European Bank Stocks Face Headwinds After Strong Rally but Investors Eye Further Opportunities

European bank shares, which have surged more than 40 percent so far this year, are now entering a testing phase as renewed political uncertainty in France weighs on sentiment. Yet, despite the challenges, the sector’s powerful performance remains difficult for investors to overlook. According to LSEG data, anyone who invested in European banks five years ago would now be sitting on a net return of about 300 percent, compared with roughly 70 percent for the wider market.

The rally has been underpinned by robust earnings in recent years, driven by relatively high interest rates prior to recent cuts and an improved growth outlook, with many banks exceeding profit expectations. But questions remain about sustainability. Morningstar senior equity analyst Johann Scholtz cautioned that as rates decline, future earnings could flatten or even fall, while tariffs may increase companies’ bad-loan provisions, which RBC has so far noted as stable. “We definitely expect corporate defaults to increase as a result of tariffs,” said Scholtz.

Morgan Stanley analysts observed that second-quarter results confirmed their view that net interest income (NII)—the difference between what banks earn from loans and investments and what they pay on deposits—had reached its floor earlier than anticipated. They forecast a return to growth in 2026.

Even if earnings momentum slows, the sector could benefit from an end to European Central Bank rate cuts and the definitive close of the negative-rate era. “People really underestimated the damage that zero and negative interest rates, that we had for a decade, did to European banks,” said Scholtz. A recent European Parliament report noted that European banks remain more sensitive to rate movements than their U.S. counterparts, with NII accounting for 60 percent of net operating income.

Though interest rates have eased from their peak of 4 percent, they are not expected to fall far below 2 percent, especially as an EU-U.S. tariff agreement calms economic concerns. “We’re almost in a sweet spot where banks are able to finally benefit from these deposit franchises that they have, but at the same time, you’re not seeing that stress on the credit side,” explained Shanti Das Wermes, portfolio manager at MFS Investment.

Expectations of limited further cuts in the UK have bolstered banks like NatWest, Lloyds and Barclays, whose shares are up 35 to 50 percent this year, although they remain below pre-2008 crisis levels.

Confidence in the sector is also reflected in valuations. The price-to-book ratio for the average bank in the STOXX Europe 600 Banks index has climbed to 1.12, after years languishing below one, signaling renewed optimism in the ability of lenders to create shareholder value. Still, performance has been uneven. German and Spanish banks have led the way amid merger speculation around Commerzbank and Sabadell, alongside support from Germany’s fiscal stimulus and Spain’s resilient economy. German business confidence in August even hit a 15-month high.

By contrast, Switzerland’s UBS has faced mounting headwinds from stiff U.S. tariffs, near-zero interest rates, and fresh capital regulations. French banks have also shown how fragile sentiment can be, with shares tumbling this week on renewed political instability. Societe Generale suffered its steepest daily decline since April on Tuesday.

Broadly, however, investors perceive the sector as less risky than in the past. Credit default swaps have fallen sharply, with Deutsche Bank’s CDS now around 54 basis points, far below the 200 bps spike during the 2023 U.S. banking turmoil. High-risk AT1 bank bonds have also rebounded after their credibility was shaken during Credit Suisse’s collapse. “They (AT1s) are a lovely combination – great returns. Effectively investment grade paper without the investment grade tag,” said Ian Birrell, CIO at Premier Milton, noting his significant exposure to financial stocks.

European banks recently hit their highest level since 2008, with analysts emphasizing that leverage is lower and the sector more robust than before the financial crisis. Still, some investors are cautious. Christian Sole, deputy head of Fundamental European Equity at Candriam, said his firm had invested heavily in banks before the COVID-19 crisis when valuations were “very cheap,” but he now strikes a more neutral stance. “The momentum is still positive, but the price is not allowing us to be too optimistic,” Sole remarked, adding that recession risks, though not part of his forecast, are not factored into valuations.

Others, however, see weakness as an opening. Morgan Stanley this week reiterated its call to “buy the dip” in European banks following recent declines.

By fLEXI tEAM