This is a pivotal moment for eurozone banks. On June 9, the ECB's Governing Council confirmed its plan to start normalizing its monetary policies. The first steps have begun and will continue into July: the end of net asset purchases, the first interest rate rise in 11 years, and the first repayments of TLTROs by eurozone banks. Although interest rate increases should generally benefit eurozone banks for now, the ECB's gradual normalization again will again move the funding question to the fore.

S&P Global Ratings estimates that, overall, eurozone banks will be able to repay upcoming TLTRO (targeted longer-term refinancing operations) maturities until end-2024 with existing liquidity buffers and while maintaining adequate regulatory liquidity coverage ratios (LCR). In practice, we do not expect that eurozone banks will meaningfully accelerate TLTRO repayments, and we think they will manage upcoming maturities with a mix of repayment and refinancing, including potentially via the European Central Bank's normal refinancing operations, depending on price conditions.

Looking further ahead, S&P Global Ratings' economists consider that the journey toward normalized ECB monetary policies will be a long one, with much uncertainty about its pace and extent (see "Implications Of The ECB's Policy Normalization For Interest Rates, The Balance Sheet, And Yields," published on June 9, 2022). For banks, the normalization of refinancing operations would mean the end of cheap, long-term, and stigma-free ECB funding.

In particular, the end of TLTROs will likely lead to a tightening in banks' net stable funding ratios (NSFR). Our sensitivity analysis shows that term funding needs could become significant as banks seek to maintain NSFR levels comfortably above the minimum requirement while continuing to finance the economy. This is especially the case in Greece, and to a lesser in Italy. In this context, the ability to raise low-cost term funding will again become a key competitive advantage, enabling banks with a strong funding profile--including low-cost franchise-driven deposits--to continue lending and reap the benefits of higher lending rates.

Finally, the longer-term reduction of its securities portfolio is not without execution risks for the ECB, and with potential downside risks for banks. S&P Global Ratings' economists expect this reduction to take place very gradually and not start before the end of 2024. With a major buyer leaving the market, financial asset values could take a hit, all else being equal. For eurozone banks, this would mean potential mark-to-market losses, with a negative impact on regulatory capital ratios, and a faster-than-expected or excessive repricing of risks by financial markets represent a key downside risk that will continue to hang over certain banking systems.

The monetary policy normalization process will have limited implications for eurozone banks' creditworthiness and therefore their ratings in the short term. Although funding costs will likely increase gradually over time, especially in banking systems that face potential term refinancing gaps, the context will be rising policy rates that would largely offset the hit to net interest margins. For the eurozone economy, this means that borrowing will become more expensive for households and corporates - due to higher policy rates and banks' attempts to pass on spread widening, and banks may also tighten standards/appetite for new lending if the economy weakens. The ECB will monitor this closely, and we think that it would likely react potentially by launching a new round of TLTRO-like operations--if it sees that the withdrawal of its refinancing operations could lead to serious funding issues in certain banking systems. That's especially given its stated willingness to avoid financial fragmentation that could originate from a widening of spreads on European government bonds.

What the ECB normalization process entails for eurozone banks

The normalization of ECB monetary policies will be a multiyear process, whose extent and pace remains largely uncertain (see the timeline, table 1, and chart 1). That's because the central bank's monetary policies have grown in complexity in the last decade, involving not only the determination of policy rates, but also the management of a €9 trillion balance sheet including €5 trillion of securities and €2.2 trillion of long-term lending to eurozone banks. The ECB has stated that flexibility, optionality, and gradualism will remain its guiding principles as it normalizes its monetary policies. Much will also depend on the evolution of financing (including market) and economic conditions, as the ECB remains a data-driven authority. What's more, our economists do not rule out the possibility that the central bank will pause the normalization process if economic conditions deteriorate significantly.

