Rather than pausing as expected by many observers, the European Central Bank (ECB) raised its main refinancing operations (MRO) rate by 25 basis points (bps) to an all-time high of 4.5% to combat still high inflation in the euro area.
The ECB’s revised upwards forecast of 3.2% inflation in 2024 underpins the ECB’s opinion that inflation is “too high for too long” (above its 2% medium-term target).
The increase is still credit positive for euro area banks, the revenues benefiting from higher interest income, said Moody’s analysis.
“Nevertheless, banks’ operating environment is expected to deteriorate in 2024, which will weigh on bank’s lending while most banks will be under heightened pressure to increase rates on deposits.”
The ECB hinted in its accompanying statement that interest rates may have reached a plateau, stating that maintaining interest rates at current levels over an extended period would help achieve monetary stability.
“This decision doesn’t preclude further hikes if inflation were to persist above the expected trajectory,” said Moody’s.
Euro area inflation fell to 5.3% in August from 7.0% in April, but the ECB’s forecast for 2023 and 2024 has been revised upwards.
The ECB also noted that the transmission of monetary policy had been forceful through tightened financing conditions and lower economic growth: the European Commission in September lowered its forecasts for GDP growth in the European Union (Aaa stable) to 0.8% from 1.0%.
“However, the latest hike reinforces the ECB’s message that the risk of recession remains subordinate to its mission of achieving price stability.”
In its assessment of risks, the ECB doesn’t rule out a weakened economy if the effects of monetary policy were stronger than expected.
“Euro area banks – notably Spanish, Italian and Dutch banks – reported very strong profits in the first half of the year, but continually decreasing lending activity will constrain loan repricing benefits in countries where variable rate loans comprise the bulk of banks’ loan book.
“French banks are a notable exception, with net interest income decreasing because of steep hikes in the remuneration of regulated savings.
“Deteriorating debt affordability and tightened credit standards will continue to weigh on lending activity to both companies and households.
“In Spain, record earnings for banks in 2022 and 2023 in the higher interest rate environment have led the government to impose special one-off taxes on “extra profits”, a decision which is currently under discussion in Italy.”
While similar measures could also be enacted in other countries, the ECB, in an opinion issued in response to the Italian government’s proposed tax, highlighted the downside risks involved with such decisions.
The ECB pointed out that lower lending volumes, higher funding costs, and increased cost of risk could, over the monetary tightening cycle, offset the initial positive impact of rate hikes and even lead to a negative impact on banks’ profitability.
“Furthermore, banks’ funding costs will increase because of a higher proportion of interest-bearing deposits in the customer funding mix; banks’ customers will continue to reallocate their cash balances toward more attractive types of deposits and other forms of remuneration such as assets under management.”
Euro area banks’ sight deposits from customers fell 7% year-over-year in June, while term deposits increased 49%.
“Should the decline in sight deposits continue, banks will be pressured to raise the rates they offer, eroding a part of the benefit to profitability from higher lending rates,” warned Moody’s