Despite record profits, the ECB is sounding the alarm: Why the risk situation for banks is now "historically unprecedented".

"Inverse stress test": Is the regulatory authority preparing for a worst-case scenario? Trade war and tariffs – the underestimated threat to your financial institution

At first glance, the European banking landscape appears more robust than it has in years: coffers are full, the interest rate turnaround has brought the institutions dream returns, and capital buffers significantly exceed legal requirements. But behind this glittering facade, according to the European Central Bank (ECB), a "perfect storm" is brewing.

The guardians of the euro have drastically sharpened their tone, warning of a "historically unprecedented accumulation of risk." It is a warning that demands attention, as it breaks with the regulators' usual restraint. This time, the danger does not primarily stem from the balance sheets themselves, but from a novel confluence of external shocks: geopolitical tensions, a looming global trade war, the crisis in the commercial real estate market, and the incalculable consequences of climate change form a toxic mix that could strike the system at its most vulnerable points.

While banks are still celebrating record profits, regulators are already preparing radical measures – from novel “inverse stress tests” to strict capital requirements for climate risks. The following analysis delves deep into this paradox: It examines why current strength can be deceptive, how geopolitical conflicts can suddenly lead to loan defaults, and why the biggest challenge for Europe’s banks is yet to come. Find out what happens when the changing times hit the financial system.

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Europe's banks in the stranglehold of a historic risk accumulation

With its latest warning, the European Central Bank has sent a remarkable message to the European banking sector. The risk situation for the financial system has reached a historically unprecedented level. This assessment marks a significant turning point in the communication of banking supervisors and warrants in-depth economic analysis beyond the usual crisis warnings.

The Frankfurt regulators based their assessment on an unusually broad range of structural risk factors. The combination of geopolitical tensions, a fundamentally altered trade policy, climate-related natural disasters, demographic shifts, and technological upheavals creates structural weaknesses in the system that reinforce each other. This list is noteworthy because it goes beyond classic financial risk factors and addresses systemic vulnerabilities deeply rooted in the transformation of the global economic order.

The assessment that the risk of extreme events is higher than ever before requires precise contextualization. This formulation does not necessarily imply that the probability of individual shocks has increased, but rather that the simultaneity and mutual reinforcement of different risk channels has reached a new level. It involves a risk accumulation in which individual events can trigger cascading effects that propagate beyond traditional boundaries.

The paradox of the robust surface

The tension between the acute risk warning and the simultaneous observation that banks are currently in good shape reveals a fundamental challenge for modern financial supervision. Eurozone institutions present themselves with robust capital buffers, stable liquidity, and historically high profitability. Return on equity rose to more than ten percent in the second quarter of the year, a figure that puts the institutions in a comfortable position. The Common Equity Tier 1 (CET1) ratio is over sixteen percent, well above the regulatory minimum requirements. The non-performing loan ratio remains at a low nineteen tenths of a percent.

These figures paint a picture of a resilient sector that not only survived the period of rising interest rates but even profited from it. Following the end of the zero-interest-rate phase, the institutions were able to generate substantial net interest income and simultaneously benefit from strong stock markets through higher commissions in securities trading. The annualized return on equity reached a value of just over ten percent in the middle of the year, meaning that European banks can demonstrate sustainably profitable business models for the first time in years.

But this superficial robustness can be misleading. The profitability of these institutions relies heavily on favorable macroeconomic conditions, which can change rapidly. Net interest income will shrink as interest rates continue to fall, while refinancing costs will initially remain at a higher level. At the same time, while the quality of assets is stable, it is already subject to discernible pressures in certain segments. The non-performing loan ratio in Germany has risen from 1.5 to 14 tenths of a percent since the middle of last year, while it has tended to fall in southern European countries. This divergent trend points to differing economic dynamics that are differentiating the seemingly homogeneous picture of a robust European banking sector.