Chart 1

For eurozone banks, the start of the normalization process is a pivotal moment, the end of a decade-long era of unconventional monetary policies, which had its pros and cons and forced banks to adapt (see "From 'Whatever It Takes' To Wherever It Leads: The Euro Preserved, But The Region Changed," June 23, 2022). The normalization of ECB policies will bring not only benefits but challenges. Rising interest rates will be clearly beneficial for eurozone banks' profits in the next year or two, though the positive effects may take a few quarters to materialize and higher inflation as well as a more uncertain macro environment are likely to somewhat dampen the overall net benefit (see "When Rates Rise: Not All European Banks Are Equal," June 8, 2022).

After that, the normalization process, chiefly constituting the normalization of bank refinancing operations and the reduction in ECB securities holdings--will move the funding question back to the fore for eurozone banks (see table 2). In the next two years, eurozone banks generally appear well placed to repay maturing TLTRO facilities with existing liquidity buffers, including the massive €1.3 billion maturing in June 2023. However, all banks are not equally well placed, and the return to normal refinancing operations may lead to more funding cost discrimination across banks. Also, the reduction of the ECB's securities holdings may weaken financial asset values, leading to potential mark-to-market losses for banks, which tend to carry rate-sensitive financial assets.

Importantly, there is no historical precedent for such a large-scale normalization of monetary policies, and therefore uncertainties abound.

Execution risks for the ECB and downside risks for eurozone banks loom large. First, faced with TLTRO repayments, certain banks may prefer to restrain net lending growth, rather than refinance at a higher cost. This could have negative effects on the real economy and ultimately negative ripple effects on credit quality and profits. Second, discrimination in access to term funding may lead to renewed risks of financial fragmentation across eurozone banking systems. Third, the reduction of its securities portfolio will be very complex for the ECB to execute. Along the way, financial markets may reprice risk faster or more excessively than expected, anticipating potential policy changes by the ECB due to a higher-than-expected core inflation, for instance. Meanwhile, eurozone banks will need to navigate these choppy waters. Much will rest on the ECB's capacity to retain its gradual and pragmatic approach over time: maintaining market confidence in the banking system and ensuring adequate credit supply to the economy by remaining supportive of banks while at the same time pushing them to stand on their own feet.

Table 2

Eurozone Banks Should Be Able To Repay TLTRO With Existing Liquidity

By end-2024, eurozone banks will need to repay about €2.2 trillion of TLTRO maturities to the ECB, assuming the ECB does not launch a new TLTRO-like program. The relative importance of outstanding TLTRO funding varies greatly across banking systems (see chart 2).

Chart 2

Eurozone banks have built up large liquidity buffers over time, with their average LCR at a lofty 173% as of end-2021. We have modeled the effect of upcoming TLTRO repayments on LCRs and found that, in all banking systems, TLTRO repayments could be made with existing liquidity buffers while maintaining average LCR levels comfortably above minimum requirements (see chart 3). That's because banks have mainly parked the TLTRO funding back at the ECB, therefore conserving liquidity in anticipation of future repayments and have used a significant share of liquid assets as collateral with the central bank. That these liquid assets will gradually become unencumbered will somewhat offset the reduction in liquid assets caused by repayments (see chart 4). This estimate assumes a static balance sheet, that is, no change in net outflows, and was conducted at system level, therefore masking potentially idiosyncratic issues. However, we are sufficiently confident in concluding that eurozone banks are overall well placed to manage the impact of TLTRO repayments with existing liquidity.

In practice, we expect eurozone banks will repay TLTRO lines at maturity. They have little to no financial incentives to accelerate repayments given the still-positive carry induced by the rise in the ECB's deposit facility rate. Also, we expect that banks will use a mix of solutions to deal with TLTRO maturities, depending on the price conditions at the time: repayments with existing liquidity, but also refinancing, either with the ECB under its normal refinancing operations, with other banks, or in the market.

Chart 3

Chart 4

The End Of TLTRO Will Likely Lift Funding Costs For Eurozone Banks Over Time

Beyond the issue of TLTRO repayments, the normalization of ECB refinancing operations would mean the end of a long period of cheap, long-term, and stigma-free funding provided to all banks irrespective of their credit standing and with very favorable collateral requirements.

