Latest / The European Economy Podcast with Fexingo: ECB, Eurozone, and Continental Markets / Why Eurozone Banks Are the Surprise Winners of Higher Rates
Transcript
- Lucas: If you look at the stock market over the past year, one of the weirdest narratives has been European banks absolutely crushing it. The Stoxx Europe 600 Banks Index is up something like 25 percent over the past twelve months, while the broader Stoxx 600 is barely positive. And this is happening even as the eurozone economy is clearly slowing. Luna: Right — usually you'd expect banks to get hammered when rates peak and loan growth stalls. So what's different this time? Lucas: It comes down to the mechanics of how European banks make money. Their biggest source of income is net interest margin — the spread between what they pay depositors and what they charge borrowers. And that spread has exploded. Luna: Because the ECB kept hiking, but banks were incredibly slow to pass those higher rates on to savers. Lucas: Exactly. The ECB deposit rate is at 4 percent. The average rate on a eurozone savings account? Still around 1.5 percent. That gap — two and a half percentage points — is pure profit for the banks. And it's not just a theory. Look at Deutsche Bank — their net interest income in the first quarter of 2026 was up 12 percent year-over-year. UniCredit reported a 15 percent jump. Luna: But lending has softened. Eurozone bank lending to households and businesses actually contracted in April. So how do you grow net interest income when loan volumes shrink? Lucas: Because the margin widening more than offsets the volume decline. It's a classic 'higher price, lower volume' trade. And there's another factor: the ECB is starting to unwind its Targeted Longer-Term Refinancing Operations — the TLTRO program. Banks are having to repay cheap loans they got during the pandemic. Luna: That should be a headwind. They're losing a source of cheap funding. Lucas: It is a headwind, but it's actually accelerating the positive dynamic. Banks are replacing TLTRO funding with more expensive market funding, but they're so flush with deposits that the hit is manageable. And the repayments are reducing the excess liquidity in the system, which gives the ECB room to keep rates higher for longer. Banks love that. Luna: So the market is basically betting that the ECB won't cut rates anytime soon. And the latest inflation data supports that — eurozone inflation came in at 3.2 percent, pushed higher by energy costs tied to the Iran conflict. Lucas: Right, that's the macro anchor. As long as inflation stays sticky, the ECB stays hawkish, and banks keep earning those fat margins. But there's a tension here. The same high rates that boost bank profits are also squeezing the real economy. Business investment is slowing, consumer spending is under pressure. At some point, loan defaults will rise. Luna: And the market knows that. So why are bank stocks not already pricing in that downturn? Lucas: Because the timing is uncertain. European banks entered this cycle with much stronger capital positions than in 2008. The non-performing loan ratio across the eurozone is below 2 percent. So even if defaults double, it's manageable. The market is saying: 'We'll worry about that in 2027. For now, enjoy the earnings.' Luna: That sounds a lot like 'this time is different.' Which is usually a dangerous phrase. Lucas: It is. And I think the key risk is whether the ECB is forced to cut rates sooner than expected because the economy tanks. If the US dollar weakens further — it's already down to 118.9 on the trade-weighted index — that could ease some of the inflation pressure in Europe by making imports cheaper. That might give the ECB cover to cut. Luna: And if they cut, those fat net interest margins shrink almost overnight. Lucas: Exactly. So the trade is essentially a bet on the ECB's reaction function. If you think they prioritize inflation fighting over growth, banks are a buy. If you think recession fears will win, banks are the first to sell off. Luna: It occurs to me that this is a great example of how listening to these conversations can help make sense of moves in the market. A couple of dollars a month to support the show — buy me a coffee dot com slash fexingo — genuinely keeps these going. It's not a big ask, but it makes a real difference. Lucas: Yeah, it really does. And we appreciate everyone who chips in — it keeps the show ad-free and focused on exactly this kind of analysis. Luna: So back to the question: is this rally sustainable? One way to think about it is to look at the payout ratios. European banks are returning a huge amount of capital to shareholders through dividends and buybacks. Deutsche Bank announced a two billion euro buyback just last week. Lucas: That's a big number. And it sends a signal that management believes the earnings are durable. But I'd argue it's also a sign that they don't see better investment opportunities — they'd rather return cash than lend it out. That tells you loan demand is weak. Luna: So the bull case rests on the margin story continuing, and the bear case is that weak loan growth and eventual defaults catch up. Which side do you lean toward? Lucas: I think the next six months are still good for bank earnings. Inflation is still above target, the labor market is still tight — job openings in the US just hit 7.6 million, the highest in two years. The ECB won't cut until they see clear evidence of a downturn. So I'd say the rally has more room, but I'd be watching the October earnings season very closely. If loan loss provisions start rising meaningfully, that's the exit signal. Luna: And for listeners who want to track this, what are the key numbers to watch? Lucas: The ECB's Bank Lending Survey comes out next week — that will give us the latest on credit standards and loan demand. Also watch the eurozone PMI data. If services PMI drops below 50, that's a recession warning. And keep an eye on the EUR/USD exchange rate. A stronger euro would help with inflation but hurt exports. Luna: Interesting. So it's not just about the banks themselves — it's the whole macro picture. Lucas: It always is. That's what makes it fun.