Amid a broad consensus that core inflation will remain above target for another two years, S&P Global Ratings' economists expect the European Central Bank's (ECB's) monetary policy to continue normalizing once rates have peaked. If inflation does indeed exceed the target for another two years, we believe the current passive form of quantitative tightening (QT) could give way to a more active form, which would involve the ECB starting to sell bonds on the market.
Today, the ECB holds about €5 trillion in bonds and we believe it could reduce this sum by €1.0 trillion-€1.5 trillion. This is on top of a €600 billion balance-sheet reduction via targeted longer-term refinancing operation (TLTRO) repayments that are set to take place by the end of 2024. One important question is at what speed the reduction in bond holdings should occur.
For eurozone banks, a hypothetical acceleration of QT would not have a major direct impact on their capital adequacy or liquidity and funding ratios. However, it would fuel the normalization of funding costs and net interest margins already under way (see "European Banks: Protecting Liquidity Will Come At An Increasing Cost," published June 29, 2023). Indeed, active QT would likely lead to deposit outflows, as nonbanks use bank deposits to buy parts of the bonds that the ECB sells.
The ECB could also decide to lower the remuneration of banks' excess reserves to incentivize them to buy parts of these bonds. A key determinant of banks' willingness to buy the ECB's bonds will be the risk-adjusted spread between the yields on the bonds and the rate at which banks can deposit their excess reserves with the ECB, namely, the deposit facility rate (DFR; currently 3.75%). For now, this spread is mostly negative, meaning that banks have few incentives to swap deposits at the ECB for bonds.
Besides this, the acceleration of QT could lead to unpredictable secondary effects on banks and the financial system at large. In the U.S., where the Federal Reserve restarted its QT program in April 2022, banks have seen deposit outflows weigh heavily on their funding, liquidity, and spread income. In the eurozone, we see banks as well placed to manage the transition, but we are mindful that QT could also have profound implications for financial institutions' business models and financial profiles. Competition for a shrinking pool of deposits could intensify, leading to a rise in banks' funding costs. Tighter liquidity conditions could exacerbate refinancing risks for nonbanks. Banks may also increase exposures to their domestic sovereign over time, thereby reinvigorating the so-called sovereign-bank nexus--the interconnectedness of sovereigns and banks--which was a major catalyst of previous financial crises.
As the ECB proceeds with QT, we expect it to remain data-dependent, taking into account the future path of core inflation expectations, as well as the effect of its policies on banks and broader financial stability. Careful communication and pragmatic delivery will be key in this regard. However, we consider that the ECB has multiple tools to address liquidity issues should they arise in the banking system, such as the mechanism of full allotment for bank refinancing operations or, for sovereigns, the as-yet-untested transmission protection instrument.
In this Credit FAQ, we answer questions about the ECB's progress with QT and its potential effects on banks in the eurozone.
Frequently Asked Questions
What is QT and what has the ECB already done in this regard?
From a pure accounting perspective, QT is the reverse operation of quantitative easing (QE). Under its QE policy, the ECB--alongside many other major central banks--purchased securities directly from the market, financing these purchases by creating reserves and injecting them into the financial system. Under QT, the ECB extinguishes these reserves, either by letting the bonds that it holds lapse on maturity, or by selling them outright in the market. The former approach is passive QT, as the ECB simply waits for the bonds' maturity, and the latter is active QT.
As of August 2023, the ECB still holds close to €5 trillion of bonds, mostly of it under its APP (€3.3 trillion) and the rest under its pandemic emergency purchase program (PEPP; €1.7 trillion). The ECB started to purchase securities under the APP in October 2014, to support the monetary policy transmission mechanism and provide the amount of policy accommodation necessary to ensure price stability amid very low inflation. In March 2020, the ECB launched another temporary QE program, the PEPP, to counter the serious risks that the COVID-19 outbreak posed to the monetary policy transmission mechanism and the economic outlook for the eurozone.
Since March 2023, the ECB has gradually implemented the passive form of QT, first by reinvesting only partially maturing bonds under its APP, and then from July 2023, by fully ending such reinvestments. Between March and the end of August, the ECB reduced its stock of bond holdings by €100 billion. It is still fully reinvesting securities under the PEPP.
What are the ECB's main considerations with regard to the pace and form of QT?
