A recent report by Fitch Ratings has shed light on the risks European banks could face due to higher interest rates during economic stress. The European Banking Authority’s latest stress testing exercise has exposed the challenges banks may encounter with elevated rates affecting their funding positions and core banking operations.
The stress test results clearly illustrate the dangers of further upward interest rate shocks and the potential increase in funding costs. Fitch warns that this will particularly impact banks holding substantial volumes of long-dated unhedged fixed-rate assets on their balance sheets.
The combination of higher funding costs and rising credit losses would create significant pressure on banks’ earnings and leave their capital ratios more vulnerable to depletion. Banks that experience weaker net interest income under the stress tests’ adverse scenario will face greater strain on their capital positions.
According to the adverse scenario, net interest income is projected to fall by 19% due to higher funding costs outpacing higher lending margins. Over a three-year period, aggregate net interest income is expected to be 21% lower compared to the stress tests’ baseline scenario.
Despite the challenges posed by the adverse scenario, the stress tests also showed that higher interest rates had a positive impact on banks’ earnings in 2023, according to the EBA’s baseline scenario. The first-half earnings reports of 2023 indicate that, for many banks, net income has benefited even more from higher rates than the EBA’s tests imply.
Banks with high proportions of variable-rate lending, particularly in Greece, Portugal, and Spain, have reaped the most benefits from the higher interest rates. Net interest income has risen for most banks as pass-through rates on deposits have yet to increase significantly.
As the European banking sector navigates the complexities of a changing interest rate environment, it will need to carefully manage funding costs and credit risks to maintain financial stability. The stress test results serve as a timely reminder for banks to assess their exposure to interest rate fluctuations and implement appropriate risk management strategies to safeguard their capital and earnings.
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