Under normal conditions, refinancing operations provide a limited backstop for banks to obtain short-term funding against a limited set of good quality collateral, within an overall refinancing amount set beforehand by the central bank. Such refinancing operations aim to influence pricing conditions on the interbank market. In the past decade, on the contrary, central banks have provided unlimited access to their funding at a predetermined rate (fixed-rate full allotment), broadening the set of eligible collateral to include a much larger set of bank assets and extending maturity until up to four years. In this way, central bank funding has become a source of long-term, cheap and stigma-free funding for banks.

Table 3

Over the last decade, eurozone banks have greatly enhanced their funding profile, reducing reliance on wholesale funding. Indeed, the aggregate loan-to-deposit ratio for large eurozone banks fell to 104% at the end of 2021. In many countries, the loan-to-deposit ratio is comfortably below 100% (see chart 5).

Chart 5

However, the end of TLTRO funding will lower the amount of available stable funding (ASF) to eurozone banks and therefore weigh on their net stable funding ratios (NSFR), all else remaining equal. Of note, the drop in NSFR would start to take place one year before the actual maturity of the instrument. According to applicable regulation, half of the amount of a given ECB funding line drops out of the ASF when its remaining maturity is less than one year, and the other half drops out when the remaining maturity is less than six months. This means that eurozone banks are starting already now to manage the impact of the TLTRO's end on their NSFR.

In its December 2021 risk assessment report, the European Banking Authority (EBA) indicated that the EU-level NSFR stood at 129% as of June 2021, and that this ratio would drop to 115% if all TLTRO funding were to be repaid. We have extrapolated these EBA findings to derive the potential NSFR reductions in eurozone banking systems stemming from the repayment of TLTRO (see chart 6). We found that the NSFR could come close to the minimum requirement (100%) in one banking system, Greece, and could drop to below 110% in Italy. This is because these countries have been relatively higher users of TLTRO funding (in proportion of their overall funding base) and, in the case of Greece, operated with a below-average NSFR ratio in June 2021.

Chart 6

We consider these estimates as conservative because they exclude the fact that part of the assets (central government bonds, covered bonds) pledged to the ECB under the LTRO would generate lower required stable funding (RSF) once they become unencumbered. This means a positive boost to the NSFR, given that the RSF is the denominator of the ratio. However, this reasoning does not take into account the potential increase in RSF over time and until the end of TLTRO due to increased net lending, for instance.

To take this into account, we conducted a sensitivity analysis of the potential stable funding gap that could remain for large eurozone banks after their repayment of TLTRO. This gap would depend on:

• How low banks are ready to let their NSFR drop, considering that the minimum regulatory requirements stand at 100%, but most banks would want to maintain a management buffer above this level; and
• The path of RSF, which will itself depend on the composition of the collateral pledged for TLTRO operations and becoming unencumbered upon repayment, as well as growth in net lending and other long-dated assets until end-2024.

Our analysis shows the amount of stable funding that eurozone banks would need to source, after the full repayment of TLTRO, to fund a growth in RSF while maintaining comfortable NSFR levels (see table 4). In Greece, we find that any increase in RSF would need to be funded by ASF to maintain compliance with NSFR requirements. In France, Italy, and Spain, there would also be a need to access stable funding to fund any increase in RSF if banks were to maintain a 110% NSFR.

Table 4

This analysis underlines that, for eurozone banks, the new funding normal--without TLTRO's favorable conditions--will likely mean more competition for:

• Secured issuance, notably covered bonds, the cheapest source of funding, but one that requires that banks have programs in place and adequate unencumbered assets. Since the beginning of 2022, we have seen issuance volume of covered bonds at a decade high (see chart 7);
• Deposits, especially term deposits; and
• Unsecured wholesale funding.

Chart 7

This increased funding competition, at a time when investors' purse strings have tightened, will drive prices higher, just as inflationary expectations have already led to a rise in risk-free yields. Such increased funding costs will likely partly offset the benefits from rising lending rates and slow the rise in net interest margins. In this context, the strength of banks' funding franchise, meaning their capacity to access long-dated term funding or deposits at relatively low cost, will become again a key competitive advantage. The gradual reduction in the funding provided by the ECB to the real economy (via its net purchase of securities) may create opportunities for banks to pick up new business. At the same time, investments to finance the economic transition--notably to a low-carbon economy but also to overhaul supply chains amid deglobalization--could also lead to a pick-up in loan demand. In a context of higher lending rates, the capacity of banks to source affordable funding in sufficient volume will be crucial if they are to reap the full benefits.

