Euro banks may confront a new kind of rate risk

It’s been more than a decade since the euro area’s last interest-rate increase, but this year will very likely finally see one again. Banks, lost in a desert of ever weaker interest income, are desperate for the small rewards that a couple of hikes will bring. But there are stark risks that higher borrowing costs and a slowing economy may quickly bring back problem loans to some countries.
The European Central Bank (ECB) sets the same rate for the 19 euro members, but how that rate effects each country varies widely because local banks lend in different ways. A higher rate will lift income on lending faster at banks like Banco Bilbao Vizcaya Argentaria SA in Spain and UniCredit SpA in Italy than BNP Paribas SA of France or Deutsche Bank AG of Germany, for example.
Likewise, higher interest payments will also hit the wallets of borrowers in Spain and Italy more quickly than in France and Germany. The implication is that southern European economies will slow and problem loans potentially grow again sooner than their northern neighbors.
The big difference is in mortgages. In Spain and Italy, home-loan costs are linked to three-month and 12-month interbank lending rates, so monthly repayments for existing debt closely track the ECB’s rates. In France and Germany, home loans have longer-term fixed-rates, so costs only rise on new mortgages.
Credit cards and other consumer debts reprice in tandem with ECB rate changes in all these countries, as do corporate loans. But mortgages take up the biggest share of bank assets and have a larger effect on consumer cash flows.
There will be a difference among countries on discretionary spending, like restaurants and retailers, too, according to work by Carraighill, a Dublin-based independent financial-research firm.
In Spain, a half-percentage point increase in the ECB’s benchmark rate, taking it back to zero, will cut such consumption by 1% annually. In Germany, the effect will be only 0.3%.
In futures markets, the implied interest rate in a year’s time is 0.67%, according to UBS analysts, which suggests the ECB will hike by more
than double Carraighill’s baseline.
But debt-servicing expense isn’t the only issue. The higher energy costs that are driving inflation will also hurt discretionary consumer spending power through home utility bills and car fuel.
Assuming suppliers only pass through 25% of recent energy cost rises, Carraighill reckons a 6% cut in household budgets for Germany, France and Italy and 4.5% for Spain.
Rising debt and energy costs, including for companies too, will quickly choke economic activity and demand, says David Higgins, analyst at Carraighill. This suggests a dim outlook for banks.
But others see less reason to fear a return of rapidly growing bad loans than when the ECB last raised rates in 2011. European banks are starting from a better place with most of the problem debt from the last decade cleared off their books. Their strong capital bases will allow them to absorb more trouble without looking unstable.
On top of that, nearly 400 billion euros ($432 billion) of loans to companies are covered by Covid-era government guarantees, according to analysts at Bank of America Corp. That gives extra protection against bad debts for banks.
Stronger capital bases also make it easier for banks to absorb losses from falling bond prices as yields rise. US banks lost billions on rising Treasury yields in the first quarter, leading some to slow their share-buyback programs.
But European banks may be better off on this front anyway: They have invested less of their excess funds in government debt than their US peers did. As the ECB stops buying
government bonds, banks have much more “cash” in the form of deposits at the ECB that they can invest in bonds instead.
And for the first time in about eight years, all German government bonds with maturities of at least two years actually pay a positive yield. It may
not be much, but it’s
something.
European bank stocks have performed terribly since the invasion of Ukraine and are priced at crisis valuations even though earnings forecasts have improved. Alastair Ryan, banks analyst at Bank of America, says this shows that investors have jumped straight to worrying about too many interest rate increases from the ECB.
European economies are finely balanced. Higher interest rates are going to do very little if anything to rein in energy costs. Nor will they help export demand from a slowing China and an untouchable Russia, which combined constitute Europe’s second-biggest market after the US.
Europe’s banks desperately need higher rates to boost income, but the ECB must be careful: It will be far easier to go too far in fewer steps than in the US — for the economy and for banks.

—Bloomberg

Paul J Davies is a Bloomberg Opinion columnist covering banking and finance. He previously worked for the Wall Street Journal and the Financial Times