Most European banks reported increasing net interest income (NII) in the first quarter of 2022, spurred by the gradual rise in short- and long-term interest rates. In response to rising inflation, several central banks in the region have raised policy rates and the European Central Bank (ECB) has indicated that it will follow suit in July 2022. S&P Global Ratings' economists expect that this could be around 25 basis points (bps) in quarterly increments, with the aim of reaching a neutral target rate for repurchase agreements (repos) of around 1.5% by the end of 2023--this would represent a 150 bp increase from current levels for repos and 200 bps for the deposit rate. The Bank of England has raised its policy rate four times since December 2021--from 0.1% to 1% by the end of May--and our economists expect this to reach 1.75% in the course of 2024. In Switzerland, the rise in interest rates will likely start well after the ECB lift-off, according to our economists, and plateau below 1% in 2025.

S&P Global Ratings recently surveyed the disclosures of 85 large European banks, representing a combined €31 trillion of assets (see Annex for more information on the data set). Under applicable regulations, European banks have estimated the impact of rising interest rates on their NII and the economic value of their equity (EVE) (see Box 1). Our analysis found that rising interest rates would lift NII for 80% of banks in the sample, with an average increase of 12.1% from 2021, assuming a parallel interest rate shock of +200 bps. Excluding Swiss banks, where local regulations require highly conservative assumptions in how they model the effect of interest rate shocks, and weighting for the relative assets of surveyed banks, the average impact on NII is 16.8% (14.3% for the eurozone). These findings are in line with our modelled estimates and confirm our view that rising interest rates would provide a meaningful lift--though not a cure-all--to European banks' profitability (see When Rates Rise: Eurozone Bank Earnings Will Too--Especially For Retail).

Interestingly, our survey revealed certain outliers in bank disclosures, with differences in rate sensitivity across European banking systems. Of the 10 countries for which our sample contains more than three banks, U.K. and Italian banking systems stand to benefit the most, with a weighted-average NII impact above 25% (under a parallel shock scenario of +200 bps). For Spanish, German, Danish, and Austrian systems, the impact stands between 10%-16%, while in France and the Netherlands it would be less than 10%. Our survey also showed that higher interest rates would lead to a decline in the EVE for most banks (76%).

While our findings provide insight into the impact of rising rates on European banks, they don't tell the whole story. As previously stated, higher inflation--a key driver of rising interest rates--increases wage pressure and therefore operational costs for banks--a trend already apparent in the U.S. and the U.K. (see The Russia-Ukraine Conflict: European Banks Can Manage The Economic Spillovers, For Now). Over the medium term, rising interest rates may also lead to tighter real financing conditions in the economy, stretching the debt-servicing capacity of weaker borrowers. We expect the net impact on NII to remain positive for European banks overall, despite higher operational and credit costs somewhat offsetting this. As a result, we could revise upward our forecasts for some banks' profitability, though not necessarily take rating actions--this would require a more structural improvement in profitability.

For Most Banks, Higher Interest Rates Would Lift NII, But Hit Economic Value

Many European banks report that higher interest rates would have a positive effect on their NII (80% in the survey). Swiss banks are negative outliers: 11 of 13 Swiss banks in our sample reported a negative impact on NII. These banks represent the bulk of the 17 banks that reported a negative impact on NII. As noted above, we believe that this is mainly due to the exclusion of cash held at the central bank from the estimates, meaning that they are assumed not to benefit from additional interest income on these central bank positions.

Similarly, many banks report that higher interest rates would be detrimental to their EVE (76% in the survey). The positive outliers (24% of banks) are spread across 12 countries and include, for instance, four large Spanish banks (Santander, Bankinter, Kutxabank, Caixabank), as well as Nordea and National Bank of Greece.

Chart 1

These results are in line with our expectations overall:

Broadly positive impact on NII.   This metric reflects the impact of rising interest rates in the short-to-medium term--in regulatory disclosures, the impact is measured on the first year of NII. The impact on NII is influenced by the share of short duration assets that the bank holds (for example, floating-rate loans) relative to the typically longer behavioral duration of liabilities (for example, demand deposits). The latter is subject to modelling assumptions, but past observations show that banks' assets tend to reprice faster than liabilities (see chart 2). All else being equal, higher NII implies stronger profitability for European banks.

