Six months ago, we stated that many banks that reported return on tangible equity in the mid-to-high teens in 2023 would be hard-pressed to repeat this feat in 2024 (see "Ten Takeaways From The Big European Bank Giveaway," published March 14, 2024). With half-year results season coming to a close, it seems we were broadly, but not entirely, correct. Most European banks' mid-year 2024 results suggest credit conditions that are still quite benign:

• The delay in policy rate cuts has supported banks' NIMs.
• Asset quality has not deteriorated significantly and banks don't expect it to do so either.
• Deposit stability remains, but deposit betas continue to rise.
• Banks completed a substantial portion of 2024 funding plans amid supportive market conditions.
• Customer activity will likely pick up slightly.
• Most banks' earnings will likely remain robust into 2025, but earnings growth will likely slow down significantly, compared with previous years.

It's A Mixed Bag

Banks' shared expectation of gradually falling policy rates is only part of the story.  On an individual level, banks' outlooks differ considerably, which is demonstrated by diverging net interest income (NII) expectations. Credit demand is not uniformly weak, while the combined effects of asset spreads, liability spreads, and hedging on NIM trends will differ significantly across Europe's national banking systems. A rebound in fee activity benefited many, but not all, investment and commercial banks in the first half of this year.

Overall, we expect European banks' earnings will hold up slightly better over 2024-2025 than we had anticipated, while capital ratios will likely be in line with our previous expectations.  Nevertheless, most European banks' earnings growth prospects for 2025 are challenging. This is especially the case in countries such as France and Germany but may be less so in Spain, Portugal, and Greece, where economic growth will likely be strongest. Investors will want to understand where banks' normalized NIMs will land if policy rates bottom out in 2025, how banks will manage cost pressures, and where asset quality will weaken most. Considering geopolitical risks and fragile market confidence, we expect bank treasurers will push to complete their 2024 market funding plans over the coming few weeks.

Our outlook bias for the sector remains positive.  It benefits from further potential improvements in our 'BB/BBB' ratings on banks in Greece, Cyprus, Italy, and Spain that could follow improvements to our Banking Industry Country Risk Assessments (BICRAs) for these markets. That said, macro trends-–linked to economic factors, government indebtedness, and banks' balance sheet characteristics-–and banks' propensity to increase shareholder distributions after periods of outperformance suggest few upsides, albeit no major downside risks, for higher-rated banks. Aside from the aforementioned cases, positive and negative actions are therefore likely to be selective, built on idiosyncratic features.

Nine Takeaways From This Results Season

1. Our base assumptions were largely confirmed.

We made only three rating changes on major European banks following second-quarter result announcements. We upgraded Commerzbank AG (A/Stable/A-1) on its improved structural earnings, raised the long-term rating on BPCE (A+/Stable/A-1) on its expanded subordinated bail-in buffer, and revised our outlook on the rating on De Volksbank N.V. (A/Negative/A-1) to negative from stable after the regulator criticized its risk management.

This follows actions in the preceding month when we:

• Upgraded the leading Greek banks in recognition of the improved resilience of the domestic banking system;
• Upgraded Bank of Cyprus Public Co. Ltd. (BB+/Positive/B) as its risk-adjusted capitalization has strengthened, given our view of easing economic risks for banks operating in Cyprus and the bank's improved earnings generation;
• Revised our outlook on Iccrea Banca SpA (BBB-/Positive/A-3) to positive on improved operating conditions in Italy and the group's potential for more sustainable returns and resilient asset quality over the coming quarters;
• Revised our outlook on UBS Group AG (A-/Stable/A-2) to stable from negative as it showed good progress in its integration of Credit Suisse; and
• Affirmed our ratings on ING Groep N.V. (A-/Stable/A-2) and Société Générale (A/Stable/A-1) as we don't expect the moderate changes in their capitalization to change our broader credit view of them.

