US yields fell, yet European bank stocks dropped 3.7% in a single day. Don't banks make more money when rates go up?

When higher rates are good for banks

Banks earn the spread between money they borrow cheaply (deposits) and money they lend at higher rates (loans). So profits grow when short-term policy rates rise and deposit rates lag behind. The latest rise in European yields is different. The ECB made no new decision during this collection period, and what rose were long-dated yields such as the German 10-year at 3.65% (highest since 2009) and the French 10-year at 4.74%. The cause is not an overheating economy but fiscal concern, as shown by the German-French spread widening to about 111bp. This kind of rise in yields does less to widen bank margins than to cut the value of the government bonds banks hold.

The real channel: valuation losses on bond holdings

When bond yields rise, bond prices fall. When banks mark these bonds to market, the losses eat into their capital. European banks have piled up large amounts of their own governments' debt since 2011, and the market calls the loop in which shaky public finances weaken bank capital, and bank bailouts in turn worsen public finances, the "doom loop" (Reuters column). Moody's judged the impact on French banks to be limited, as government bonds exposed to valuation losses amount to about 12% of average common equity Tier 1 (CET1) capital (Moody's analysis cited by Newsquawk). On the numbers alone that is manageable, but share prices react first to the suspicion that "this loop may be spinning again" rather than to the size of the losses.

Notably, the decline was not concentrated in French banks. UK banks fell harder, with HSBC and Barclays -4.1% and Lloyds -4.5%. It is better read as a repricing of discount rates across European long-term yields than as a credit problem in a specific country.

Historical precedents

All three ended with central bank intervention. Today the ECB is in no position to buy bonds readily because of inflation, and the US and Japan are tightening at the same time. The difference this time is that the exit of intervention may open later than in the past.

Why US banks should be viewed differently

In the US, the gap between the 10-year (5.237%) and the 13-week bill (3.982%) is 1.255%p, a positive yield curve. That structure favors the bank business of borrowing short and lending long. Still, XLF gained only +0.11% on 10/1 and was weak intraday on rate pressure. If long-term yields rise further, talk of valuation losses on US bank bond holdings could return, so the tailwind from the yield spread and the headwind from valuation losses are offsetting each other.

What should investors do?

• Hold off on buying European bank ETFs on the dip. It is not too late to wait until after France's 2027 budget in October to see whether the 111bp German-French spread narrows.
• A byproduct of this channel is dollar strength. EUR/USD was -0.81% (1.1249) and the dollar index 102.03. That weighs on the won (1,358.4 won) and emerging market assets, so investors who track overseas assets in won terms should calculate the currency effect separately.
• If you hold US bank stocks, use whether the 10-year breaks back above 5.3% as your stop-loss line. Above that level, valuation loss concerns are likely to outweigh the yield spread tailwind.