We have already written in our columns that European banks have changed their status in recent years, moving from shunned stocks on the market to a key driver of outperformance for European indices. 

They had two major arguments in their favour: rock-bottom valuations and stronger earnings momentum, thanks to higher interest rates, a regulatory environment that has stabilised and restructuring efforts successfully completed by some of them.

To this, we should add the sector's consolidation dynamic, even though there is still resistance, particularly when it comes to cross-border mergers.

As a result, European banks have clearly outperformed the rest of the market over the past three years.

 

Source: MarketScreener

Still a value play?

However, the rally is clearly running out of steam. After a 60% gain between early January and mid-August, the Stoxx 600 Banks index has been consolidating for three months.

Banks now face lower interest rates - the ECB has cut its key policy rates eight times between the summer of 2024 and summer 2025 - which is negative for net interest margins.

Moreover, the re-rating phase (the rise in valuation multiples) is probably behind us. For years, European banks traded at less than 1x their book value; which is no longer the case. Looking at the largest players, the price-to-book ratio (PBR) of Banco Santander is 1.3, that of Unicredit is 1.5, and that of Intesa Sanpaolo is 1.6.

Banco Santander book value. Source: MarketScreener

Intertwined fates

There are, however, still reasons to be optimistic. First, there will be significant capital returns to shareholders in the coming years.

Second, interest rates should remain higher than before the Covid pandemic. The likelihood of a return to a zero-rate environment, which was very damaging to banks' profitability, now appears low.

Finally, it is worth noting that several European indices are highly dependent on bank performance. Intesa Sanpaolo and Unicredit are the two largest constituents of the MIB, while three of the five largest weights in the IBEX are banks.