We believe that the ECB largely follows a data-driven approach in defining its monetary policy strategy. This includes setting its main policy rates, but also deciding on the pace of QT and the size and modalities of its refinancing operations for banks. The evolution of medium-term core inflation expectations is a key consideration for the ECB.
Alongside core inflation expectations, the ECB is likely to factor in several uncertainties as it implements its QT program, starting with the financing needs in the real economy, particularly governments'. As QT amounts to the withdrawal of a key source of demand for government bonds, a sharp increase in bond supply could lead to upward pressure on yields. Between March 2015 and March 2017 alone, the public sector purchase program had an estimated -20% impact on eurozone banks' holdings of government securities compared to pre-program levels.
A second source of uncertainty is the financial system's capacity and readiness to absorb these refinancing needs. It will therefore be crucial for the ECB to estimate banks' actual needs for excess reserves, as this will determine how far QT can go without putting pressure on banks' liquidity.
Today, excess reserves stand at around €3.7 trillion, while we estimate that banks' actual demand for such reserves could effectively be as low as €1.7 trillion. This means that the ECB could withdraw over €2 trillion of excess reserves from the system (see "Estimating Eurozone Banks' Demands For ECB Reserves" below), bearing in mind that €600 billion of this sum is already earmarked to disappear by end-2024 in the form of TLTRO repayments.
The final uncertainty for the ECB will be the impact of QT on yields and the capacity of financial and nonfinancial actors to manage the ECB's withdrawal from the bond markets. We do not expect the impact of QT on yields to mirror that of QE decisions, which were taken in times of acute crisis. For instance, we do not expect a return to the yields and spreads just before the ECB made its QE decisions. That said, QT's actual impact on yields remains particularly hard to predict.
Estimating Eurozone Banks' Demands For ECB Reserves
As the ECB proceeds with QT and reduces excess reserves, it will need to decide on the pace and the endpoint of this process. A crucial consideration will be the scale of banks' demands for excess reserves. But the answer is not straightforward. The optimal level of excess reserves in a post-QE world remains largely uncertain (see "Complete Fed Balance Sheet Normalization Is Still Years Away," published Aug. 16, 2023). We understand that some central bankers may find benefits in returning to the pre-financial crisis world of scarce reserves and lean balance sheets (see "Getting up from the floor," by Claudio Borio of the Bank for International Settlements, published as SUERF policy note no. 311 in May 2023).
According to a recent working paper by David Lopez-Salido and Annette Vissing-Jorgensen presented at the ECB forum on central banking in Sintra, Portugal, banks' demand for reserves largely depends on a trade-off between the costs of holding reserves (the money market rate) and their remuneration (the DFR, plus a convenience yield), as well as the level of deposits (see "Reserve Demand, Interest Rate Control and Quantitative Tightening," published by the Federal Reserve Board on Feb. 27, 2023). By our estimates, the demand function proposed in the paper for European banks fits well with the actual reserves they held at the ECB over time (see chart 1). We estimate the function as follows:
The euro short-term rate (ESTR) is the main money market rate; the DFR is the remuneration rate for reserves sitting in the ECB's deposit facility; and the main refinancing operation (MRO) rate is the rate at which banks can borrow liquidity from the ECB under a repurchase agreement. Large gaps between the actual reserves and our estimate of the demand function only hold between July and September 2022, when the ECB announced changes in the remuneration of reserves. This episode is more of an outlier caused by uncertainty in demand, rather than a misspecification of our demand function.
We use this function to estimate the amount of reserves that banks would likely want to hold given their current level of deposits and under normal liquidity conditions. Under such conditions, the spread between the money market rate (the ESTR) and the rate of remuneration on reserves is close to its long-term average of 5 basis points (bps). These parameters are the same as those in a blogpost published by the Bank of England titled "What do we know about the demand for Bank of England Reserves?," published on Feb. 22, 2023). Under these parameters, we estimate that European banks would probably be willing to hold reserves of around €1.7 trillion, almost half as much as at present (see chart 1). This estimate should be seen as a landing zone to be reached gradually rather than an immediate target.
What are S&P Global Ratings' expectations for the ECB's QT program and monetary policy normalization?
As the ECB shares the broad consensus that core inflation will remain above target for another two years, we expect the normalization of its monetary policy to continue once rates have peaked.
