Past pain can live long in the memory. This has certainly been the case for European banks, a sector investors have largely steered clear of for the best part of two decades, having been burned during the Global Financial Crisis (GFC) and the eurozone sovereign debt crisis. However, Europe’s banking stocks have been gradually regaining the confidence of investors over the last few years. How did this once maligned sector change its fortunes and does it still offer value in global equity portfolios?

Deep scars of past crises

To find out whether there is value in the European banks sector today, we need to look back to see where the sector has come from. The banks were at the epicentre of the GFC in 2008 and faced a further challenge a few years later with the onset of the eurozone debt crisis. These two events shook investor confidence in Europe’s lenders and the subsequent decades of ultra-loose monetary policy and tighter regulations squeezed the profitability of an already struggling sector. It was the perfect storm.

Naturally, regulators put in place new rules to buffer companies in the event of another credit crunch. Banks were forced to sell bad assets and raise cash to meet new capital requirements, shoring up balance sheets but foregoing any meaningful returns in the process. With eurozone interest rates falling to ultra-low levels in the 2010s, it became increasingly hard for banks to make money.

Hard work paying off

While meeting new capital requirements was particularly painful for Europe’s banks, they emerged in a much healthier position. Since the GFC, they have become substantially better capitalised, and they have de-risked and delevered. When Covid hit the markets in 2020, the sector was able to navigate the pandemic with little fuss. The European Central Bank (ECB) ordered the sector to pause dividends, but no bank was in the position where it needed to raise capital anyway.

It was a similar situation when Silicon Valley Bank collapsed in 2023, followed by the failure of Credit Suisse. While both events had the potential to stress the entire financial sector, they were largely brushed off by European banks.

At the same time, profitability started to pick up, amid a post-pandemic surge in inflation that has forced global central banks to raise interest rates. Eventually, after a long period of low-to-negative rates, eurozone interest rates rose sharply through 2023 and are now in the sweet spot of 2.0%-2.5%. In Europe, this meant that the banks’ net interest margins—a key measure of profitability—could begin to expand once again, which helped to drive stronger returns.

Returning animal spirits

Underpinned by the significant improvement in fundamentals, confidence in the European banks sector was able to build gradually. While investors poured into fast-growing US tech stocks in 2023 and 2024, causing their valuations to balloon, the European banking sector was quietly outpacing the European market, driven entirely by underlying earnings growth.

The European banks sector is now in its fifth year of outperformance vs. the US stock market.

It took the uncertainty surrounding President Trump’s economic policy to encourage investors to return to the sector in force. Investors seeking better value in European markets have been attracted to the sector by the potential for a narrowing in the valuation gap between banks in the US and Europe, given the convergence of return on equity (ROE) of European banks with US banks. The result has been a re-rating of the European banking sector.

Where are we now?

We believe the recent re-rating has changed the dynamics for European banks, with the sector now approaching fair value, in our view. Nevertheless, the banks offer a healthy yield, while there are several upside risks that could provide further support to share prices.

The most obvious catalyst is the potential for significant fiscal loosening to fund greater defence spending, and the likely uplift that this would give to the European economy. The need to boost European defence spending in response to President Trump’s America First agenda is placing a higher sense of urgency on moves towards a European savings and investments union, with the European Commission suggesting that close to €1 trillion will need to be raised to boost Europe’s defences and improve Europe’s infrastructure. If implemented, these spending commitments would be positive for Europe’s banks, through increased lending, financing and investment opportunities.

There are also several downside risks to the sector’s performance, not least from US tariff volatility. While banks are not directly impacted by President Trump’s tariffs, they are indirectly exposed via a slowdown in growth, with the economic uncertainty increasing the risk of a recession. A weaker European economy would be negative for the banks’ short-term earnings and dividends, particularly if combined with imported deflation from cheap Chinese imports diverted from the US, which would likely see a significant fall in short-term rates.

However, the bond markets (forward curves) are not suggesting a sharp fall in interest rates in Europe. A return to the prolonged ultra-low rates of the 2010s is not expected. And even if tariff-induced economic weakness hits the banks’ short-term earnings, our forecast for 13% normalised return on equity remains unchanged.

We’ve already seen the sector recover some of the ground lost from early April’s market volatility, and with any lingering investor concerns over bank balance sheets increasingly being consigned to the past, we remain constructive. There is value to be had in Europe’s banks, but we think it is essential to be active in this space to seek out those stocks that offer true long-term value.