions Committees meet quarterly to review macroeconomic conditions in each of four regions (Asia-Pacific,
Latin America, North America, and Europe, the Middle East, and Africa). Discussions center on identifying credit risks and their potential
ratings impact in various sectors, as well as borrowing and lending trends for businesses and consumers. This article reflects the view
developed during the EMEA Credit Conditions Committee discussion on Sept. 28, 2017.

Only a rating committee may determine a rating action and this report does not constitute a rating action.

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Additional Contacts:
Felix Ejgel, London (44) 20-7176-6780; felix.ejgel@spglobal.com
Lotfi Elbarhdadi, Paris (33) 1-4420-6730; lotfi.elbarhdadi@spglobal.com
Elena Iparraguirre, Madrid (34) 91-389-6963; elena.iparraguirre@spglobal.com
Andrew H South, London (44) 20-7176-3712; andrew.south@spglobal.com
Gareth Williams, London +44 (0)20 7176 7226; gareth.williams@spglobal.com
Natalia Yalovskaya, London (44) 20-7176-3407; natalia.yalovskaya@spglobal.com

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