European banks can cope with pressure on government bond yields

European government bonds have sold off sharply this week in the wake of Germany’s market-moving fiscal measures, while European equities, especially those of banks, have moved in the other direction.

For some, the magnitude of this upward shift in bond yields may bring to mind the tumult of early 2023, when the persistent rise of US Treasury (UST) yields over the preceding 12 months left a number of US regional banks with increasingly high unrealised losses in their investment portfolios.

For investors, it is worth understanding how the different regulatory regimes in the US and Europe lead to material differences in the risk banks carry on their balance sheets, and by extension why this sell-off in European rates is not causing the same level of concern.

Interest rate risk in the banking book, or IRRBB, is the regulatory term for mismatches that can arise between banks’ assets (for example loans and securities) and liabilities (for example deposits) in response to interest rate movements. Each bank manages its IRRBB with the intention of reducing these naturally occurring mismatches. If a bank cannot adequately manage its IRRBB, sharp moves in interest rates can eat into both earnings and capital levels.

Looking at the latest absolute moves in rates, the yield on 10-year Bunds has widened to around 2.82% today, up from 2.36% at the start of this year and 2.02% at the start of 2024. For comparison, the yield on 10-year USTs moved from 1.51% to 3.87% over the course of 2022, a climb of 236bp. So this move in Bunds has clearly been far more contained, though scrolling through the headlines of 2025 thus far it is fair to say we have a long year and plenty of uncertainty ahead of us.

To recap, the conditions that led to the failure of Silicon Valley Bank (SVB) and the problems at other US regional banks in early 2023 were created in the years and months that preceded the widening in UST yields. SVB itself enjoyed strong inflows of deposits post-Covid, which the bank invested in longer dated USTs as it sought to maximise its return; the sharp rise in yields meant the bank suffered unrealised losses on its UST position in its liquidity portfolio, which prompted questions around its viability and led to the outflow of deposits that eventually brought about its collapse.

It is important to note here that SVB was not unique in the way it accounted for the holdings of government bonds on its books. Indeed, all US banks account for these holdings in the same way and still hold on to the unrealised losses (see chart 8 here) and remain susceptible to interest rate shocks. What was unique about SVB was the combination of longer duration in the liquidity book, enormous unrealised losses compared to its capital, as well as a fickle depositor base.

Moving to Europe, the picture could not be more different.

First, regulation in Europe essentially forces banks to hold very low interest rate risk. In particular, in line with the Bank for International Settlements (BIS) recommendations, in a shock scenario European banks cannot suffer losses greater than 15% of Tier 1 capital for a 200bp move in interest rates. For some context, the Office of the Comptroller of the Currency in the US discloses rates shocks for US banks on a semi-annual basis. Based on its latest report (here), a 200bp move in rates led to an economic value loss as large as 23% among banks with at least $10bn in assets (and even higher for banks with smaller balance sheets). SVB did not disclose its economic value loss at all as of its last reporting period at the end of 2022.

Second, the geographic dispersion of the European banking sector means banks take a different approach to managing their investment books, by hedging away the rate exposure and focusing on the swap spread component of the relevant sovereign instead. Essentially this means European banks tend to hold mostly the credit risk of their respective sovereign (and associated risk of spread widening vs swaps) as opposed to the interest rate risk embedded in the swaps.

Lastly, as a side effect of quantitative easing (QE), European banks have heavily diversified their holdings of liquid assets away from government bonds. As an example, we calculate that over half the liquid assets of UK banks are in highly liquid central bank reserves that carry a floating rate. In mainland Europe, the allocation to central bank reserves versus government bonds differs among banks, and while some for example took the opportunity to capture widening swap spreads in French government bonds last year, this on the whole did not increase interest rate risk on balance sheet.

Clearly, large interest rate moves will always draw attention to the banking sector considering the natural mismatches between banks’ assets and liabilities. However, we take comfort in the fact that European banks’ exposure to interest rates is well managed and robustly regulated. We do not expect to see headlines around material unrealised losses on European banking books, even in a scenario where the recent pressure on Bunds and other European government bonds continues.