Resurgent European bank shares, up over 40 percent this year, face testing times with sentiment already being challenged by renewed French uncertainty.
Still, investors may find it hard to ignore the pull of Europe’s best performing sector of the year so far. An investor who bought into European banks five years ago is sitting on a net return of around 300 percent versus 70 percent for the broader market, LSEG data shows.
Here’s a look behind the rally and what’s next.
Earnings’ bounce may not last
Strong earnings, bolstered by relatively higher interest rates in the past few years – before recent cuts – and brighter growth prospects have driven the rally, with a majority of banks outperforming earnings estimates.
Morningstar senior equity analyst Johann Scholtz argues that alongside falling rates, future earnings are likely to be flat-to-lower with tariffs potentially lifting companies’ bad-loan provisions, which RBC says have been stable until now.
“We definitely expect corporate defaults to increase as a result of tariffs,” said Scholtz.
Morgan Stanley analysts said Q2 earnings supported a view that net interest income (NII), the difference between earnings on loans and investments and what banks pay on deposits, has bottomed sooner than expected and notes growth should resume in 2026.
No more rate cuts
Even if earnings momentum ebbs, banks should draw support as European Central Bank rate cuts near an end while the negative-rates era appears firmly in the past.
“People really underestimated the damage that zero and negative interest rates, that we had for a decade, did to European banks,” said Morningstar’s Scholtz.
A recent European Parliament study found that European banks are especially sensitive to rates compared to US peers, with NII making up 60 percent of net operating income.
While rates have fallen from a peak of 4 percent, they are not expected to drop much below 2 percent as an EU-US tariff deal eases economic uncertainty.
“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,” said MFS Investment portfolio manager Shanti Das Wermes.
Winners, losers
A sign of confidence in banks’ prospects of generating more shareholder value is a rise in the price-to-book ratio for the average lender in the STOXX Europe 600 Banks index, comparing a lender’s market value with the value of its assets. It’s risen to 1.12, after years of trading below one.
Yet, not all lenders are performing equally well. German and Spanish bank shares have outperformed given M&A prospects around Commerzbank and Sabadell.
Spain’s vibrant economy supports banks intertwined with the broader economy, Germany’s fiscal stimulus bolsters growth prospects and German business morale in August hit a 15-month high.
In contrast, Switzerland’s UBS faces challenges from high US tariffs, 0 percent rates and new capital regulations.
This week’s tumble in French bank shares on renewed political turmoil, highlights how quickly sentiment can turn. Societe Generale on Tuesday suffered its biggest daily fall since April.
UK banks have also been supported by expectations that further rate cuts will be limited, but they too face challenges.
