Europe’s banks should prove resilient, despite falling rates

Europe’s banks are on track to outperform the broader European equity market for a fourth consecutive year. Yet as the European Central Bank continues to ease monetary policy, we examine whether the sector can weather a lower interest rate environment.

Rising interest rates since the pandemic have been a blessing for European banks, increasing net interest income as net interest margins expanded. Combined with cost discipline and low levels of loan loss provisions, this has improved returns on equity.

Capital ratios have also increased in recent years and European banks are - mostly - comfortably capitalised. Some even have considerable excess capital. As a result, capital return has been a highlight for investors in the banking sector. Average dividend yields plus share buyback yields should add up to an average total capital return yield of more than 10% over 2024-2025.

Capital ratios have also increased in recent years and European banks are - mostly - comfortably capitalised

Earnings implications

However, while European banks’ pre-tax profit in the second quarter of 2024 was 10% ahead of market expectations, net interest income was only in line with expectations, and is no longer producing positive surprises. The earnings beat was driven by revenues from non-interest incomes streams, such as fees, trading and investment banking, or loan-loss provisions and costs.

Falling interest income may lead to less favourable earnings per share (EPS) momentum, a key driver for bank share prices, and may even lead to EPS downgrades for some banks. 

This is particularly true for rate-sensitive banks such as those in Italy, Spain or Sweden. In Spain, mortgages are typically priced on the 12-month Euribor, the euro-denominated money market benchmark, which has been decreasing. This could lead to pressure on net interest margins over time. Banks benefiting from fixed asset repricing into higher rates, or with hedges in place (such as in France and the UK) should be more resilient.

Of course, lower rates can help loan growth, which has been elusive in recent years. In fact, we see signs that Spain’s long deleveraging period may be ending. A rebound in loans could help to offset some of the net interest margin pressure. Non-interest revenue also tends to benefit from lower rates and many banks have bolstered these activities, as well as working hard to reduce their interest rate sensitivity.

As long as interest rates do not drop below around 2%, profitability should remain relatively resilient

As a result, the earnings upgrade cycle looks over, with even some risk of earnings downgrades. Still, as long as interest rates do not drop below around 2%, profitability should remain relatively resilient. We see return on tangible equity for listed banks stabilising around 11% or 12% in 2025-26, compared with a level around 13% today. This should support capital generation and also capital return, which remains one of the key attractions of the sector to investors.

Improving resilience

However, slowing earnings momentum could lead banks’ managers to search for other earnings drivers. That may lead to increased merger and acquisition (M&A) activity and may have been behind a recent hostile takeover bid in Spain, or an Italian bank’s acquisition of a stake in a German bank. In both cases there are cost synergies as these can be considered home-market transactions (the Italian bank also owns a German bank). In these cases, synergies are higher. Given the fragmented structure of the European banking market, pure cross-border deals still look complex and synergies harder to achieve. That said, bolt-on deals to scale a business or acquire a new capability are more frequent and generally better received by investors. We expect more activity on this front, as well as perhaps some more in-market activity. But we are wary of cross-border M&A generally, as value creation can prove difficult. This suggests that investors should not expect a wave of cross-border deals.

Banks have worked to improve resiliency by reducing some rate sensitivity, bolstering fee income revenues and, in some cases, pondering in-market acquisitions

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While falling interest rates could lead to some earnings pressure, banks have worked to improve resiliency by reducing some rate sensitivity, bolstering fee income revenues and, in some cases, pondering in-market acquisitions. This should lead to their returns on tangible equity stabilising above historical levels, and in turn support capital return. At around 7%, dividend yields are particularly attractive for income-seeking investors. The sector is also inexpensive at a price-to-earnings ratio of around seven times 2025 estimates, and still below its historical average of eight-times earnings. The cost of equity also remains high in Europe given macroeconomic and political concerns. For a further boost the market needs some reassurance on these subjects – as well as confirmation that profits can be resilient. That may come, thanks to hedges, certain assets on the balance sheet repricing higher, fee income and investment banking revenues. We prefer banks with exposure to these trends, and that return capital.

For now, we retain our neutral view on the European financial sector and its banks. Instead, we prefer the risk-reward profile available elsewhere, including the materials sector for its exposure to high-quality cyclical businesses, and the energy sector, for its attractive total shareholder returns.