ECB warns of capital risks to badly-prepared banks for rate hikes

The European Central Bank has signalled that about 45 per cent of the euro-area's biggest 111 banks may be forced to hold more capital in reserve to deal with risks as a result of "shock" interest rate increases.

The disclosure was given in a presentation by Korbinian Ibel, the ECB's director-general for macro-prudential supervision, on Monday as he unveiled the results of a stress test of how large banks in the currency region would be able to cope with various hypothetical interest rate changes.

The ECB did not give results for individual banks and a spokesman for the Central Bank of Ireland declined to say how Irish lenders fared in the exercise.

According to the findings, a hypothetical increase in interest rates by 2 percentage points would increase banks’ aggregate net interest income by 4.1 per cent this year and 10.5 per cent in 2019. This could be achieved by banks increasing rates on loans at a faster pace than deposits.

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However, a 2 percentage-points rate hike would also dent banks’ common equity Tier 1 capital ratios, a key measure of lenders’ ability to withstand surprise losses, by 2.7 per cent. This is a result in the value of their bond investments declining as their market yields rise.

Mr Ibel said, however, that banks’ assumptions on how customers handle their deposits are largely based on experience of declining interest rates for almost a decade. Euro area banks have a total of €4.5 trillion deposits where customers can demand their money back immediately.

“These projections are strongly influenced by the assumptions banks make about their customers’ behaviour,” the ECB said. “For example, under a rising rates scenario, the ‘stickiness’ of retail deposits constitutes a critical assumption for the increase in net interest income to take place.”

Customer behaviour

Similarly, banks face problems if they do not have a good handle of how interest rate hikes may change patterns of customers repaying loans early.

Mr Ibel said that if banks are only beginning to realise the risks of rising interest rates to customer behaviour following engagement from the ECB, they face being required to hold additional capital “because the risk management would not be 100 per cent proper”.

The presentation showed that 12 banks are very well prepared, 48 are well prepared. Mr Ibel said that these lenders could see the level of capital they are required to hold on their balance sheets fall as a result.

However, the remaining 51 banks face being forced to hold additional capital “as a starting point”, and the prospect of “more intense supervisory discussions” on interest-rate risks.

Mr Ibel said that ECB and national central bank supervisors could also take other mitigating factors into account when finalising capital ratio numbers for individual banks.