In this context, switching from a passive to an active form of QT appears to be a possible next step, although the timing and pace of such a switch remain highly uncertain. We believe that QT will first continue to focus solely on the reduction of the APP, which was set up to combat the risk of deflation. Meanwhile, the PEPP, which was set up in response to the COVID-19 pandemic, will likely remain untouched until end-2024, although this is certainly not the only possibility. The ECB could end reinvestments under the PEPP program before end 2024 as an intermediate step before selling bonds from the APP portfolio.
The key question is therefore how far and how fast the ECB will conduct QT. Today's market expectations are for the APP to still amount to €2.2 trillion at the end of 2026, compared with €3.3 trillion today, and for the PEPP to be €1.4 trillion the same date (€1.7 trillion today). This corresponds to a total reduction of €1.4 trillion, which is in line with our estimate of the reduction in excess reserves net of TLTRO repayments. But this is a reduction over three and a half years, which could be achieved via a purely passive form of QT given the duration of the existing portfolios. However, if the ECB feels it needs to reduce these amounts sooner than the end of 2026, it will likely decide to actively sell bonds. The form of reduction (active or passive QT) that the ECB chooses will largely depend on inflation trends (see chart 2).
Another area of policy normalization that the ECB could combine with QT is the operational framework, that is, the way in which the ECB provides liquidity to banks and remunerates reserves.
The ECB could decide to lower the remuneration of banks' reserves in parallel with an acceleration of QT, thereby further incentivizing banks to refinance maturing bonds. This would limit the ECB's own financial losses, which are bound to be significant in the case of active QT. In July 2023, the ECB took a step in this direction by lowering the remuneration of banks' minimum reserves from the DFR to 0%. A potential further step in that direction would be to reintroduce a form of deposit tiering, whereby the ECB would remunerate only a portion of excess reserves at the DFR.
The ECB could also decide to modify the spread between its key rates, known as the rate corridor. The wider the spread between the DFR and the MRO rate, the further money market rates could deviate from the DFR, making it less attractive for banks to hold reserves. At the moment, the corridor is asymmetrical. The spread between the DFR and the MRO rate of 50 bps is larger than the spread between the MRO rate and the marginal lending facility at 25 bps. Historically, the corridor was symmetrical.
Apart from rates, the ECB could consider changing the terms of its refinancing operations for banks, and in particular its full allotment procedure. Under this procedure, the banks determine the level of excess reserves since the ECB provides them with as much reserves as they request. The ECB might, over time, see benefits in returning to more normal refinancing operations, offering a set amount of liquidity to regain control over the volume of excess reserves in the system. However, we consider that this would remove an important safety mechanism for eurozone banks' funding, and that it is likely to only come up for consideration at a later stage in the monetary policy normalization process.
Finally, the ECB could increase its reserve coefficients, that is, the minimum ratio of deposits that banks must hold as required reserves. Currently, the reserve coefficient is set at 1% of banks' overnight deposits and deposits or bonds maturing in under two years, but historically it had been 2%, until 2012.
How does QT work in practice for eurozone banks?
To determine how active QT would affect banks, we looked at the following two scenarios:
- Scenario 1: The ECB sells its bonds to a eurozone bank.
- Scenario 2: The ECB sells its bonds to a eurozone nonbank financial institution (NBFI; for example investment funds, insurance corporations, or pension funds).
Those scenarios are not mutually exclusive. As QT unfolds, the ECB will sell a fraction of its holdings to eurozone banks and NBFIs, but also to players outside the eurozone. In the latter scenario, we assume that the effect on the eurozone banking system would be limited and hardly quantifiable. Therefore, we exclude it from our analysis.
Scenario 1: The ECB sells its bonds to a eurozone bank. In this scenario, the bank's balance sheet size remains the same following the transaction, as the bank would simply swap its holding of reserves for bonds that the ECB previously held. In doing so, the bank would assume the associated credit, market, and liquidity risks, and the operation would also affect its earnings depending on the spread between the rate at which the ECB renumerates reserves and the bonds' yields.
Scenario 2: The ECB sells its bonds to a eurozone NBFI. In this scenario, because the NBFI has no reserves with the ECB, it will use cash in the banking system, typically deposits in a eurozone bank. Because of their indirect role in this case, banks would not assume any credit risk or market risk, but would see deposit outflows.
If eurozone banks bought bonds from the ECB under active QT, how would this affect their financial positions and regulatory metrics?
