European banks, seen by many as a type of doomsday device, have shown to be remarkably resilient in recent years. After a lost decade recovering from the Great Financial Crisis (GFC), between 2020-2023 they were faced with the fallout of the covid pandemic, energy crisis and inflation spike. During this series of mini crises they have shown that something has finally changed. The slow but steady improvements in capital strength, risk costs and efficiency have led to a vastly improved investment proposition.

A brief history

Those who invested in European banks over the past 15 years have mostly been disappointed. Investment returns have been exceptionally low as the banks had to invest in their business, recapitalising and restructuring after the GFC. In the US the recapitalisation was done much more forcefully in 2008/09 with a large amount of new equity being put in by the US government. The same process in Europe was much slower and more painful and was paid for by shareholders over the past decade and a half. The starting point was worse, and the process was slowed down by the Eurozone government debt crisis in the beginning of the 2010s.

Many investors have since avoided the sector entirely because of what were perceived as structural issues, and that sentiment is still strong to this day. However, we feel that the long, slow march towards a well-capitalized, profitable sector mostly ended in recent years. That fact is still underappreciated by the market.

Capital strength

European banks have made big strides in bolstering their balance sheet. The CET-1 ratio (the most important measure of capital buffer) has steadily increased in the past decade. Through multiple rounds of new regulation, banks had to constantly reinvest their profits in the business to further bolster their capital buffers. During that process they also held on to capital well in excess of minimum requirements in anticipation of even stricter regulation.

However, we have reached the end of this cycle. Capital buffers are strong, and the sector has shown its resilience in recent years. Further regulatory changes should have a less pronounced impact. Because of that, management is getting increasingly confident about what their long-term capital requirements are. This finally allows them to allocate excess capital towards increased shareholder returns.

Graph 1: Capital adequacy European Banks (%)

Source: UBS, April 2024

Graph 2: Non-performing loans as a % of gross loans

Source: UBS, April 2024

Cost of risk and efficiency

Another consequence of the GFC was that regulators reigned in risky lending structures by banks. It made banks structurally less risky. Their business became simpler, which has led to lower volumes of non-performing loans and reduced loan losses. A more defensive business generally should command a higher valuation.

However, a simplified, less risky business also means lower margins. This put structural pressure on the profitability of European banks. To compensate, banks had to become more efficient. Branches were closed, and banking was digitalized at a rapid pace. Slowly these businesses became less complex and more efficient. The positive effects of that, however, were until recently overshadowed by the persistently low interest rates in Europe. The efforts made thus did not lead to improved profitability until interest rates started to rise.

Still undervalued

The relentless pressure of the multitude of headwinds faced by the sector meant that valuations were pushed to extreme lows. The recent strong improvement in profitability has led to a strong rally with banks being the best performing sub-sector in Europe since the end of May 2022 (Stoxx 600 sector total returns, 31/05/22 – 31/05/24) However, even after this rally on the back of normalising interest rates the sector remains attractively valued, trading at 7x forward earnings, with a dividend yield of around 7%.

Some may argue that the rise in rates is just a short-term benefit that lifts all boats, which will fade once interest rates start to decline and hence these earnings are unsustainable. Although we agree that this may mask that some banks are still low quality and have significant work to do on aggregate the trends for the sector are positive. It can also be argued that the previous decade of zero- or negative interest rates were the anomaly. Forward markets certainly agree, with expectations for interest rates equal to the current 10-year rates.

As mentioned previously many banks have shown commitment to refocus on shareholder returns. Dividend yields are already attractive and are increasingly being complemented by share buybacks. There are few sectors which match the European banks in terms of total shareholder yield currently.

Graph 3: Valuation & dividend yield of European Banks

Source: UBS, April 2024

Graph 4: RoE% of European Banks

Source: UBS, April 2024

Ticking the boxes

Banks have stabilized their businesses, increased their efficiency, and refocused on their simple core offering, taking deposits and lending. As a result, an increased number of banks have become more stable cash-generative businesses. In our view this is the core requirement for an attractive investment.

Banks are now a lot better capitalised and much more resilient. With the rebuilding of the balance sheets done, we view returning excess capital to shareholders through dividends and buybacks as sensible from a capital allocation perspective. Finally, there remains significant margin of safety in valuation.

Banks will always be a cyclical business, and we are not arguing that all banks in Europe are a sound investment. However, there are enough that tick our boxes of strong cash generation, sound capital allocation at an attractive valuation. Although many investors still find it easy to come up with reasons to ignore European banks, we believe that they, at the very least, merit a closer look these days.