Europe’s banks have had a stellar year. Now they face one big question in 2026

European banks are on track for their strongest year since 1997, with the Stoxx 600 Banks Index surging nearly 60% since the start of the year.

The region’s lenders enjoyed a strong earnings season, with HSBC and UBS among those posting profit beats in the third quarter, while select names — including Commerzbank and Societe Generale — have seen valuations more than double over the past 12 months.

It all caps what Benjamin Goy, head of European financials research at Deutsche Bank, called a “stellar year” for the sector. “European banks are well capitalized. Most of them, or all of them, are in significant excess capital territory,” Goy told CNBC.

But as lenders look to maintain their momentum into 2026, the big question now weighing over management teams is what to do with this excess capital.

While organic growth opportunities are improving, banks are now “so profitable, you can do more,” Goy said.

Share buybacks and capital dividends are frequently used and provide low execution risk. But focus is expected to tilt toward another option — inorganic growth, namely M&A activity — next year, allowing banks to diversify revenue streams and bolster growth.

“That’s something the sector had been missing for almost a decade,” Goy said. “There’s confidence coming back among management teams. Investors are increasingly supportive, and the deals announced are actually typically earnings-accretive, and that’s why even the acquirers’ stock price tends to go up. We would expect more of this activity to happen.”

Speaking to CNBC’s “Europe Early Edition” on Dec. 9, Goy said that both Italy and the UK were consolidation hotspots, with activity dominated by domestic “bolt-on” deals where “execution risk is lower, and synergies are strong … [and where it’s] easier to announce profitable deals.”

Several of Deutsche’s top picks for the year — including Monte dei Paschi, Erste Group, Bank of Ireland and Barclays — are expected to be involved in such activity.

Competition for so-called “product factories” — such as wealth and asset management and insurance — is likely to prove particularly fierce within the M&A sphere, though cross-border activity remains challenging, owing to greater execution risk, typically lower synergies, and political scrutiny, he added.

Elsewhere, investment strategists also pointed to strong loan and deposit growth, which is expected to further underpin the sector’s resilience in 2026.

RBC BlueBay Asset Management said European banks have benefitted from a growing desire among global investors to diversify their equity exposure away from U.S. tech this year, with strong cyclical sectors — including financials — seeing repeated earnings upgrades, resulting in re-ratings.