Overall, we see the direct impact on banks' balance sheets as limited, both in terms of capital and liquidity, as banks would swap reserves for bonds with high regulatory value and limited credit and liquidity risk. That said, banks would increase their exposure to interest rate risks. The impact on profits would also be more uncertain and largely depend on the ECB's decisions on the remuneration of reserves, which it could take to incentivize banks to hold more bonds and smooth the QT process.
The incremental increase in credit risk would have a limited bearing on banks' capital adequacy ratios. We use our risk-adjusted capital (RAC) ratio to assess the effect on banks' solvency of them swapping cash reserves for the bonds that the ECB held under its APP. Contrary to the regulatory capital ratios, our RAC ratio captures the credit risk associated with holding government bonds, which constitute the bulk of the ECB's holdings. Risk weights under our RAC model are higher for exposures to lower-rated sovereigns.
For the purposes of our analysis, we assess the QT impact as if banks were acquiring ECB holdings indiscriminately, although it is fair to assume that banks would prefer sovereign bonds to corporate ones, leading to an even more contained impact on their solvency and liquidity ratios.
We analyzed the potential impact on eurozone banks' weighted average RAC ratios representing about 75% of their assets. We assessed how the RAC ratio would evolve, all else being equal, depending on the amounts of bonds that the ECB will eventually decide to sell and the share of these bonds that eurozone banks will purchase.
We found that the impact on the RAC ratio would range from 25 bps to less than 1 bps. We are therefore confident that banks have room to absorb holdings from the ECB from a credit risk perspective. The average impact lies between 1 bps and 5 bps in our base-case scenario, where we assume that the ECB would sell off €1.0 trillion-€1.5 trillion of APP bonds, and that the take-up rate among eurozone banks would range from 20% to 40%, in line with counterparties' distributions at the time of the ECB's asset purchases.
We believe that this robust performance partly reflects the fact that the ECB's holdings meet its high standards for eligible collateral and therefore constitute highly rated assets.
|Impact of APP bond sales on eurozone banks' RAC ratios--sensitivity analysis|
|Amounts of bonds sold by the European Central Bank (bil. €)|
|Share of bonds acquired by eurozone banks||--||500||1,000||1,500||2,000||2,500||3,000||3,345|
|RAC as of December-end 2022. RAC--Risk-adjusted capital. Source: S&P Global.|
That said, the assets' distribution could differentiate the impact between banks. Banks tend to acquire more government and corporate bonds from their respective countries of domicile. Typically, Italian, Spanish, or Portuguese banks end up with a higher share of risk-weighted assets than their Dutch or German counterparts due to their lower sovereign credit ratings. Nevertheless, based on our previous calculations, the impact would remain manageable for the banks we rate.
Increased exposure to interest rate risk would require cautious management. Aside from credit risk, banks would also take on incremental interest rate risk by swapping reserves for bonds. Under the prudential framework, interest rate risk generates capital requirements under Pillar 1 for bonds held in the trading book, and under Pillar 2 for bonds held in the banking book. An increase in regulatory market risk-weighted assets would negatively affect RAC ratios, all else being equal--we have not included this impact in our RAC sensitivity analysis as these effects are difficult to simulate.
More broadly, banks would need to manage this incremental interest rate risk to avoid building up large unrealized losses if interest rates continue to rise. Over time, banks' appetite for interest rate risk and the quality of their interest risk management could be a key source of differentiation in their broader risk profile (see "European Banks: Potential Interest Rate Volatility Calls For Caution," published July 19, 2023). Hedging interest rate risk also comes at a cost.
The impact on the funding and liquidity regulatory ratios would also be limited, as most of the bonds that the ECB holds are level 1 high-quality liquid assets (HQLAs). Looking at the composition of the APP, we estimate that 81% of bonds would qualify as level 1 HQLAs, therefore receiving similar regulatory treatment to reserves held at the central bank. Only around 4% would be classified as level 3 assets, therefore providing no liquidity or funding benefits for regulatory ratios.
