European banks could look at bolstering fee income, cost-cutting and acquisitions to reduce their reliance on net interest income as central bank rate hikes come to an end.

Rising interest rates have provided a huge boost to European banks' net interest income (NII), a key stream of earnings that represents the difference between interest received and interest paid out. Aggregate NII among the continent's largest lenders rose 18.6% year over year in the third quarter, S&P Global Market Intelligence data shows.

With central bankers now indicating a stabilization of rates and deposit margin tailwinds fading, new growth drivers are necessary to ensure sustainable profitability. Banks can have a "relentless focus on cost efficiency" combined with the development of fee-generating business, such as asset management, to reduce reliance on NII, said Marco Troiano, head of financial institutions at Scope Ratings.

"Very low interest rates had been the norm for a decade, so the recipe for banks to compensate is well known," said Troiano.

Spanish lenders Banco Bilbao Vizcaya Argentaria SA (BBVA) and Bankinter SA and Germany-based Commerzbank AG were among the large European lenders most reliant on NII in the third quarter, Market Intelligence data shows.

Universal banks such as HSBC Holdings PLC, Barclays PLC, Deutsche Bank AG and UBS Group AG were among the least dependent on NII.

Focus on fees

Wealth creation, modest banking fee repricing opportunities, capital markets tailwinds and an ongoing shift to credit cards will boost the fee income of European banks, according to analysts at Deutsche Bank Research. The analysts also anticipate a cyclical recovery of investment banking revenues amid a rebound in corporate finance activity and fees.

Deutsche Bank AGOTP Bank Nyrt. — which operates across central, eastern and southeast Europe and is among the banks with the highest proportion of fee income in their revenue mix — grew its third-quarter fee income by 14% year over year and 4% quarter over quarter in foreign currency-adjusted terms. Fees in tourism-oriented Croatia, stronger income from fees on deposits, transactions, cards and securities in the core Hungarian market, and asset growth at OTP Fund Management bolstered the result.

Austria-based Erste Group Bank AG, which is also present in various central and eastern European markets, expects fees, rather than lending income, to drive its revenue growth for 2023 and 2024. The bank's fee income reached a record high of €662.9 million in the third quarter, driven by higher income from payment services and asset management fees.

The improving macro outlook in countries outside the eurozone could enable Erste's fee income to outperform that of peers active only in Western Europe, CFO Stefan Dörfler said during the bank's latest earnings call.

Cost control has been front of mind for banks in the midst of persistent high inflation. UBS, the bank with the highest cost-to-income ratios among Europe's large banks, plans to cut more than $10 billion in costs by 2026 through its integration with Credit Suisse. Next-placed Deutsche Bank, long hampered by high costs, has promised €2.5 billion of savings in 2023.

"I do believe that it's most important for our credibility that we achieve those cost targets which we have given to the market, and we will do so," CEO Christian Sewing said in October.

M&A recovery

The search for new growth drivers could also rekindle appetite for M&A, both domestic and cross-border. "Diversification of revenues via acquisitions of asset and wealth management, but also insurance assets, is likely to remain popular," according to Deutsche Bank Research.

BNP Paribas SA could invest more of its excess capital in mergers and acquisitions in 2024 if economic growth slows and market turmoil presents takeover opportunities, its top executives said in October. The French bank earlier said it was eyeing deals in its most capital-efficient business lines, which include insurance, global markets and asset management.

Deutsche Bank recently completed the acquisition of Numis Corp. PLC, a smaller scale investment bank focused on UK-listed companies. The transaction will help Deutsche to benefit from the expected pickup in corporate finance activity, its executives said.

Elsewhere, UniCredit SpA recently acquired a 9% stake in Greek lender Alpha Services and Holdings SA in a deal which also saw the two banks combine their Romanian operations, while Intesa Sanpaolo SpA also agreed to buy Romanian lender First Bank SA. In total, there were 45 European bank M&A transactions in the third quarter, down from 59 in the year-ago period, a recent Market Intelligence analysis showed.

Continued source of upside

To be sure, European banks will continue to enjoy elevated NII in a higher-for-longer rate scenario. While the current level of profitability is not sustainable, profits will remain well above the pre-rate hike levels, said Sonja Forster, vice president of global financial institutions at DBRS Morningstar.

There is still room for NII growth in 2024, particularly in the first half of the year, though the picture will be more heterogeneous, analysts said.

"In general, we see better performance for national champions with business models anchored in retail as they tend to be price makers and have lower deposit betas," Troiano said. "At the other end of the spectrum, smaller banks that rely more on wholesale or brokered deposits will see more pressure on their cost of funding."

Lenders in Spain or Ireland could benefit from higher NII in the coming quarters as deposit betas have been very low, and at the same time assets are still repricing, Forster said. CaixaBank SA and Banco Santander SA both forecast further lending income growth in the first half of 2024.

Dutch banks, in particular ABN AMRO Bank NV, could also enjoy a temporary increase in NII due to the fact that the Netherlands has a very high proportion of interest bearing deposits, a significant part of which has already repriced, while the repricing of assets continues, Forster noted. French banks are affected by regulation on retail loan and deposit pricing, which constrains NII growth, but these banks are expected to benefit more in 2024.

For other markets such as Italy, NII has already peaked or might peak in the fourth quarter as tailwinds and headwinds largely offset each other, according to Forster. In the UK, Barclays and NatWest Group PLC recently lowered their net interest margin outlook for 2023 as the positive impact of higher central bank rates gives way to rate-related pressures.

NII growth is also expected to slow at the six largest banks in the Nordics, with Svenska Handelsbanken AB (publ) CFO Carl Cederschiöld recently saying the Swedish bank was getting "closer and closer to the peak."