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More than a decade has passed since the last rate hike in the euro area, but this year there will most likely finally be another one. Banks, lost in a desert of declining interest income, are desperate for the small rewards that a few rate hikes will bring. However, there are major risks that higher borrowing costs and a slowing economy could quickly bring bad debt back to some countries.
The European Central Bank sets the same interest rate for the 19 euro members, but how that interest rate affects each country is very different as local banks lend in different ways. For banks like Banco Bilbao Vizcaya Argentaria SA in Spain and UniCredit SpA in Italy, a higher interest rate will boost lending revenues faster than, say, France’s BNP Paribas SA or Deutsche Bank AG.
Similarly, higher interest payments will hit borrowers’ wallets faster in Spain and Italy than in France and Germany. The implication is that southern European economies are slowing and bad debt may start growing again sooner than their northern neighbors.
The big difference is in mortgages. In Spain and Italy, the cost of home loans is indexed to 3-month and 12-month interbank lending rates, so monthly repayments on existing debt are closely aligned with ECB interest rates. In France and Germany, home loans have longer-term fixed interest rates, so costs only increase for new mortgages.
Credit cards and other consumer debt are being re-evaluated along with ECB interest rate changes in all of these countries, as is corporate lending. However, mortgages take up the bulk of bank assets and have a greater impact on consumer cash flows.
There will also be differences between countries when it comes to discretionary spending, such as restaurants and retailers, according to the work of Carraighill, a Dublin-based independent financial research firm. In Spain, increasing the ECB’s reference interest rate by half a percentage point to zero will reduce this consumption by 1% per year. In Germany, the effect is only 0.3%.
In futures markets, the implied rate of interest a year away is 0.67%, according to UBS analysts, suggesting the ECB will hike more than double Carraighill’s baseline.
But debt servicing is not the only problem. Higher energy costs, which are driving inflation, will also hurt consumers’ discretionary purchasing power through household utility bills and auto fuel. Assuming suppliers pass on only 25% of recent energy cost increases, Carraighill expects household budgets to be cut by 6% 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 points to a bleak outlook for banks.
But others see less reason to fear a return of rapidly growing non-performing loans than they did when the ECB last hiked rates in 2011. Their strong capital base will allow them to absorb more problems without appearing unstable.
In addition, according to analysts at Bank of America Corp. Almost 400 billion euros ($432 billion) in loans to businesses backed by Covid-era government guarantees. This offers banks additional protection against bad debts.
A stronger capital base also makes it easier for banks to absorb losses from falling bond prices when yields are rising. US banks lost billions in the first quarter on rising Treasury yields, prompting some to slow their share buyback programs.
But European banks might be better off on this front anyway: they have invested less of their excess funds in government bonds than their US counterparts. With the ECB no longer buying government bonds, the banks have a lot more “cash” in the form of deposits with the ECB to invest in bonds instead. And for the first time in around eight years, all German government bonds with maturities of at least two years are actually paying a positive yield. It might not be much, but it’s something.
European bank stocks have performed terribly since the invasion of Ukraine and are rated at crisis ratings despite improving earnings forecasts. Alastair Ryan, banking analyst at Bank of America, says this shows investors were immediately concerned about too many rate hikes by the ECB.
The European economies are finely balanced. Higher interest rates will do very little, if anything, to contain energy costs. Nor will they help support export demand from a flagging China and an untouchable Russia, which together make up Europe’s second largest market after the US
Europe’s banks badly need higher interest rates to boost earnings, but the ECB needs to be careful: it will be much easier to go too far in fewer steps than in the US – for the economy and for the banks.
More from the Bloomberg Opinion:
• Zero is a good target for ECB rates: Gilbert & Ashworth
• All the ways banks can be hit by Putin’s war: Paul J. Davies
• This was the week the Fed finally found out: Jenny Paris
This column does not necessarily represent the opinion of the editors 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.
For more stories like this, visit bloomberg.com/opinion
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