Geopolitics as a systemic risk driver

The classification of geopolitical risks as a key threat to financial stability marks a paradigm shift in banking supervision. For decades, regulation focused on quantifiable financial risks such as credit, market, and liquidity risks. While geopolitical factors were considered in stress tests, they were viewed more as external shocks than as an independent risk category. This perspective has fundamentally changed.

Geopolitical risks impact banks through multiple, often difficult-to-predict channels. They can manifest as increased loan defaults when geopolitical tensions disrupt supply chains or export markets collapse. They influence market risks through abrupt capital flows and currency volatility. Operational risks rise due to the threat of geopolitically motivated cyberattacks. Liquidity risks can arise when international refinancing markets freeze. And finally, geopolitical disruptions affect the business models of the institutions themselves when trading patterns shift or regulatory fragmentation increases.

The current geopolitical situation is characterized by an unprecedented complexity. The war in Ukraine has fundamentally called into question European energy security and activated sanctions mechanisms with far-reaching consequences for cross-border financial flows. The conflict in the Middle East carries the potential for further oil price shocks and regional instability. Tensions between the United States and China are manifesting themselves in a technology conflict that is reshaping global value chains. Trade conflicts between major economic blocs threaten to reverse decades of trade liberalization.

For European industry, which has traditionally relied heavily on global trade integration, this presents existential challenges. The automotive, chemical, and pharmaceutical industries are among the sectors most likely to be affected by protectionist tendencies. American trade policy has escalated unprecedentedly this year, with tariffs of 25 percent on automobiles and vehicle parts, and a base tariff of 15 percent on the majority of European exports to the United States. Tariffs of up to 50 percent have even been imposed on steel and aluminum.

The trade war as a macroeconomic stress factor

The impact of this trade policy on the European economy, and thus indirectly on banks, is considerable. Model calculations from various institutions predict growth losses for Germany and the Eurozone on the order of one percent of gross domestic product over a two-year period. For individual, highly export-oriented economies such as Ireland, the effects could be even more pronounced, with declines of up to one-twelfth of a percentage point of gross domestic product.

These macroeconomic pressures would impact bank balance sheets through various channels. First, loan demand would suffer, as companies postpone investments in an uncertain environment. Simultaneously, the ability of existing borrowers to meet their payment obligations would be weakened. This is particularly true for medium-sized enterprises in export-oriented sectors, which are less diversified than large corporations and have smaller financial buffers.

The situation is particularly precarious in the automotive supply industry. Even before the latest tariff escalation, two-thirds of the surveyed suppliers reported difficulties accessing bank financing. Banks are demanding higher interest rates, more extensive collateral, stricter contract terms, and shorter loan durations. This development is hitting companies at a time when they must make massive investments in the transformation to electromobility, while their margins are at historically low levels. The risk of an increase in insolvencies in this sector is real and would burden banks with rising loan defaults.

Deutsche Bank, in its analysis of American trade policy, pointed out that Ford and General Motors could face cost burdens exceeding ten billion dollars, with a decline in operating profit of four to seven billion dollars annually. While these figures pertain to American manufacturers, they illustrate the scale of the disruptions that tariffs can cause. European manufacturers face similar risks, especially given their significant market share in the United States and the inability to relocate production in the short term.

The commercial real estate dilemma

Another critical risk area that banking supervisors are closely monitoring is commercial real estate loans. While this segment accounts for only about ten percent of total bank loans in the euro area, it is of disproportionate importance for financial stability. The European Banking Authority reported that the share of non-performing commercial real estate loans more than doubled within twelve months, from 2.2 to 5 percent, representing an increase from 6.2 to 14.2 billion euros in absolute terms.

The reasons for this development are multifaceted and structural in nature. The environment of high interest rates has dramatically increased debt service costs for existing borrowers, particularly for variable-rate loans and expiring fixed-rate periods. At the same time, the profitability of many commercial properties has deteriorated, as structural changes such as the trend toward working from home reduce the demand for office space. Inflation drives up rents, operating costs, and construction costs, thus diminishing owners' capital reserves.

