By Nicolas Hardy and Dierk Brandenburg

Banks now have very little incentive to repay TLTROS until the biggest tranches expire next June. Increasing the interest subsidy to banks could be seen as a controversial move but the ECB has a sound policy rationale to incentivise banks to maintain excess liquidity as the euro area economy enters a difficult winter. This may put extra financing demands on banks.

The concurrent move to stabilise money markets by lifting the 0% cap on government deposits adds further stability to the transition of higher policy rates as it avoids a possible collateral shortage if debt-management agencies transfer their holdings into the repo market.

The ECB’s decisions do question whether it can reduce its balance sheet at all as it normalises its policy stance, which we expect it to address in future meetings. While the ECB is committed to reinvesting its holdings, it needs to manage excess liquidity in the banking system carefully to avoid undermining the impact of higher policy rates.

Remunerating excess liquidity will continue given that more interest-rate increases are priced in for this year and next. But there is no indication as to where this trend will end i.e. where the perceived optimal rate level lies at which point inflation goes back to the ECB’s 2% medium-term target. The current rate level is still ‘so far away’ from this target rate level, President Lagarde indicated.

On the downside, government bond yield curves are likely to flatten in view of slowing growth. This removes some of the benefits of higher policy rates for banks. The updated central macroeconomic growth forecast for the Euro Area is now in line with consensus (+0.9% in 2023) but that remains optimistic as consensus has been deteriorating rapidly in recent weeks in view of the accelerating energy crisis in Europe.

This will weigh on the asset-quality outlook for European banks, though it remains to be seen to what extent the energy price crisis is alleviated by fiscal policy measures and lending support, such as for utilities struggling to meet margin requirements.

We believe that in the short-term, the impact of rising rates on banks’ performance should be a net positive. But this benefit should reduce materially over time, even disappear in the context of a looming recession.

Balance-sheet repricing will lead to higher more interest revenues over time. Credit demand should remain supportive in the coming months as borrowers attempt to lock in the most favourable rates in anticipation of further rate increases. That said, lending dynamics may slow if banks put on hold or delay loan approvals until rates increase. With rising expectations of a recession, underwriting criteria will be tightened, limiting access to bank lending for a growing portion of retail and corporate clients.

Tighter financing conditions and a contraction of economic activity will also increase cost of risk for banks, although this should be gradual and moderate in the short-term given the time lag between economic slowdown and non-performing loan formation. The catch-up effect in 2023-2024 can be significant, however. Credit risk is clearly more at risk in countries where the bulk of bank lending is at variable rates.