Can European bank stocks withstand the "interest rate cut crisis"? Clues will be revealed in the financial report

Since the 2008-09 financial crisis, the health of major European banks has been good; propelled by stock buyback plans driven by years of capital accumulation, restructuring, cost cutting, and supportive central bank policies—these plans have boosted bank profits, and bank stocks have generally seen double-digit increases this year.

However, now with falling interest rates and a deteriorating Eurozone economy, the biggest source of revenue for commercial banks—net interest income—is under pressure, and investors hope to see these banks maintain their long-term profitability.

Deutsche Bank (DB.US), Lloyds Bank (LYG.US), and Barclays Bank (BCS.US) will release their third-quarter financial reports this week, while UBS (UBS.US) and HSBC (HSBC.US) will also release their reports next week. The reports are expected to show these banks' continued profitability, with strong investment banking activities offsetting the decline in profit margins and weak demand for loans from consumers and businesses.

But investors need more confidence. In addition to looking for evidence of asset quality resilience, they are also seeking sharper strategies, lower costs, and the potential to outperform the market in a low-growth global economy.

European Banking Sector Sees Wave of Mergers and Acquisitions in "Survival in Numbers"

In the past 3 months, merger deals have captured the imagination of bank boards. BNP Paribas (BNPQY.US) of France acquired AXA Investment Managers, UniCredit increased its stake in Commerzbank, sparking rumors of cross-border integration.

Filippo Maria Alloatti, Head of Credit Financials at Federated Hermes, said: "Estimates show that if the European Central Bank cuts interest rates as expected, up to €600 billion (US$652 billion) in net interest income could be at risk by the first half of 2025. Management teams are actively taking measures... exploring opportunities for strengthening acquisitions in asset management, wealth management, and even niche financial technology."

For example, NatWest Group (NWG.US) of the UK acquired Metro Bank's residential mortgage business; furthermore, media reports suggest that HSBC's new CEO, Georges Elhedery, may have a greater impact on the bank's structure than previously imagined.

Credit rating agency Scope Ratings believes that the government's sale of bank shares held during the crisis has removed one obstacle to reaching deals, but other obstacles remain.

McKinsey analysts say executives need to reach "escape velocity" to differentiate themselves from their peers and increase attractiveness to investors. McKinsey stated in its "2024 Global Banking Annual Review" that in order to maintain the return on tangible equity profit rate, banks need to cut costs at a rate 2.5 times faster than the rate of income decline.

McKinsey stated that globally, only 14% of banks have a price-to-book ratio (P/B) above 1 and a price-to-earnings ratio (P/E) above 13, which is more than four times lower than companies in all other industries Pacific Investment Management Company (PIMCO)'s credit research director Philippe Bodereau stated that European banks are dividing into two camps: those with the potential to emulate their American counterparts and achieve sustained double-digit return on equity, and those stuck in low single-digit growth levels. He said, "I think these institutions should engage in some strategic self-reflection."

Rate cuts pressure net interest income, benefiting investment banking

UBS and Barclays are expected to report a rebound in third-quarter investment banking revenue, especially in equity and advisory fee income. Earlier financial reports from American competitors JPMorgan (JPM.US), Morgan Stanley (MS.US), and Goldman Sachs (GS.US) have exceeded expectations.

Rating agency Moody's stated that similar to the U.S. banking sector, European banks are not expected to see a significant deterioration in asset quality, but there are concerns in the market that commercial real estate (CRE) could erode capital. However, stress tests on 21 European banks showed that even under severe loan quality shocks, the capital adequacy ratios of banks with the highest CRE risk exposure relative to common equity tier 1 (CET1) capital were higher than the CET1 capital levels' lowest thresholds.

HSBC analysts remain cautious about unexpected negative growth in net interest income. Net interest income is a key indicator of profitability, reflecting the difference between the income a bank earns from loans and the interest it pays to depositors. HSBC prefers asset-gathering stocks like Credit Agricole and KBC Group over BNP Paribas and ING Group (ING.US), with the latter's net interest income momentum seen as the weakest.

Barclays analysts stated that with improved prospects for loan (especially mortgage) growth, Lloyds Banking Group and NatWest Group in the UK are expected to continue to report growth in net interest income for the third quarter.

Concerns about a potential increase in bank taxes in the UK in the October 30 budget are weighing on market sentiment. However, UBS mentioned that if the UK government chooses not to change the current arrangements, domestically-focused bank stocks could rebound by over 5%