The European Central Bank (ECB) released a financial stability review stating the outlook remains fragile as macro-financial conditions weaken.
Euro area banks have proven resilient to shocks since the pandemic and their profitability has been rising. At the same time, they are facing headwinds from three main sources. First, their funding costs are expected to increase as they gradually pass on higher interest rates to depositors and the composition of their funding shifts away from overnight deposits towards more expensive term deposits or bonds.
The pass-through of policy rates to depositors by euro area banks remains limited for overnight deposits, leading to a shift towards term deposits. The pass-through of policy rates to bank depositors has not substantially changed since the publication of the previous Financial Stability Review published in May and remains sizeable only for term deposits.
After years of low rates, banks’ deposit books have been skewed towards overnight deposits. But while overnight deposits are constantly repriced at the prevailing rates, banks have been reluctant to increase these overnight rates more substantially. At 0.3% and 0.7% respectively, interest rates on overnight deposits from households and from non-financial companies (NFCs), which account for the largest share of outstanding deposit volumes in both segments, correspond only to a pass-through rate of 7% and 18% of the change in policy rates since summer last year.
These deposit betas are low compared with past hiking cycles, making it likely that a more substantial rise in deposit rates will weigh on interest margins, and hence bank profitability, going forward. There is a substantial dispersion of deposit betas across not only different types of deposit and counterparty but also euro area countries, which is to some extent driven by regulation as well as by competition among banks.
The differences in remuneration between deposit types has led to a gradual shift from overnight to term deposits since the start of the hiking cycle, in line with historical regularities, and funds have remained largely within the banking sector. The fact that deposit outflows have been higher than inflows into money market funds in absolute terms could be related to higher consumption and working capital costs in a context of higher inflation.
Second, bank asset quality can be expected to suffer under a combination of higher debt service costs and a weak macroeconomic environment. And third, bank profitability will have to face a substantial drop in lending volumes stemming from higher lending rates coupled with lower loan demand and tighter credit standards.
Overall, the euro area banking system is well placed to withstand these risks. Macroprudential authorities have increased buffer requirements in recent months to make banks more robust. To help safeguard the resilience of the financial system, macroprudential authorities should maintain capital buffers together with existing borrower-based measures that ensure sound lending standards to make it easier for banks to navigate the turn of the financial cycle.
However, it is essential that remaining Basel III reforms are implemented faithfully and that the banking union is completed. A comprehensive and decisive policy response to address structural vulnerabilities in the non-bank financial sector, stemming for example from liquidity risk or leverage, is still required to enhance the resilience of the financial system.