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European banks face a double test: earnings season meets the Fed and ECB
Key takeaways
Higher rates are a double-edged sword: they support lending income but can hurt bond portfolios and borrowers.
Strong profits are only half the story: earnings will test lending margins, credit quality and the outlook for 2027.
Cheap does not always mean attractive: sustainable profitability, strong balance sheets and sensible valuations matter more than ever.
European banks have enjoyed a remarkable comeback, helped by higher interest rates, stronger profits and generous shareholder payouts. But the relationship between banks and interest rates is becoming more complicated.
This week offers an important test.
The Federal Reserve announces its interest-rate decision on Wednesday, 28 October, followed by the European Central Bank (ECB) on Thursday, 29 October. Both are expected to keep rates unchanged, while some of Europe's largest banks publish their third-quarter earnings.
The timing matters. European banking shares have recently come under pressure, particularly in France, as rising government borrowing costs revive concerns about financial stability.
The paradox is simple: the same higher interest rates that helped banks earn more money could now become one of their biggest risks.
When higher rates stop being your best friend
Banks have a relatively straightforward business model. They collect deposits, lend money and generally earn more on loans than they pay depositors.
When central banks raise rates, banks can often charge borrowers more without immediately increasing the interest paid on deposits. This difference, known as the net interest margin, can improve profitability.
That has been an important driver of Europe's banking recovery.
In September, the ECB raised its deposit rate to 2.50%, while the Fed lifted its benchmark range to 3.75% to 4.00%.
But higher rates are not always good news.
First, depositors eventually demand better returns, increasing banks' funding costs. Second, expensive mortgages and business loans can discourage borrowing or make existing debts harder to repay.
There is also a third problem: government bonds.
When bond yields rise, existing bonds generally lose market value. Banks holding large government bond portfolios may face losses, pressure on their financial strength or higher funding costs. Some accounting rules allow them to avoid recognising temporary market losses immediately, but that does not eliminate the underlying risk.
This distinction matters. The ECB directly influences euro-area lending conditions, while the Fed affects international funding costs and global financial markets.
For investors, the question is no longer simply whether interest rates rise or fall, but whether a bank can remain profitable across different interest-rate environments.
Earnings season: look beyond the headline profits
The coming days offer a useful comparison between different banking models.
HSBC reports on 27 October, followed by BNP Paribas, Deutsche Bank, Banco Santander and UBS on 28 October. ING, Société Générale, BBVA and Danske Bank follow on 29 October, with Crédit Agricole and NatWest scheduled for 30 October. Italian lenders Intesa Sanpaolo and UniCredit report on 3 and 9 November, respectively.
Each provides a different perspective. HSBC offers insight into Asian markets and wealth management. Deutsche Bank reflects investment banking conditions, while Santander and BBVA operate across several economies. But perhaps the most interesting case comes from Switzerland. Following Credit Suisse's collapse in 2023 and its takeover by UBS, the Swiss government wants stricter capital requirements to prevent another banking crisis. The objective is straightforward: make banks hold larger financial cushions to absorb potential losses. UBS, however, argues that the proposed rules would make it less competitive internationally. Its chairman has warned that excessively strict requirements could force the bank to reconsider its future in Switzerland. The dispute now extends beyond shareholders. On 25 October, the Swiss Bank Employees Association warned that up to 12,000 of UBS's roughly 34,000 Swiss jobs could be at risk in a worst-case scenario involving relocation, a sale or a merger. These are potential losses, not announced redundancies. UBS's Wednesday earnings therefore offer another important question: how much can tougher regulation affect a bank's future profitability and shareholder returns? This is relevant well beyond Switzerland. Stronger capital buffers make banks safer, but holding more capital can also reduce the returns they generate for shareholders. Ultimately, investors need to look beyond whether earnings beat expectations. Are lending margins holding up? Are more customers struggling to repay debts? Can banks continue paying dividends without weakening their financial strength? A bank reporting record profits while its borrowers become less reliable may be less attractive than one delivering modest but sustainable growth.
Cheap banks or expensive problems?
Valuations make the story particularly interesting.
The STOXX Europe 600 Banks index trades at approximately 11.4 times expected earnings and 1.5 times book value, compared with 14.6 times expected earnings for the broader European market.
Book value represents a bank's assets minus its liabilities. Paying 1.5 times book value means paying EUR 1.50 for every EUR 1 of accounting equity.
French lenders appear particularly inexpensive. According to S&P Global Market Intelligence, BNP Paribas, Société Générale and Crédit Agricole traded below eight times estimated earnings at the beginning of October, versus a median of 10.3 times for 20 major European banks.
Yet the discount reflects genuine concerns about French public finances, political uncertainty and government borrowing costs.
Banks today generally have stronger capital buffers and better supervision than during Europe's sovereign debt crisis. Nevertheless, their exposure to government debt remains important.
For investors, valuation only becomes meaningful when compared with sustainable profitability. A bank consistently earning attractive returns on shareholders' capital may deserve a higher valuation. Another generating unusually strong profits during favourable conditions might look cheap just before earnings weaken.
Risks: what could go wrong?
Three risks deserve attention.
A prolonged rise in government bond yields could put additional pressure on bank balance sheets, especially in countries facing fiscal uncertainty. Rising deposit costs could squeeze lending margins, while weaker economic growth could increase loan defaults.
The early warning signs include widening gaps between government bond yields, declining net interest margins and rising credit losses.
Investor playbook: a simple banking health check
Track lending profitability: compare net interest income with deposit costs, rather than focusing exclusively on headline earnings.
Watch credit quality: rising loan defaults alongside weakening economic growth can signal future pressure on profits.
Compare price with profitability: assess valuations alongside sustainable return on equity, not just current earnings.
Examine shareholder payouts: dividends and buybacks matter most when supported by healthy capital buffers and resilient profits.
The most valuable asset is resilience
European banks do not necessarily need interest rates to rise further to remain attractive investments. Nor would falling rates automatically make them worse businesses.
What matters is their ability to generate sustainable returns while managing the risks that come with lending money, holding bonds and financing economic activity.
This earnings season offers an opportunity to distinguish banks benefiting from favourable conditions from those with genuinely durable earning power.
The recent sell-off may have created more interesting valuations, but lower prices alone do not guarantee better long-term returns.
Ultimately, the best banking businesses are not necessarily those making the most money when conditions are favourable. They are those that continue making money when conditions change.