European banks are about to face a new kind of interest rate risk

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More than a decade has passed since the last interest rate hike in the euro zone, but this year will most likely see one again. Banks, lost in a wasteland of ever-lower interest income, are desperate for the small rewards that a few hikes will bring. But there are big risks that higher borrowing costs and a slowing economy will quickly bring back problem lending in some countries.

The European Central Bank sets the same rate for all 19 members of the euro, but the effect of this rate on each country varies greatly as local banks lend in different ways. A higher rate will increase loan income faster at banks like Banco Bilbao Vizcaya Argentaria SA in Spain and UniCredit SpA in Italy than BNP Paribas SA in France or Deutsche Bank AG in Germany, for example.

Similarly, higher interest payments will also hit the wallets of borrowers in Spain and Italy faster than in France and Germany. The implication is that southern European economies will slow and problem lending will potentially rise again sooner than their northern neighbours.

The big difference is mortgages. In Spain and Italy, home loan costs are linked to three-month and 12-month interbank lending rates, so monthly repayments of existing debt closely track ECB rates. In France and Germany, mortgages have longer fixed rates, so costs only increase on new mortgages.

Credit cards and other consumer debt are repricing in parallel with ECB rate changes in all of these countries, as are corporate loans. But mortgages take up the largest share of bank assets and have a greater effect on consumer cash flow.

There will also be a difference between countries when it comes to discretionary spending, such as restaurants and retailers, according to work by Carraighill, an independent financial research firm based in Dublin. In Spain, an increase of half a point in the ECB’s reference rate, bringing it to zero, will reduce this consumption by 1% per year. In Germany, the effect will only be 0.3%.

In the futures markets, the implied interest rate one year ahead is 0.67%, according to UBS analysts, suggesting the ECB will more than double Carraighill’s benchmark level.

But debt service charges aren’t the only problem. Higher energy costs that are fueling inflation will also hurt consumers’ discretionary purchasing power through utility bills and car fuel. Assuming that suppliers only pass on 25% of recent energy cost increases, Carraighill expects a 6% reduction in household budgets for Germany, France and Italy and 4.5% for Spain.

Rising debt and energy costs, including for businesses, will quickly stifle economic activity and demand, said David Higgins, analyst at Carraighill. This portends a bleak outlook for banks.

But others see less reason to fear a return to fast-growing bad debt than when the ECB last hiked rates in 2011. European banks are starting from a better place with most of the ECB’s problem debt. last decade erased from their books. Their strong capital bases will allow them to absorb more trouble without appearing unstable.

On top of that, nearly 400 billion euros ($432 billion) of business loans are backed by Covid-era government guarantees, analysts at Bank of America Corp say. This gives additional bad debt protection for banks.

Stronger capital also makes it easier for banks to absorb losses from falling bond prices as yields rise. U.S. 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 have their US counterparts. As the ECB stops buying government bonds, banks have far more “cash” in the form of deposits at the ECB than they can invest in bonds instead. And for the first time in about eight years, all German government bonds with a duration of at least two years are actually earning a positive yield. It may not be much, but it is something.

European bank stocks have performed terribly since the Ukraine invasion and are priced at crisis valuations even as earnings forecasts have improved. Alastair Ryan, banking analyst at Bank of America, says it shows investors were immediately concerned about too many interest rate hikes from the ECB.

European economies are finely balanced. Higher interest rates will do little or nothing to control energy costs. Nor will they help export demand from a slowing China and an untouchable Russia, which together constitute the second largest European market after the United States.

European banks desperately need higher rates to boost their incomes, but the ECB must be careful: it will be much easier to go overboard in fewer steps than in the United States — for the economy and for the banks.

More from Bloomberg Opinion:

• Zero is a good destination for ECB rates: Gilbert and Ashworth

• All the Ways Banks Can Be Affected by Putin’s War: Paul J. Davies

• It was the week the Fed finally got it: Jenny Paris

This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

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

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