Stability descends on the banks, for now

"The foundation of a bank's health, namely its ability to 'self fund', has returned for European banks," point out banking analysts at Espirito Santo Investment Bank. "Banks are using the improved normalcy in the wholesale markets to wean themselves off their heavy subscriptions to LTRO funds."

That improved funding backdrop reflects the ECB's decision in September to do "whatever it takes" to save the euro - through the purchase of as much sovereign debt in the secondary market as needed to generate confidence. That "has gone a long way to alleviating (albeit not fully removing) the systemic tail risk of a eurozone break up," observes Espirito Santo. "Banks are now operating in an environment close to what can be considered 'normal' after the turmoil of the past 18 months."

From a share price perspective, this ECB-induced stability has been a game-changer - the FTSE 350 banks index, for example, has risen nearly 50 per cent since 1 June. But just because collapse has apparently been averted, it doesn't automatically follow that banks' prospects have improved - far from it.

No signs of growth

The biggest threat remains the weak economic backdrop. The UK's economy contracted 0.3 per cent in 2012's final quarter and prospects going forward look bleak. The IMF expects the UK economy to grow just 1.1 per cent in 2013 and the eurozone a mere 0.2 per cent, with Italy and Spain set to remain mired in recession. The trouble is that such weak economic conditions, as analysts at Berenberg Bank point out, "means higher loans losses, deterring banks from lending".

There's also a problem with credit demand. Not only does it inevitably slide in times of economic downturn, but the world is already heavily indebted - the debt burden of the western economies has never been higher. So, unlike after past downturns, demand for credit is already looking satisfied to a large extent. "High levels of debt would suggest that demand has been maxed out," reckons Berenberg Bank. "The deleveraging phase of the debt cycle can last up to 35 years (eg, the UK 1945-80). Thus we expect anaemic growth to be a multi-decade event." If that's the case, investors should expect the banks to struggle for far longer than they traditionally have following recessions.

Reputations and regulations

The banks are still tackling a long list of self-inflicted wounds, too - in the form of reputational issues. The resulting compensation payouts are the biggest near-term cost facing the sector - at least in the UK - with the latest hit looking set to come from the mis-selling of interest rate swap products. Last month, the FSA announced that over 90 per cent of sales reviewed had failed to comply with one or more regulatory requirements. Sector analysts, however, do not think the costs here will spiral as they have done with the payment protection insurance (PPI) mis-selling saga. So far, the UK's banks have set aside about £11bn to cover PPI compensation costs, with Barclays (BARC) announcing a further £600m PPI hit just this month. "Unlike PPI, there is not a near-automatic presumption of guilt," says analyst Ian Gordon of Investec Securities. "We estimate that the incremental cost to the industry could be £1bn."

Fines for various misdemeanours are another problem. Standard Chartered (STAN) has had to pay $667m (£423m) in fines to regulators for alleged avoidance of US sanctions against Iran, and HSBC (HSBA) was hit with a $1.92bn money laundering fine in December. Barclays has paid a £290m fine for Libor-rigging and it could be far bigger for Royal Bank of Scotland (RBS). The terms of Barclays' Qatar fund raising from 2008 are currently being investigated by the FSA and the Serious Fraud Office, too. "Some external analysts have suggested that major UK banks may incur a further £4bn to £10bn of unrecognised PPI and Libor-related costs," noted the Bank of England in its most recent Financial Stability Review.

A heavy regulatory agenda is another headwind. Quite apart from Basel III's tough capital requirements, there's an array of other regulatory proposals which, if implemented, will carry big costs. Of particular significance is the EU's Liikanen Review which, like the UK's Vickers report, proposes some degree of separation between retail and investment bank-type activities. Regulatory change is also raising the worry that capital ratios may not be as healthy as they seem - possibly meaning some combination of fund raisings, reduced dividends and less lending. That reflects the possible impact of such proposals as the harmonisation of the risk weightings that are applied to loans - these often vary substantially between banks. Other threats include plans to review capital requirements for trading activities, or the enforcement of capital and funding subsidiarisation rules - meaning operations such as overseas bank branches would need to be separately capitalised.

Europe at a glance

Against such a backdrop, investors should brace themselves for bad news from the impending full-year reporting season. Deutsche Bank (DBK) has already reported a painful €2.2bn fourth-quarter loss after bad loan write-offs and litigation provisions, and remains weakly capitalised compared with its peers. And Spain's Santander (SAN) saw 2012 profits fall 59 per cent after hiking provisions against its struggling property book. According to business intelligence company SNL Financial, similar property-related losses are expected to hit Banco Bilbao Vizcaya Argentaria (BBVA) and Banco Popular Español (POS), while losses at Bankia (BKIA) could balloon to €11.33bn. Meanwhile in France, SNL reckons lenders have been hit hard by their exposure to Greece and thinks Crédit Agricole (CRAP) will report a net loss and Societe Generale (GLE) see net income fall heavily. And in Italy, bad loans in the sector grew 15 per cent to almost €118bn in the year to the end of September.

UK sector view

The UK's banks are just as exposed to the hefty regulatory agenda and the weak economic backdrop as their European peers, leaving few reasons to buy their shares. Yet today's more stable conditions also make the sell case less compelling. Indeed, our sell tips on Barclays (279p, 26 May 2011), RBS (226p, 9 Aug 2012), Lloyds (LLOY) (28.64p, 14 Jun 2012) and HSBC (511p, 1 Dec 2011) have all proven poorly timed and we're now exiting that advice.

That's not to say the four don't face challenges. Barclays is still repairing its reputation - this month it announced the departure of finance director Chris Lucas and group general counsel Mark Harding, as the bank removes management connected to past scandals. Plans to scale back the investment bank carry risks, too - it will leave Barclays even more exposed to weak retail banking conditions. And, while HSBC's Asian operations offer comfort, the bank still faces credit quality concerns in North America. Meanwhile, Investec expects Lloyds and RBS to reveal full-year pre-tax losses of £1.43bn and £3.38bn, respectively - with no dividends, possibly, for years. Still, as long as the ECB continues to intervene, it's hard to see the share price gains of recent months being lost and we move to hold recommendations for all four.