The European banking sector has been under significant pressure in the past few years due to low interest rates, a series of massive fines and a European economy that has lagged. The view that Eurozone interest rates will start to trend upwards sometime next year and a US Federal Reserve that has increased its benchmark rate last week seem to indicate that the worst is over, at least on the interest rate front.

Rising interest rates are especially positive for bank earnings. This mainly occurs because of two factors. The first is the natural sticky tendency of bank liabilities. Term deposits keep paying the same amount, despite increases in interest rates, up to maturity. Thus margins increase as interest rates are adjusted immediately on the asset side, typically loans and bond investments.

The second factor, which is less commented upon, is that higher margins are easier to maintain at higher interest rates. When rates are low it is not easy to justify a significant difference between the lending rate and the borrowing rate. In addition, at ultra-low rates attracting the required funds for lending becomes increasingly difficult.

Banks under a low interest rate regime, therefore have to balance a shrinking deposit supply with an increasing loan demand, with the pressure increasing the more interest rates decrease. The opposite becomes true as interest rates increase. Banks should be able to increase margins more comfortably the higher interest rates go.
However, the main problem with European banks has been their balance sheet. Underperforming loans has been the main weakness of European banks since the financial crisis. And here emerges the main difference between US banks, which addressed the problem early in the crisis, and European Banks, many of which still carry the scars. Increasing profitability generated from the expected margin increases should be positive towards banks’ capital requirements.

Investors have various ways to play the European banking sector. On the risky side, investors can opt for a periphery play. Excluding Greek and Cypriot banks, Italian banks are probably a speculators playground. Spanish banks are strongly on way to recovery. The share price of Banco Santander, for example, has gained 42 percent since September. Still, if the European recovery persists, further gains may be expected.

Alternatively, one could go for an ETF that captures the performance of the whole European Banking Industry. The European Banking Index has gained 36 percent since September. There are several ETFs that replicate the performance of this index.

For those wanting to avoid the periphery, investment in the top French Banks may be a good option. Societe General has gained 54 percent since September. BNP Paribas, while having some exposure in Italy still managed to gain 33 percent since September.

Assuming that the current interest rate scenario persists, European Banks would probably continue to outperform most sectors. Other positive outcomes could be a relaxation of capital rules and the development of a European Bad Bank.
On the negative side, the main risks continue to be event risk that could derail the fragile recovery. The next stop is probably the French election. This is the time when Investors may take advantage of any weakness to enter the market.

This article was issued by Antoine Briffa, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article is being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.