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Spain: Selected Issues

Author(s):
International Monetary Fund. European Dept.
Published Date:
January 2017
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Banking Sector: Facing New Challenges While Balance Sheet Adjustment Continues1

A. Introduction

1. This chapter discusses a few new macro-financial challenges that have emerged against the backdrop of ongoing balance adjustments. Following a summary of the current landscape of Spain’s financial system (Section B), which was reshaped by the major banking sector reforms and adjustments in the economy, this chapter explores four macro-financial questions: (i) what has been the impact so far from the low interest rate environment on banks’ profitability and what could be implications going forward (Section C), (ii) what could be the spillovers to the Spanish banking system from more difficult macro-environments in emerging economies (Section D), (iii) what challenges arise from the low profitability for the ongoing bank balance sheets adjustment (Section E), and (iv) how could low profitability impact banks’ capacity to support economic growth over the medium term once credit growth picks up (Section F). Section G concludes with a discussion of policy implications.

B. Current Landscape

2. Spain’s financial system remains largely bank-dominated. For financial institutions operating in Spain, banking system assets amounted to about 250 percent of GDP, which accounted for 70 percent of aggregated assets, as of end-2015 (Table 1). Meanwhile, insurance companies, pension funds, and investment funds accounted for 17 percent of aggregated assets. Banks are thus playing a relatively more important role in financial intermediation in Spain than in other major advanced economies. Shadow banking, which amounted to around 20 percent of GDP as of end-2014,2 is also rather small in Spain (Figure 1). Spain appears to host one of the largest securitization markets in the euro area (after Ireland, Italy, and the Netherlands). The securitization activity largely involves financial vehicle corporations that issue debt instruments to hold securitized loans that are largely kept on banks’ balance sheets, with their assets amounting to about 20 percent of GDP. In terms of financial markets, outstanding private sector debt securities issued domestically and internationally amounted to 68 percent of GDP and stock market capitalization stood at 62 percent of GDP as of end-2015. The local bond market is dominated by government securities.

Table 1.Spain: Financial System Structure, 2007-15
In billion eurosIn percent of GDPIn percent of total assets
200720112015200720112015200720112015
Financial institutions 1/
Total assets4,2074,4773,889389418360100.0100.0100.0
Banks2,9353,2562,73027230425269.872.770.2
Insurance companies2332492852223265.55.67.3
Pension funds102102125910122.42.33.2
Other financial institutions93787074887816922.319.419.2
o/w: Investment funds15525314233.56.5
o/w: Financial vehicle corporations457227432110.25.8
Financial markets
Outstanding debt securities1,2911,7811,651119166153
o/w: Government338673917316385
Stock market capitalization821446672764262
Sources: Bank of Spain; BIS, Debt Securities Statistics; ECB; FSB, 2015 Global Shadow Banking Monitoring Report; IMF, World Economic Outlook database; and IMF staff estimates.

Based on operations in Spain.

Sources: Bank of Spain; BIS, Debt Securities Statistics; ECB; FSB, 2015 Global Shadow Banking Monitoring Report; IMF, World Economic Outlook database; and IMF staff estimates.

Based on operations in Spain.

Figure 1.Selected Advanced Economies: Financial System Structure

Sources: ECB, Banking Structural Financial Indicators; FSB, 2015 Global Shadow Banking Monitoring Report; IMF, World Economic Outlook database; and IMF staff estimates.

3. Following the extensive restructuring in the aftermath of the global financial crisis the Spanish banking system is now more concentrated. On the back of a series of mergers and acquisitions, the number of deposit-taking institutions decreased by about a third during 2008–15 to 134.3 In particular, only two savings banks remain, down from 47 in 2007, partly due to their excessive exposure to the housing market boom and subsequent bust. As a result of system-wide consolidation, the banking system has become more concentrated, with the Herfindahl index doubling between 2007 and 2015 (Figure 1). The significant banks (14 in total) under the oversight of the Single Supervisory Mechanism (SSM) account for about 93 percent of banking system assets on the consolidated operations basis.

4. The banking system comprises two large international banks, with the rest mostly operating only in Spain. The two largest banks—Banco Santander and BBVA—have thrived on their globally-diversified retail banking business, with their overseas operations primarily in the form of subsidiaries that are locally funded and managed. Operations outside Spain contribute around 85 percent of group-wide earnings of these two largest banks whose combined assets account for about 57 percent of banking system assets. The rest of the system comprises Spanish entities, as well as foreign subsidiaries and branches. Among other significant banks, three involve traditionally commercial banks, eight are derived from former savings banks, and one is formed by a group of credit cooperatives. These twelve institutions account for around a third of banking system assets. Foreign subsidiaries and bank branches in Spain are numerous (about 100) but assets are relatively small (about 4 percent of banking system assets).