2. NIM trends are diverging.

Most European banks' NIMs ballooned in 2023 as assets repriced faster than liabilities, though the effect was uneven. The delayed start of the European Central Bank's policy rate cuts was supportive, but rates are now trending downward. Competition in the lending and deposit markets, depositor behavior, and banks' hedging programs will dictate the path ahead. While market activity seems to have picked up, corporate and household loan growth will likely be very slow--though banks in the U.K., for example, appear more optimistic.

Quarter-over-quarter reporting implies that banks' NIMs have peaked in many markets, while deposit margins will weaken as policy cuts continue through end-2025. Even so, the potential decline in many banks' NIMs through 2025 will be unequal, and some banks may buck the trend. Individual banks' NIM trends will depend on the pace and depth of central banks' policy rate cuts, as well as central banks' stance on reserves remuneration, banks' hedging and investment strategies, and spreads on new lending. For example, the Swiss National Bank's decision to further trim the remuneration of reserves from Oct. 1, 2024, will add pressure to Swiss banks' NIMs, which are already falling. Among others, NII will depend on lending volumes, which vary and are affected by generally weak credit demand.

Many Swiss, Polish, and some Nordic banks' quarter-over-quarter NII declined meaningfully in the second quarter. In contrast, U.K. banks' NII held up well as higher-than-expected deposit stability and rising re-investment proceeds from their structural hedges compensated for other NIM pressures. UniCredit, Intesa Sanpaolo, and BNP Paribas expect NIM support as previous negative hedge results have ebbed. Elsewhere, many banks reported improved returns on their replication--that is, cashflow-hedged investment--portfolios. Overall, the banking sector's median NII has likely reduced by about 1% quarter over quarter.

Chart 1

3. Fee income became a valuable adjunct.

Relative returns from banks' capital-intensive investment banking divisions tend to lag relative returns from their retail and corporate businesses. Nevertheless, Barclays, BNP Paribas, Deutsche Bank, DNB Bank, and NatWest Group were among those that benefited from a pick-up in market activity in the first half of 2024.

Banks in the Nordics and elsewhere benefited from rising fee income across many business lines, including wealth and investments, insurance, retail, and corporate banking. That said, some of this fee income could weaken through the end of this year. We expect the performance of diversified banks that aren't overly dependent on NII will benefit when rates fall.

4. Many banks will struggle to maintain positive operating jaws.

Through 2023, the marked rise in revenues allowed most European banks to report strongly positive operating jaws--that is, percent growth in revenues minus percent growth in operating expenses--despite sharply rising costs. This has become far more challenging. While we don't expect a collapse in revenues in 2025, slow to negative revenue growth shines a light on the drivers of the ongoing rise in banks' operating costs. Some of these drivers relate to flexible costs, including bonuses, that can be readjusted. Others, such as inflation-linked pressures on salaries and infrastructure, are permanent or unlikely to ease, as is the case with substantial ongoing investments in risk management and technology. While a handful of banks target to reduce costs in nominal terms in 2025, we expect most will experience cost increases of about 3%-6%. Combined with weak revenue growth, this implies negative operating jaws as well as a decline in preprovision income for many banks (see chart 2). In turn, this could put pressure on banks' management teams to consider further cost control measures or take more risk to maintain earnings momentum and meet market expectations.

Chart 2

5. Asset quality remains resilient, but commercial real estate (CRE) remains a weak spot.

European banks' asset quality remains robust. In their 2023 results presentations, many European banks expected a gradual normalization in borrower defaults and credit costs over 2024-2025, from previous unsustainably low levels. In the second quarter of 2024, some banks slightly revised upward (Deutsche Bank) or downward (HSBC) their guidance for cost of risk in 2024. Most banks saw a very modest increase in stage 2 and stage 3 loans--corresponding to a slight deterioration in the underlying asset quality--and continued small releases of stocks of provisioning overlays.

CRE remains a hot topic for some banks with material exposures, given ongoing refinancing needs in the sector, especially in the U.S. Significant German banks' exposure to the U.S. CRE market is sizeable, at €52 billion as of end-2023, which represented 18% of their total CRE exposures. These CRE exposures will likely continue to represent a source of credit provisioning for German banks over 2024-2025, given comparatively low coverage ratios. More broadly, the European Central Bank has criticized some supervised banks' CRE valuations and lack of provisioning overlays in this asset class.

