Investors must be aware of opportunities as interest rates rise

15 August 2022 Consultancy.uk 5 min. read

In response to the record rates of inflation seen across the continent, interest rates are finally rising throughout Europe’s banking system. Martin Rauchenwald, a partner at private equity investor Financial Services Capital, explains the opportunities and risks this presents to investors.

The interest rate turnaround, a key talking point for the banking sector for years, has suddenly become a reality in Europe. Investors are now wondering several things now. Is there such a thing as a good or a bad interest rate rise impetus? Does the interest rate turnaround help financial services firms? Would the net effects for banks’ P&Ls really be positive? And if a recession threatens now, will the interest rate turnaround be over before it has even started?

Let’s first look at banks to understand the impact of higher interest rates. One of the biggest challenges in the past for banks was how to invest excess liquidity.

Martin Rauchenwald, Partner, Financial Services Capital

If you wanted to invest into a safe asset that was still yielding a positive interest yield, then you had no choice but to accept at least a maturity of 15 years for a bond investment. Today the minimum maturity is eight months only. This is a huge game changer: one of the backbones of profit generation in banking – the “maturity transformation” – is back.

Banks typically defer passing on the higher interest rates for deposits (currently at -0.01% and practically unchanged from a year ago) but are fast in increasing the interest rate charged for credit. Compared with one year ago, the average mortgage is now 60% more expensive (1.12% a year ago vs 1.81% today) and the average loan to corporates is 133% more expensive (0.78% a year ago vs 1.82% today) according to German Bundesbank data.

But the interest rate increase doesn’t only have positive effects for banks. If a bank invested heavily in long-maturity, fixed-rate instruments over recent years, the valuation of these instruments is now severely reduced, leading to negative P&L and capital effects. Even if this might only be a temporary effect because of the pull to par effect (the repayment will in most cases still be 100%), the pain will still be felt.

Going through the various P&L and capital effects line by line it becomes clear that we are confronted with a mix of positive and negative developments of a temporary and more permanent nature. A good reference is the last ECB bank stress tests, which although conducted five years ago still gives us pointers.

Interestingly, the tests revealed that there were banks that should benefit in both equity and net interest income - but there were also banks that would lose twice. The driver that divides the winners from the losers is mainly the structure of the asset side of the balance sheet – fixed rate vs variable interest rate instruments, the longer the maturity, the higher the impact. Overall, there were more winners than losers, so for the market, rising rates – specifically accompanied by a steeper yield curve – are a good thing.

Possible outcomes

But are the results of the ECB stress test still valid under the current macroeconomic environment dominated by high inflation and a looming recession? Are rising interest rates in such a case merely “peanuts” compared with what else is happening in bank P&Ls and balance sheets?

We must watch out for the following points to understand the effects of a recession:

  • If the economy collapses, credit defaults explode. It is questionable whether the European states and the ECB would once again be willing (or able) to act as aggressively as in the corona crisis.
  • If the economy collapses, new business freezes. Lower loan volumes mean lower interest income.
  • If the economy collapses, this could even jeopardise the interest rate turnaround as a whole. Because it seems questionable that the ECB will raise interest rates aggressively in the event of a recession.

So where are the opportunities and how can investors take advantage?

Looking at asset strategy, it is quite obvious that banks which underwrote low margin loans aggressively in the last decade in a hunt for additional volume will be impacted negatively. On the other hand, players which maintained high credit approval standards and demanded risk adequate pricing will not only withstand a less benign economic environment but be able to strengthen their market position. The decision in what segments a lender is participating will be more important than ever.

For small and medium sized players, funding will become more costly again. The era of free money from the ECB is over and tapping the most beneficial sources of funding will require a level of sophistication that few markets participants have invested in over the last couple of years.

Finally, on operational efficiency, most players still have a long way to go in terms of their cost and efficiency. In today’s world, a tech-enabled infrastructure offers huge benefits and will also contribute massively to counteract the impact of high inflation.

We believe this moment to be a highly compelling, once in a generation, investment opportunity brought about by a confluence of market factors: a complex and fragmented economic and regulatory backdrop; a low point in valuations and institutional inertia, which has given rise to an industry at an inflection point with an urgent need for operational and digital transformation.

Overall, it becomes clear that rising rates have the potential to provide a tail wind for banks and other financial services firms, but hoping on rising rates as a cure for meagre past profitability will not work. A comprehensive set of value creation measures is needed.

For specialist investors, there is a unique opportunity to capitalise on this market environment to transform businesses through hands-on, operationally focused and technology-enabled value creation. The return for investors who can act decisively now and take advantage of the current low valuations will be very rewarding.