French banks caught in crossfire, but fundamentals are solid

France has been the primary focus of the European rates markets in the past week, with domestic political risk and debt concerns adding to a general sell-off across government bonds.

The downturn has driven the yield on 10-year French government bonds (OATs) to 4.99%, its highest level since 2002. This has seen the OAT-Bund spread reach 146 basis points (bp), and frankly the technical picture does not lead us to believe that we have reached a ceiling yet. Indeed, we feel various politicians are guilty of adding fuel to the fire with various irresponsible commentary, and the environment is such that unfortunately there is an abundance of poor judgment coming from those in the leadership (or those wanting to make advances for it).

Banks always find themselves in the crossfire when there is pressure on their domestic sovereign debt, and for good reason. Normally the fortunes of the sovereign are closely tied to the strength of the underlying economy, and the same goes for the assets that banks hold on their balance sheets (mortgage claims, corporate borrowings etc.). As a result, and unsurprisingly, over the last few weeks we have seen French banks underperforming their European peers, both in the equity and credit space.

We would not minimise any fallout from sovereign stress in France on the financial sector as well as the broader economy, and we continue to carefully monitor these developments.

Specifically, let’s address the few obvious risks facing the banking sector. The current situation heightens the risk that a rating agency will downgrade the sovereign, which could spill over to the banking sector, driving up funding costs making the sector less competitive globally and constraining lending action (particularly as the largest French banks are global players). Elevated fiscal budgets also lead to unpredictable policy responses, raising the risk of new or higher banking taxes (as is currently being rumoured in the UK, for example) or changes to regulated savings products such as Livret A, which may impact bank margins.

In addition, higher yields are generally less favourable for the French banks, as they tend to hold long duration assets (mortgages) that are funded by deposits, creating a real risk of margin compression. We saw this dynamic play out during 2022 and 2023, though back then the delta in rate changes was significantly higher than now, and the banks have absorbed those developments (today’s magnitude of changes in rates has not been quite the same).

Having said all that, we do believe there are some mitigants that should help keep the sector’s fundamentals resilient through this period.

First, the immediate risk has always been from banks and insurers holding government paper and the clear bank-sovereign feedback loop. Back during the euro area crisis, Italian banks for example came under heavy market and rating agency scrutiny for their sizeable holdings of Italian government bonds (BTPs) as the BTP-Bund spread hit record highs. This disparity versus other regions remains (see Exhibit 1), even if individual sovereign exposures have reduced.

The focus is now on the French banks and their holdings of OATs. As per the European Central Bank (ECB) data in Exhibit 1, relative to European peers French banks are not big holders of their own government bonds. We estimate that the largest French banks have OAT exposures that are around 15-30% of their Common Equity Tier 1 (CET1) capital (Italian banks had in excess of 100% CET1). And in some cases, nearly all these OAT exposures are held at amortised cost, so changes in the government bond valuations lead to little sensitivity in the regulatory capital ratios, even if these bonds can still be reassessed by rating agencies and their valuations can reduce the value of collateral for liquidity purposes.

Second, it is worth noting that the big three French banks (BNP Paribas, Société Générale and Crédit Agricole) generate over 50% of their revenues outside of France (only around a quarter of BNPP’s revenues and a third its of assets sit in France). This is not to say that pressure on the corporate and retail sector would not feed into asset quality deterioration for these banking groups – indeed, we would not be surprised to see management creating some forward-looking credit provisions against that part of the business in upcoming reporting periods. However, the benefit of diversification for these large banking groups is real and the foreign revenue pillars can provide stability when the domestic sovereign is facing stress.

Third, whenever political noise spills over to the real economy, there is a real risk that non-performing loans (NPLs) will rise on banks’ balance sheets. French GDP is still projected to grow by 0.5% in 2026, before recovering to 0.9% and 1.1% in 2027 and 2028 respectively, according to Bloomberg Consensus data. There is some room for these growth rates to move down before we hit a recessionary environment that would typically be associated with a rise in NPLs. It is also worth noting that savings rates in France remain high (see Exhibit 2), which should provide some buffer for the headwinds caused by the political uncertainty.

While the valuations of French banks have underperformed the rest of the European banking sector in recent weeks, we believe the banks remain fundamentally resilient, a view we expect to be supported by their upcoming quarterly results.

At the same time, while French bank credit spreads have visibly widened – including in the Additional Tier 1 (AT1) space – a large share of this widening has been driven by the underperformance of OATs. Despite our positive view on the resilience of the banks, it is difficult to envisage a situation where further widening of the OAT-Bund spread does not continue to transmit directly to the banks themselves. As a result, given the technical picture behind the OAT-Bund spread is not very clear to us just yet, and credit spreads more broadly remain relatively tight, it is perhaps premature to step into the secondary market with strong conviction.

Instead, we would prefer to participate in opportunistic primary market deals from French banks, where issuers will now hopefully (and finally) put some new issue premium concession on the table once the market reopens.