The European Central Bank said it expects to lift restrictions on dividend payments and share buybacks for the continent’s lenders later this year, signaling it believes banks are resilient enough, despite a challenging environment under the pandemic.

With Thursday’s decision, the ECB is following the footsteps of the Federal Reserve, which recently ended temporary limits on payouts. Since then big banks such as Morgan Stanley, JPMorgan Chase & Co. and Bank of America Corp. have all increased their dividends.

The economic outlook in Europe has improved and banks have maintained strong levels of capital, Andrea Enria, head of banking supervision at the ECB, told European Parliament members at a hearing. Banks’ profitability has also recovered from drops in the first half of last year, when they had to set aside money to cover for potential loan defaults.

“In the absence of materially adverse developments, we plan to repeal our recommendation as of the end of the third quarter of 2021 and return to reviewing dividends and share buybacks as part of our normal supervisory process,” Mr. Enria said.

The Euro Stoxx Banks index has rebounded sharply since late 2020 and is up almost 30% this year, compared with 15% in the Euro Stoxx 50 blue-chip index. Shares of big eurozone banks like UniCredit SpA, Banco Santander SA and Société Générale closed up more than 2% Thursday.

The issue of dividend payments is particularly important for banks on the continent because they need reasons to attract investors. Lenders have for years struggled to generate profits amid sluggish economic growth and negative interest rates.

The ECB imposed a ban on dividend payments and share buybacks in March last year when the pandemic slammed markets. In December, it ended the ban but kept limits to how much banks could distribute to shareholders.

Despite the overall bullish tone, Mr. Enria said concerns remain over the quality of the loan books of banks. Some banks have started reducing loan-loss provisions in the first quarter, even though it is too early to say whether customers are out of the woods, he said. Government support has helped many companies stay afloat, and until that is fully lifted, it is difficult to see the full impact the pandemic has had in different parts of the economy.

Mr. Enria also warned that some banks are taking on more risks by lending more to already indebted customers. “The very low credit quality leaves the market vulnerable to further shocks, including sudden asset repricing,” he said.

Write to Patricia Kowsmann at patricia.kowsmann@wsj.com