The salvation for depressed European bank earnings is supposed to be rising interest rates. But, writes Brian Caplen, against a backdrop of worsening credit and tougher regulation this may not play out as well as expected.

Investors are generally bullish on European banks expecting that economic recovery and rising interest rates will boost profits. But the counter-argument is that balance sheets are still stretched, credit conditions are getting worse not better, regulation is tougher, and anyway rising interest rates are of limited use in increasing net interest margins.

In fact, falling interest rates usually work better in terms of increasing margins because liabilities reprice faster so the difference between what the bank pays for short-term deposits and what it receives for longer term assets grows. Rising interest rates could have the opposite effect in that banks start paying more for deposits before they can reprice assets. (Of course, non-interest-paying current accounts do benefit from rising interest rates as they just stay the same while assets reprice.)

On top of this many banks these days do not take much in the way of interest rate risk and match-fund their loans and deposits. The direction of travel of the regulation is designed to further curb what have been good earning opportunities in the past.

Regulators are seeking to decrease leverage, loan-to-deposit rates have come down and on the horizon is the Net Stable Funding Ratio.

Banking analyst at the private bank Berenberg, James Chappell, says in a report called ‘But I’m holding on’: “We struggle to see banks delivering on over-hyped earnings expectations... we expect a traditional credit cycle as rates get raised too far. We expect an economy that looks to be late-cycle with credit growth ahead of underlying earnings, but unlike recent cycles it has too much debt so is more sensitive to rates. We do not expect a repeat of 2008-09 in terms of credit costs, but do think loss-given defaults could be higher due to the debt burden that we carry.”

This is the big problem for many European banks. They have not resolved all the bad loan problems from the last crisis and with interest rates low for so long many borrowers are overextended. Even moderate interest rises may lead to deteriorating credit taking a toll on earnings more significant than the longer term benefits of a positive yield curve. 

See The Banker's interview with James Chappell here.

Brian Caplen is the editor of The BankerFollow him on Twitter @BrianCaplen

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