Originally published in Eurofi magazine.

The past few weeks have shown that rapid rate hikes come with consequences and that, despite the regulatory overhauls after the global financial crisis, banks can still fail. While some of the ingredients of those failures were US- or bank-specific, contagion worries have hit European banks, wiping out almost a quarter of their market cap since the recent peak in 2022.

Rate-increase cycles play out for banks in different ways over multiple horizons.
Phase one, the short-term, is typically beneficial: Deposit betas remain low, net interest margins (NIM) increase, earnings improve, and valuations rise accordingly. That was a main driver of market cap gains for European banks last year.

Phase two, the medium term, is more balanced. Deposit betas go up as customers hunt for better rates—and recent bank failures have accelerated that journey, with some depositors fleeing to safety and banks pricing up. In addition, the active side of the balance sheet starts to feel the impact of higher rates. Corporate defaults increase, particularly among those most exposed to inflationary drivers such as energy-intensive sectors. As incomes lag rising inflation, housing affordability decreases and mortgage volumes come down, offsetting NIM gains. And rate increases impact the banking book, resulting in mark-to-market losses if banks are forced to sell assets.

In phase three, the longer term, NIM volatility increases, because interest rates can go up or down in the future. The recent bank turbulence may have accelerated the journey toward this phase; while the ECB and the Fed went ahead with rate hikes, markets are uncertain on future central bank decisions.

To manage through this crisis, banks should embrace three short-term priorities.

First, they should reactivate their deposit gathering muscle, through better understanding of deposit behaviour and advanced pricing capabilities supported by models that inform volume and margin trade-offs and liquidity positions aligned with bank targets. This requires targeted, client segment specific commercial actions, revisiting fund transfer pricing and relationship manager incentives supported by marketing campaigns.

Second, banks should ensure their interest rate risk in the banking book (IRRBB) setup is fit for purpose in the new environment to deliver balance sheet and earnings stability. Given the speed of rate hikes, this requires increased management attention and reinforced governance.

Third, banks should examine liquidity reserves, including the ability to monetize securities positions under stress scenarios, and revamp their crisis preparedness, including revisiting resolution and recovery plans and running tabletop exercises that address the potential impact of social media in a bank run.

In terms of strategic agendas, European banks have been returning capital to shareholders through buybacks and dividends to boost valuations; price/book ratios were at approximately 0.6 at the beginning of 2022 and rose to about 0.8 before the crisis unfolded in early March. This can’t endure in the long term. Banks need to convince shareholders that some of this capital is better used invested in business model transformation and a move toward more efficient client-centric platforms.

Many banks have failed to deliver on that front and now need to ramp up their performance transformation capabilities to succeed. Some banks could use this capital to expand their footprints through mergers and acquisitions (M&A) for scale and diversification — both in terms of funding and lending/investment choices.

The ECB’s thoughtful application of the Liquidity Coverage Ratio and the Net Stable Funding Ratio has proven critical so far, but there are other areas policymakers and regulators to review. While the ECB has been welcoming of cross-border M&A, more may be needed to help banks pull the trigger. Regulators should consider creating a “European Banking Label” based on providing financing in multiple European economies to incentivize banks to make these moves. This should be done jointly with the banking and capital markets union, which are needed to help banks diversify funding bases and manage exposures more actively via a vibrant securitization market.

If the global financial crisis showed anything, it is that there was a huge divergence between banks that adjusted business models quickly and those that didn’t. It is likely this movie will play out again.

Find the original piece here.