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LONDON/PARIS (Reuters) - Europe's banks are expected to post sharp profit falls in second quarter results as they count the cost of the debt crisis and try to anticipate the impact of the Libor interest-rate rigging scandal on the industry.
The European economy is heading towards recession, making companies nervous about issuing stocks and bonds. Trading has slowed and this has hurt investment banking, typically the most lucrative part of a bank's business.
Retail banking is also under pressure with many southern European lenders weighed down by bad debts that have surged as the economy soured. Spanish banks are the worst hit and have sought a rescue from Europe to stay afloat.
Analysts expect belt-tightening and more bad debt provisioning when the bulk of Europe's banks start to report results this week. They will also be looking for hints on the impact of the Libor scandal on the industry and future revenues.
"After a pick-up in Q1, we expect Q2 to be weak, and we struggle to see a meaningful pick up in H2," Credit Suisse research analysts said in a note to clients.
"We expect to see banks revisiting restructuring plans, with capacity slowly coming out of the industry."
Deutsche Bank DBKG.n has already said earnings will be lower than expected when they are released next week due to the weak euro and poor trading activity. It is expected to give details on how to bring down its cost base, a move that will likely include job cuts.
France's BNP Paribas (BNPP.PA) and Switzerland's UBS UBSN.VX are also expected to suffer from investment banking weakness.
The region's banks are also being squeezed by new capital ratios, requiring them to set more cash aside and they are bracing for a European Commission review into whether banks should separate their investment and retail arms.
The Libor scandal has also added to pressure on banks although the impact on second quarter earnings is not clear.
More than a dozen banks are under investigation by authorities in Europe, Japan and the United States over the suspected rigging of the London interbank offered rate, which is used to price trillions of dollar worth of financial products.
Barclays was last month fined 290 million pounds by U.S. and UK regulators for manipulating Libor. More banks are being investigated and could face fines and legal battles that may run for years.
"It's (the scandal) a good indicator of just how opaque the banking industry is - we are still not entirely sure how some sections of a bank make their money and now almost everything is falling under suspicion," said Andrea Williams, European fund manager at Royal London Asset Management.
"People are questioning the higher returns some banks were making in certain areas so it's another worry for investors."
European banks are forecast to make an average return on equity (ROE) of 8 percent this year and 10 percent next, but the number could be much lower if the economy gets worse.
Most European banks had a ROE of more than 10 percent before the 2008 financial crisis.
Investors will be wondering why to invest in a sector facing so many challenges.
"We are still very much cautious and extremely selective (about investing in banks)," said Stefan Angele, CIO of Swiss & Global Asset Management. "The sector as a whole still faces severe headwinds and has lost a lot of trust. It will take time to change this and regulatory pressure will likely persist."
Sluggish trading is expected to be the main reason for the drop in banks' second quarter profits.
A J.P. Morgan report in late May forecast a slowdown in trading of fixed-income currency and commodities of up to 32 percent quarter-on-quarter. Equities trading was expected to fall 14 percent, and credit trading was seen dropping by 35 percent quarter-on-quarter, the report said.
BNP Paribas, Societe Generale (SOGN.PA) and Credit Agricole (CAGR.PA) are expected to feel pressure from investment banking results that will be mediocre at best, with Basel 3 capital adequacy targets under scrutiny for the latter two French banks.
Credit Suisse CSGN.VX said last week it was raising 15.3 billion Swiss francs ($15.44 billion) in additional capital under regulatory pressure of its own from the Swiss National Bank, which had called for urgent action to improve its capital.
Investors will also be paying close attention to Spanish banks, some of which are fighting for survival.
Spain has demanded banks beef up provisioning as it tries to contain the damage from a burst real estate bubble in 2008 and an ensuing recession and has asked for up to 100 billion euros in European aid.
Italy's top banks, Unicredit (CRDI.MI) and Intesa Sanpaolo (ISP.MI), are also expected to stay out of the red, though both banks will see sharp declines in profit from a year ago, hurt by rising non-performing loans and muted customer activity.
Editing by Erica Billingham and Anna Willard