6. Sector valuations continued to improve.

We view the sector's significantly improved financial performance and strengthening investor sentiment as supportive from a credit perspective. Nordic banks aside, leading European banks' price-to-book ratios remain below those of banks in other developed markets, such as Canada, the U.S., and Australia. Yet the median of about 0.9x implies that shareholders see distributions as generally sustainable over the medium term and the banks as investible (see chart 3). Banks will need to live up to these market expectations over the medium term. If NII stalls or declines in 2025, banks' management teams will be hard-pressed to formulate a compelling earnings growth story. Further cost control will likely be a good start and additional risk-taking could also be on the cards for some.

Chart 3

7. Small surprises yield significant stock price movements.

Q2 results led to a few surprises (see chart 4), including:

• NatWest, which saw a favorable reaction from investors after management revised upward its revenue guidance.
• Standard Chartered announced a $1.5 billion share buyback after reporting a rise in first-half profits, improved revenue guidance for the rest of the year, and confirmed plans to reduce cuts by $1.5 billion over three years.
• Danske Bank reported solid results and revised upward its earnings guidance to a net profit of Danish krone (DKK) 21 billion-DKK23 billion, compared with DKK20 billion-DKK22 billion previously. The bank decided to pay out an interim dividend and plans to distribute the released capital from the sale of Norwegian retail operations as special dividend at the end of this year.
• SEB reported strong results and announced a new share buyback program. Nevertheless, its stock price fell, possibly because analysts see other banks' stock returns offering more value. SEB continues to have one of the highest valuations in terms of price-to-book value among European banks.
• Deutsche Bank reaffirmed revenue and cost guidance for 2024 and increased its guidance for credit loss provisions. The 8% share price decline on the day of the announcement seems to have been mostly driven by management's statement that there will be no share buybacks in the second half of the year. However, it will now revisit its distribution plans as it has since settled with some of the Postbank plaintiffs.
• Commerzbank met analyst consensus, but management presented a slightly downbeat outlook for the year, including meaningful earnings sensitivity to rate cuts.
• Société Générale, which continues to struggle to generate earnings that exceed its cost of capital.

In all cases, credit developments were immaterial. Consistent with recent bouts of wider stock market volatility, however, these episodes show that bank valuations are currently highly sensitive to moderate news developments.

Chart 4

8. Spare capital will continue to flow heavily into shareholder distributions, among others.

Above-target capital ratios, expected solid profitability into 2025, low credit growth, and a manageable Basel 3 endgame have given bank management teams the confidence to continue sizable shareholder distributions--a process they started in 2022. Given that our earnings base case is relatively benign for most banks and our assessment of banks' capitalization is forward-looking and rarely sensitive to small changes in capital ratios, these distributions are unlikely to weigh on ratings.

Sector dealmaking will likely continue, with cross-border mergers and acquisitions remaining challenging. Yet the uplift in bank valuations, evident excess capital buffers beyond management targets, and the powerful incentive to underpin earnings growth if NIMs decline could mean that further deals, similar to BBVA's offer for Banco de Sabadell S.A. in May 2024, will follow. These deals could be targeted, for example, at seizing in-market synergies or increasing fee-driven revenue diversification, such as BNP Paribas' planned acquisition of AXA Investment Managers.

9. Funding conditions remain supportive, for now.

Resilient deposit volumes and the related modest competition for marginal deposits have been key supports for European banks' NIMs. Customers undertook some further terming out of deposits until mid-2024, but this trend has likely dissipated now. There were no new significant government interventions in national deposit markets--indeed, the Belgian government's one-year retail bond comes due in September, meaning a substantial portion of the €22 billion it attracted could return to the deposit market.

Most leading European banks reported that they had made substantial progress in their 2024 funding plans in the first six months of this year. Demand continues to underpin constructive financing conditions as investors seek to lock in returns against a backdrop of falling interest rates. That said, bank treasurers will likely push to complete their 2024 market funding plans over the coming few weeks, considering geopolitical risks, the uncertain U.S. economic outlook, and fragile market confidence.

