“Seeing the transmission of our (ECB) monetary policy”

The key chart

The key message

In the 16 March 2023 ECB press conference, President Lagarde commented that, “we are beginning to see the transmission of our monetary policy.” Her comments reflect the fact that loan demand is slowing across the euro area (EA) as borrowing costs rise and credit standards tighten. Good news for President Lagarde and her colleagues at the ECB, perhaps, but much less positive for EA banks and for the wider economy however. Three key points:

1. Pressure of banks’ top line growth – net interest income – is rising. Since loan growth peaked in September 2022, the costs of household (HH) and corporate (NFC) deposits have risen faster than the costs of HH and NFC borrowing
2. Pressure on banks’ credit quality is also rising. Borrowing costs are rising at a much faster rate than in previous hiking cycles, giving borrowers much less time to adjust. Banks were already citing asset quality concerns as a reason to tighten credit standards in 2023. Current trends are unlikely to help
3. Risks to the outlook for economic growth are tilted to the downside. From (1) and (2), economic growth is likely to slow as the cost of borrowing increases and access to credit becomes harder

Recall that five macro factors are the main drivers of bank sector profitability (and share price performance): the level of ST rates; the level of LT rates; the shape of the yield curve; growth in private sector credit; and growth in GDP.

The bull case for European banks in 4Q22/1Q23 rested largely on valuation and the sensitivity to the first of these five factors (note that c.70% of new loans to HHs and NFCs are on variable rates.) The macro foundations were far from complete, however. Furthermore, the positive impact of rising ST rates on banks net interest income may be overstated for reason (1) above, at least since 3Q22.

The valuation argument remains. Banks’ equity prices appear cheap in absolute terms and in relation to their history, but intensifying macro headwinds help to explain why…

Transmission of our (ECB) monetary policy

Private sector credit (PSC) growth peaked recently at 6.7% YoY in September (see chart above). NFC credit grew 7.8% at this point, and made the largest contribution to total loan growth (3.1ppt). HH credit grew 4.4% and contributed 2.3ppt.

By January 2023, PSC growth had slowed to 4.5% YoY. NFC credit growth slowed to 5.4% YoY, but remained the fastest growing segment and largest contributor to total growth (2.1ppt). HH credit growth also slowed to 3.4% YoY, a 1.8ppt contribution to total growth.

Bank lending rates are increasing at a faster rate than in previous hiking cycles (see chart above). Over the past twelve months, the composite cost-of-borrowing (CCOB) for NFCs has risen 220bp to 3.36%, the highest level since December 2011. Over the same period, the CCOB for house purchase has risen 177bp to 3.10%, the highest level since April 2013.

Banks are also tightening their lending standards. According to the January 2023 EA bank lending survey, credit standards tightened substantially in 4Q22 for both NFC and HH lending. Banks also indicated that they expected further net tightening of credit standards in both sectors in 1Q23. Banks were already citing asset quality concerns as a reason to tighten credit standards in 2023. Current trends are unlikely to help.

As noted in “Competing for funding”, competition for ST liabilities was intensifying in the EA well before the collapse of Credit Suisse. EA banks experienced outflows of ST liabilities in three of the past four months since October 2022. This reflects four consecutive months of overnight deposit outflows. Inflows of other ST deposits have not been enough to compensate. They also come at a higher cost.

The composite interest rate (CIR) for new NFC deposits with agreed maturity (part of M2-M1) has risen 231bp over the past twelve months to 2.01%. This is the highest rate since January 2009 (see chart above). The CIR for new HH deposits with agreed maturity has risen 140bp over the same period to 1.64%, the highest level since January 2014.

Since September 2022, when volume growth peaked, the rise in the composite cost of NFC and HH deposits has exceeded to rise in the cost of NFC and HH borrowing. The CIR for NFC deposits has risen 127bp while the COB of NFC credit has risen by 123bp. Similarly, the CIR for HH deposits has risen 96bp while the COB of HH credit has risen by only 65bp.

Conclusion

CMMP analysis focuses on the implications of the interaction between the money sector, including central banks and banks, and the real economy. Where are we now?

• Money sector (1) – the central bank: President Lagarde is correct to observe that we are beginning to see the transmission of monetary policy. That said, inflation remains at 8.5% (and ranges widely from 4.8% in Luxembourg to 20.1% in Latvia) and is “projected to remain too high for too long”
• Money sector (2) – EA banks: loan demand is slowing; pressure on net interest margins is rising and credit quality risks are rising too
• The real economy – HHs and NFCs: the cost of borrowing is rising at a much faster rate than in previous hiking cycles and access to credit is also falling

In short, the message from the money sector is aligned with that of the ECB – risks to the outlook for economic growth in the EA are tilted to the downside.

Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.