|Estimate of the HQLA treatment of bonds held under the APP|
|Estimated HQLA treatment||Level 1||Level 2A||Level 2B||Level 3|
|Data as of Sept. 1, 2023. We assume that PSPP holdings are made up of EU member state government bonds. We derive the HQLA treatment of ABSPP and CSPP holdings from the ratings distribution, features the ECB has disclosed, and S&P Global assumptions. Having insufficient disclosures on the CBPP3 holdings, we classify them conservatively as level 2B assets. ABSPP--Asset-backed securities purchase program. CSPP--Corporate sector purchase program. CBPP3--Third covered bond purchase program. PSPP--Public sector purchase program. Sources: ECB and S&P Global assumptions.|
As a result, we estimate that the impact on the liquidity coverage ratio (LCR) would be limited, all else being equal. While banks would see their reserve balances drop, they would receive bonds mostly of similar liquidity value in exchange. Depending on bonds' HQLA assessment and the associated haircuts, the impact on the numerator of the LCR ratio could vary. Based on our assumptions, the impact on the LCR is likely to be negative but modest, considering the high share of level 1 assets (see table 3).
|Impact of APP bond sales on eurozone banks' liquidity coverage ratios|
|Amounts of bonds sold by the ECB (bil. €)|
|Share of bonds acquired by eurozone banks||0||500||1,000||1,500||2,000||2,500||3,000||3,345|
|Data as of first-quarter 2023. Note: The starting point is the aggregated liquidity coverage ratio for significant eurozone banks as the ECB reported in its Supervisory Banking Statistics. Source: ECB.|
Similarly, for the net stable funding ratio, level 1 bonds do not require any additional stable funding, while level 2A bonds would typically increase the required amount of stable funding by 15%, level 2B bonds by 50%, and level 3 bonds by 85%, based on the applicable regulation. This would lead to a decrease in the net stable funding ratio, all else being equal. Here again, the impact would be largely contained (see table 4).
|Impact of APP bond sales on eurozone banks' net stable funding ratios|
|Amounts of bonds sold by the ECB (bil. €)|
|Share of bonds acquired by eurozone banks||0||500||1,000||1,500||2,000||2,500||3,000||3,345|
|Data as of first-quarter 2023. Note: The starting point is the aggregate net stable funding ratio for significant eurozone banks as the ECB reported in its Supervisory Banking Statistics. Source: ECB.|
The impact on profitability is more uncertain and will ultimately depend on the remuneration rate on excess reserves. The impact on profits will eventually depend on the spread between the rate at which the ECB remunerates reserves--0% for required reserves and the DFR for excess reserves--and the yield on the bonds that the ECB sells. As of today, this spread is negative for most bonds and most maturities (see chart 5). Under these terms, banks are therefore unlikely to purchase the ECB's bonds in large amounts due to the penalizing effect on profits.
To incentivize them, the ECB could consider lowering the remuneration on the reserves its offers to banks. We estimate that the ECB's recent decision to lower the remuneration of required reserves to 0% will lead to an interest income loss of roughly €6 billion per year for eurozone banks. This represents around 2% of significant eurozone banks' 2022 net interest income.
Going further, a lowering of the DFR--which banks receive on their €3.7 trillion stock of excess reserves--could have a much larger impact. A decrease in this DFR of 100 bps would lead to a further loss of €37 billion of interest income per year, all else being equal, equivalent to about 13% of 2022 net interest income.
With such a lowering of the remuneration of reserves, the ECB would give banks a greater incentive to diversify their liquidity portfolio away from ECB reserves, for instance by purchasing government bonds sold under QT. Banks would therefore mitigate the dent in profits mentioned above.
If nonbanks refinanced maturing bonds, what effect would this have on eurozone banks?
In this situation, banks would not directly assume the incremental credit or market risk as they would not purchase bonds from the ECB. Therefore, there would be no impact on their capital adequacy ratios.
The main impact would be via the reduction in deposits held by NBFIs, the purchasers of ECB bonds. As nonbanks draw down their deposits at commercial banks and use the money to acquire the ECB's bonds, the banking system faces a potential reduction in deposits.
For example, if we assume that nonbanks in the eurozone acquire 40% of the ECB's €1.5 trillion of bonds for sale, the banking system could see outflows of around €600 billion, corresponding to about 3% of total eurozone deposits at end-2022. All else being equal, this would lead the loan-to-deposit ratio to increase by about 280 bps to 92.5%.
|Impact of APP bond sales on eurozone banks' loan-to-deposit ratios|
|Amounts of bonds sold by the European Central Bank (bil. €)|
|Share of bonds acquired by nonbank financial institutions and financed by deposits withdrawn from eurozone banks||0||500||1,000||1,500||2,000||2,500||3,000||3,345|
|Data as of end-December 2022. Note: The starting point is the aggregated loan-to-deposit ratio for all eurozone banks as the ECB reported. Source: European Central Bank.|
Such moderate deposit erosion at the system level could push deposit and overall funding costs higher. This, coupled with the ongoing repricing of banks' liabilities, would pressurize banks' net interest margins in the medium term. In this way, QT would accelerate the normalization of banks' net interest margins already under way.
