Fitch Ratings has said that it believes 2008 will be a considerably more challenging year for major European banks than 2007. The largely positive ratings trend in recent years will be eroded as bank earnings come under increasing pressure from the ongoing financial market turmoil, the agency says in a special report, entitled "Outlook for Major European Banks in 2008: More Stormy Waters Ahead".

Fitch has taken negative rating actions on four of the 20 largest European banks since the credit market crisis began in August 2007, including downgrades of Long-term Issuer Default Ratings (IDRs) on two banks. The agency does not exclude further negative rating actions in the coming months if the current highly illiquid and volatile market conditions persist, although it does not expect wide-scale or multi-notch downgrades. The Long-term IDRs of this group of banks remain high, mainly within the 'AA' range. Fitch is of the opinion that most of these banks are sufficiently robust to weather a prolonged downturn in operating conditions.

"The current market conditions are likely to prevail until at least the end of the first quarter of 2008," says Alison Le Bras, Managing Director in Fitch's Financial Institutions Group and principal author of the report. "Furthermore, if the current liquidity squeeze should develop into a fully-blown credit crunch, this could have a severe impact on the real economy, which in turn would have significant ramifications for banks, including a sharp slowdown in credit growth."

A reduction in structured finance business would compromise earnings from capital markets activities, and some banks' capitalisation may come under pressure if they have to bring off-balance sheet vehicles back on to their balance sheets. Fitch also has concerns about the impact of a less favourable economic outlook on the overheated housing markets in some countries, such as Spain and the UK.

The pace of consolidation could slow down in 2008 as banks tread more cautiously in a more challenging environment. At the same time, falling bank share prices would make potential acquisition targets more affordable, and with cost efficiency and the realisation of synergies at the heart of many major banks' strategies, it is likely that some will continue to look out for attractive acquisition opportunities.

Although full-year 2007 results are likely to remain relatively robust for most major European banks, second half results are clearly coming under pressure. The Swiss giant, UBS AG, has announced that further substantial write-downs on its sub-prime exposure in Q407 will result in a second consecutive quarterly loss and possibly a loss for the full year. It is not inconceivable that other banks will also reveal more write-downs on structured credit products, mortgage-linked assets or leveraged lending commitments, although Fitch would expect the figures to be less significant than those of UBS.