By Rochelle Toplensky

Even as optimism about a vaccine-led recovery rips through global markets, European banks remain valued for a deeply uncertain future. There are no easy answers, but going private could be a solution for smaller ones.

Shares in the region's lenders have risen 20% this year, but still trade at less than two-thirds of forward book values, on average, with some as low as a quarter of book. Such stubbornly low valuations might be expected to attract cash-rich private-equity investors looking to cut costs, consolidate companies or even liquidate assets.

So far, buyout firms have snapped up nonperforming loans but mostly shied away from entire banks, largely due to regulatory concerns. Yet officials may be warming to the idea that private equity has a part to play in the sector's next consolidation wave.

Despite high levels of capital, some banks are likely to be squeezed by souring loans once government-support programs roll back in the wake of the pandemic. This will add to a host of existing problems that have sapped the profits of Europe's lenders over the past decade, including rock-bottom interest rates, fierce competition and underused bank networks.

One persistent hope is that mergers could improve industry profits. Cross-border transactions remain unlikely without long-stalled EU-level reform, but there have been some domestic deals lately: Italian Intesa Sanpaolo bought UBI last year and Spanish CaixaBank is acquiring Bankia. Few involve Europe's biggest banks, though. Most giants are instead focused on cutting costs, investing in IT systems and cross-selling services to raise returns.

The absence of industry buyers leaves European banking regulators in need of other options for strengthening shaky lenders. This could open the door for private equity's special blend of roll-ups and cost cutting, which has historically been frowned upon by banking officials. There are early signs of action: HSBC is talking to a private equity buyer about its French retail operations in what looks to be a test case for the strategy.

One example of regulators encouraging deals is a move by the European Central Bank to allow buyers to create negative goodwill if they buy below book value -- a tool that was used successfully in the U.S. after the 2008 crisis. This badwill can be added to capital to offset restructuring costs or nonperforming loans.

There is no shortage of possible targets, even before any nonperforming loan crunch. For example, the U.K. has many midsize "challenger" banks that have become challenged themselves, including the Cooperative Bank, Virgin Money, Metro bank, Monzo and the banking units of retailers Sainsburys and Tesco.

Deals will still be tricky, as many regulatory concerns remain. Cerberus Capital Management was interested in the Cooperative Bank last year, but the tie-up fell apart. One apparent concern was over so-called mortgage prisoners -- borrowers stuck paying the private equity company high-interest mortgages for years, in contrast to comparable bank customers whose loans were refinanced at lower rates. Leverage levels could be another barrier to transactions, given the heavy reliance on debt financing by both buyout companies and lenders.

Still, Europe's regulators want a more robust banking system, and have few options. Unconventional thinking will be necessary.

Write to Rochelle Toplensky at rochelle.toplensky@wsj.com

(END) Dow Jones Newswires

03-09-21 0734ET