Eurozone banks continue to report solid full-year results for 2021 after a tumultuous 2020. Following the steepening in the yield curve late last year, investors have focused attentively on what upside this might provide to banks' earnings prospects in 2022 and 2023. Furthermore, there is now widespread market expectations that the European Central Bank will bring forward its first rise in policy rates to this year.

S&P Global Ratings estimates that eurozone banks would on aggregate benefit from a potential rise in interest rates. Our economists acknowledge the ECB could start preparing markets for monetary policy normalization as soon as March 2022 depending on the set of new macroeconomic forecasts it sees before its next policy-setting meeting (see "The ECB Opens The Door To A Rate Liftoff," published on Feb. 8, 2022). At the earliest, the ECB would very likely raise policy rates only after it phases out net asset purchases, meaning not before December 2022. What's more, they expect a normalization in policy rates to be gradual.

A rise in policy rates would increase market rates and have a positive impact for eurozone banks, as the direct boost to net interest income (NII) would likely surpass any negative impact from potential second-round effects on economic growth, asset prices, and volatility. In their recent fourth-quarter 2021 earnings presentations, a few eurozone banks made positive announcements about the impact of rising rates on their revenues, though their disclosures so far raise several analytical questions (see box 1). Modeling the potential impact of a 100 basis points (bps) increase in policy rates for eurozone banks, we find that the annual increase in NII could range between 7%-10%, depending on the assumed shape of the yield curve.

Nevertheless, we believe that a gradual liftoff in interest rates would not be a cure-all for the profitability of many eurozone banks, which will need to continue transforming their businesses and improving efficiency. The impact from a potential rise in interest rates would greatly vary, depending on a bank's business model. Benefiting most would be retail banks, for which NII represents a large share of total income and where banks were unable to fully pass on negative policy rates to depositors--namely retail depositors.

Our earnings forecasts for rated banks include the recent increase in market rates (see chart 1). If our economists were to forecast an earlier revisions to the ECB's policy rate, we would further revise our bank earnings forecasts to reflect the impact on market rates. These revisions would not be model-based but rather incorporate our analytical judgment about each bank's sensitivity to the interest rate environment, as well as our expectations about what management teams would do with increased core profitability--invest in growth or rather distribute to shareholders.

Chart 1

Table 1

An interest rate increase of 100 bps could lead to a 7%-10% aggregate rise in NII for eurozone banks

We modeled the impact of two potential scenarios of increases in interest rates on aggregate NII over two years for all eurozone banks, with a balance sheet starting point as of third-quarter 2021. We focused on interest-earning assets and interest-bearing liabilities, and we made assumptions about their repricing time based on typical trends observed in the region--although banking models vary greatly across eurozone countries. For TLTRO (targeted longer-term refinancing operations) funding, we assumed the end of the 50 bps cost advantage in the first year (currently planned by the ECB to happen in June 2022) and a further 50 bps increase in the second year. We also assumed growth in interest-earnings assets (except cash and central bank balances) of 5% each year, and growth in interest-bearing liabilities of 2% each year (except in TLTRO funding) to reflect very high deposit levels at the starting point (Sept. 30, 2021).

We envisage scenarios with different shocks on both short- and long-term rates (see table 2). For each in-scope asset or liability, we assumed it would be priced either on the short- or the long-term rate.

Table 2

The modeled outcomes show that, in the first year, eurozone banks would post a NII gain of €18 billion, equivalent to 6.9% of their last four quarters of NII, under a scenario of a 100 bps parallel shift in market rates. The impact would be more pronounced in case of a steepening of the yield curve (Scenario 2), with a 10.1% rise in NII. This is because loans to corporates and households, which represent 56% of total interest-earnings assets considered in our analysis, are typically priced on long-term rates and therefore would benefit from the extra yield curve under a steepening scenario, while the assumption is that deposits are to be priced based on short-term rates. Beyond this modeled outcome, several banks have put in place interest rate hedging policies, which could provide a further contribution to profits as structural hedges roll over to higher rates than maturing positions.

In the second year, a continuation of the pace of interest rate increases would lead to broadly similar results, under Scenario 1, while an acceleration of the increase under Scenario 2 would lead to a more significant 20.6% increase in NII in year 2 compared with year 1. However, such a rapid and accelerating pace of rate increases would likely have second-round effects such as lower economic growth, asset prices, and increased volatility. The positive impact on NII would, therefore, be balanced by a relatively more negative impact further down in the income statement.

