Eurobanks are facing a new form of interest rate risk

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It is more than a decade since the eurozone’s last rise in interest rates, but this year it will most likely finally be seen again. Banks, lost in a desert with ever-weaker interest income, are desperate for the small rewards that a few increases will bring. But there is a high risk that higher borrowing costs and a declining economy could quickly bring problem loans back to some countries.

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

Likewise, higher interest payments will also hit the wallets of borrowers in Spain and Italy faster than in France and Germany. The consequence is that the southern European economies will slow down, and problem loans will potentially grow again faster than their northern neighbors.

The big difference is in mortgages. In Spain and Italy, mortgage costs are linked to three- and 12-month interbank lending rates, so the monthly repayments on existing debt closely follow the ECB’s interest rates. In France and Germany, home loans have a longer fixed interest rate, so costs only increase on new mortgages.

Credit cards and other consumer debt are being repaid in line with changes in ECB interest rates in all these countries, as are corporate loans. However, mortgages fill the largest share of bank assets and have a greater effect on consumers’ cash flows.

There will also be differences between countries in terms of discretionary spending, such as restaurants and retailers, 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, bringing it back to zero, would reduce such consumption by 1% annually. In Germany, the effect will only be 0.3 per cent.

In futures markets, the implied one-year interest rate is 0.67%, according to UBS analysts, suggesting that the ECB will raise more than double Carraighill’s baseline.

But debt service is not the only problem. The higher energy costs that drive inflation will also hurt consumers’ discretionary purchasing power through household bills and car fuel. Assuming suppliers pass only 25% of recent energy cost increases, Carraighill expects a 6% cut 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, says David Higgins, an analyst at Carraighill. This indicates a weak outlook for banks.

But others see less reason to fear a return of fast-growing bad loans than when the ECB last raised interest rates in 2011. European banks are starting from a better place with most of the problem debt of the last decade cleared out of their books. Their strong capital base will allow them to absorb more problems without looking unstable.

On top of that, nearly $ 400 billion ($ 432 billion) of corporate loans are covered by Covid-era government guarantees, according to Bank of America Corp. analysts. It provides extra protection against bad debts for banks.

Stronger capital base also makes it easier for banks to absorb losses from falling bond prices as interest rates rise. U.S. banks lost billions on rising government interest rates in the first quarter, prompting some to slow down their share buyback programs.

But European banks may be better off on this front anyway: they have invested less of their surplus funds in government debt than their American counterparts did. As the ECB stops buying government bonds, banks have much more “cash” in the form of deposits with the ECB, which they can invest in bonds instead. And for the first time in about eight years, all German government bonds with a maturity of at least two years actually provide a positive return. It may not be much, but it’s something.

European banking stocks have performed terribly since the invasion of Ukraine and are priced for crisis ratings, although earnings forecasts have improved. Alastair Ryan, a banking analyst at Bank of America, says this shows that investors have gone straight to worrying about too many interest rate hikes from the ECB.

European economies are well balanced. Higher interest rates will do very little, if anything, to curb energy costs. Nor will they help with export demand from a declining China and an immovable Russia, which together make up Europe’s second largest market after the United States

Europe’s banks desperately need higher interest rates to increase income, but the ECB must be careful: it will be far easier to go too far with fewer steps than in the US – for the economy and for the banks.

More from Bloomberg Opinion:

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

• All ways banks can be affected by Putin’s war: Paul J. Davies

• This was the week the Fed finally found out: Jenny Paris

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

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

More stories like this are available at bloomberg.com/opinion

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