Investors in European bank shares have been rattled by recent turmoil in the sector. But many banks are in much better shape than widely perceived, and the sector is subject to much tighter regulation than in the US. Select financial stocks should be able to weather the storm and perform well over time.
The March banking failures in the US and Europe jolted markets. Silicon Valley Bank, Signature Bank and Credit Suisse were different stories. But there is a common denominator: they all succumbed to risks created by higher interest rates that ultimately led to a crisis of confidence and rapid bank runs. This was somewhat surprising, because higher interest rates are generally good for banking businesses.
Investor concerns are understandable, and interest-rate risks warrant vigilance. However, major controversies in an industry often prompt an emotional market overreaction, as share prices are pushed down indiscriminately across a sector. In situations like this, investors who identify mispriced shares can uncover undervalued companies that aren’t vulnerable to the same risks with strong long-term return potential.
Dynamics Are Different in Europe
Europe’s retail banking sector is rooted in a resilient business model, in our view. Banks in Europe generally have a much larger retail deposit customer base than their peers in the US, where money market funds are popular vehicles for deposits. As a result, many European lenders source more of their funding from millions of household and business depositors. In our view, these customers represent a highly diversified and sticky base, which reduces concentration risk—the danger of a relatively small number of large clients withdrawing their funds simultaneously.
What do banks do with these deposits? Some funds are parked at central banks, where the lender earns interest and enjoys liquidity. Other funds are lent out at higher rates, and banks earn income from the spread between interest rates of deposits and loans. This is known as net interest income—the most basic source of banking earnings.
Higher interest rates help banks earn more net interest income. This is a very different dynamic than the one faced by SVB, which paid a heavy price for investing in Treasury bonds that got hit when interest rates rose. Banks that rely on net interest income as the bread and butter of their earnings mix should benefit in today’s high-rate environment.
Europe’s banking sector offers fertile ground for finding banks like these. Net interest income has posted solid growth in recent years (Display). And European banks have enjoyed stronger earnings upgrades than any industry in the region.