Balance sheets are healthy after years of de-risking and de-leveraging. Asset quality continues to be benign with no excessive loan growth, portfolios have been cleaned up, and direct exposure to tariff-related sectors is moderate. Meanwhile, capital ratios remain at historically strong levels, despite significantly increased shareholder returns. However, the most significant improvement in fundamentals in recent years has been in profitability. This had been the missing piece in the sector’s recovery, but the rise in interest rates post-Covid has resulted in a material increase in net interest income (NII), which has significantly increased the loss-absorption capacity of the banks.

Importantly, we expect profitability to remain resilient and substantially higher than in the years of ultra-low interest rates before 2022. This has also resulted in improved resilience in the recent stress test by the European Banking Authority (EBA), which was based on harsh adverse scenarios including a cumulative real GDP contraction in the EU of 6.3%, a rise in unemployment of more than 6 percentage points and inflation rising 10.7% over the three-year test period to 2027. In this hypothetical stress test, the sector’s aggregate Common Equity Tier 1 (CET1) ratio remained solid at 12% after the adverse scenario depletion, as net earnings were significantly improved from prior stress tests, absorbing higher losses. 

In this context, it is worth noting that in our recent GFICC quarterly strategy meeting, our macro outlook has improved, with our predicted recession risk reduced to 10% from 15%, crisis risk reduced to 5% from 10%, and above-trend growth rising to 20% from 10%. We think this solid macro backdrop provides a favourable environment for the European banking sector, but we will of course remain very focused on risks posed for the sector by any significant macro and interest rate shifts, as well as (geo)-political and fiscal risks. 

Profitability improvement has enhanced resilience

The rise in interest rates post-Covid has significantly bolstered the sector’s largest revenue line, NII. Return on tangible equity for banks in our coverage has improved, narrowing the gap with US banks, and we think higher levels can be sustainably maintained. It was reassuring to see that interest rate risk has been well managed, partly reflecting strong regulatory focus on this area.

Importantly, earnings also remained resilient as rates have come down from the highs. While coming off the peak during 2025, NII has only seen a moderate single-digit decline on average for our coverage, despite eight European Central Bank rate cuts (-200 basis points in total) since June 2024 (Exhibit 1).

In the second quarter of this year, most banks indicated that NII is stabilising. NII is expected to grow again from 2026, driven by solid loan and deposit volumes, lower deposit costs, structural hedges, as well as the steeper yield curve, which has increased management confidence in guidance. Moreover, fee and commission income has improved considerably from last year, as transaction volumes recovered and costs remain well managed.

Opinions, estimates, forecasts, projections and statements of financial market trends are based on market conditions at the date of the publication, constitute our judgment and are subject to change without notice. There can be no guarantee they will be met.

Capital ratios remain robust

Capital ratios are strong and stable, with the average CET1 ratio rising to 15.2% at end-June 2025, based on J.P. Morgan Asset Management coverage, per company data. This level is comfortably above requirements, despite significant share buy-backs, higher dividend payouts, and higher RWAs (risk-weighted assets) from the implementation of end-game Basel III rules, underpinning the banks’ position of strength.

The sector’s average buffer to MDA (maximum distributable amount i.e. the buffer above the minimum capital requirements) remains very comfortable at around 390bps and covers the 370bps aggregate CET1 drawdown in the recent EBA stress test (Exhibit 2). Moreover, assuming the release of the countercyclical capital buffer (CCyB) in a macro downturn, a further 90bps could be added to this buffer. All said, we think that the European banks in our coverage would be well positioned to weather a pronounced macroeconomic downturn and escalating geopolitical risks due to their improved profit generation and strengthened balance sheets.

Asset quality has remained benign despite macro and geopolitical risks

The sector’s exposure to pockets of risk, such as commercial real estate, has been very manageable and direct exposure to tariff-exposed sectors is also moderate. Meanwhile, lower interest rates are also supportive for asset quality and unemployment – a key driver for higher provisions – remains very low. We expect credit losses to normalise from current levels, but to remain relatively low. At the same time, we only expect a slight deterioration in banks’ non-performing loan ratios from the current lows of 1.8% as at 2Q25 (Exhibit 3).

M&A activity has picked up

Most banks in our coverage remain focused on organic growth or smaller bolt-on deals. However, we have seen some successful in-market M&A deals (particularly in the UK), and the incentive to boost scale and cost efficiencies may result in further such transactions especially among smaller banks. Such deals tend to be ratings positive to neutral with smaller acquiror banks often seeing meaningful spread upside.

At the same time however, in-market deals in Italy and Spain have met political resistance, hindering the number of completions to date. Meanwhile, large cross-border deals continue to be unattractive for banks given the incomplete Banking Union which prevents banks from fully realising the benefits of such deals. Ultimately, we think further M&A will be important and advantageous for European banks’ competitiveness.

Investment implications

Bank bonds have performed very well year-to-date and now trade at the tights, much like other spread products (based on Bloomberg Euro Aggregate Banking Senior TR Index, as of 7 October 2025). That said, fundamentals are resilient and demand remains very strong given attractive yield levels. Bank supply technicals also look good, as banks have significantly frontloaded issuance this year. We therefore still like subordinated bank securities (in particular AT1 (Additional Tier 1)) of European banks, focusing on good structures with low extension risk, where risk adjusted carry still looks appealing and supply and demand technicals are supportive. AT1 deals have seen significant oversubscription levels throughout this year, demonstrating the strong demand for yield.

Thematically, we still like select banks in the European periphery, where tremendous fundamental progress has been made, the sovereign risk is currently low and spread levels still look attractive versus core banks. At compressed spread levels, we also think selectively moving up in quality trades in the sector makes sense.