Banks: Dream Profit Days Are Over with ECB Rate Cuts – Beware of Danger Zones and High-Risk Sectors

Italian Banks and the Impact of ECB Rate Cuts

How far will Italian banks, and more generally Eurozone banks, feel the effects of the upcoming rate cuts from the ECB led by Christine Lagarde? What will be the ramifications of these cuts on the profitability of credit institutions that have seen a significant rise in earnings in the last two years, thanks to monetary tightening?

As Italy’s political discourse heats up ahead of the government’s 2025 budget proposal, discussions surrounding bank profits, often labeled as “windfall profits,” are becoming more pronounced.
However, economists point out that the financial health of banks is not as robust as it appears at first glance.

End of the Profit Windfall

Firstly, the favorable conditions that allowed banks to showcase impressive financial figures over the past couple of years, driven by ECB rate hikes, have significantly diminished.
This shift began in September 2023, when Lagarde announced a halt to monetary tightening that had been in effect since July 2022.

The benefits that banks enjoyed started to wane towards the end of the previous year, particularly when the European Central Bank (ECB) decided against further rate increases, citing a decrease in inflation as a factor.
Following this, the ECB cut rates twice as of June 6, 2024, marking the beginning of monetary easing.

Upcoming Rate Cuts

This monetary easing, while still present, is likely to weaken further, with expectations set for a new rate cut at the upcoming ECB meeting on October 18.

In the coming weeks, key financial results from banks for the third quarter of 2024 will be unveiled, covering the period from July to September.
Experts doubt that these results will confirm what has been branded as a “profit bonanza.” It seems that the golden era for banks may indeed be behind them.

Profitability Threshold and Concerns

Analysts like Claudia von Türk from Lombard Odier have determined a critical interest rate threshold for Eurozone banks’ profitability: banks are expected to remain secure as long as rates do not fall below 2%.
Von Türk estimates a return on tangible equity (RoTE) for European listed banks will stabilize at around 11% to 12% by 2025-26, which would still support capital generation and distribution vital for investor interest.

Thus, while concerns surrounding a decline in dividend payouts may be alleviated, this offers only temporary relief as long as rates hold above 2%.
However, the favorable monetary environment that has bolstered credit institutions is dissipating, particularly as evidenced in the second-quarter 2024 results.

Impact on Net Interest Income

The impending cuts will directly influence the net interest income (NII)—the balance sheet component most sensitive to interest rate changes.
According to analysts, a decrease in NII may trigger a downward spiral in earnings per share (EPS) for banks.

Consequently, analysts might issue downgrades on EPS forecasts for certain institutions.

Regional Variations in Sensitivity

Banks more susceptible to interest rate shifts, like those in Italy, Spain, and Sweden, could experience margin compression.
For instance, in Spain, mortgages often track the 12-month Euribor, which continues to decline.

Conversely, banks in France and the UK, having hedged against interest rate risks, might fare better by capitalizing on the repricing trend aligning fixed rates with higher values.

French banks, however, have enjoyed less benefit from ECB rate hikes due to a higher prevalence of fixed-rate mortgage portfolios, resulting in lower NII while being more shielded from rate cuts compared to their Italian counterparts.

According to S&P Global, UK and Italian banks were anticipated to gain the most from rising rates, while French and Dutch banks would experience lesser impacts.

The Resilience of UK Banks

Interestingly, UK banks may demonstrate greater resilience amidst rate cuts, tracking back to their proactive hedging measures.
Financial Times highlighted banks like Barclays, Natwest, and Lloyds, noting their strategies to manage interest rate volatility.
Analysts predict Barclays’ NII could see a 13.5% growth from 2024 to 2026, exceeding £14 billion.

Outlook for European Financial Sector

In conclusion, von Türk holds a “neutral” outlook on the European financial sector, noting some positive aspects such as dividend yields around 7%, appealing to yield-seeking investors.
She also highlights the sector’s current valuation as attractive, with a price-to-earnings ratio of approximately seven times expected earnings for 2025.

However, persistent high equity costs amid economic and political concerns require reassuring signals for investors, particularly regarding banks’ profit stability.
Hedging operations play a critical role in this context, enabling banks to reset balance sheet assets to higher values, coupled with expected growth in fees and revenues from investment banking activities, leading Lombard Odier to favor institutions that reward shareholders with dividends.

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