European bank subordinated debt
the risk is volatility, not fundamentals
Middle East tensions, high-profile defaults in private credit, and broader macro uncertainty have fuelled investor concerns around the potential impact on the European banking sector.
09 April 2026
Direct exposures to the Middle East and private credit are not a credit story. Even in a more stressed macro scenario, the sector's record capital buffers and strong profitability should provide ample room to absorb losses. Typically, the key risk for subordinated debt investors is price volatility, particularly given a starting point of tight valuations in Additional Tier 1 (AT1) Contingent Convertibles (CoCos). We discuss why we believe conservative positioning and active management are key in the current environment.
European banks' direct exposure to the Middle East and private credit is limited and not a credit story
The direct impact from the conflict in the Middle East is broadly immaterial for the European banking sector. According to European Banking Authority (EBA) data, EU bank’s direct exposure to the Middle East is negligible, at below 0.5% of total assets1. Looking at two of the most exposed banks in Europe, HSBC's exposure to the Middle East is around 2% of total exposures, while the United Arab Emirates (UAE) represents approximately 2% of Standard Chartered’s total assets2.
While the conflict in the Middle East has taken centre stage over the past weeks, private credit remains an area of concern for investors. A perfect storm of negative headlines, including several high-profile defaults that led to banks taking losses on asset-backed lending exposures (Tricolor, MFS), has triggered concerns around banks’ exposures to private credit.
What is private credit?
In simple terms, private credit refers to lending by non-banking financial institutions outside the traditional banking system or public capital markets. For example, Tricolor (a non-bank financial institution, NBFI) provided subprime auto loans to individuals, focusing on higher-risk borrowers (undocumented, no credit score, etc). Banks provided financing secured to Tricolor backed by collateral (loan portfolios). Banks' exposure to private credit therefore refers to the financing of NBFIs involved in private credit. This would typically include financing for private markets firms, such as private credit funds or business development companies (BDCs), secured against portfolios of private credit (loans to corporates, individuals etc), or even lending to highly leveraged corporates owned by private equity firms.
Private credit has become a concern partly due to the above-mentioned high-profile cases, some of which were driven by governance failures and collateral misrepresentation (including double pledging of collateral)3, rather than issues inherent to private credit itself. Concerns have also emerged as defaults and stress have picked up in the overall private credit market, notably in the software sector amid AI-related disruption. Several private market firms, including BDCs and private credit funds, have restricted redemptions, while some listed vehicles have experienced material share price declines.
For banks, exposure to private credit is moderate, sitting around 3% of exposures for the sector overall. Disclosures are not fully comparable and transparent, however, for a sample of ten European banks (large European banks which disclosed their exposure), private credit ranges from 0 to 5% of exposures or loans, levels that appear highly manageable. Taking Deutsche Bank (DB) as an example – one of the European bank with the highest disclosed exposure to private credit, the group had reported EUR 25.9 billion of exposure to private credit as of Q4 2025, equivalent to around 5% of loans.4 This compares to approximately EUR 10 billion of excess capital and an estimated EUR 13 billion earnings buffer over 2026-2028 (average annual pre-provision profits based on Bloomberg consensus estimates), or roughly EUR 23 billion of combined buffer. This buffer would cover around 90% of private credit exposures.5
Simplistically, even in a scenario where defaults on private credit rise to 25% with minimal recovery (20%) this represents less than two quarters of earnings for DB – clearly not a credit story. In banking, the quality of exposures trumps quantum, and DB discloses that over 90% of exposures are investment-grade rated, with very conservative lending standards.6
The bottom-line is that the sector’s direct exposure to private credit is limited and not a credit story. Further weakness may lead to earnings pressure, but in our view, this is highly manageable, given the sector's current large earnings buffers.
Chart 1: European bank’s direct exposure to private credit is limited
Source: Atlanticomnium SA, company reports, as at 26 March 2026.
Capital strength expected to support bondholders in case of more pronounced indirect and second-round effects
While the direct exposure of the European banking sector to the Middle East and private credit is limited, the second-round effects are typically the most painful. A combination of higher inflation and lower growth would weigh on the creditworthiness of individuals and corporates, which in turn could lead to higher loan loss provisions. The impact on banks’ revenues would likely be mixed: slower lending growth and reduced corporate activity (M&A etc) could be partly offset by a higher-for-longer rate environment and increased volatility that tends to benefit market-making activities.
Even in a more stressed macro scenario, the sector seems to have ample buffers to absorb a potential rise in loan losses. Taking HSBC as an example, the group is expected to make around USD 45 billion in average annual pre-provision profits (profits before taxes and loan losses) over 2026-2028, equivalent to 4.1% of loans7. This means that in any given year, the bank could afford to ‘lose’ up to 4% of loans outstanding before excess capital is impaired. As a comparison, HSBC’s loan losses during Covid-19 in 2020 were less than 1% of loans, and while loses peaked at 2.7% of loans during the worst year of the 2008 Global Financial Crisis (GFC).8
The sector therefore starts from a clear position of strength, with record-high levels of capital (> EUR 500 billion of excess capital for EU banks)9 on top of strong profitability – underpinning solid fundamentals. However, even if any macro deterioration could be highly manageable through earnings alone, bank subordinated debt would not be immune to market volatility. Previous episodes of macro stress, such as Covid-19, Russian invasion of Ukraine and the rates/inflation shock in 2022, led to elevated volatility despite strong fundamentals.
Chart 2: HSBC could absorb 1.5x peak GFC losses with earnings
Source: Atlanticomnium SA, company reports, as at 26 March 2026. Forecast figures are based on estimates and are uncertain by nature. There is no assurance that the estimated figures will materialise.
Navigating uncertain markets with an active management approach
Despite elevated uncertainty, valuations – whether subordinated debt of financials or credit more broadly – remain towards the tighter end of the range. Spreads on AT1 CoCos of 275 basis points (bps) remain well below the longer-term average of 420 bps (over the last 10 years), and we have seen spreads peak at 600-800 bps in previous episodes of stress (Covid-19, 2022, banking mini-crisis of 2023).10 The typical premium that investors currently receive to go down the capital structure is also limited. For example, AT1s currently offer less than 150 bps (1.5%) of spread and yield pick-up over Tier 2 bonds (Tier 2s), well below the long-term averages.11
Chart 3: Absolute and relative spreads on AT1 CoCos are tight
Source: Atlanticomnium SA, Bloomberg, as at 26 March 2026, spread = z-spread (bps).
From a risk-management perspective, the limited pick-up in spread and yield that AT1s offer compared to Tier 2s needs to be weighed against the difference in volatility between the two. During market sell-offs, extension risk tends to dominate AT1 pricing, as bonds are re-priced to perpetuity, which can lead to large drawdowns. Looking at the last risk-off episodes, AT1s drawdowns have been close to 3x larger than those of Tier 2s on average.
Chart 4: AT1s experienced circa 3x the drawdown of Tier 2s in previous risk-off episodes
Source: Atlanticomnium SA, Bloomberg, as at 26 March 2026.
In this context of tight valuations and high uncertainty, we believe that subordinated debt investors may consider being conservatively positioned to mitigate downside risks. Positioning higher up the capital structure, in senior and Tier 2 bonds, could allow investors to benefit from the sector’s strong fundamentals while reducing exposure to potential spikes in volatility. In our view, active management remains essential, as we believe a pronounced risk-off scenario could create an attractive entry point in AT1 CoCos, with significant upside potential on the recovery.
Romain Miginiac is a Portfolio Manager and Head of Research at Atlanticomnium, and co-manages credit and sustainable bond strategies for GAM Investments.