Bank profitability in the euro area in times of high inflation

* The author would like to thank two anonymous reviewers and the editor for their valuable comments, which helped significantly to improve the quality of this text. The views and opinions expressed in this article are those of the author and do not necessarily reflect the official policy or position of the Croatian National Bank.

¹ While changes in key policy rates affect the borrowing costs of the non-financial sector indirectly – by altering the conditions under which banks can borrow from the central bank or deposit excess liquidity with the central bank – asset purchase programs directly reduce interest rates on the bonds that are purchased under the program.

² At the height of the 2010-12 sovereign debt crisis, banks from the most affected euro area countries had to deal with several challenges which weighed on their profitability, including a weak economy and the resulting subdued demand for loans, large stocks of non-performing loans, high provisioning costs, and impaired access to market financing, as money market investors were reluctant to lend to banks headquartered in fiscally vulnerable member states (Paries, Jacquinot and Papadopoulou, 2016; ECB, 2018a). Moreover, as they had to meet more stringent capital and liquidity requirements introduced after the global financial crisis, banks’ lending capacity was constrained, limiting further their ability to generate income.

³ It is important to note that excess liquidity at the system level does not decrease when banks increase their lending activity. When a bank grants a loan to its client and the client uses the money to spend or invest, the money circulates within the banking system, from their bank’s account with the Eurosystem to other banks’ accounts with the Eurosystem, but liquidity at the system level remains unchanged. The overall level of liquidity changes almost exclusively as a result of central bank monetary policy operations.

⁴ While interest rates on household deposits never fell below zero, interest rates on corporate deposits were actually negative from late 2019 to mid-2022. This could be attributed to banks taking advantage of the fact that some corporations keep large amounts of liquidity in their bank accounts for payment purposes, making it inconvenient for them to switch entirely to cash when deposit rates turn negative. Households, on the other hand, can more easily switch to holding cash, which limits the banks’ ability to impose negative rates on them.

⁵ In the period from 2014 to 2021, Croatia recorded steady current and capital account surpluses driven by sizeable inflows from EU funds. As these inflows exerted strong appreciation pressures on the kuna exchange rate, the Croatian National Bank frequently intervened by purchasing foreign currency from commercial banks and the government. Given that the central bank maintained an accommodative policy stance at the time, no measures were taken to sterilize the domestic currency liquidity created through these interventions, with the result being a persistent rise in excess liquidity in the banking system.

⁶ On the other hand, it can be economically reasonable to issue a long-term loan with a fixed interest rate below the deposit facility rate if the lender expects the deposit facility rate to fall during the repayment of the loan. Indeed, in some euro area member states, interest rates on new housing loans remained below the deposit facility rate throughout the monetary policy tightening cycle.

⁷ Due to hedging, some banks were able to benefit from interest rate increases even on the basis of outstanding loans granted at a fixed interest rate. In particular, Dries et al. ( 2022) noted that euro area banks increased their reliance on interest rate derivatives since inflation started to rise in early 2021 in order to hedge loans with fixed interest rates against the expected shift in monetary policy.

⁸ This was a result of several country-specific factors. First, Croatia introduced the euro on 1 January 2023, which was associated with a significant increase in excess liquidity, given that the reserve requirement rate – which was 9% until then – had to be brought down to 1% to be in line with the ECB’s calibration. The additional liquidity freed up on this occasion allowed banks to enjoy low funding costs even after the ECB started raising its key rates, which indirectly enabled them to earn a solid net interest income without increasing lending rates significantly. Second, in the previous years when monetary policy was highly accommodative, most housing loans were issued at an interest rate that was fixed for at least part of the repayment period. Third, prior to the adoption of the euro, the vast majority of variable-rate loans were granted using the National Reference Rate as benchmark, which is quite stable over time. For this reason, the sharp increase in EURIBOR did not have a material impact on variable-rate loans in the domestic market. Finally, the Croatian legal framework contains provisions that limit the amount by which banks can raise interest rates on variable-rate loans. These provisions, which apply to both outstanding and new loans to households, further limited banks’ ability to pass on higher money market interest rates to their customers (CNB, 2023).