Europe News

It’s the return of the yield but a long road ahead for European banks

The European banking sector has seen enough worries in the last few years owing to low interest rates, massive fines and weak earnings results. But with the Federal Reserve increasing its benchmark interest rate by 25 basis points on Wednesday, markets seem to be celebrating the return of the yield.

Rising rates are particularly beneficial for banks, which have seen their profitability squeezed by low interest rates. But while the banking sector is cheering the move a number of analysts say the road still remains challenging for European banks since the European Central Bank is still lagging behind when it comes to tightening monetary policy.

"The issue with banks has been an issue of balance sheets. They haven't had balance sheet strength, in fact they haven't managed to have loan loss provisions that U.S. banks did early on in the cycle," Jonathan Bell, Chief Investment Officer at Stanhope Capital, told CNBC Wednesday.
Bell further added that as a result banks haven't been able to lend or grow and have needed more capital.

"We are seeing capital increases slowly so it is slowly getting back to normal but we are not there yet. So even if you have margin increases you still haven't got to the problem of solving the balance sheet issue."

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A number of analysts have said that European banks face an entire basket of uncertainties that tend to weigh on their performance. Big banks like and have reported weak earnings growth in 2016. The situation is quite different with big U.S. banks such as , and that have posted stronger-than-expected profits in 2016.

"What you have to see is when they start lending again, when do they start making loan loss provisions and then they are healthy enough to do so. That's the time that they recover," Bell said.

A lot of it also boils down to when the ECB starts to move the wheel on tightening its monetary policy. According to the International Monetary Fund, the European banking sector faces three major headwinds – these include high levels of non-performing loans, excess capacity in the banking system and the Bank Recovery and Resolution Directive (BRRD), which requires an 8 percent bail-in of a bank's creditors, including very large foreign banks and hedge funds before taxpayers are on the hook.

"The return on assets for European banks is structurally low at 0.25 to 0.50 percent, compared with about 1 percent at U.S. banks," the IMF report said.

Skyline of London
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Mike Bell, global markets strategist at JP Morgan Asset Management, says government bond yields in the U.S. and Europe are likely to move higher still, driven by firmer growth and inflation, a faster pace of U.S. rate rises than is currently priced and an announcement of Quantitative Easing tapering by the ECB at the end of this year.

"Higher bond yields tend to be beneficial for banks as it reduces net interest margin pressures. As a result we are constructive on the outlook for core European retail banks but remain more cautious on the outlook for European investment banks," JP Morgan's Bell said.Follow CNBC International on Twitter and Facebook.