European Banks: Riding High but Facing the Limits of the Rally
GerikSummary:
European bank stocks have surged over 40% in 2025, vastly outperforming broader markets, but questions are mounting about whether earnings, rates, and sentiment can sustain the rally amid tariff risks, political turmoil...
Earnings Tailwinds and Their Limits
The rally in European banks has been underpinned by a rebound in net interest income (NII), thanks to years of relatively higher rates and improved growth expectations. Many banks beat earnings forecasts, with second-quarter results reinforcing optimism that NII had bottomed earlier than expected. Analysts at Morgan Stanley even project growth resuming in 2026.
However, as Morningstar’s Johann Scholtz points out, this momentum may fade. With rates already falling from their 2024 peak of 4% and tariffs likely to raise corporate default risks, loan-loss provisions are set to climb. The U.S.-EU tariff détente has eased some uncertainty, but defaults tied to trade frictions could reintroduce stress, limiting earnings upside.
Rate Environment: The “Sweet Spot”
After a decade of negative or zero rates that eroded margins, the current level above 2% but below the 4% peak has created a “sweet spot” for European lenders. Deposit franchises are finally paying off without yet triggering major credit quality stress. Investors have rewarded banks, with their price-to-book ratios rising above 1.1 for the first time in years.
In the UK, expectations of limited further cuts have buoyed NatWest, Lloyds, and Barclays, whose shares are up between 35% and 50% this year. Yet, none have regained pre-2008 levels, reminding investors of structural scars.
Performance across Europe is uneven. German and Spanish banks are thriving, supported by fiscal stimulus, robust domestic growth, and M&A speculation around Commerzbank and Sabadell. In contrast, Switzerland’s UBS faces headwinds from tariffs, zero rates, and tightening capital rules. France has emerged as a risk point: renewed political instability triggered Societe Generale’s steepest one-day drop since April, a reminder of how fragile sentiment remains.
Risk Perception Has Shifted
Despite political and trade risks, investors now perceive banks as less risky than in past crises. Credit default swap spreads have narrowed sharply, with Deutsche Bank’s CDS at 54 bps compared to above 200 bps in 2023. High-yield AT1 bank bonds, once questioned after Credit Suisse’s collapse, are enjoying renewed investor appetite, delivering equity-like returns without the investment-grade label.
Analysts are split on whether the rally has more legs. Some, like Candriam’s Christian Sole, are cautious, noting that while momentum remains positive, valuations leave little room for error, especially with recession risks not fully priced in. Others, like Morgan Stanley, argue that pullbacks should be seen as buying opportunities, given stronger bank balance sheets, lower leverage, and structural resilience compared to 2008.
Source: Reuters
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