C. Profitability and Low Interest Environment

5. Profitability has remained well below the pre-crisis level but has so far been stronger than that of many European Union (EU) peers. As of 2016Q2, the return on assets for banking business in Spain over the past year was about 0.7 percentage points lower than in 2007, largely owing to lower net interest income and other operating income (0.27 and 0.35 percentage points, respectively), with broadly similar impairment costs. Nevertheless, Spanish banks had higher return on assets than EU peers, resulting from stronger pre-loss income despite larger impairment costs (Figures 2 and 3). They also enjoyed markedly larger net interest income, benefiting from their business model being more oriented to retail banking. In addition, Spanish banks managed to keep the cost-to-income ratio at a favorable level, against the background of costly retail banking business especially in terms of staff expenses. However, the falling trend in operating expenses has reversed more recently.

Figure 2.Selected European Economies: Profits, Income, and Cost Structure

Sources: ECB, Consolidated Banking Data; and IMF staff estimates.

Figure 3.Spain: Profitability and Earnings

Sources: Bank of Spain; IMF, Financial Soundness Indicators database; SNL; and IMF staff estimates.

1/ For banking business in Spain, the aggregate figure of net income in 2011 and 2012 is amplified by the segregation process of savings banks’ business to newly-created banks, with a significant portion of the shares of these new banks being part of the savings banks’ investment portfolios. Profits/losses of these new banks would thus be counted twice. See Bank of Spain (2012) for more details.

2/ Based on entities that have been identified as global systemically important banks since 2012.

6. Profitability has varied widely across Spanish banks. In 2015, the two large international banks, along with three domestic-oriented banks, registered a relatively high return on assets by the European benchmark. They largely benefited from their overseas subsidiaries that were operating in more favorable conditions, such as larger net interest margins. Other significant banks with above average profitability in 2015 benefited from their operating cost efficiency and limited asset impairment.

7. Profitability challenges arise from low interest rates, limited room to reduce funding costs, and continued deleveraging.

  • Repricing of loans in Spain is sensitive to money market rates. In Spain, interest rates for new lending have fallen towards the levels prevailing in core euro area economies, as confidence in the banking system and the euro zone improved. In fact, the average interest deposit and lending rates based on outstanding deposits and loans have declined more rapidly in Spain than in other parts of the euro area (Figure 4). The repricing of interest rates charged for lending to small and medium enterprises (SMEs) and for house purchases is particularly more sensitive to changes in benchmark interest rates (e.g., EURIBOR) in Spain than in other European economies. Furthermore, housing loans account for a larger share of banks’ total assets in Spain. A simple scenario calculation indicates that a further reduction of net interest margins by 10 basis points could lower significant banks’ net income before taxes by about 10 percent, with differing interest rate sensitivities across banks.4

  • Banks have limited room to further reduce overall funding costs. In particular, resident deposits account for about 55 percent of total funding, while the average interest rate on outstanding term deposits is at a very low level (Figure 4). In addition, banks will not benefit as much from negative interbank interest rates given their lesser use of interbank funding.

  • At the same time, Spanish corporates and households have continued to deleverage and bank lending has continued to fall (Figure 4).5 For the banking system to maintain net interest income from lending activity as a consequence of compressed interest margins, it would take credit to grow by about 5.5 percent annually which compares with IMF staff projections of annual credit growth of slightly above 1 percent over the next five years.6,7 The Bank of Spain also assess the macroeconomic credit gap to still be large and negative (see Bank of Spain, 2016b).

Figure 4.Spain: Challenges due to Low Interest Rates and Continued Deleveraging

Sources: Bank of Spain; Haver Analytics; IMF, International Financial Statistics; and IMF staff estimates.

1/ Based on the coefficient β from bivariate regression: ΔRt = α + βΔEURIBORt, where Rt is the deposit and lending rates, with Δ representing changes of interest rates over the period of 6 months.

2/ Based on total financial liabilities (excluding equity instruments), which include borrowings and accounts payable.

3/ Based on banking business in each jurisdiction.

8. The restructuring in the aftermath of the crisis has helped Spanish banks to be among the most cost-efficient in Europe, although operating expenses have been rising since 2013.

Banks in Spain have seen a significant reduction in offices and employees since 2008 as a result of banking system consolidation (Figure 5). The cost-to-income ratio of Spanish banks appears competitive on the consolidated operations basis, despite relatively large operating expenses thanks to strong net interest income deriving from overseas retail banking business (Figure 2). Meanwhile, the cost-to-income ratio for banking business in Spain is also at about the same level, reflecting overall efficiency among domestic-oriented banks as well. However, staff and administrative expenses for banking business in Spain have steadily increased from the trough in early 2013, with most significant Spanish banks experiencing an increase in operating costs (Figure 5).