The European Central Bank has identified several deficiencies in banks' valuation and monitoring of collateral through targeted audits. Instead of market-based valuations that take current developments into account, credit institutions are relying on potential future values ​​or even values ​​that do not reflect the current market situation. This lack of conservatism in valuing collateral carries the risk that actual losses in the event of loan defaults will be higher than anticipated.

The situation with commercial real estate is particularly precarious because it can have a potential amplifying effect during crises. If more loans default and properties come onto the market, this leads to a further decline in prices, and the value of the collateral for all commercial real estate loans also decreases. This feedback mechanism between loan defaults and asset losses was a key feature of the financial crisis of 2008 and could recur, albeit in a less severe form.

The European Central Bank has therefore called on institutions to improve their frameworks for credit risk management in commercial real estate and to ensure closer monitoring of property valuations. On-site inspections will pay particular attention to the data used for valuations and the consideration of current market developments. Institutions found to have significant deficiencies should expect supervisory action.

The stress test architecture as an early warning system

Given the unpredictability of the risks outlined, the European Central Bank has announced a remarkable methodological innovation. In 2026, a so-called reverse stress test on geopolitical risks will be conducted for the first time. With this methodology, supervisors will not, as is usually the case, present banks with a scenario to which they must react, but will instead define a specific asset loss or capital depletion and ask the institutions themselves to develop plausible scenarios that would lead to this outcome.

This reversal of perspective is insightful for several reasons. First, it forces banks to examine their specific vulnerabilities in detail. Each institution has different risk profiles to geopolitical shocks due to its business model, geographic presence, and clientele. A reverse stress test exposes these institution-specific weaknesses. Second, the methodology encourages creative risk management. While predefined scenarios tend to reflect known risks, self-developed scenarios can also capture less obvious or novel threats. Third, aggregating scenarios from all institutions provides supervisors with valuable information about the diversity and concentration of systemic risks in the banking sector.

The inverse stress test complements the regular stress tests conducted by the European Banking Authority and the European Central Bank every two years. The most recent stress test, conducted in the summer, revealed that 64 banks from 17 EU and EEA countries, representing approximately 75 percent of banking assets in the EU, would remain resilient even under a severe hypothetical economic downturn. The simulated scenario included a sharp deterioration in the global macro-financial environment, driven by a resurgence of geopolitical tensions, increased trade fragmentation including tariff increases, and persistent supply shocks.

Despite losses of €547 billion, the banks would maintain strong capital positions and retain their ability to continue supporting the economy. The Common Equity Tier 1 (CET1) ratio would fall by an average of €370 basis points to 12 percent. This capital reduction is smaller than in the 2023 stress test, which is interpreted as a sign of increased profitability and more efficient risk management.

However, these results should be interpreted with caution. Stress tests are based on assumptions and models that can only ever be approximations of reality. Actual crisis reality is typically more complex, dynamic, and characterized by feedback effects that are inadequately represented in static models. Furthermore, stress tests demonstrate resilience under the assumption that institutions do not fundamentally change their business models. In real crises, however, banks adapt their strategies, which can lead to unexpected behaviors and systemic effects.

Climate risks as a long-term threat

The European Central Bank has made significant efforts in recent years to integrate climate risks into its supervisory practice. These risks impact banks through two main channels. Physical risks arise from the direct effects of climate change, such as extreme weather events that damage assets or disrupt business operations. Transition risks result from the necessary transformation to a low-carbon economy, which renders certain business models obsolete and requires significant shifts in the economic structure.

In 2020, banking supervisors published guidelines outlining their expectations for institutions regarding climate and environmental risks. Since then, they have systematically monitored the implementation of these expectations and, where deficiencies were identified, initially issued requirements for improvement. In 2024, the European Central Bank announced that it would also impose fines in cases of persistent shortcomings. Several institutions in the euro area have already received warnings for their inadequate handling of environmental and climate risks.

