London: Europe’s banks may be on the point of a turnaround as economic growth returns to the continent and the European Central Bank prepares to review the industry’s assets, said Kinner Lakhani, Citi Banking Sector Analyst.

The ECB on last Thursday started allotting the first funds under its so-called targeted longer-term refinancing operations (TLTRO). The bank announced that Eurozone lenders had borrowed just €82.6 billion ($106.9 billion) in four-year loans from its new facility, falling short of many analysts’ expectations.

“The disappointing auction does not mean that all hope is lost. There are 7 of these auctions in total, so the funds could go … eventually. Added to that, this auction takes place at a tricky time for banks, the results of the ECB’S own bank stress tests, billed as the test to end all tests, are due at the end of next month,” wrote Kathleen Brooks, Research Director UK EMEA at FOREX.com

No wonder banks are keeping their balance sheets as clean as possible and not engaging as anything that either makes them look like they are lending to risky borrowers, or that they are desperate and need cheap funds from the ECB.

Some analysts say this could spark fresh speculation that the ECB will resort to even more drastic stimulus measures.

Lakhani said banks in Europe are at an inflection point and ripe for increased return on capital, as fresh liquidity is pumped into the system through both TLTRO and ECB’ plans to buy asset backed securities later this year. Citi analyst expects the asset buying will eventually include sovereign bonds held by banks that will release funds to banks.

The TLTRO combined with the asset quality review (AQR) and the banking sector stress test are likely to show improved balance sheet health of most banks with a small number of failures expected in the stress test

“Banking sector is on a recovery path and TLTRO and other asset buying programmes should accelerate that process. Post AQR, Lakahni expects significant provision releases for banks in some of markets where asset bubbles happened and banks were forced to take huge provisions against NPLs. With NPLs stabilising, new NPL creation is also expected to decline.

Critics argue that in the context of poor credit demand, improved liquidity may not help banks in asset growth and profitability.

Lakhani has a different take. “Credit demand may be low, but that is not the point. Easy liquidity to banks is a key element in stabilising the sector after a prolonged period of recession,” he said.

Citi said it was maintaining an overweight recommendation on European banking sector. Next year will be pivotal and banking shares may rally 13 to 14 per cent versus 8 per cent for the equity market as a whole.

An ECB review of the balance sheets of about 130 banks, which began last month, “should serve to reduce the sector risk premium,” said Lakhani

Ever since the financial crisis impacted the European banks’ balance sheets, these banks have been forced to forsake dividends, boost capital and sell businesses. Even today many banks are busy cleaning up the legacy of the crisis from their balance

The TLTRO operation comes ahead of the ECB’s comprehensive assessment of lenders’ balance sheets, aimed at ensuring the soundness of banks’ health. The results of the review, including a stress test, will be published next month and the ECB will start as euro-area bank supervisor in November.

The ultimate value of the TLTROs, which run through 2016, and programs to buy asset-backed securities and covered bonds was estimated at 1 trillion euros. With the poor take-up of TLTRO funds, question remains whether the ECB’s proposed measure of purchasing covered bonds and asset-backed securities will help it to achieve its goal of expanding the central bank’s balance sheet to EUR 1 trillion. The next TLTRO will be held in December and subsequent quarterly operations are largely tied to banks increasing lending to companies and households.

Even in the context of ECB pumping additional liquidity in the banking system, Lakhani warns that he expectations on banks’ balance sheet expansion should be modest. “While regulatory changes have reduced the need for massive bank funding, disintermediation is gaining ground.