Banking on Defense: Why European Banks Hold the Key to Defense SMEs' Asymmetric Returns

The Ukraine war has triggered a seismic shift in European defense spending, with NATO-aligned countries pledging to spend over 2% of GDP on defense—a level unseen since the Cold War. Behind the headlines about fighter jets and missile systems lies a quieter but critical story: the small and medium-sized enterprises (SMEs) that form the backbone of Europe's defense supply chain. These firms—many of which are overlooked by investors—face a dual challenge: securing financing to scale amid surging demand, and navigating ESG-driven headwinds that could undermine their growth. For investors, the answer to this puzzle may lie in the balance sheets of Santander (SAN) and UniCredit (UCG), two banks uniquely positioned to profit from the EU's defense renaissance.

The SME Defense Dilemma: A Financing Gap, But a Structural Tailwind

European defense SMEs—2,500 companies contributing €158.8 billion to turnover in 2023—produce everything from radar systems to drone components. Yet they face a liquidity crunch. Traditional lenders have historically avoided the sector due to its perceived risks: long development cycles, geopolitical uncertainty, and dependence on government contracts. The European Investment Bank (EIB) estimates that SMEs in the sector face a financing gap of €20–30 billion annually to meet rising orders.

Here's where the EU's post-2022 reforms come in. The European Defence Fund (EDF) and the ReArm Europe Plan have allocated €8 billion and €800 billion respectively to boost R&D and joint procurement. The EIB has tripled its defense-related lending to €3 billion, with a focus on SMEs. This creates a sweet spot for banks that can bridge the gap between these SMEs and institutional capital.

Why Santander and UniCredit Are Underappreciated Plays

While both banks have exposure to defense SMEs, their strategies and risks diverge:

UniCredit (UCG): The Direct Play

UniCredit has direct exposure to defense supply chains through its corporate lending and advisory services. Italy's €20–25 billion order for Leonardo's Centauro armored vehicles, for example, relies on a network of SME subcontractors—many of which are UniCredit clients. The bank's 2024 Q3 report highlighted a 22% increase in loans to industrial SMEs in Germany and Italy, key defense hubs.

Asymmetric upside: UniCredit's 2025 targets include a 15% rise in SME lending in core markets. With €150 billion earmarked for EU defense via the SAFE loan program, the bank stands to benefit as SMEs scale production.

Santander (SAN): The ESG-Adjusted Opportunity

Santander's defense exposure is indirect but growing. While its direct loans to defense SMEs are smaller than UniCredit's, it is a leader in ESG-linked financing. For instance, Santander's €5 billion synthetic securitization with the EIB prioritizes gender-equality projects, which may include SMEs in defense logistics or cybersecurity.

Risk caveat: Santander's focus on ESG could backfire if ESG funds shun defense stocks entirely. However, its diversified exposure to European SMEs—coupled with strong Spanish and Portuguese defense ties—buffers this risk.

The ESG Crossroads: A Threat, But Also an Edge

ESG pressures are a double-edged sword. Defense stocks have seen €3.7 trillion in ESG fund outflows since 2020, as investors flee “controversial” sectors. Yet this creates a valuation gap: defense SMEs often trade at discounts to their growth potential. Banks like UniCredit and Santander can exploit this by:
1. Offering ESG-compliant financing (e.g., green bonds for defense tech that reduces environmental impact).
2. Partnering with the EIB to structure loans that meet ESG criteria (e.g., gender equality mandates).

Investment Strategy: Banks + ETFs for Asymmetric Returns

For investors, the path forward is twofold:

1. Buy the banks:
2. UniCredit (UCG) offers leverage to SME lending growth, trading at a 25% discount to its 2020 defense boom valuation.

3. Santander (SAN) is a safer, ESG-conscious option, with a 12% dividend yield anchoring its stock.

4. Pair with sector ETFs:

5. The European Defense ETF (DEFENSE ETF) provides broad exposure but lacks the banking sector's upside.

Conclusion: A Structural Shift, Not a Sideshow

The EU's defense renaissance isn't a fleeting headline—it's a decade-long transformation. Banks like UniCredit and Santander are the unsung heroes of this story, with balance sheets poised to capture SME growth while navigating ESG minefields. For investors willing to look past the headlines, these stocks offer asymmetric returns in a sector primed to outperform.

Final caveat: Monitor ESG fund flows closely. If defense divestment accelerates, even banks could face headwinds. But for now, the tailwinds are too strong to ignore.

Data as of June 2025. Past performance does not guarantee future results.