By Steve Slater and Sarah White
LONDON/MADRID (Reuters) - Grim as forthcoming results from many of Europe's banks may be, they could help mark a turning point in the sector's fortunes.
Earnings are expected to be squeezed as banks pay for past mistakes and clean up balance sheets to prepare for looming European Union health checks. Yet the underlying story could be the sector at last getting back on a firmer footing.
Some investors have already been voting with their wallets to that effect and the sector <.SX7P> earlier this month rose to its highest in nearly three years. In the past 12 months it has outrun European stocks as a whole <.FTEU3> by 7 percentage points, according to Reuters data.
Headline numbers for many banks though aren't likely to be pretty.
Deutsche Bank fired a warning shot this week as the flagship German lender rushed out news of a 1.2 billion euro (969.9 million pounds) loss for the fourth quarter 10 days early. Many of its rivals are likely to repeat at least some of its mix of higher litigation and restructuring costs and a steep drop in bond trading revenues.
Some are also expected to get potential bad news out of the way before the European Union's looming health checks, taking a prudent stance on loan losses that would dent profits but could improve confidence they are cleaning up their balance sheets.
"We think the top 20 banks will take the opportunity to take large Q4/Q1 impairments to clean up assets, which will enhance market confidence and facilitate the deleveraging and healing process," said Morgan Stanley analyst Huw van Steenis.
Most banks should show a slim rise in earnings for the full year, underpinned by higher income from lending, lower costs and an improvement from some hefty losses on loans in 2012, although the mixed fourth-quarter performance will show the recovery is fragile, analysts said.
Europe's banks are due to undergo health checks later this year by the European Central Bank, which investors say is key to restoring confidence. The test will be based on a review of the quality of assets (AQR) and will determine if banks need to raise more capital to insulate themselves against shocks.
Belgium's KBC has said it will take a 775 million euro provision in the fourth quarter to cover losses in Ireland and elsewhere to clean up its books ahead of the health check. And other banks, especially those in Spain, Italy and Portugal, could take a similarly prudent stand, analysts said.
"Right across southern Europe we expect provisioning levels to be high. We would have expected it anyway, but with the ECB tests (looming), banks have every incentive to try and maximize provisions, without deteriorating capital levels," said Daragh Quinn, banking analyst at Nomura in Madrid.
Spain's Sabadell set the tone this week when it reported fourth-quarter provisions of 429 million euros, up 16 percent from a year ago.
Spanish banks are still clearing up their balance sheets as they recover from a real estate crash that wiped out 2012 earnings and clogged up their books with repossessed homes, and some are expected to capitalise on a likely rise in net lending income to top up provisions.
MISHAPS, RESTRUCTURING & GRIM TRADING
Lenders there also cut holdings of sovereign debt by the most in four years in November, which many had relied on to make trading gains, due to uncertainty around how these holdings will be treated in the stress tests.
Banks could also pay more to cover fines or set aside cash for litigation. European regulators handed out a record 1.7 billion euro fine last month on six firms for manipulating benchmark interest rates, and U.S. authorities are handing out fines over issues like the sale of mortgage-backed securities.
Many banks, including Deutsche, HSBC , Barclays and UBS , are seeing operating costs fall as they streamline operations, but that restructuring comes with an upfront cost.
Royal Bank of Scotland will take an extra impairment charge of between 4 billion pounds ($6.7 billion) and 4.5 billion in the fourth quarter to cover the accelerated run-down of 38 billion pounds of assets put into a "bad bank" it has created.
With earnings squeezed on several fronts and pressure still on to improve capital and leverage ratios, banks are expected to take a cautious approach to dividends, although Lloyds could offer to pay its first dividend since it needed a government rescue five years ago.
That would pave the way for Britain to sell more of its 33 percent stake, possibly right after the results, bankers said.
Revenue from investment bank arms in the fourth quarter are likely to fall after a bad end to the year in fixed income trading, as the U.S. Federal Reserve made plans to start tapering its bond buying.
Deutsche Bank's fixed income revenue in the fourth quarter tumbled 31 percent from a year ago, far worse than an average fall of 4 percent reported by the five big U.S. banks, and Barclays could show a similar drop to its European rival.
UBS and Credit Suisse should have fared better, as they are more reliant on advisory and investment banking units, where income at U.S. banks rose 9 percent on average from a year ago.
(Editing by David Holmes)