The European banking sector and the European economy, in general, are under intense pressure. Economic growth has struggled to gain traction, the European Central Bank's (ECB) unprecedented monetary policy support has been necessary to fend off deflationary pressure, and European banks have an estimated $1 trillion or more in bad loans. After several years of slow or negative loan growth for many banks, there are reasons for optimism in 2016; European macroeconomic conditions appear to be firming, and new credit cycles may be in the very early stages in Europe and the United States.

Overall, 2016 is likely to be a better year for European banks, but not one of breakout growth. Loan activity is expected to expand at a faster pace than 2015, but it will still be relatively slow. Even if growth surprises on the upside, profits are likely to be squeezed by the low interest rate environment.

European Economic Picture Appears to be Firming

After the 2008 global financial crisis, the European economy never regained its footing. After averaging 2.2% growth from 2000 to 2007, the eurozone countries have averaged only 0.8% growth from 2010 to 2015.

However, the broad economic outlook is slowly improving according to a number of measures. For example, the ZEW Economic Sentiment Survey, a balance of financial analysts and investors surveyed believe current euro area macroeconomic conditions are bad, and expectations for the next six months are net positive but deteriorating. Consensus forecasts call for about 1.5 to 1.8% gross domestic product (GDP) growth in the euro area in 2016 – not an outstanding growth rate, but decent, given the circumstances. Also, the WMA Investor Outlook Survey indicates that the market expects a fairly flat outlook for European stocks during the year. Nevertheless, the ECB is likely to maintain a very aggressive stance with its quantitative easing program and negative interest rate policy.

European Banking Sector Gaining Traction

The banking sector is also getting back on its feet. Over the past several years, many banks have taken advantage of the carry trade to strengthen their financial positions. Additionally, the latest ECB Euro Area Bank Lending Survey points to loosening credit standards and greater demand for loans. In particular, credit standards and loan conditions are easing, and demand is increasing to meet funding needs for capital expenditures and working capital. European bankers expect these trends to continue into at least the second quarter. These are signals of a thawing credit environment, and perhaps the beginning of a new credit cycle, which could propel banks' balance sheet growth and profitability.

Risks Remain

While lending activity may be picking up in Europe, the banking sector is generally in better health thanks to tighter regulation and stronger capitalization. However, asset quality should not be overlooked as a top risk. High numbers of bad loans create vulnerability to economic setbacks, particularly in the periphery countries of Portugal, Spain and Greece. The low interest rate environment (the ECB has pushed short-term rates into negative territory) will put pressure on the profitability of banks as net interest margins are likely to be very narrow as long as the ECB keeps its foot on the monetary policy throttle.

Best Bets

In this environment, banks with the strongest balance sheets in terms of capitalization, asset quality, and portfolio diversification across industries and geographies should do the best. For example, U.K. and Nordic banks have relatively stronger asset quality, profitability and capital than their European peers. Central and Eastern European banks are better positioned to reap rewards from faster economic growth relative to Western Europe. However, these banks have greater regulatory uncertainty that could weigh down profits.