Chart 2

Broadly negative impact on EVE.   This metric reflects the impact of interest rate shifts on the overall economic value of the balance sheet of the bank--that is, the impact over the entire life of the assets and liabilities whose value is discounted. Since banks typically hold more interest-earning assets than liabilities, an increase in interest rates--which depreciates the economic (net present) value of assets and appreciates the economic (net present) value of liabilities--would typically have a negative impact on EVE--which is the difference between the two. The relative share of assets with longer duration (for example, mortgage loans) tends to drive fluctuations in EVE. Banks reporting a positive impact on EVE from rising interest rates would typically hold a large proportion of floating rate loans. In itself, a negative impact on EVE from rising rates does not pose a particular concern as banks can take appropriate measures to reduce their interest rate risk exposure. This explains why, under the regulation, a material estimated negative impact (that is, higher than 15% of Tier 1 capital) allows supervisors to intervene, though not as an automatic response.

The Magnitude Of Impact Varies Across Banks

On average, European banks report that a parallel 200 bps interest rate increase would lift their NII by 12.1% compared to 2021. The average impact would be 16.8% when weighting by total assets and excluding Switzerland given the specific regulatory requirements there. For eurozone banks, the impact is 14.3%, which is in line with our top-down modelled estimates and would represent an additional €37.3 billion of NII for the largest eurozone banks--all else being equal, an increase of 26% of profit before tax. These estimates assume static balance sheets and a parallel increase in interest rates--the impact would automatically be larger if we assumed loan growth and/or a steeper yield curve.

Although these banks' estimates are subject to regulatory guidance and supervisory scrutiny, they remain sensitive to key assumptions on the pace of repricing of assets and deposits. In particular, banks model the repricing of non-maturing (demand) deposits based on observed client behaviors, but these observations were largely made in a period of declining interest rates. How customers will react in a higher inflation/higher rate environment might turn out differently. So far, though, the main NIM benefit for large U.K. banks has been the minimal pass-through of rate increases to depositors. Also, technological changes, such as the broader adoption of online banking, have reduced switching costs between banks. We therefore expect higher competition and potentially more rate sensitivity for banks' liabilities than in the past.

Table 1

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As for EVE, the average impact of a parallel 200 bps interest rate increase comes out at -3.4% of Tier 1 capital for European banks, well below the trigger for potential supervisory action specified in the regulation. We found only one bank reporting an EVE/Tier 1 capital impact higher than 15%, and 11 with an impact between 10%-15%. We believe that banks with higher reported impact on EVE have some options to reduce their exposure to IRRBB, for instance by modifying their asset mix or using of hedging techniques.

Table 2

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Some European Banking Systems Are More Rate Sensitive Than Others

Our survey included European banks in 25 countries. Of the 11 countries for which our sample contains more than three banks, U.K. and Italian banks stand to benefit the most, with an average impact on NII (weighted by total assets to get a more representative picture at system level) above 25%, measured against a parallel +200 bps increase in interest rates. This is followed by Spanish, German, Danish, and Austrian banks with an average impact between 10%-16%, while French and Dutch banks report less rate sensitivity with less than a 10% impact on NII. Switzerland and, to a lesser extent, Sweden are negative outliers, with -29% and -5%, respectively.

Only Spanish banks report a positive impact on EVE from rising interest rates, which is largely due to their higher share of floating rate loans.

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High Inflation Clouds The Benefits Of Rising NII

Our findings only provide insight into the impact of rising interest rates on European banks' top-line profitability. This view is therefore partial as a rise in interest rates, which is correlated with higher inflation, would impact other dimensions beyond NII, namely operational and credit costs. In that regard, the current evolution seen in the U.S. and in the U.K. is a reasonable harbinger for what is to come for continental European banks given that these countries are slightly more advanced in the rate tightening cycle. (See U.S. Banks: Net Interest Income Gains Offer Buffer Amid Emerging Risks and U.K. Banks Are Poised For Higher Revenues And Elevated Costs In 2022 on RatingsDirect.)

