The European supervisor warns about the dangers of raising rates for banks

The change in the monetary policy of the European Central Bank (ECB), which has adopted a more restrictive stance, taking interest rates in the eurozone to 4.5%, has meant a boost to the income of financial entities, but It also carries a series of negative effects. The three European Supervisory Authorities (EBA, EIOPA and ESMA – ESA) have identified at least three in their Autumn 2023 Joint Committee Report: rates (bonds), liquidity and credit.

The document notes that these perverse effects pose challenges to banks, insurers, asset managers and other financial entities and explains that proper management is crucial to maintaining financial stability and adequately mitigating the systemic risk it entails.

Regarding the first, the supervisors explain that it is true that the end of low rates and the associated increase in fixed income yields can be benefits for financial institutions across the board. However, during the transition to this new environment, bond portfolios are exposed to significant interest rates since this implies a decrease in the prices of debt securities, which not only affects the economy, but also the balance sheets of financial entities.

As of February 2023, the EBA estimated net unrealized losses at €75 billion for EU banks, although potential losses are not expected to materialise. Additionally, as part of their interest rate activity, banks actively manage these portfolios.

On the other hand, the increase in interest rates will point to the profitability of banking by 2023. from demand accounts to fixed-term deposits.

Credit and liquidity risk

The rise in interest rates also implies an increase in financing costs, not only for companies and families, but could also fuel banking costs at the same time “as banks face higher costs through other “. channels, including wage inflation, those related to digital transformation.” In the medium term, moderation in the pace of credit granting could mitigate the impact of wider margins.

Precisely, an increasing percentage of banks indicated to the EBA that they expect to reduce large loan portfolios to SMEs, companies, consumer credit and residential mortgages in the next 12 months. The reduction in credit would have an immediate impact on banks’ revenues, but would also carry long-term negative implications for economic growth.

Finally, supervisors identify a third risk: liquidity. This jumped after the beginning of a crisis of confidence that caused the bankruptcies of some medium-sized American banks and the rescue of Credit Suisse. These events brought to light the extent to which financial institutions may be vulnerable to a rapid and sudden outflow of deposits. “They also show that liquidity risk control by all financial institutions is even more important now that a period of abundant liquidity is coming to an end,” the document explains.

However, while admitting that liquidity positions remain at solid levels, they continue to decline slightly. The coverage ratio (LCR) fell from 167.9% in the first quarter of 2022 to 163.7% in the first quarter of 2023. It is still important that banks continue to comfortably guarantee liquidity reserves, especially while using these Buffers to partially repay the outstanding volumes of central bank financing (TLTRO).

Given this, the report recommends that supervisors use other available tools to, for example, monitor the maturity phases or financing concentration. The EBA has provided guidance to supervisors through, for example, the Internal Liquidity Adequacy Assessment Process (ILAAP) which provides detailed information on funding risk and strategy, on liquidity buffers, collateral management and liquidity risk. In the special case of insurers, even if they do not have deposits, policyholders can cancel their contracts.

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