The effect of such deposit outflows on the LCR and the NSFR is more uncertain and will depend on the nature of the deposits that are withdrawn. In the simplest case, where a nonbank withdraws from a sight deposit, the bank would see a matching decrease in the numerator and denominator of its LCR, meaning an increase in the ratio.
The same case would have a neutral bearing on the NSFR as banks do not count sight deposits as stable sources of funding. In the longer run, there could be negative repercussions for the LCR and NSFR if the nonbanks decide to rebalance their deposit mixes, especially by reducing their long-term deposits to mitigate the outflows of short-term ones.
What are the potential secondary effects and risks of monetary policy normalization for financial institutions in the eurozone?
The normalization of the ECB's monetary policies, including QT and the accelerated repayment of TLTRO financing, is a paradigm shift for eurozone banks. We consider that eurozone banks are well placed to manage this transition, with elevated liquidity and capital buffers, and high earnings providing loss-absorption capacity. That said, we remain mindful that the full effects of monetary policy normalization will only become apparent over time. We see four main channels of transmission through which monetary policy normalization could have profound implications for banks' business models and financial profiles.
Intensified competition for a shrinking pool of deposits could weigh on funding costs. As said, we expect eurozone banks to see some deposit outflows in the event that QT accelerates, and due to the overall slowdown in economic and lending growth. This would undoubtedly lead to more intense competition for deposits. As of the end of June 2023, we estimate the deposit beta--that is, the share of ECB policy rates that eurozone banks have passed through to the rates on new deposits--at only 21% for eurozone banks, with significant differences across jurisdictions (see chart 6).
We expect this deposit beta to gradually increase due to the increased competition for deposits, but also the pressure from clients, regulators, and the broader political authorities. As such, banks' ability to raise low-cost funding via deposits or in the markets will again become a key competitive advantage. In other words, the strength of banks' funding franchises, including their deposit franchises, will be a key determinant of their financial performance (see "The New Normal For Eurozone Banks: Strong Funding Franchises Are Back In Vogue," published July 7, 2022).
In a more adverse scenario, deposit outflows could also test the resilience of a bank's funding profile and create liquidity pressures for weaker banks. However, eurozone banks appear well-placed to manage this risk, and the ECB has tools to provide liquidity directly to the banking sector and meet banks' demands for reserves as QT proceeds. The main safety mechanism in this regard is the full allotment procedure under the ECB's bank refinancing operations. We believe that the ECB is unlikely to modify this part of its operational framework over the course of the QT program.
A rise in long-term yields or spreads could lead to fair value losses on banks' debt securities portfolios. This could drag on banks' earnings and regulatory capital, as they hold the majority of debt securities either for trading or at fair value through other comprehensive income (see "Will Unrealized Losses On Financial Assets Affect Ratings On European Banks?," published Jan. 19, 2023). Unrealized losses on portfolios at amortized cost do not impinge on accounting or regulatory accounts, but can nonetheless lead to a loss of market confidence when coupled with a liquidity crisis. So far, unrealized losses have remained contained, representing €73 billion or 5% of common equity tier 1 capital for significant eurozone banks as of end-February 2023 (net of hedging). With an acceleration of active QT, we could see more volatility in interest rates and spreads, which will test eurozone banks' interest rate risk-management practices (see "SLIDES: European Banks: Potential Interest Rate Volatility Calls For Caution," published July 19, 2023).
In many ways, the possible trends we describe here are similar to those at play in the U.S. banking system, where the Federal Reserve started its latest phase of QT in April 2022 (see "U.S. Banks Webinar 2Q 2023: An Uphill Climb As Funding Costs Rise," published Aug. 23, 2023). For U.S. banks, QT has led to meaningful deposit outflows. Deposits held by Federal Deposit Insurance Corp.-insured banks fell 6% between the first quarter of 2022 and the second quarter of this year, and weighed heavily on banks' funding, liquidity, and spread income.
