Although the long-awaited rise in interest rates will be beneficial to western European banks, the hikes will not be a panacea for their profitability problems, according to S&P Global Ratings.
Years of ultra-low rates have impaired the ability of banks to generate revenues and led to a decline in net interest income, but low funding costs and cost of risk, along with the improving western European economy, have supported lenders' efforts to adapt to the more challenging environment, the rating agency said in a sector commentary Jan. 14.
As the European Central Bank is moving toward a gradual normalization of monetary policy, the cost of risk will rise again and cheap funding will be harder to obtain. Many banks are still caught up in a "costly adaptation of business models" as they seek to address technology challenges and changes in regulation.
Even if the ECB starts hiking interest rates, they will still remain at historic low levels for a while, and will not be able to provide a short-term relief on profitability, Ratings said. "Indeed, we believe low rates are increasingly weighing on profitability indicators as flexibility by banks to adapt is coming to an end," the credit analysts said.
Lenders resilient, but sustainability is in question
Over the past three years, western European banks have shown a fair amount of resilience against the negative effects of low interest rates with net interest margins remaining firmly in the range of 1.5% and 2.0%, according to the ratings agency's analysis of the 50 largest institutions in the region.
However, this trend is not sustainable in the long run. It was only possible because interest expenses were also on the decline and banks were actively managing their balance sheet to reduce funding costs and offset falling asset valuations, Ratings said.
The rating agency expects the repricing of assets following the first rate hikes to be faster than that of liabilities. Even so, this will be a gradual rather than a radical game changer for western European banks, it said.
"[T]his repricing will happen in parallel with the rebalancing of funding structures, and depositors will turn again to remunerated products and longer-dated instruments with the fattening of interest rates," Ratings said.
Forecasting rate hikes
New bank resolution rules — which require lenders to hold additional reserves of loss-absorbing instruments to be used in case they run into trouble — will likely boost new debt issuance and affect funding costs as lenders face more market volatility in 2019. This could further impede banks' ability to benefit from the increasing interest rates, the agency said.
In a first step, the ECB should hike its deposit rate by 15 basis points in September and continue with increasing other rates by 25 basis points as early as December, Ratings projected. From 2020 onward, the ECB is expected to raise rates two times a year, the agency said. The phasing out of the ECB's asset purchasing program and the predicted rate hikes are expected to result in "some tightening of financing conditions in the eurozone" but the normalization should be slow enough to prevent any abrupt rise in borrowing costs, according to the credit analysts.
To read the full S&P Global Ratings report please click here.