A determination by Europe's most powerful central bankers to keep interest rates low might save the continent's fragile banking system from short-term pain but undermines long-term profitability and encourages excessive risk-taking.

The Bank of England's new governor Mark Carney raised eyebrows on July 4 when he said market expectations of higher interest rates were "not warranted," a policy departure for a central bank that traditionally plays its cards close to its chest until monthly rate decisions are taken.

Hours later, the European Central Bank's president Mario Draghi echoed the same guidance for eurozone rates, saying monetary policy should remain "accommodative."

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The commitment to lower interest rates means Europe's banks, still fragile after the 2007-2009 crisis and facing stress tests in mid 2014 that could trigger fresh capital demands, have less cause to fear an interest rate shock that would dramatically change their funding and lending costs after four years of record low rates.

That has been identified as a major risk by authorities including the Bank of England, the Dutch National Bank and Switzerland's Finma, since it could trigger higher loan defaults, a hit to margins over a transition period and lower equity values for banks.

But once rates have stabilized at higher levels, banks earnings should improve, and they are less tempted to pursue riskier lending and investment.

"We are trapped between a rock and a hard place," said Gert Wehinger, a senior economist with the OECD's financial directorate. "The more we have extremely low interest rates, the more we have risks accumulating ... If you lift them now, you can trigger something even worse, which means recessions and banks defaulting."

A PAINFUL ADJUSTMENT

Most major banks provide some disclosure on what would happen to their 'net interest income', or lending margin, if rates rose. In eight of Europe's biggest 10 banks, those disclosures show margins rise as rates rise. At HSBC, annual net interest income would rise by 1.4 billion dollars if rates rose by 0.25 percent a quarter for four quarters.

But that rosy picture belies a more complex truth. The banks' figures show what would happen if all short-term and long-term interest rates moved by the same amount, typically a 1 percent increase, but that rarely happens.

Central bank action affects short-term rates more than long-term rates, which are buffeted by a wider range of influences, such as supply and demand and long-term rate expectations.

Banks typically earn money at long-term rates, on lending such as mortgages, but borrow for shorter terms, so they prefer a rising yield curve over time. If short term-rates rise and long-term rates don't, the bank is squeezed.

Even if long-term rates rise, they can't necessarily be applied to all the bank's long-term loans — 20-year fixed-rate mortgages are popular in many European markets — while customers will quickly expect higher interest on their deposits.

"The question there is, will banks be able to refinance on the long run these very low long-term mortgage rates," said Professor Martin Hellmich, of the Frankfurt School of Finance & Management. "That is one thing where you have substantial risk."

LOANS TAKE A HIT AS RATES RISE

The more down-to-earth risk banks face from higher interest rates is higher defaults, once borrowing costs eventually rise.

"Low interest rates are tempting many people to buy their own house or private apartment despite the sharp rise in prices," said Patrick Raaflaub, the head of Switzerland's regulator Finma said at an event on March 26.

"But will these new buyers be able to cope with a higher interest burden if interest rates rise?"
Such fears were behind the BoE's June decision to ask banks for more information on their interest rate risk by September. Holland's DNB asked for something similar earlier in the year, "with special emphasis on mortgages."

Even if borrowers don't default, fixed rate loans are still worth less to a bank in a rising interest rate environment.

The income stream of loan repayments, taking into account the bank's own borrowing costs, is known as net present value, and is a key input into the 'real' value of a bank.

In its 2012 annual report, Dutch bancassurer ING said a 1 percent rise in interest rates would reduce its net present value by 2.14 billion ($2.81 billion) euros. Even a hit that large is not immediately recognized by banks.

"Changes in the book value of a loan only have to be recognized if the borrower's creditworthiness has deteriorated," said Christoph Memmel, an economist with Germany's Bundesbank.

"Present value losses caused by increases in the risk-free (central bank) interest rate have no immediate consequences for a bank's profit and loss."

Regulators aren't blind to the risk, and banks do have to hold some capital for it under part of the capital framework known as Pillar 2, which stresses their 'banking books' against a 2 percent rise or fall in rates. But the picture is incomplete, and investors have little sight of the real risks.

CAPITAL CONSEQUENCES

The capital hit is more apparent on banks' trading books - the 'available for sale' (AFS) securities they hold which have to be regularly revalued, or 'marked to market'. These take an immediate hit if interest rates rise, as a bond paying 4 percent is immediately less valuable if new issues pay more.

In a June 19 note, KBW analyzed how the equity of 36 European banks would be hit by a 1 percent fall in the value of their AFS debt securities, an analysis that depends on the relative size of AFS holdings, not the portfolios' attributes.

It found that Portuguese bank BPI would be worst hit, with shareholders' equity falling by almost 6 percent for every 1 percent fall in the value of its AFS debt.

"Unsurprisingly, the banks in the periphery, with lower equity base and higher ALM/carry trade portfolios, are most leveraged, with negative marks," the analysts said.

The ALM/carry trade portfolios hold higher-yielding bonds that banks bought with cheap money from the ECB.

Among the bigger banks, France's Credit Agricole and Belgium's KBC would suffer falls of about 2.5 percent in equity for a 1 percent fall in the value of their AFS instruments. Falls would be lowest at Credit Suisse, at just over 0.1 percent, and Lloyds, less than 1 percent, KBW said.

KBW said investment banks were less exposed to AFS losses than many investors perceive because they have slimmed down their portfolios so much. The 'Value at Risk' (VaR) linked to interest rates has fallen by two thirds across Europe's four biggest investment banks, KBW said.

Some investment banks would benefit from higher interest rates for some business areas, it added. Banks' pension deficits would also look better in a higher interest rate environment.

Pulling an overall picture from the many moving parts can be difficult, but history suggests the transition to higher rates is a painful one. "Banks (shares) have underperformed in the four tightening periods over the last two decades, and by 9 percent on average," KBW said.

Once higher rates are bedded in, most bankers acknowledge it is better for profitability; several have told their investors about the drag of low interest rates on margins.

Policymakers also believe higher interest rates lead to more sustainable lending and investment. At a London conference on June 26, ECB executive board member Benoit Coeure detailed how low interest rates could promote bank risk-taking.

The crisis-tackling policies introduced by the ECB were designed to enable banks to continue lending into the real economy "by taking new risks," he noted.

"The concern is, however, that persistent liquidity sows the seeds for market turmoil."

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