European banks look poised for long-awaited comeback

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Seven years after the financial crisis's first warning signs cropped up, European banks finally seem ready for a rebound.

While institutions in other hard hit regions, such as the United States, kick-started their recovery years ago, Europe's banks have been dogged by weak economies and massive recapitalization programs.

As the economic backdrop improves, there's an argument to be made that the turning point has come – an idea that investment fund Hamilton Capital Partners is now convinced of.

You need only scan media headlines to realize the euro zone economy is no longer the basket case that it was from 2010 to 2012. Not only are its economic crises fewer and far between, the region's gross domestic product is growing – albeit barely.

This underlying growth is key for European banks, because the region's companies are much more prone to borrow from their financial institutions then to tap bond investors for new money. And while banks were scared to lend for the longest time, Hamilton notes their provisions for credit losses finally started to subside in 2013, instilling more confidence to dole out funds once again.

Better yet, European banks are in much better financial shape in 2014. While many were the world's least capitalized banks heading into the crisis, they continue to get their acts together, both by shedding their riskiest assets and holding more capital.

Hamilton believes they've done so in a way that is beneficial to shareholders.

"It is hard to overstate how much more favourable the regulatory environment has been for European banks, and their equity investors, than it has been for U.S. banks," the fund noted. While the U.S. slapped banks with tough rules and big fines, European policy has been much more nuanced. Banks in the region have more or less been able to earn their way out of problems, shedding assets over time and carving out a bigger share of profits to beef up capital.

The big message: by not raising boatloads of capital, the banks haven't diluted their shareholders nearly as much as some global peers. So if a recovery takes hold, each share still has claim on a sizable portion of profits.

There are other factors at play. Interest rates have bottomed out in Europe, as has Euribor, the benchmark lending rate. As these improve over time, bank lending margins get fatter.

But maybe most importantly, bank valuations are still suffering. As Hamilton notes, although the sector's health has improved dramatically, share prices haven't moved much since 2010. So while there are risks, "investors are getting paid to assume these risks in the form of depressed valuations."

Yet Hamilton is well aware that these risks can't be ignored – even if they're already factored into share prices. Despite an economic recovery, the rebound is incredibly fragile.

Beyond that, banks themselves face tough scrutiny this year, including an asset quality review, balance sheet assessments, and then stress tests. They're also susceptible to the proposed European banking union, which could force them to siphon off some profits to create a bailout fund for future crises.

And if the regional economy continues to recover, some of their easier profits will dissipate. For instance, banks have taken advantage of Europe's Long-Term Refinancing Operations, a form of stimulus that allows them to borrow cheaply and invest the money in securities such as sovereign bonds that pay higher yields.

Even with all those risks, Hamilton believes European banks look a lot like U.S. banks did in 2010. The return for American financials has been pretty lucrative since.