What We'll Be Watching

Within our base-case scenario, the future development of preprovision earnings remains the main uncertainty and an area of potential divergence in European banks' performance. Beyond this, our perceived key risks for the banking sector include:

• A harder economic landing, which could impair some vulnerable portfolios beyond our expectations;
• An increase in risk-taking by some banks to offset revenue growth pressures and sustain earnings growth; and
• Financial instability due to market volatility.

An increase in these risks would have individual, rather than systemwide, rating implications. Banks that are most vulnerable to these risks are those with:

• A narrow lending focus, for example on CRE;
• Relatively large exposures to unsecured retail loans and loans to small and midsize enterprises;
• A stronger reliance on rate-sensitive funding, including market funding and term deposits;
• Perceived business model challenges, for example poor efficiency, weak competitive positions, or major restructurings; and
• Deeper connections to non-bank financial institutions, necessitating agile and effective risk management.

Related Research

Sector publications

• U.K. Banks Are Well Positioned For Sustained Strong Performance After First-Half Results, Aug. 8, 2024
• Fee Income Increase Largely Buffers Top-Tier Nordic Banks' Q2 Earnings Against Waning Interest Income, Aug. 5, 2024
• Credit Conditions Europe: Keep Calm, Carry On, June 25, 2024
• Ten Takeaways From The Big European Bank Giveaway, March 14 2024
• Top European Bank Rating Trends In 2024: The Future Is Now, Jan. 24, 2024
• EU Banking Package: Inconsistencies Temper Framework Improvements, Jan. 9, 2024
• European Banks: Cyclical Earnings Boost Is No Panacea, Nov. 21, 2023
• European Banks: Potential Interest Rate Volatility Calls For Caution, July 19, 2023
• European Banks: Protecting Liquidity Will Come At An Increasing Cost, June 29, 2023

Publications on individual banks

• Netherlands-Based De Volksbank Outlook Revised To Negative After Second Administrative Fine Procedure; Ratings Affirmed, Aug. 14, 2024
• Deutsche Pfandbriefbank Continues To Navigate Difficult Commercial Real Estate Markets, Aug. 14, 2024
• Commerzbank AG Ratings Raised To 'A/A-1' On Strengthened Performance And Capitalization; Outlook Stable, Aug. 7, 2024
• Bulletin: ABN AMRO Bank's CEO's Exit Has No Immediate Ratings Implications, Aug. 2, 2024
• Bulletin: Standard Chartered To Maintain Adequate Capitalization Following Solid First Half, July 31, 2024
• Netherlands-Based NIBC Bank N.V. Affirmed At 'BBB'; Outlook Remains Stable, July 29, 2024
• Basler Kantonalbank (BKB) And Subsidiary Bank Cler Ratings Affirmed; BKB Liquidity Revised To Adequate From Strong, July 23, 2024
• Basellandschaftliche Kantonalbank 'AA+' Rating Affirmed; Outlook Stable; Liquidity Revised To Adequate From Strong, July 19, 2024
• BPCE Upgraded To 'A+' On Increased Senior Non-Preferred Issuance To Boost Loss-Absorbing Capacity; Outlook Stable, July 15, 2024
• Positive Rating Actions Taken On Eight Greek Banks On Resilience To Economic Cycles And Improving Funding Profile, July 4, 2024
• ING Groep N.V. 'A-/A-2' Ratings Affirmed Despite Reducing Capitalization; Outlook Stable, June 26, 2024
• Societe Generale 'A' Rating Affirmed As Capital Builds Up While Performance Still Lags; Outlook Stable, June 20 2024
• Bank of Cyprus Upgraded To 'BB+' On Reduced Economic Imbalances And Stronger Capitalization; Outlook Positive, June 18, 2024
• Iccrea Banca Outlook Now Positive On Improved Domestic Operating Conditions; Seven Italian Banks Affirmed At 'BBB-/A-3', June 18, 2024
• Outlook On UBS Holdings Revised To Stable On Decreasing Tail Risks; Ratings Affirmed, June 4, 2024