A surge in market interest rates amid monetary policy tightening had a favourable impact on bank profitability in Croatia. Improved profitability mostly mirrors a high level of liquid assets, mainly in the form of deposits with the central bank and, to a lesser extent, higher margins in transactions with the government and corporates. By contrast, rising competitiveness in the financing market in the past months has led to a marked increase in deposit interest rates. The intensity of the fall in profit due to higher interest expenses will depend primarily on the speed of the transfer of monetary funds from overnight to time deposits. It is very difficult to project the speed of the increase in the share of time deposits since the share of time deposits was almost only falling in the past ten years, driven by a steep plunge in deposit rates. Under a moderate scenario, bank profit might fall by one to two fifths, while under an extreme scenario, which assumes that the share of time deposits will return to historical highs, bank profit might fall by almost two thirds. Further growth in interest income propelled by a gradual maturing of old loans granted at lower interest rates and an increase in interest rates on a portion of existing loans granted at variable rate, could partly mitigate the fall in bank profit relative to projections, but it is not likely that they could fully offset this fall.

Changes in market interest rates affect bank profitability through a range of complex channels, depending on the specific circumstances of each system and change over time^[1]. With banks engaging in asset maturity transformation, which is the practice of granting long-term loans against short-term sources of funding (Figures 1.a, Figure 1.b), the growth in market rates tends to spill over faster to interest expenses of banks than to their interest income. This structural characteristics of the system exposes banks to interest rate risk, which they typically try to avoid by actively managing their balance sheet structure and maturity profile or by employing market interest rate derivatives. The first approach includes different methods of adjustments of assets and liabilities sensitiveness to interest rate changes, such as holding considerable yield-carrying liquid (short-term) assets in accordance with current market conditions or negotiating variable interest rates on asset instruments. The growth in market interest rates also affects non-interest income through several main channels such as the effects on the valuation of held-for trading debt instruments, risk hedging instruments in the form of derivatives and income from fees and commissions. And lastly, interest rate growth may impair the ability of bank clients to settle their liabilities as they fall due. This interest rate-induced credit risk typically materialises with a time lag, so its unfavourable impact on profitability can only be seen later than other effects. Thus, the relationship between the level of interest rates and bank profitability is not always equal or stable over time but depends on specific market circumstances, business policies of banks and overall macroeconomic environment.

Figure 1 A large share of transaction deposits against long-term loans has led to maturity gap widening

Source: CNB.

The growth in interest rates in the current cycle of monetary policy tightening has thus far boosted domestic banks’ profitability (Figure 2). This is mostly reflective of the high level of short-term liquid assets, largely in the form of reserves with the central bank (Figure 3), which, owing to the growth in ECB key interest rates carry higher yields. Rising profitability is also due to relative slowness in raising deposit rates. The banks thus expanded their interest margins by raising interest rates on new loans and to a lesser extent on the existing loans, both in transactions with corporates and the government, increasing their net interest income considerably (Figure 4). By contrast, the interest rate spread in transactions with households remained relatively stable, with both interest rates on deposits and loans witnessing no major changes. However, this trend first came to a halt and then reversed towards the end of last year (Figure 5).

Figure 2 Return on equity rose to levels unseen in the previous decade

Note: The return on equity (ROE) for 2023 is annualised based on the last cumulative profit for the first nine months of 2023.
Source: CNB.

Figure 3 The entry into the euro area further increased the liquidity level of the domestic banking system

Sources: CNB, ECB.

Figure 4 Strong contribution of the central bank to net interest income growth

Source: CNB (data processed by authors).

Figure 5 The growth in interest rate spread came to a halt

Note: The interest rate spread is calculated as the difference between the interest rate on loan balances and deposit balances by sectors. Total includes all sectors.
Source: CNB (data processed by authors).

A surge in interest rates on household time deposits started affecting bank profitability towards the end of the third quarter of 2023. The interest rates on household time deposits have started growing faster since September 2023, with a time lag when compared to corporate time deposits, which rose sharply already in the first half of last year. Growing competition on the market of sources of financing is supported especially by issues of government securities catering to households and attempts of some banks to increase market shares.

The share of time deposits in total corporate deposits rose last year from 6.8% to 23.9%, which is still much below this share’s level in the period of high deposit rates ten years ago.

Despite a visible increase in interest rates on new time deposits, interest expenses of banks have risen only slightly thus far because the interest rates on overnight deposits remain very low, and the share of time deposits in total deposits is still relatively small compared to the highest recorded levels. More precisely, the share of time deposits in total corporate deposits rose last year from 6.8% to 23.9%, which still much below this share’s level in the period of high deposit rates until ten years ago. By contrast, the share of time deposits in total deposits of households only started growing slowly recently, reaching 27% towards the end of last year, thus just beginning to close the gap when compared to the maximum 80% recorded in the first half of the previous decade.

