European and UK banks brace for economic recovery and green finance expansion

The outlook for European and UK banks remains tempered by geopolitical tensions, rising public debt and evolving regulatory frameworks that increasingly emphasise sustainability and digital resilience. As inflation continues its descent, banks across the region are recalibrating their strategies to navigate a landscape defined by fiscal expansion, green finance mandates and technological disruption.

Economic outlook

The IMF anticipates that GDP growth in the Eurozone will stabilise at 1.0% in 2025, reflecting marginal improvements in domestic consumption and industrial activity. The UK’s economy is projected to grow by 1.6%, bolstered by trade recovery and fiscal stimulus measures. Inflation across both regions is forecast to decline to between 2% and 3% by late 2025, paving the way for interest rate cuts by the ECB and the Bank of England (BOE) from mid-year onwards. Despite this relatively positive trajectory, the banking sector must contend with slowing credit demand, increased capital requirements and new regulations aimed at addressing climate risk and enhancing financial stability.

A key driver of banking sector activity will be the expansion of green finance, as European and UK institutions align with the European Union (EU)’s Green Deal and the UK’s net-zero targets. Sustainable finance is forecast to grow substantially, with green bond issuances expected to increase in 2025. Banks that actively integrate ESG criteria into their lending and investment portfolios will be well-positioned to capture market share, though this transition introduces complexities, including higher compliance costs and the challenge of balancing profitability with sustainability.

Economic growth across Europe and the UK is showing signs of resilience, supported by ongoing fiscal stimulus and improving trade relations. The ECB’s anticipated rate cuts in the third quarter of 2025 reflect confidence that inflation is returning to manageable levels. However, lingering geopolitical uncertainties and supply chain disruptions continue to constrain growth, preventing a more robust recovery.

The BOE, facing similar economic conditions, is projected to reduce interest rates gradually to around 3.5% by the end of 2025. While lower borrowing costs are expected to stimulate housing markets and consumer spending, the UK economy remains susceptible to external shocks, particularly those stemming from post-Brexit trade adjustments and ongoing conflicts in Eastern Europe.

European banks are benefiting from fiscal support measures, including the EUR 750 billion (about $780 billion) NextGenerationEU (NGEU) fund, which continues to finance infrastructure, digitalisation and renewable energy projects. This influx of capital is not only fostering economic recovery but also creating opportunities for banks to finance large-scale projects aligned with the EU’s climate goals. However, concerns regarding rising public debt persist, with southern European economies such as Italy and Spain experiencing debt-to-GDP ratios estimated at more than 140%, increasing the risk of sovereign bond market volatility.

In the UK, fiscal policies aimed at boosting productivity and infrastructure investment are expected to drive credit growth. However, the banking sector faces headwinds from declining property values and weaker consumer spending. Real estate prices in London and Manchester have fallen by estimated 7% year-on-year, reflecting higher mortgage rates and reduced affordability. Despite this, UK banks are expanding digital lending platforms and exploring fintech partnerships to improve operational efficiency and attract younger, tech-savvy customers.

Regulatory developments and sustainability initiatives

The regulatory landscape for European and UK banks is undergoing rapid transformation as policymakers prioritise climate resilience, financial stability and technological advancement. The ECB’s focus on climate risk assessments and mandatory ESG disclosures will shape banking practices for years to come, with banks required to integrate climate considerations into their stress testing and capital planning by 2025. This aligns with broader EU-wide initiatives, including the Sustainable Finance Disclosure Regulation (SFDR) and the Corporate Sustainability Reporting Directive (CSRD), which are designed to enhance transparency and accountability in sustainable finance.

In the UK, post-Brexit regulatory reforms are aimed at fostering greater market competitiveness. The Financial Conduct Authority (FCA) has introduced new ESG labelling standards and is expanding its oversight of sustainable investment products to prevent greenwashing. Additionally, the BOE’s Climate Biennial Exploratory Scenario (CBES) continues to guide banking institutions in assessing long-term risks associated with climate change and energy transition.

Despite these advancements, regulatory divergence between the UK and the EU remains a pressing concern. UK banks operating within the European Union must navigate complex and often fragmented regulatory environments, resulting in higher compliance costs and operational inefficiencies. To mitigate these risks, major banks such as HSBC, Barclays and Lloyds are expanding their operations in Frankfurt, Paris and Dublin, ensuring access to European markets while safeguarding against regulatory misalignment.

Challenges in the banking sector

A series of interconnected risks threaten to undermine financial stability and economic recovery across Europe and the UK. One of the most pressing challenges is the rise in sovereign debt across southern Europe, which could trigger bond market instability and increased funding costs for banks exposed to government debt. Italy’s debt-to-GDP ratio, projected to exceed 140% by 2025, remains a focal point for investors concerned about long-term fiscal sustainability.

In the UK, rising household debt and declining property values present significant risks to financial institutions. Higher mortgage rates have contributed to increased delinquencies, prompting banks to raise provisions for potential loan losses. The BOE has highlighted increasing risks in the CRE sector, cautioning that rising credit losses could put pressure on UK banks. Its Financial Stability Report indicates that vulnerabilities persist, particularly in segments exposed to commercial property downturns.

Geopolitical tensions, particularly the ongoing war in Ukraine, continue to disrupt energy markets and supply chains, contributing to economic uncertainty. European banks are increasingly exposed to corporate defaults in sectors reliant on stable energy prices, such as manufacturing and transportation. While diversification efforts are underway, the broader implications of geopolitical instability remain difficult to forecast.

Cybersecurity threats are another area of concern, with more European and UK banks reporting threats from cyberattacks. As banks expand their digital services, the need to invest in cybersecurity infrastructure and AI-driven threat detection systems becomes paramount. Failure to address these vulnerabilities could result in significant financial and reputational damage.

Opportunities in green finance and digital transformation

Despite the challenges, European and UK banks are uniquely positioned to capitalise on growth opportunities in green finance, digital transformation, and regional diversification. The EU’s EUR 1 trillion (about $1.4 trillion) Green Deal Investment Plan over 2021 to 2030 provides banks with ample opportunities to finance renewable energy projects, smart infrastructure and climate adaptation initiatives. UK banks are similarly expanding their green finance portfolios, with cumulative green bond issuances surpassing GBP40 billion ($48.9 billion) in 2024.

The rapid pace of digital transformation is reshaping banking operations across the region. Traditional banks are accelerating their adoption of cloud computing, AI-powered lending platforms, and blockchain technology to enhance efficiency and reduce costs. In the UK, digital-only banks such as Monzo, Revolut and Starling continue to gain market share, prompting larger banks to modernise their digital offerings.

Expansion into Central and Eastern Europe is another key growth strategy, with banks capitalising on higher growth rates in emerging European markets. The UK’s financial institutions are similarly targeting emerging markets in Asia, the Middle East and Africa, seeking to diversify their portfolios and reduce dependency on domestic economic conditions.

The banking sectors in Europe and the UK face a year of strategic transformation as they adapt to evolving economic, regulatory and technological landscapes. While growth prospects remain modest, banks are well-positioned to drive long-term stability by expanding their presence in green finance, embracing digital innovation and navigating geopolitical risks. By aligning with sustainability goals and prioritising operational resilience, European and UK banks can continue to play a pivotal role in fostering economic recovery and financial stability.