As inflation is still here with us, central banks keep raising interest rates. FED’s main rate has reached 4.75% while ECB’s has reached 3.5%. At the same time, while we talk, the inflation in February in the US has been steadily dropping but is still very high at 6% annually, while in Germany it is at staggering 8.7% compared to the February last year.

Why central banks raise interest rate to fight inflation?

• Reduced borrowing and spending: Higher interest rates make borrowing more expensive, which discourages individuals and businesses from taking out loans. This leads to a decrease in consumer spending and business investment, which in turn reduces aggregate demand. With lower demand, businesses have less pricing power and are less likely to increase their prices, thus helping to control inflation.
• Increased saving: Higher interest rates make saving more attractive, as individuals can earn more interest on their deposits. This encourages people to save more and spend less, which further reduces aggregate demand and, consequently, inflationary pressures.
• Currency appreciation: When a central bank raises interest rates, it often leads to an appreciation of the country’s currency. This is because higher interest rates attract foreign investors seeking better returns, which increases the demand for the currency. A stronger currency means that imports become cheaper, and this can help reduce inflation, as imported goods and services make up a portion of the overall price level.
• Inflation expectations: Central banks also use interest rate adjustments to signal their commitment to maintaining price stability. By raising interest rates, they send a message to businesses, investors, and consumers that they are serious about controlling inflation. This can help anchor inflation expectations, reducing the likelihood that people will adjust their behavior in anticipation of higher inflation (for example, by demanding higher wages or raising prices).

Certainly, raising interest rates can have several drawbacks that central banks need to carefully consider before taking action. Here are some of the potential negative consequences:

• Slower economic growth: When interest rates rise, borrowing becomes more expensive, which can lead to reduced consumer spending and business investment. This may cause a slowdown in economic growth, as less money is being spent on goods and services. In extreme cases, raising interest rates too much or too quickly can push the economy into a recession.
• Increased burden on borrowers: Higher interest rates can make it more difficult for both individuals and businesses to repay their existing debts, as the cost of servicing those debts increases. This can lead to increased financial stress, potential defaults, and even bankruptcies. In particular, individuals with variable-rate mortgages or other floating-rate loans can face significantly higher payments, which may strain their budgets and reduce their disposable income.
• Income inequality: Higher interest rates can disproportionately affect lower-income households, as they often have a higher debt-to-income ratio and rely more on borrowing for day-to-day expenses. As interest rates rise, these households may face greater financial strain, exacerbating existing income inequalities. Moreover, since higher interest rates generally lead to higher returns on savings and investments, wealthier individuals who have more assets may benefit, further widening the income gap. This gap should also be considered across Europe, I.e. South vs North.
• Tighter credit conditions: When interest rates increase, banks and other financial institutions may become more cautious in their lending practices, tightening credit standards to minimize the risk of defaults. This can make it more difficult for businesses, particularly small and medium-sized enterprises (SMEs), to secure financing for their operations or expansion plans, potentially hindering job creation and economic growth.
• Negative impact on interest-sensitive sectors: Some sectors of the economy are particularly sensitive to changes in interest rates, such as housing, construction, and capital-intensive industries. Higher interest rates can lead to decreased demand for housing (due to higher mortgage costs) and reduced investment in construction and infrastructure projects. This may result in job losses and a slowdown in these sectors.

Central banks need to carefully weigh these potential drawbacks against the benefits of raising interest rates to control inflation. The challenge lies in finding the right balance between managing inflation expectations and promoting economic growth while minimizing adverse effects on borrowers and vulnerable sectors of the economy.

The elephant in the room

An increase in interest rates by central banks can have significant implications for poorly managed banks with maturity mismatches in their deposits and investments with no hedges of interest rate risk. Maturity mismatch occurs when a bank’s liabilities (such as customer deposits) have shorter maturities than its assets (such as loans and investments). In such situations, higher interest rates can affect these banks in several ways.

Poorly managed banks with maturity mismatches may face liquidity risks when interest rates rise. As the rates on deposits and other short-term liabilities increase, customers may choose to withdraw their funds and invest elsewhere in search of higher returns. If a bank cannot replace these funds or liquidate assets quickly enough to meet withdrawal demands, it may face a liquidity crisis, which can lead to insolvency.

Higher interest rates can also lead to an increased burden on borrowers, raising the risk of loan defaults. For banks with maturity mismatches and poor asset-liability management, this increased credit risk can result in higher provisions for loan losses, reduced profitability, and a weakened balance sheet.

Banks with maturity mismatches may have a significant portion of their assets invested in long-term, fixed-rate securities (such as bonds). When interest rates rise, the market value of these securities declines, as they become less attractive compared to new securities offering higher yields. This can lead to capital losses for the bank and a decline in the value of its investment portfolio.

When a bank with a maturity mismatch relies on short-term funding sources to finance longer-term assets, it faces refinancing risk. As interest rates rise, the cost of refinancing these short-term liabilities increases, putting pressure on the bank’s profitability and overall financial stability.

Decreased costs of switching banks in Europe due to Open Banking rules, combined with almost instantaneous information transmission on social media and rapid increase in interest rates by ECB are an ideal setup for a bank run on badly managed banks. In the long run, that could lead to a healthier banking system in Europe and eliminate the badly managed banks. But history teaches us that governments lead by their short reelection horizons will end up spending tax payers’ money to rescue these poorly managed banks with maturity mismatches in their portfolios.

P.S.
How to recognize badly managed banks?

• Currently a risk free rate offered to banks by ECB has reached 3.75% annually. If your bank offers you a significantly lower savings rate, the bank is likely badly managed.
• The second one is more sophisticated and very difficult to check unless you are a central bank. If a large portion of bank’s portfolio is invested into long term fixed income instruments with a yield significantly lower than 4%, while most of their deposits are on current account and not term deposits with higher maturity – there is a significant issue.