• First, in a higher-inflation environment, banks will face heightened pressure on wages and other operational expenses. In the U.S., where inflation started to increase before Europe, cost pressure has already started to materialize for banks, with noninterest expenses up 7.2% in first-quarter (Q1) 2022 compared with Q1 2021 for all banks insured by the FDIC (Federal Deposit Insurance Corporation). Given the current tight labor markets, the competition for talent means that banks face higher wage bills, especially for certain skills such as IT.
• Second, over the medium term, tighter financing conditions will stretch the debt-servicing capacity of weaker borrowers--for example, corporates that are unable to pass on higher input costs to customers, or households taking a material hit to their real disposable income. Under this context, we expect an uptick in credit costs. We saw this in the first quarter this year as banks increased their provisions against assets which are still performing but for which they have observed a significant increase in credit risk. However, such provisions remain low by historical standards, and actual delinquencies have not started to rise.
• Finally, and specific to the eurozone, the rise in policy rates will also coincide with the phasing-out of the favorable interest rates on the TLTRO (targeted longer-term refinancing operations) program, which is scheduled for June 2022. The ECB estimates that the resulting hit to eurozone bank profits represents between 59-126 bps of return on equity, meaning between €10 billion-€20 billion of additional interest costs for the largest eurozone banks. Eventually, the impact will largely depend on individual banks meeting the lending thresholds (and therefore on the new TLTRO rate that they will receive) and on the TLTRO early repayment decisions that they may make. We note that, given the rising market funding rates, eurozone banks are not incentivized to repay TLTRO, which is likely to reduce the negative impact on profitability.

We expect rising interest rates to be a net benefit for most European banks under our base case, but the benefit to NII could vary significantly. Weakening asset quality might affect some banks more than others, whether due to economic prospects for their domestic market or the composition of their loan book. Importantly, such cyclical improvements may lead us to revise our forecasts upward, though they are unlikely to warrant positive rating actions in and of themselves, for several reasons:

• Our analysis focuses primarily on structural and risk-adjusted profitability rather than cyclical profitability as a feature of creditworthiness (see Box 1 and As Near-Term Risks Ease, The Relentless Profitability Battle Lingers For European Banks, published on June 24, 2021). European banks will need to continue transforming their business models and improving efficiency to enhance structural core profitability.
• Economic risks are stacked to the downside. Inflation could be more persistent than under our economists' base case, with economic growth lower and unemployment higher (see Credit Conditions Europe Q2 2022: Seismic Shocks, Security & Supply).
• We remain mindful of comparability with leading banks in other regions. Even with higher cyclical profitability, many European banks will barely cover their cost of capital unless they deliver a structural improvement in business strength.

Annex

Our survey is based on information disclosed by banks in their annual reports and Pillar 3 reports. These disclosures provide a detailed overview of the effect of different interest rate shock scenarios on the economic value of equity (EVE) and net interest rate income (NII). For many banks, especially in the EU, this information is largely standardized because it is based on the EBA Disclosure Template EU IRRBB1. Regarding the effect on EVE, it considers six different interest rate scenarios; for NII, it considers two.

However, regulators do not yet fully prescribe the exact scenario to be used for the calculation of the NII effect--the relevant EBA standards are still under consultation. In particular, for NII (EVE) 14 (6) banks have used their own internal scenarios, and we have scaled up the reporting estimate to a normalized +200 bps, thereby assuming linearity of the impact. Finally, another source of discrepancy might come from specific local regulatory requirements, such as those in Switzerland.

For the "Parallel up" scenario, we have collected NII impact estimates for 85 banks and EVE impact estimates for 84. For 80 banks, we have both NII and EVE impact estimates. The country split for each category is shown below (see table 3).

Table 3

Editor: Alexandria Vaughan. Digital Design: Tim Hellyer.