The share of time deposits in total deposits of households only started growing slowly recently, reaching 27% towards the end of last year, thus just beginning to close the gap when compared with the maximum 80% recorded in the first half of the previous decade.

The impact of growth in interest rates on time deposits on profitability will depend on the speed and intensity of the transfer of overnight deposits to time deposits. To quantify the possible effect of more expensive sources of financing on bank profitability, aside from developments in interest rates on deposits, it is necessary to assume the trajectory of time deposits, i.e. the speed at which monetary funds will return to time deposits in the conditions of higher deposit rates. The interest rates on new time deposits have probably come close to the maximum levels that can be expected in this cycle of monetary policy tightening, so the assumed levels move only slightly above the current ones. Thus, the assumed increase in interest rates on household and corporate time deposits of 3% and 3.5%, respectively, is slightly above market averages (Figure 6), but fits the upper band of interest rates offered on time deposits in individual banks. This assumption rests on the expectation of a further transfer of deposits into banks offering higher interest rates, the process that began towards the end of last year, which should propel the advance of the offered interest rates towards the upper part of the current band. At the same time, interest rates on corporate time deposits are assumed to remain at 3.5%, close to their current level. Unlike interest rates, which have probably already mostly undergone most adjustment to the new conditions, the process of the return of monetary funds to time deposits is still in a relatively early phase and it is difficult to project its trajectory at this point.

As the previous decade was marked exclusively by a fall in the share of time deposits in total deposits (see Figure 7) driven over time by a fall in interest rates, we actually have no experience with the reverse process. As a result, the simulation considers a wide range of scenarios, from those where current shares remain unchanged to those where shares quickly return to historical maximums.

Figure 6 Interest Rates on outstanding time deposits and new business time deposits

Note: The dotted green line shows the target rate used in the simulation of price change.
Source: CNB.

Figure 7 Share of time deposits in total sector deposits

Note: The figure shows the shares of time deposits in total deposits by sector. The dotted lines show historical maximums of individual sectors’ time deposits, while the values on the right show the required nominal amount of the reclassification of transaction deposits into time deposits, by sector, to reach that maximum amount.
Source: CNB.

Any considerable transfer of overnight deposits to time deposits might reduce bank profitability considerably (Table 1). Bank profitability under the scenario that assumes that the share of time deposits will remain at existing levels, with a small additional, system-wide increase in deposit interest rates (3% on household time deposits and 3.5% on corporate time deposits), would be faced with a fall in nominal profit of approximately EUR 248m, or some 14% of the estimated profit for 2023. Under the second, borderline scenario that assumes the return of time deposits to maximum historical levels, bank profit would drop sharply, by over EUR 1.1bn, or over 60% of the estimated profit for 2023. However, this scenario does not seem particularly likely over a short-term, with more probability in materialising being the scenarios in the middle of the observed bands, under which profitability might fall by 20% – 40% of the nominal profit for 2023.

Table 1 Sensitivity analysis of the effect of deposit transfer and price change on profitability

Note: Grey-coloured square assumes that the current structure of deposits remains the same with the assumed growth in interest rates on household and corporate time deposits of 3% and 3.5%, respectively. Nominal profit is shown before taxes.
Source: CNB.

Further growth in interest income amid higher market rates might mitigate to an extent the unfavourable impact of growth in interest expenses on profitability. A gradual maturing of the existing loans granted at low interest rates and rising interest rates on variable rate household loans will continue to contribute to interest income of banks. The growth in deposit rates will propel the increase in the national reference rate (NRR), which will gradually affect loans tied to this rate. Such an increase in interest rates on existing loans will result in the elevation of legal restrictions applying to loans granted at variable interest rates, which will in turn increase the interest rates on loans tied to the EURIBOR, which are currently mostly at the level of the legislative restriction.

The impact of the increase in interest expenses is expected to outpace the potential increase in interest income, given that households have a larger amount of deposits than loans, particularly loans with variable interest rates over a short term.

The impact of the increase in interest expenses is expected to outpace the potential increase in interest income, given that households have a larger amount of deposits than loans, and particularly loans with variable interest rates over a short term. Namely, since a relatively high share of household loans was granted at fixed-to-maturity rates or at fixed rates over a multiple-year period, there is a relatively small number of existing loans with variable rates over a short-term, which has a positive effect on interest income. And lastly, the effects of interest expenses growth might be somewhat smaller than estimated if interest rates are kept below the levels of the upper part of the range due to deposit inertia, or lack of propensity on the part of depositors to move deposits on account of interest rates.

1. Borio, C., Gambacorta, L. and Boris, H., 2015: The Influence of Monetary Policy on Bank Profitability, BIS Working Paper No. 514 (BIS), available at http://www.bis.org/publ/work514.pdf ↑