Spanish and Irish banks that depend on the European Central Bank for liquidity could see their profits squeezed as rising interests rates hike funding costs and push more borrowers into arrears.
A series of ECB hikes will likely increase non-performing loans in Spain and Ireland as borrowers are already stretched due to high unemployment and weak economic growth.
Funding has also been a problem for Spanish, Irish and Greek banks over the last year after they lost access to interbank funding because of the sovereign debt crisis.
An increase in euro zone rates will translate into higher funding costs for the banks, which in the case of Ireland and Greece have grown dependent on the ECB for liquidity.
Irish banks will likely have to pass on the full rate increase to savers, while the gain in their own higher lending rates will be neutralized by the higher cost of ECB funding.
Spanish banks' profit margins, already squeezed by an aggressive deposit war at home, will also be affected by higher rates on deposits because of a lag in passing those rates on to borrowers.
"In the short term, there will be a further squeeze on margins and we will see evidence of this in the second quarter," Renta 4 Spanish bank analyst Nuria Alvarez said.
Banks with purely domestic business such as Spain's unlisted savings banks, seen at the heart of the country's financial woes, are expected to suffer most from margins contraction.
Loan volumes will also drop as credit becomes more expensive, Alvarez said.
Markets expect a rise in the refi rate, which the ECB uses to lend to commercial banks, of 0.25 percentage points on Thursday.
Ireland and Spain are vulnerable to the interest rate tightening cycle as they have a high percentage of floating mortgages and fragile banking sectors that are in the process of recapitalization to revive stagnant lending.
Removing the cushion of low mortgage rates from Spanish and Irish homeowners is certain to tip some of them into arrears, eating into bank capital already battered by heavy losses on property loans.
An upward spiral in ECB rates could not come at a worse time for Ireland, which last week unveiled a 24 billion euros ($34.26 billion) funding gap on banks' balance sheets.
After a vicious cycle of tax increases and cutbacks, with more in the pipeline as part of an EU/IMF bailout, and many borrowers stuck with massive mortgages on homes now worth a fraction of what they paid, even two-income households struggle.
"There is no getting away from the fact that if interest rates go up there are a lot of people who at the margin will find that makes the difference between being able to pay the mortgage or not," said Eoin Fahy, chief economist with Kleinwort Benson Investors.
Around 80 percent of Irish residential mortgages are on variable interest rates and 50 percent track the ECB's rate.
Latest data from the Irish central bank showed the number of residential mortgages in arrears had jumped by over half in 2010 and that one in 10 mortgages was either in arrears or restructured due to financial distress.
But Ireland's plans to recapitalize its banks to the tune of 70 billion euros should shield them from the impact of rising loan loss provisions due to ECB rate hikes.
SPANISH MORTGAGE COSTS
In Spain, three months without payments mean a bank must categorize a loan as non-performing. However, in the short term, experts do not see a fresh wave of property repossessions.
Spain saw a 237 percent increase in the amount of mortgages outstanding between December 2002 and December 2008, when a property bubble burst, plunging the economy into recession that saw unemployment climb to 20 percent.
Almost 90 percent of these mortgages are tied to the 12-month Euribor money market rate, which is up 0.5 percentage point this year in anticipation of the ECB's tightening, adding 500 euros to the annual cost of servicing a 100,000 euro loan.
"Ultra-low interest rates and the extension of subsidies to the unemployed whose benefits have run out helped Spanish households cope with mortgage payments and the job shakeout," Morgan Stanley analysts said in a recent report on the Spanish economy.
These factors will not remain so favorable for much longer, as temporary unemployment support has now expired and interest rates are about to resume their upward trend, the analysts said.
But Bank of America Merrill Lynch said rising mortgage costs ought to be manageable for Spanish consumers through 2011 and 2012, assuming continued austerity measures, subdued employment trends and persistently tight lending.
The bank forecasts costs at about 0.3 percent of household consumption in 2011, rising to about 0.6 percent in 2012.
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