Edmund Shing:
Hello and welcome to a new podcast from BNP Paribas Wealth Management. I am Edmund Shing, Chief Investment Officer. In today’s podcast, I want to talk about European banks. Why do I want to talk about European banks? Because this is one about top convictions for 2026.
This may be surprising after the very strong performance of European banks in 2025. Let's not forget they went up by 67% over 2025, the strongest-performing sector pretty much of all sectors in the European stock market. You might think after such stellar performance over 2025 that there cannot be more to go surely. We think there is more to go for several reasons. I think to make it quite clear, we believe European banks, despite the strong performance last year, remain undervalued because they're backed by strong earnings growth and strong shareholder returns. We believe there are new opportunities within the banking sector, particularly for better productivity to emerge for higher returns with limited risks. We still see about 15% estimated upside for European banks this year. Okay, not as good as 2025, but then is that really surprising? 15%+ dividends, to which you can add another 5%, giving a total return of around 20%. It's still a very healthy return expectation.
If we look at US banks, they're not bad, but we really prefer European banks for a mixture of strong profitability, earnings growth, earnings revisions, and most importantly, much cheaper valuations. So let's get into it. Why European banks? Clearly, we've had years of challenges and restructuring for the European banking sector in the wake of the global financial crisis of 2008. So the sector really underperformed dramatically from 2008 to 2022 due to the restructuring, the building up of balance sheets, the increase of regulations, all of which hit the banking sector and had led to subnormal returns for that span of 14 years.
Since late 2022, European banks have outperformed quite handily, not least in 2025. So that's been very positive. What we can see here is that we can continue to see a combination of factors. Firstly, economic recovery. Secondly, we have had rising interest rates. So remember back in 2022, interest rates rose from 0%, which was a very bad place for European banks to be because they couldn't make money on deposits. Well, now they can make some money on deposits. We also have steepening yield curves, which traditionally have been very good for banks because they tend to receive cash and pay interest on the short end of the curve, and they tend to lend at the longer end. So in fact, the steeper the yield curve, or the higher the long-term interest rates are compared to short-term interest rates, the better it is for banks. And certainly, since 2023, we have seen a so-called steepening of the yield curve, so a widening of this gap between short- and long-term interest rates in favour of long-term interest rates going higher, which has been a pretty good environment for banks globally, including banks in Europe.
If we look this year, we can see a continuation of economic recovery in Europe. We have, of course, defence and infrastructure plans at the German, but also at the European level, meaning increased spending on these sectors, on these segments of activity. We see increased investment, equally well by corporates, which has led to greater loan demand for which banks are well positioned. And even if we look at the household sector, households are also borrowing more money largely to fund house purchases.
So when we look at it, we are expecting something like a 4% growth in loan demand this year for European banks in 2026 over 2025, which is a pretty healthy level of overall loan growth, which of course drives earnings growth. At the same time, we expect very limited write-offs, so really very little bad news to come on the balance sheets from bad debt, because the economy is in fact improving. This can be a factor of risk when the economy goes into recession, because typically you get a sharp rise in bad debts, which means that you get provisioning, and this impacts the earnings of banks. And this is exactly what happened during and directly after the global financial crisis of 2008. Today, in contrast, you have not only very healthy balance sheets for European banks. In fact, Tier-1 ratios are in the mid-teens, which is a very healthy ratio in terms of balance sheet strength. So strong, in fact, that banks in Europe are able to buy back their shares, increasing the total shareholder return and decreasing share count, which is a way of not only returning cash to shareholders, but at the same time improving earnings growth. And this is exactly the dynamic we continue to see. And European banks this year should continue to maintain a very healthy level of share buybacks, in addition to healthy growth of dividends paid out to shareholders.
If we look at potential catalysts aside from economic growth in Europe, well, we have a number of directives which could actually really help at the European Union level, the first one being the Savings and Investment Union. Again, this is an EU initiative to better channel savings towards productive investments. So again, that could be very good for banks because we could see an increase in fee income from savings and investment products for banks if this is put into effect more and more across Europe.
Secondly, a potential Capital Markets Union, which would lead to much more of a single market for financial products, which would be a very welcome move to improve productivity and effectiveness across the European Union, which would have a particularly positive effect on the European banking sector. And as I mentioned before, the fact that we have these major initiatives, spending plans for European infrastructure and defence, which will require substantial financing, again another driver for earnings growth at banks.
Not only do we have all of that, but of course we have the impact of technology. Of course, we talk about AI, but remember that financials and banks, in particular, remain one of those sectors that should benefit from being an early adopter of AI in terms of improving productivity, particularly in middle-office and back-office processes, which are actually quite archaic in many banks. So again bringing those up-to-date with the aid of technology and AI should certainly improve productivity. And of course, the transition to digital banking and away from bank branches, physical branches, actually again also in the long term continues to aid productivity and therefore earnings growth at the banks because this leads to a lower need for quite as many employees over time. So you do get a positive effect from so-called natural wastage as employees retire and are not replaced on a one-for-one basis.
So when we look at all of that, pretty much I would say the drivers, both at the economic level, at the potential regulatory level in terms of catalysts from the European Union, and of course the continued strong shareholder returns in prospect, both from growing dividends but also from continued share buybacks. We haven't even mentioned the potential for more broader merger and acquisition activity, which I think still is there across Europe and could be again another major catalyst for the European banking sector. And of course, if we think about valuation, banks are still relatively cheap at just over 10x forward earnings, so that P/E compares to a P/E for the US banking sector of over 15 times. So relative to the US banking sector, the European banking sector currently trades at a discount of one third, which is much greater than the typical discount of somewhere between 15% to 20%.
So again, on a relative basis, European banks do present a really quite positive value despite the strong growth last year because again, there has also been strong growth in earnings. And if we look at the relative profitability in terms of return on equity across the European banking sector last year, for the first time in many a year, the average European banking return on equity level, i.e, profitability, was on average higher than that for the US banking sector, and that hasn't been seen for a long time.
So all in all, when we take in valuation, potential for positive shareholder returns, including a 5% dividend yield, strong earnings growth, and strong balance sheets with a positive economic backdrop and potential for catalysts at the M&A and regulatory European Union level, we still think there's more to go for European banks, and it remains one of our preferred sectors within the European stock market.
Thank you very much for listening to this podcast from BNP Paribas Wealth Management. Please like, share, and subscribe to our weekly series of podcasts. And until the next time, goodbye.