A decisive step was taken in 2025 when the European Central Bank announced its intention to permanently integrate climate and natural risks into its supervisory practice and, for the first time, include them in the supervisory review and assessment process. This means that climate risks can now trigger independent Pillar 2 capital surcharges if institutions' risk management is deemed inadequate. Furthermore, transition planning will become a mandatory part of supervision. Banks will be required to systematically assess how well their borrowers are managing the transition to a low-carbon economy.

This integration of climate risks into capital-based banking supervision marks the transition from voluntary dialogue to binding regulation. It is the result of a multi-year process that began with initial self-assessments by banks, was deepened by a climate stress test, and is now culminating in regulatory consequences. The banking sector has received this development with mixed feelings. On the one hand, it recognizes the relevance of climate risks and has already made significant progress in integrating them into risk management. On the other hand, it warns against excessive capital requirements that could impair its competitiveness.

The challenge in quantifying climate risks lies in their long-term nature and uncertainty. Unlike traditional financial risks, which can be based on historical data, climate risks require forward-looking analyses spanning decades. Modeling these risks involves significant uncertainties, as it must make assumptions about technological developments, policy measures, and societal preferences. Nevertheless, considering these risks is essential, as their potential impact on financial stability could be substantial.

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Cyber ​​resilience as an existential necessity

Alongside climate and geopolitical risks, cyber resilience is increasingly coming into focus for banking supervisors. Progressive digitalization is making financial institutions more dependent on information technology and, at the same time, more vulnerable to cyberattacks. The threat ranges from criminal activities such as ransomware attacks to state-sponsored attacks with geopolitical motives.

In its annual report on banking supervision, the European Central Bank emphasized that digitalization is essential for banks to remain competitive, but must be accompanied by sound risk management that addresses issues such as over-reliance on IT service providers and the ongoing threat of cyberattacks. The supervisory authority has announced that it will intensify its work in this area.

Recent cyber resilience stress tests have shown that while banks are generally well-prepared, they also need to improve their cyber resilience, which is very costly. This finding highlights the dilemma facing these institutions. On the one hand, they must invest significantly in their technological infrastructure and security systems to protect themselves against cyber threats. On the other hand, they are under pressure from their shareholders, who have short-term dividend expectations. Balancing long-term investments in resilience with short-term payouts is crucial for sustainable growth.

With the Digital Operational Resilience Act, which became fully applicable in 2025, the European Union created a comprehensive regulatory framework designed to strengthen the digital operational resilience of financial institutions. Implementing these requirements necessitates significant organizational and technical adjustments by banks. In 2025, supervisors will be specifically examining the extent to which financial institutions effectively manage their IT risks and whether their policies are not merely theoretical but are embedded in their business processes.

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Demographic change as a creeping transformation

Another structural factor identified by the European Central Bank in its risk analysis is demographic change. This impacts the financial system through various channels. The aging population in Europe leads to changes in the demand for financial services, adjustments in the business models of financial institutions, and shifts in asset portfolios.

For banks, the aging of society initially means a shift in the customer base. Older customers have different needs than younger ones: they are less interested in consumer loans and more in wealth management and retirement planning. The majority of wealth belongs to the older generation, making them an attractive customer group for financial institutions. At the same time, the aging workforce presents banks with human resources challenges, particularly regarding knowledge retention and the recruitment of qualified professionals.

From a macroeconomic perspective, demographic trends reduce the potential growth of economies due to a shrinking working-age population. This dampens credit demand and makes it more difficult for banks to generate revenue. Furthermore, an aging population may be more inclined to dissipate assets rather than accumulate new ones, which could impact capital markets and investment financing. Some analysts fear that when the baby boomer generation wants to sell their accumulated savings and homes, there will be many sellers of assets but relatively few buyers from the younger generation, potentially leading to a erosion of asset value.