Higher real interest rates could further dampen lending growth and raise credit and counterparty risks for banks. QT's actual impact on yields remains particularly hard to predict. Should real interest rates rise further as a result of QT, borrowers would face tighter lending conditions. Positive real interest rates are typically associated with lower investment, lower GDP growth, and can ultimately cloud prospects for banks' asset quality (see "European Banks' Asset Quality: Tougher Times Ahead Require Extra Caution," published April 20, 2023).
For banks, we see three pockets of risk. First, cost-of-living pressures mean that weaker households could face difficulties in repaying unsecured consumer loans. Second, declining customer demand could hit small-to-midsize enterprises with weak balance sheets or poor pricing power--we see smaller, owner-managed enterprises as particularly vulnerable. Third, commercial real estate loan books are typically more sensitive to tightening funding conditions, as they both heighten refinancing risks and lower the value of the underlying properties.
Besides this, higher rates could also affect some NBFIs with less capacity to manage higher-for-longer real interest rates and high refinancing needs. We have in mind highly leveraged real estate investment funds; broader investment funds running structural liquidity mismatches, such as open-ended investment funds; or finance companies relying on the public markets to refinance themselves.
Finally, the QT program could also cause bouts of market volatility as the bond markets try to anticipate the ECB's next move. Such episodes of market volatility typically expose financial and nonfinancial actors transacting in derivatives. These derivatives are often helpful for risk-management purposes but can face massive margin calls. Unlike banks, the ECB has fewer options to support nonbanks directly, and would likely need to halt its QT program in a case of systemic stress.
Over time, QT could revive the sovereign-bank nexus in the eurozone. With active QT, eurozone banks could gradually increase their exposure to eurozone government bonds, most likely with a strong and persistent domestic bias. As of July 2023, exposures to the domestic sovereign represented about 5% of eurozone banks' total assets, ranging from 18% in Croatia (highest) to 0.2% in Luxembourg (lowest). Although such exposures declined during QE, as the ECB was buying large amounts of government bonds, we expect this trend to gradually reverse as a result of QT.
The so-called sovereign-bank nexus, that is, the interdependencies between banks and their domestic sovereign, was a major catalyst of eurozone banking and sovereign crises in the last decade. Banks' management of this risk, its treatment in EU bank regulation, as well as market participants' perception of it, could therefore return to the top of the agenda over time.
Today, all EU banking rules assign government bonds very high regulatory value irrespective of the sovereign credit rating. This means no risk-weighting for capital purposes, full liquidity value, and no single-obligor limits. The question of the regulatory treatment of such bonds regularly resurfaces in political debate, most recently, at a June 2022 Eurogroup meeting dedicated to the completion of the Banking Union. However, it is quickly abandoned due to some EU member states' strong opposition to change. The Basel Committee on Banking Supervision (BCBS) published a discussion paper on the regulatory treatment of sovereign exposures in December 2017 (see "Basel Paper On Banks' Sovereign Exposures: Not Enough To Undo The Doom Loop," published March 8, 2018), but we have not perceived regulators in Europe expressing an interest in the BCBS' proposals.
- U.S. Banks Webinar 2Q 2023: An Uphill Climb As Funding Costs Rise, Aug. 23, 2023
- Complete Fed Balance Sheet Normalization Is Still Years Away, Aug. 16, 2023
- European Banks: Potential Interest Rate Volatility Calls For Caution, July 19, 2023
- European Banks: Protecting Liquidity Will Come At An Increasing Cost, June 29, 2023
- European Banks' Asset Quality: Tougher Times Ahead Require Extra Caution, April 20, 2023
- Will Unrealized Losses On Financial Assets Affect Ratings On European Banks?, Jan. 19, 2023
- The New Normal For Eurozone Banks: Strong Funding Franchises Are Back In Vogue, July 7, 2022
- Basel Paper On Banks' Sovereign Exposures: Not Enough To Undo The Doom Loop, March 8, 2018
This report does not constitute a rating action.
|Primary Credit Analyst:||Nicolas Charnay, Frankfurt +49 69 3399 9218;|
|Secondary Contacts:||Pierre Hollegien, Paris + 33 14 075 2513;|
|Giles Edwards, London + 44 20 7176 7014;|
|Chief Economist, EMEA:||Sylvain Broyer, Frankfurt + 49 693 399 9156;|
|Economist:||Aude Guez, Frankfurt 6933999163;|
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