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Rising bond yields will support European bank profitability in the near term
By Marco Troiano, Financial Institutions
Our base case for European banks in 2025 had anticipated a decline in profitability driven primarily by net interest margin normalisation as interest rates decline. However, the announcement of a significant increase in fiscal stimulus in Germany and a surge in bond yields across the continent could challenge this assumption and allow banks to sustain higher profitability levels for longer.
While the ECB has been on a monetary easing path, it has acknowledged the heightened uncertainty and kept significant flexibility for future decisions. Prospects of greater fiscal stimulus could alter macroeconomic growth and inflation dynamics and prompt the central bank to keep interest rates at higher levels than previously expected. Last week’s market moves, including an increase in German bund yields, increases in long term rate expectations across Europe and a strengthening of the EUR against major currencies, would appear to support this view.
With higher rates and potentially steeper yield curves, European banks could continue to benefit from higher commercial spreads for longer than previously anticipated, extending the positive results streak of 2022-2024. Higher rates could weaken loan demand and pose asset-quality risks, but this will not necessarily be the case if the higher rate environment results from a stronger economic growth backdrop.
Whether this favourable environment of positive rates and a positively-sloped yield curve turns from cyclical to structural matters to banks’ credit profiles. So far, we have discounted the surge in bank profitability as temporary, and likely to reverse with the turning rate cycle. As such, our credit ratings, which assess bank creditworthiness across the cycle, have not experienced widespread upwards migration. However, should the current rate environment become entrenched, so too will high sector profitability, which would be credit positive for some issuers.
The biggest winners in this scenario are banks with large captive deposit bases. These banks benefit from less price-sensitive deposits, resulting in lower relative funding costs as interest rates rise, supporting higher net interest margins and overall profitability. Conversely, business models that rely to a greater extent on wholesale funding or more price-sensitive deposits may come under pressure as they struggle to remain competitive as their cost of funding increases.
While the current rate environment supports European bank profitability, we highlight the risk that a broader relaxation of fiscal discipline in Europe may result in a less favourable environment for banks in the medium term.
While Germany (AAA/Stable) with its relatively strong fiscal position may have the capacity to finance increased defence and infrastructure spending, other large euro area countries face more significant fiscal constraints. If these countries engage in further deficit-driven spending, financial stability risks could rise, with potentially negative consequences for banks.
