European banks have leveraged the higher interest rate cycle to boost profitability and maximise shareholder payouts, which are now nearing full capacity, according to Morningstar.
As Q3 banking earnings approach, Morningstar’s Q3 Banking Pulse report has highlighted that while the window for large-scale investment opportunities has closed, the sector remains undervalued.
Risk indicators have shown signs of easing, supported by stabilising interest rates. Despite a lacklustre economic growth outlook, Morningstar reported that the risk of significant credit losses is minimal. The sector displays structurally higher profitability compared to five years ago, and solid capitalisation across major institutions suggests a stable and healthy European banking landscape.
Johann Scholtz, senior equity analyst at Morningstar, said: “For European banks focused on retail, we anticipate flat or slightly decreased earnings in Q3 2024. Lower interest rates may impact net interest margins, while inflationary pressures on costs are expected to persist. Conversely, European banks with significant investment banking operations could benefit from increased debt capital market activity and strong secondary market trading results. With unemployment remaining low, we foresee continued robust credit quality in retail lending. However, insolvencies are rising in some areas, potentially leading to a moderate decline in corporate lending quality.”
Market reacts to Bank of England rate cut
Despite challenges, the report has highlighted that credit quality in retail lending remains strong, with low unemployment levels helping to sustain consumer lending. However, rising insolvencies in certain regions may contribute to a moderate decline in corporate lending quality, which could affect banks more exposed to business loans.
Another key takeaway is that interest rates remain higher than previously expected, allowing banks to earn wider spreads on cheap deposits for longer. This could lead to improved shareholder distributions, even as lower rates may dampen loan demand and squeeze margins.
In the UK, banks are expected to widen lending margins if rate cuts begin to take effect. Furthermore, as housing affordability improves with lower base rates, demand for mortgages is likely to increase, with early signs of this already being observed in the market.
