European banks: impact of higher interest rates on net worth and revenues

According to the European Central Bank (ECB) in its latest Financial Stability Review of May, when assessing the interest rate risk exposures and hedging of euro area banks’ banking books, a normalisation of monetary policy, that currently means an interest rate raise scenario, should not be a major concern in terms of aggregate impact on the net worth of the euro area banking system. This happens even bearing in mind that more than half of the banks analysed would have a moderate negative impact, meaning that in the event of higher interest rates, their assets will lose more value than their liabilities, thus reducing  economic value of equity.

Main conclusions of the analysis:

• Higher interest rates at the eurozone are expected to be positive in banks’ net interest income in the short term, but they may also weigh on banks’ net worth in the medium term: On aggregate, euro area banks have a positive duration gap, which implies that if interest rates rise, assets will lose more value than liabilities, thus reducing banks’ economic value of equity.
  
  
• Interest rate risk exposure (IRR) of euro area banks: the aggregate impact of higher interest rates on bank net worth would be moderately negative, but wide variations exist at the level of individual banks. The analysis of the ECB shows that:

- a steepening of the yield curve by 200 basis points at the longer end in the third quarter of 2021 would have reduced banks’ aggregate net worth by around 4% of Common Equity Tier 1 capital. A 25% of the banks would have suffer higher negative impacts.

• Banks’ IRR exposure appears moderate on aggregate, and it has declined since 2017. Banks tend to counterbalance this risk increasing their interest rate hedging derivative activity. According to the analysis Euro area banks have held an increased volume of interest rate swaps over the last two years.