Competitive pressure from digitalization and non-banks

The financial landscape is undergoing a profound structural transformation, driven by digitalization and the emergence of new competitors. Fintech companies and neobanks like N26 and Revolut are setting new standards in terms of user-friendliness and agility. They focus on digital customer experiences, low fees, and rapid product launches, gaining market share, particularly among younger target groups.

For traditional banks, this means intensified competition that challenges their established business models. Digitalization is no longer an option, but an existential necessity. Institutions that are pioneers in digitalization significantly outperform the competition with a return on equity of 8.7 percent and also enjoy higher customer loyalty. However, the transformation of banks requires substantial investments in technology and a cultural realignment, which poses a challenge for many traditional institutions.

Besides fintechs, so-called shadow banks or non-bank financial intermediaries are also gaining in importance. These companies conduct bank-like business such as loan intermediation, investment banking, and risk hedging without holding a banking license and are therefore not subject to full banking regulation. The shadow banking system has grown considerably in recent years and now constitutes a significant part of the financial system.

Regulators view this development with concern, as shadow banks, due to their less stringent regulation, may make riskier decisions and, through their interconnections with the traditional banking sector, create systemic risks. The financial crisis of 2008 demonstrated how problems in the shadow banking system can spill over into the regular banking system and trigger a global financial crisis. The inadequate regulation of shadow banks is therefore considered by many experts to be one of the most significant unresolved challenges to financial stability.

In its Financial Stability Report of November 2024, the European Central Bank emphasized that the growing interconnections between banks and non-bank financial intermediaries represent an increased systemic risk. These institutions continue to operate in a challenging environment characterized by heightened geopolitical risks and new competitive patterns resulting from digitalization and competition from non-banks. This necessitates forward-looking risk assessments and sufficient resilience.

Regulatory adjustments and capital requirements

The regulatory landscape for banks is constantly evolving. With the implementation of Basel III into European law through the Capital Requirements Regulation III and the Capital Requirements Directive VI, institutions will face further adjustments to their capital requirements. These reforms aim to achieve more risk-sensitive capital backing and further strengthen the resilience of the banking sector.

A key element of the new regulations is the so-called output floor, which limits the benefits of using internal ratings or risk models. Banks using internal models will in future also be required to calculate risk-weighted assets for their entire portfolio using standardized approaches. Total capital requirements must not fall below a certain percentage of the risk-weighted assets calculated using standardized approaches. This floor will be phased in gradually until 2030.

For German financial institutions, the Basel III reforms will lead to an expected increase in minimum capital requirements of around eight percent by the year 2033, which in absolute terms corresponds to an increase in Tier 1 capital requirements of thirty billion euros. In comparison, approximately one hundred and sixty-five billion euros of core equity capital currently exists above the requirements, so the sector as a whole appears to be well positioned. However, the impact varies considerably between institutions, and for some, meeting the new requirements could prove challenging.

The European Central Bank is keeping capital requirements for 2026 largely stable, reflecting the sector's current robustness. For individual institutions, such as Deutsche Bank, the requirements have even been slightly reduced. However, the Pillar 2 requirements and the combined capital buffer requirement remain at a level that leaves institutions little room for additional dividends or share buybacks unless they have substantial capital surpluses.

The art of capital allocation in uncertain times

A key challenge for banks lies in allocating their capital among various competing uses. Institutions must maintain sufficient buffers to meet regulatory requirements and weather crises. At the same time, their shareholders expect adequate returns in the form of dividends and share price gains. Furthermore, banks must invest in their infrastructure, technology, and personnel to remain competitive.

The head of banking supervision at the European Central Bank has stressed that banks would be well advised to invest their current profits in strengthening their resilience. While the increased profitability of banks is good news, she said, it is imperative that they seize this opportunity to build resilience. Balancing short-term shareholder dividend expectations with long-term investments in bank resilience is crucial for sustainable growth.