The overall effect of a hypothetical rate rise on Eurozone banks' profitability would be broadly similar to that expected on U.S. banks (see "When Rates Rise: Tighter Monetary Policy Will Provide A Lift To U.S. Banks," published on Feb. 10, 2022). However, the pace of tightening is expected to be more aggressive in the U.S. than in the Eurozone, and therefore the impact on U.S. banks' profitability more pronounced.

The overall impact on bottom-line profitability would be positive but differ across business models

A rise in market rates would impact various dimensions beyond the direct effect on NII. That's because interest rates usually rise in an environment of elevated inflation (at least at the beginning of the tightening cycle), and because rate hikes tend to negatively affect the economic outlook (via the demand channel) and market prices (as cost of capital increases). However, the magnitude of these effects will depend on the pace of tightening and the broader capacity of central bankers to smoothly deliver policy rate increases. In addition, rates are an important but not all-encompassing variable determining economic and market prices; several other factors are at play.

In their most recent forecast in December 2021, our economists expect eurozone GDP growth at 4.4% in 2022 and 2.4% in 2023, with inflation declining sharply over a two-year period. Under these benign operating conditions, banks would be well positioned to reap the benefits of a rate increase, if it were to happen, as they would be able to continue controlling costs and higher rates would not result in higher credit losses.

However, a gradual rise in rates would not be a profitability cure-all for eurozone banks and the eventual impact on specific banks would depend on their business model (see table 3). We believe that retail banks would benefit most from rising rates (especially under a scenario of yield curve steepening), as their long-term loans, representing most assets and revenues, would gradually reprice while the drag from floored deposits would be eliminated as short-term rates turn positive. Also, we expect a slow repricing of retail mortgages (except in countries with floating-rate mortgages such as Spain), and mortgage affordability is typically subject to some stress testing when underwritten, so that the impact of a rates increase on credit quality should stay limited.

Universal banks would once again benefit from their diversification effect, but with a net positive outcome. Their retail activities would benefit as described above, but their capital market fees may be less buoyant than in previous years in case of lower market prices, while operating costs in investment banking tend to be sensitive to inflation. Also, universal banks typically hold large government securities portfolio, which would negatively reprice in case of rising interest rates. However, the fair value impact would mainly flow directly to equity (not to the income statement) and continue to benefit from a temporary filter on the regulatory capital until end-2022.

Finally, monoline consumer credit banks would see some benefits on interest income, as their loans typically reprice quickly, but their cost of funding is typically more sensitive to market rates, therefore leaving a somewhat positive impact on overall profitability. This sector is also typically the first hit by credit losses. That's because retail borrowers tend to stop payments first their unsecured consumer credits, when under stress--as could be the case if cost inflation runs faster than wage inflation for a period of time.

Table 3

Rating changes would be very limited

Our economists' macroeconomic expectations are a key input to the base case that underpins our forecasts for bank profitability. Therefore, if those expectations change to reflect an accelerated cycle of rate rises, this would lead us to reconsider our expectations for bank profitability. But even for banks where we might make a meaningful upward revision to forecast profitability over the next two years, there are several reasons why rating actions would be very limited:

• The benefit to net income from rising NII could be at least partly diluted by higher operating expenses, in case of elevated cost inflation, as well as incrementally higher cost of risk and taxes.
• Although gradually rising rates will help, banks will need to continue transforming their business models and improving efficiency to enhance structural core profitability.
• Our methodology focuses primarily on structural and risk-adjusted rather than cyclical profitability as a feature of creditworthiness (see Box 1: The Role Of Profitability In Bank Credit Ratings, from "As Near-Term Risks Ease, The Relentless Profitability Battle Lingers For European Banks," published on June 24, 2021).
• We remain mindful of comparability with peers in other regions, and for most eurozone majors there is little reason to envisage that they deliver more of a structural improvement in balance sheet strength or business strength and profitability.
• Most eurozone banks are currently capitalized comfortably in line with or above their medium targets, so we expect that rising profitability would rather lead to higher shareholder distributions or growth in investments than increased capital strength.

Related Research

• When Rates Rise: Tighter Monetary Policy Will Provide A Lift To U.S. Banks, Feb. 10, 2022
• The ECB Opens The Door To A Rate Liftoff, Feb. 8, 2022
• The Top Trends Shaping European Bank Ratings In 2022, Jan. 31, 2022
• As Near-Term Risks Ease, The Relentless Profitability Battle Lingers For European Banks, June 24, 2021
• When The Cycle Turns: Rising Interest Rates Will Lift, Not Propel, Western European Banks’ Profitability, Jan. 14, 2019