Risks to financial stability increase due to rapidly rising interest rates

Raising interest rates to tame inflation comes with risks to financial stability

In a bid to combat high inflation in the euro area, the European Central Bank has raised interest rates in a rapid series of hikes, from minus 0.5% to 4%. DNB President Klaas Knot said: “This was much needed, as inflation proved to be persistent and is still too high. This has made it more expensive for businesses, households and governments to borrow money. While this is a deliberate objective of our monetary policy, it comes with risks to financial stability. These risks need to be adequately managed and absorbed.”

The FSR identifies three key risks to financial stability. First, there are risks to financial markets. While the turmoil seen earlier this year has dissipated, the current lower liquidity is making it more likely that shocks in individual markets will spread to other parts of the financial system. This risk is fuelled by price volatility, especially in bond markets, which are driven by uncertainty surrounding the economic outlook and inflation, as has been evident again in recent weeks.

Credit risks due to higher refinancing risks among Dutch businesses

Second, financial institutions are facing growing interest rate and credit risks, mainly due to higher refinancing costs and lower repayment capacity among businesses. For example, 56% of total Dutch corporate debt is due to mature or subject to an interest rate review within the next two years. These businesses will be facing higher interest expenses soon.

Heightened credit risks are not yet reflected in Dutch banks' figures, but vigilance remains essential. After all, higher rates have a delayed effect on businesses’ and households’ financing costs, and hence on banks’ credit risks. This makes banks vulnerable to potential losses in the future. It is therefore important that banks factor this into their internal capital policies. Pension funds and insurers are also vulnerable to more sluggish economic growth or persistently high inflation due to the relatively high valuations of the equities and other risky assets they invest in.

Government debt weighs more heavily due to higher interest rates

The third growing risk to financial stability concerns government debt. Government support provided to businesses during the Covid-19 pandemic and to citizens during the energy crisis to support purchasing power were contributing factors in the rapid recovery of the Dutch economy. In today's higher interest rate environment, however, debt weighs more heavily on governments' budgets. It is important that countries – including the Netherlands – keep their fiscal policies under control so they can still support their economy in times of crisis. Despite the Netherlands’ relatively low debt-to-GDP ratio, which is caused in part by high inflation, the budget deficit, if left unadjusted, will likely exceed 3% of GDP in the years ahead, contravening European budget rules and limiting the scope for fiscal stabilisation.

The commercial real estate market is under pressure.

The FSR also looks at the Dutch commercial real estate market and any associated risks to financial stability. Dutch banks, insurers and pension funds have a combined exposure of €360 billion to commercial real estate. Due in part to higher financing costs, this market has been under pressure since mid-2022 – the transaction value of commercial real estate has fallen by 13% since then. Besides higher financing and construction costs, structural changes such as online shopping and remote working also play a role, reducing the need for retail and office space.

Financial institutions are not seeing these risks materialise yet

Although heightened credit risks associated with commercial real estate are not visible at banks as yet, this may change soon, if only because interest rates are expected to remain elevated for longer than in recent years. This increases the likelihood of a further decline in real estate prices, resulting in more defaults and credit losses for banks.

Insurers and pension funds are also exposed to losses caused by price corrections in commercial real estate, which have a direct impact on their balance sheets. Dutch real estate funds, in which pension funds in particular invest, have quadrupled in size over the past 15 years to some €135 billion. Nevertheless, the risks at these funds seem manageable for now, in part because the frequency at which investors can redeem their money from the funds is low.

For more information, please contact Bouke Bergsma by email at bouke.bergsma@dnb.nl or by telephone at +31 (0)6 53 25 84 00.