This warning comes against the backdrop of some institutions planning to increase their payout ratios. Deutsche Bank has announced that, starting in 2026, it will distribute 60 percent of its profits attributable to shareholders, up from the previous 50 percent. Furthermore, the bank sees potential in using excess capital for additional distributions. Such strategies are attractive from a shareholder perspective, but from a regulatory standpoint, they raise the question of whether these institutions hold sufficient capital to weather future crises.

The challenge lies in the fact that risks are often not clearly apparent in the run-up to a crisis. Banks that distribute too much capital during good times can run into trouble during bad times. The financial crisis of 2008 demonstrated how quickly seemingly sound institutions can face an existential threat when unexpected shocks occur. The higher capital requirements and regulatory capital recommendations of the post-crisis years are specifically designed to prevent such situations.

Systemic transmission channels and fragmentation risks

An often underestimated aspect of financial stability is the contagion channels between institutions and across national borders. Banks are interconnected through various mechanisms: the interbank market, shared exposure to certain asset classes, derivatives markets, and trust effects. If one institution encounters difficulties, these problems can spread to other institutions through these channels.

Two contagion mechanisms played a central role in the financial crisis. First, banks were interconnected through interbank lending, so that the crisis of one bank led to loan defaults and losses at other banks. Second, banks facing liquidity problems were forced to rapidly sell off assets, which depressed prices in the capital markets and brought further banks into trouble. These amplifying effects caused local problems to escalate into systemic crises.

Geopolitical fragmentation and protectionist trade policies could create new channels of contagion or exacerbate existing ones. If trade barriers impede cross-border capital flows or political tensions undermine confidence in certain financial centers, financial flows can shift abruptly. This can lead to liquidity problems at individual institutions and, through contagion effects, take on systemic dimensions.

The European Central Bank (ECB) is warning that financial markets are not immune to sudden turbulence. Markets are particularly vulnerable to further shocks, and the high valuations of many asset classes, combined with a high concentration of risk, increase the danger of abrupt corrections. An ECB Governing Council member warned that a politically dependent Federal Reserve could lead to turbulence in financial markets and the global economy. There is already enough turbulence due to geopolitical tensions such as the war in Ukraine and trade tensions.

Navigating the Polycrisis

The European Central Bank's comprehensive warning about a historically high risk level for banking shocks is not an isolated alarm siren, but rather an expression of a fundamental shift in the framework for the financial system. European banks are facing a polycrisis in which geopolitical upheavals, trade policy shifts, climate change, demographic changes, and technological disruptions interact and reinforce each other.

The current robustness of institutions with regard to capital, liquidity, and profitability should not obscure the fact that this stability is based on framework conditions that can change rapidly. Profitability relies heavily on the interest rate environment, which is already beginning to normalize. Asset quality is under pressure in certain segments, particularly in commercial real estate and export-oriented sectors. Operational resilience against cyber threats must be continuously improved.

The challenge for banks is to strengthen their resilience during a period of apparent prosperity. This requires proactive risk management that not only manages known risks but is also prepared for unexpected shocks. Investments in risk management, technological infrastructure, and employee training must take priority over short-term profit maximization.

For supervisory authorities, the complex risk landscape means they must continuously develop their instruments. The inverse stress test for geopolitical risks is an innovative approach that captures institution-specific vulnerabilities better than standardized scenarios. Integrating climate risks into capital-based supervision provides important incentives for long-term risk management. Intensified monitoring of cyber resilience addresses one of the most pressing operational threats.

Macroprudential policy faces the challenge of identifying and proactively addressing systemic risks without impairing banks' ability to finance the economy. Finding the balance between sufficient capital buffers and lending capacity is difficult and requires continuous adaptation to changing circumstances.

Ultimately, the resilience of the European financial system will be put to the test in the coming years. The probability that one or more of the identified risk factors will materialize is not insignificant. Crucially, the institutions and supervisory authorities will depend on how well prepared they are and how effectively the crisis response mechanisms function. This historical accumulation of risk demands equally historical vigilance and a readiness to act from all participants in the financial system.

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