Eurozone lenders face holes in interest income, reduced liquidity and higher deposit and financing costs as the end of the ultra-cheap money era begins to bite.

Fourth-quarter earnings show the first evidence of the effects of the European Central Bank's decision in October to hasten repayments due under its €2.2 trillion stimulus program, known as the third targeted longer-term refinancing operation, or TLTRO III. Final repayments are due in December 2024, to align with its efforts to tighten monetary policy.

TLTRO III was used to stimulate lending to the real economy in response to the COVID-19 pandemic, and has provided banks with a range of benefits. Many deposited unused TLTRO III funds at the ECB at higher rates than at which they borrowed in what is known as a carry trade, enabling them to earn hundreds of millions of euros per quarter of extra income.

"One of the biggest impacts of the end of TLTRO is that this benefit will disappear," Nicolas Hardy, deputy head of financial institutions at Scope Ratings, said in an interview.

Revenue headwinds

"TLTRO will have a negative impact in the first three quarters and less in the fourth quarter," said Leopoldo Alvear, CFO of Spain's Banco de Sabadell SA, one of the first eurozone banks to report fourth-quarter earnings.

French banks may struggle to make up the difference. Deposit costs at Gallic lenders are rising rapidly due to inflation-linked increases on the rates offered by regulated savings schemes such as the Livret A. Regulatory limits on the pace at which rising interest rates can be passed on to new mortgage loans, known as the usury rate, and the fact that French banks' mortgage portfolios are largely fixed-rate for long terms, puts further pressure on French lenders' NII.

French credit institutions received the largest proportion of ECB funding in the bloc, data from the central bank and credit rating agency DBRS Morningstar shows.

"[The end of TLTRO III] is somewhat of a headwind for French banks," said Arnaud Journois, vice president, financial institutions at DBRS Morningstar. "They won't benefit as much from higher interest rates as banks in other countries."

Most other eurozone banks should be able to more than offset losses with increases to net interest income — the difference between interest income and interest expenses — thanks to rising interest rates.

Many of the bloc's banks will in fourth-quarter results book large one-off losses associated with the changes to the terms of TLTRO III. Dutch lender ING Groep NV took a €315 million hit from the unwinding of derivatives taken out against its projected income on the original terms of the scheme.

"It would have been better if the ECB had said earlier that they would stop these measures," CEO Steven van Rijswijk said on a Nov. 3 earnings call when announcing the charge.

Liquidity impact

Fourth-quarter results should also reveal the first effects on eurozone's banks' liquidity from the changes to TLTRO III. Since October, banks have repaid an additional €800 billion of TLTRO IIII funds, leaving about €1.3 trillion outstanding as of Jan. 8, according to a DBRS Morningstar report.

TLTRO III helped eurozone banks retain historically high levels of liquidity in recent years, easily surpassing the 100% minimum liquidity coverage ratio set by the ECB. The average LCR at the eurozone's largest banks rose to 164% at the end of June 2022, the latest period for which data is available, from 161% at the end of 2021, according to S&P Global Market Intelligence. Cheap ECB funding had helped eurozone banks' average LCR to rise as high as 192% in 2019, the data shows.

The drop in liquidity will be one of the "big watersheds" for the European banking sector in 2023, Marco Troiano, managing director, financial institutions at Scope Ratings said during a Jan. 17 webinar. "Bank liquidity metrics are going to deteriorate from very strong levels, but they're going to deteriorate," Troiano said.

Efforts to replace some of that lost liquidity or even retain post-TLTRO III liquidity levels will force banks to take on other more expensive sources of funding. Senior unsecured funding, senior non-preferred funding and secured funding, or covered bonds, will be the three most popular funding instruments for eurozone banks in 2023, according to a December report by the European Banking Authority.

The pricing of such instruments is expected to be high due to uncertainties about the path of inflation and a subdued economic outlook, the report said. "This may pose some challenges to attain market-based bank funding at reasonable pricing," it added.

Smaller banks, bigger challenges

Covered bond issuance by European banks hit a record high in 2022 as TLTRO III and other sources of government and central bank funding dried up, according to DBRS Morningstar. Overall issuance volumes are expected to stay near record levels in 2023 as banks use covered bonds to finance upcoming TLTRO III redemptions, it said.

Smaller banks are likely to keep hold of their TLTRO III funds as long as possible to delay the need to raise funding at higher interest rates, said DBRS Morningstar.

The expected reduction in liquidity once TLTRO III funds are repaid could also increase competition for deposits as lenders are forced to offer higher rates to savers. This would add to already surging interest expenses, which on aggregate rose by more than a third in the first half of 2022 to €43 billion across the eurozone's largest banks, Market Intelligence data shows.

The scramble for deposits could begin in June following the closure of the largest of the TLTRO III repayment windows, when more than €1.3 trillion of funds are due to be repaid, said Pablo Manzano, vice president, financial institutions at DBRS Morningstar. The timing of upward pressure on deposit costs is "one of the great questions" for eurozone banks in 2023, said Manzano.

"TLTRO III was making banks more relaxed about competing for deposits," Manzano added. "After the removal of this tool, we're going to see more competition."