ECB Interest Rates Raised to 4.25%: What are the Implications for Banks?

Impact of ECB Rate Cuts on Banks

With the ECB cutting rates to 4.25% (3.75% on deposits), what will be the impact on banks? The banking sector is one of the most involved in the central bank’s policy on the cost of money, and the turn of rate cuts – which, however, has not been confirmed even for July – could leave marks on the balance sheets of credit institutions.

It is important to remember that the banking sector is the first to be linked to the decisions of the Eurotower precisely because it operates through the application of interest rates and deposit rates set in Frankfurt.
The reasoning is clear and directly involves banks: the Eurotower lowers the reference rates, it is less costly for banks to finance themselves (borrowing money from the ECB), so they act by decreasing interest rates on loans to households and businesses.
Even the deposit rate that banks receive by leaving sums as collateral with the ECB has fallen, and institutions will receive lower interest payments.

In the anticipation of an end to rate hikes, the link between bank balances and ECB decisions is therefore significant.
The first equation to make is as follows: if the ECB’s interest rates decrease (i.e., the cost of borrowed money), banks’ profits also decrease.
Why?

The sudden and strong increase in interest rates has so far meant that banks have benefited from the net interest margin, which is nothing more than the difference between active interest (what they collect from those who request financing) and passive interest (what they pay to customers depositing funds).
With higher loan costs, the bank’s active interest will rise.
On the other hand, it will decrease with falling rates.

Impact of ECB Rate Cuts on European Banks’ Profits

What is certain is that 2023 has been a golden year for European banks.
As highlighted in our analysis, adding up the net profit of the 20 largest European banks reaches €103 billion, up 32% from the €78 billion recorded the previous year…
three-quarters of these credit institutions reported profits never seen before.

Furthermore, the rise in yields linked to liquidity deposited in the bank by the saver (the deposit rate, paid by the bank to those depositing money), for example, on deposit accounts, has not kept pace with the increase in interest rates, for example, on mortgages.
This means that banks have benefited from a favorable differential between active and passive interest.

In the short term, these equations can reverse.
In the long run, however, a lower rate policy encourages the demand for liquidity and therefore the bank’s lending activity, benefiting it.
In essence, this creates an atmosphere of greater confidence among citizens and businesses, who with less burdensome installments to pay are certain they can honor the debt.
The risk of default and deteriorated loans halves, and the banks benefit from it.