Rising interest rates will boost banks’ profits but challenges lie ahead

The banking sector stands to benefit from the rise in interest rates, but there is a delicate balance to be struck in managing the default and other risks associated with the high rate of inflation, which has driven those increases.

According to the IMF, global inflation is likely to remain high for some years. Global headline consumer price index (CPI) inflation for 2022 is forecast to be 8.8 per cent. Ireland’s rate was slightly below this average figure at 8.2 per cent in September. The UK and the EU were even higher at 10.1 per cent and 10.9 per cent, respectively.

“A natural reaction on the part of Central Banks has been to increase interest rates in an effort to temper rising inflation,” says Mazars Financial Services Audit leader Michael Tuohy. “The euro zone still has relatively low interest rates, but the expectation in the markets is that they could reach at least 2.25 to 2.5 per cent by December 2023.”

Historically, rising interest rates have tended to indicate a period of economic growth, he explains. “And economic growth often leads to higher lending volumes, in turn growing a bank’s lending book thereby increasing earnings. This can happen without any widening of the spreads between the interest rate that banks pay on deposits and lend money at. If banks widen these spreads, it can increase profitability.”

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However, on this occasion, interest rate increases are the result of inflationary pressure rather than economic growth. That places a question mark on the impact on banks’ profitability.

“Most banks in Europe are well-capitalised at present,” points out Mazars Credit expert Michal Cotelnic. “The average Common Equity Tier 1 ratio – the ratio of a bank’s capital to its assets – of institutions directly supervised by the ECB stands at 15.5 per cent, up from 14.9 per cent in December 2019. This contributed to banks handling the shock in 2020 much better than they did the Great Financial Crisis, according to the ECB.”

With these extensive cash buffers in place, banks do not have to increase rates offered for deposits, but they can raise rates charged for loans. “Those cash buffers have not earned real returns for some time due to the low interest rate environment, but they can now be invested in short-term securities to take advantage of rising interest rates,” says Cotelnic.

“During a period of rising interest rates, the spread between long-term and short-term rates widens, boosting banks’ profits as they borrow predominantly on a short-term basis and lend on a long-term basis,” he adds. “Rising interest rates generally support banks’ credit profiles as they can easily increase rates on existing products. This is in contrast to deposit rates that have no requirement to be raised due to over-liquidity in the market.”

As Tuohy notes this would mean that AIB and BoI could increase their net interest income by €369 million and €435 million, respectively, if there was a 1 percentage point rise in both short- and long-term rates simultaneously. This is based on the two banks’ 2022 half-yearly disclosures.

“On the other hand, high and rapidly increasing interest rates may depress demand for new loans or the refinancing of existing loans due to decreasing creditworthiness of customers, inflationary pressures on households, and negative sentiment in relation to the high cost of credit,” he adds.

“In addition, inflationary pressure may cause a significant increase in loan default rates. While no significant increase has been observed as yet, that may well transpire if high rates of inflation persist. And inflation in Europe could remain at high levels for some time to come if the fight against it proves to be too costly.”

One of the few solutions for customers experiencing difficulty will be to refinance or renegotiate loan terms. This can include forbearance, payment moratoriums or term extensions.

“It is worth noting that some customers are already protecting themselves from interest rate hikes by switching from variable to fixed rates,” says Tuohy. “This should protect both customers and banks as the risk of borrowers defaulting on fixed-rate mortgages will presumably be lower than those on variable-rate products. After all, their monthly repayments will be largely independent of the effects of the monetary policy tightening for a certain period at least.

“For the banks, however, fixed rates can mean lower profitability, and this trend could therefore produce unforeseen consequences for the sector.”

Continuing interest rate increases may also tempt customers with savings to repay debt early to avoid higher repayments. “This makes interest rate risk management difficult for banks,” says Cotelnic.

The other threat to the banks’ profits is a potential decrease in bond valuations due to the inverse relationship between interest rates and bond prices.

“The last decade of historic low-interest rates has contributed to higher leverage and increased asset prices across Europe,” Tuohy explains. “Rising interest rates may cause a depreciation in bond values, losses in the securities portfolios of the banks and a decrease in collateral value, mainly in mortgage portfolios. This could ultimately outweigh the uplift in revenues delivered by increased interest rates, particularly when some economies are approaching recession.”

Along with increasing default rates leading to higher provisions and capital requirements, this may lead to a deterioration in capital adequacy ratios, thereby constraining the lending capacity of the banks, he adds.

Another factor that will impact banks’ profitability in the coming years is higher operating costs due to increasing salaries, real estate rental prices, materials costs and the cost of outsourced services.

In these circumstances, while the banks may be able to look forward to a boost in profits as a result of rising interest rates, the other risks generated by the current inflationary environment have the capacity to erode these additional earnings.

“Banks must therefore redouble their efforts to manage these risks in the period ahead,” Tuohy advises.