A Gradual Reduction Of The ECB's Securities Portfolios Should Be Manageable But Has Downside Risks

The second part of the normalization of the ECB's monetary policy refers to the gradual reduction of its huge investment portfolio. The ECB stopped its net asset purchases at the end of June 2022 but, unlike the U.S. Federal Reserve, it has not yet announced plans to start selling securities into the market--so-called quantitative tightening. S&P Global Ratings' economists do not expect such outright sales to take place in the near future, and they believe that it would take a very significant revision to the ECB's own medium-term core inflation expectations for the central bank to potentially consider this. Under our economists' base case, the ECB will reinvest maturing securities, with some flexibility about the profile of securities in which it reinvests, until 2024. The reduction in the ECB's securities portfolio would start only after this date and be very gradual given that the average maturity of the ECB's portfolio is seven years.

With the ECB, as a major buyer. stepping out of the market, financial asset values may drop, meaning potential mark-to-market losses for banks and other holders of debt securities held at fair value. Across the eurozone, banking systems have different relative exposures to this financial repricing risk, with banks in southern countries such as Portugal, Italy, Greece, Malta, and Spain carrying exposures to government securities above 220% of their tier 1 capital. Of these, a substantial share is measured at fair value (ranging between 32% and 42%), meaning that mark-to-market losses on these bonds would directly hit the bottom line or regulatory capital or both (see chart 8). Banks hold capital to cover unexpected losses on their trading portfolios, but these are calibrated based on historical precedents. Of note, revaluation reserves are deducted from S&P Global Ratings' Total Adjusted Capital, meaning that – contrary to regulatory ratios -- our Risk-Adjusted Capital Ratios would not be directly impacted by mark-to-market losses on bonds and other financial asset accounted at fair value through other comprehensive income.

Under our base case, that is, a very gradual reduction in ECB's securities holdings, we do not see a material risk for eurozone banks. However, an excessive repricing of risk, which could be triggered by markets anticipating more excessive policy actions by the ECB due to higher-than-expected inflation, is a clear downside risk that would hurt weaker eurozone sovereigns, corporates, and banks the hardest (see "The Russia-Ukraine Conflict: European Banks Can Manage The Economic Spillovers, For Now," April 21, 2022).

Chart 8

Limited Rating Implications, For Now

The monetary policy normalization process will likely have limited implications for eurozone banks' creditworthiness and therefore the ratings in the short term. At the eurozone level, our analysis has shown that most banks would have the capacity to repay their TLTRO funding while maintaining adequate LCR and NSFR buffers. This is because, in recent years, eurozone banks have strengthened their funding and liquidity profiles and are now well positioned to weather the upcoming transition.

Some banking systems--mainly Greece's and Italy's--may face a trickier funding equation and need to find alternative sources of term funding if and when the ECB normalizes its refinancing operations. Essentially, this will mean stiffer competition for funding in these countries, and therefore a drag on net interest margins and fewer benefits from rising rates.

Finally, we think the ECB would likely react--for instance by launching TLTRO-like operations--if it saw that the withdrawal of its refinancing operations would lead to serious funding issues in certain banking systems. That's especially given its stated willingness to avoid a wide gap in credit spreads for government bonds between the eurozone core and periphery, last seen during the eurozone crisis.

Related Research

• Implications Of The ECB's Policy Normalization For Interest Rates, The Balance Sheet, And Yields, June 9, 2022
• From 'Whatever It Takes' To Wherever It Leads: The Euro Preserved, But The Region Changed, June 23, 2022
• When Rates Rise: Not All European Banks Are Equal, June 8, 2022
• The Russia-Ukraine Conflict: European Banks Can Manage The Economic Spillovers, For Now, April 21, 2022