European banks on front foot heading into 2025

With most European banks having now delivered their Q3 2024 results, we believe the sector is firmly on the front foot moving into 2025.

Strong Q3 figures across the sector have the helped the European bank stock index (SX7E) outperform the broader European stock index (SX5E) by around 5% since the reporting period began, as of Monday’s close. This has come as no surprise given the banks’ half-year results had already provided some insight into the relatively stable underlying trends in the industry, but it is worth highlighting the positive trend across multiple fundamentals.

First, asset quality looks unequivocally strong. Higher interest rates – with 2024 being the first year to show their full effect – was always going to represent a challenge to the sector’s asset quality, testing banks’ underwriting standards as well as the resilience of their underlying economies. In light of supportive unemployment trends, asset quality in retail lending remained strong with little non-performing loan (NPL) growth to speak of. In corporate lending the only visible softening in asset quality has been in commercial real estate, and even here the weakness mostly related to the US office sector with only a handful of lenders experiencing some stress. On balance, European banks are entering the next year with a backdrop of still-low unemployment and a supportive outlook for asset quality.

Second, higher rates have continued to offer a tailwind in terms of profitability. Some of this upside has already tailed off following the series of rate cuts across the region, with net interest margins being reduced. At the same time, many banks have enjoyed (and expect to continue enjoying) a material tailwind from reinvesting the proceeds of lower rate products reaching maturity into today’s higher rate products. Narrower swap spreads offer another opportunity to improve profitability by optimising the liquid asset side of their balance sheets; banks can reduce their central bank reserve holdings and replace them with cheaper government bonds. Finally, the sector continues to focus on improving its non-interest income revenue. All-in-all, while the peak impact of higher rates on profitability has now passed, as rates fall next year banks will continue to benefit from the above tailwinds to offset some of the squeeze on margins.

Third, capital positions remain resilient with little material change to headline Common Equity Tier 1 (CET1) ratios across the sector. Heading into 2025 we expect more headlines around the expected watering-down of capital rules, and it is worth noting that the US election outcome has probably increased the chances of a more relaxed regulatory environment for US banks. This would most likely encourage European regulators to follow suit and adjust the planned ‘Basel IV’ rules accordingly to retain a level playing field. Irrespective of the outcome of these discussions, we expect the topic of capital to remain very much in vogue, not just in 2025 but in the years to come. Generally, European banks’ use of internal risk-based (IRB) models for calculating risk-weighted assets (RWAs) means they report a lower risk-weighted asset density (RWAs as a proportion of total assets) than US peers. Over time we expect European banks to move more in line with the US on this metric – a positive from a bondholder perspective – helped by significant risk transfer (SRT) transactions and on-site regulatory reviews.

Finally, the trend of consolidation we have seen in the European banking sector this year has already boosted returns for many bondholders in 2024, and in the last month or so the trend has continued with activity in Italy showing the potential for further consolidation. Moving through 2025 we expect to see the crystallisation of some of these benefits via somewhat lower competition, more efficient balance sheets and the absorption of some weaker links in the sector.

Taken together, we think the strong underlying trends across major metrics listed above suggest European banks are having one of their best years in recent memory. The risks are certainly worth highlighting: a sharper fall in interest rates than currently priced in could lead to uneven outcomes for banks relying on term deposits; ongoing discussions around capital are here to stay; and there are isolated pockets of pressure such as the regulatory scrutiny on motor financing in the UK.

Still, given overall levels of profitability (full-year 2024 return-on-equity is forecast at 11.5%) and capital, as well as the momentum behind consolidation, as fixed income investors it is fair to say we have a constructive outlook on the European banking sector as we move into 2025.