Lower rates a bigger risk for bank equities than for bonds

Market attention in the government bond market has rapidly turned from central banks holding rates “higher for longer” to the potential for “lower and sooner".

Until recently, higher for longer rates were seen as a potential risk to the banking sector, with the argument being that they would eventually reduce borrowers’ ability to service debt and lead to a higher cost of risk, thereby reducing the lofty profitability levels banks have enjoyed in recent quarters. In addition, the profit boost banks receive from higher rates tends to wear off over time, a trend we have seen already this year.

Fast forward to the past week, and weaker US labour market data has pointed to higher recession risk and faster rate cuts from the Federal Reserve (Fed) over the next two years, with European rates markets moving in sympathy. As Chart 1 shows, amid the broad sell-off across risk assets on the back of this data European bank equities clearly underperformed broader European stocks, likely reflecting investor concerns over banks’ reliance on higher for longer rates. Importantly, however, bank Additional Tier 1 (AT1) bonds, which tend to be one of the more volatile areas of fixed income in risk-off markets, were far more resilient than bank equities through the turmoil and also outperformed high yield credit.

So, if we acknowledge that higher rates are key to European bank profitability, and if rates have the potential to fall further and faster than previously, why do we maintain a positive view on AT1s?

First, the benefit banks derive from higher for longer rates on their own has its limits. The initial increase in rates is reflected in banks’ results rather quickly since the asset side of the balance sheet reprices faster than liabilities (banks naturally raise rates on customer deposits slower than central banks raise policy rates, for instance). As rates stabilise at a higher level the shift to term deposits doesn’t disappear, but it slows, as we have seen in the first half of this year. In some instances, high quality borrowers use excess liquidity to continue repaying high interest loans as they come up for refinancing, essentially reducing money supply in the economy. As the economy would continue decelerating gradually in this scenario, demand for new loans is likely to be subdued, meaning loan books stay relatively flat. At the same time, banks’ cost of risk would eventually be expected to pick up from current very low levels, even though there is little evidence of that yet. So, if we were to stay in the higher for longer environment, all these trends would likely reduce the high profitability levels we are seeing. Indeed, the consensus expectation for the return on equity (RoE) of the Euro Stoxx Banks Index in 2024 is 11.5%, while for 2025 it falls to 10.5% accounting for anticipated rate cuts.

Second, in the simplest terms lower interest rates would improve borrowers’ interest rate coverage and their ability to repay loans. Sectors which experienced the highest stress from the recent rate hikes (e.g. commercial real estate) would be clear beneficiaries of this development. In other words, for some borrowers, lower rates cannot come soon enough.

Third, we believe lower interest rates (the three-year implied policy rate is now around 2.2% for the euro area and 3.4% for the UK) would lead to a healthier interest revenue split for banks, balanced more evenly between deposit and loan margins. During the very low or even negative rate environment of a few years ago, European banks generated most of their income from loan margins; deposits, especially term deposits, were often loss-making and used to fund lending activities. Banks essentially benefited from an easy windfall as rates increased and money flowed into term deposits, which might have inflated some balance sheets and created the risk of accumulating “hot money”; in the US, some of this effect was absorbed by money market funds. Lending margins have also compressed thanks to the subdued demand for loans we have been seeing. In a lower rate environment, we would at some point expect to see increased demand for lending and a reduction of deposits as investors direct cash to more lucrative areas. The likely outcome would be deposit margins falling from their current lofty levels, while lending margins would normalise. As a result, the banking revenue model would be more balanced and less dependent on any single source of revenue, leading to fewer excesses on balance sheets. This is of course assumes rates do not turn negative again, as banks were only able to generate around 5-7% RoE in that environment.

Finally, we would argue that it is the speed rather than the overall quantum of rate cuts that is the bigger risk to individual European banks. Rapid cuts can lead to unexpected outcomes for different lenders; faster deposit outflows, for example, could put pressure on liquidity or earnings for some banks if they had to pay up for deposits. It is important to note here that we see the pace of rate cuts being gradual. Even if this did not come to pass, we should acknowledge that banks have accumulated high liquidity balances. These could easily be deployed to reduce the size of balance sheets and while staying above regulatory minimum requirements. It is also helpful that we are seeing increased efforts by the authorities to normalise the accessing of central bank facilities for non-emergency purposes. Taken together, the risk of more rapid rate cuts for certain banks is certainly there, but for the sector as a whole we believe there are sufficient mitigants in place. At the individual issuer level, credit selection will of course play a more important role.

In terms of the impact of these developments on valuations, we expect to see some continued volatility given the uncertainty around banks’ ability to adjust to a lower rate regime (and the associated lower returns on equity), not least because banks face other headwinds such as the “Basel endgame” and potentially lower economic growth and loan demand. However, as we have already seen, we think this uncertainty will be reflected most acutely in equities – particularly for banks with strong deposit franchises that rely more heavily on higher rates – where profitability is more essential to the investment case than it is for bank bonds such as AT1s. As Chart 2 shows, AT1s outperformed European bank equities markedly through the low rate (and low bank profitability) environment pre-pandemic, and kept do so as rates moved to their current elevated levels.

As we highlighted last week, during the recent market weakness AT1s traded in resilient fashion, outperforming other higher beta pockets of credit and certainly bank equities. We expect credit markets will see through this period of adjustment and remain satisfied with the new, more moderate but more balanced return profile of the European banking sector.