Figure 5.Spain: Operating Efficiency

Sources: Bank of Spain; SNL; ECB, Banking Structural Financial Indicators; and IMF staff estimates. 1/ Based on 14 significant Spanish banks.

9. Nevertheless, low profitability poses a number of challenges going forward. Strong profits provide organic sources to further strengthen capital positions that would enhance the banking system’s ability to withstand shocks. For example, in 2015 retained earnings underpinned most of the system’s buildup of capital buffers (see also Section F). Profits can also facilitate continued NPL reduction by supporting problem asset sales and/or debt relief (see also Section E). Furthermore, when the return on equity is below the cost of capital, as it is currently the case in Spain and other European banking systems, it is more difficult for banks to raise new capital.

10. Thus, sustained low profitability would put pressure on bank business models. The low profitability environment is generally a key challenge for European banks. For Spanish banks, there seems to be scope to compensate the compressed net interest income by boosting their relatively low non-interest income (Figure 2), and further improving efficiency and reducing operating costs. For the latter, the greater use of technology, the consolidation of smaller banks to attain economies of scale, and the rationalization of some branch networks that consist of many small offices (Figure 5) are among the available options.

11. The low interest rate environment also highlights the need to continue to carefully monitor any buildup of risks. At the moment, the recovery of the housing market and construction sector is at an early stage and deleveraging by corporates and households is still ongoing. However, there are some signs of increasing leverage in certain segments. In particular, the share of new mortgage loans with high loan-to-value (LTV) ratios and the average LTV ratio of new housing loans have both gone up, even if levels are still relatively low.

Leverage in Borrowing for Housing, 2004-16

(In percent)

Sources: Bank of Spain; Haver Analytics; and IMF staff estimates.

D. Cross-Border Linkages

12. The Spanish banking system has relatively strong cross-border linkages, particularly with Latin America and the United Kingdom. As of March 2016, Spanish banks’ exposures to Latin America and the United Kingdom amounted to 12.2 and 11.4 percent of total exposures, compared with 54.6 percent for their exposures to Spain (Figure 6).8 Given that Spain’s two large international banks have been pursuing their international expansion largely based on the standalone subsidiary model,9 the key channel of cross-border spillovers would be through the distribution of profits from subsidiaries to the parents, especially as Latin America and the United Kingdom are amongst the most important sources of earnings for these two global Spanish Banks.

Figure 6.Spain: Cross-Border Financial Linkages

Sources: BIS, Consolidated Banking Statistics; IMF, Financial Soundness Indicators database and World Economic Outlook database; SNL; and IMF staff estimates.

1/ Based on economies where Spanish banks have large exposures. Other euro area includes Portugal, France, Italy, and Germany. Other Latin America includes Peru, Argentina, and Colombia.

2/ Based on a sample of largest banks in each Latin American economy, with total assets of at least €5 billion.

13. The macroeconomic environment has become less favorable in some economies where Spanish banks have a strong footprint. Brazil has experienced an output contraction in recent years, although its growth prospects have started to improve. Meanwhile, many Latin America economies have already slowed down, and macroeconomic uncertainties have increased markedly especially in light of rising trade protectionism risks (e.g., for Mexico) (Figure 6). The outlook for the United Kingdom has also become increasingly uncertain in the aftermath of the ‘Brexit’ referendum. Problem assets have been on a rising trend in Brazil and Turkey.

14. Spanish subsidiaries appear to be in a solid position to deal with rising credit risk, but lower profits would weaken contributions to the parents’ capital buffers. So far, the adverse macroeconomic conditions, and deteriorating asset quality have not yet significantly marked down profitability, although NPLs typically worsen with some lag.

  • In Latin America, Spanish subsidiaries exhibit relatively strong financial performance compared with other major banks in the region (Figure 6). Given their relatively strong profitability and relatively high provisioning, Spanish subsidiaries should be able to handle additional losses. Their annual pre-impairment net income could potentially absorb about up to twice the currently still moderate NPL level. However, an increase in their asset impairments could have a sizeable impact on group-wide profitability. For example, in a scenario in which impairment costs by subsidiaries increased by a 25 percent, this would reduce the contribution of profits to group-wide capital by about 25 percent.

  • In other regions, the impact on additional credit losses would be much less. For instance, a 50 percent increase in impairment costs by subsidiaries in Turkey and the United Kingdom would reduce the contribution of profits to group-wide capital of these two banks by less than 5 percent.

E. Balance Sheet Adjustments

15. The private sector has further deleveraged while access to credit has improved. New bank lending has picked up in line with the strong economic recovery, in particular consumer credit in the case of households, and lending to SMEs in terms of type of business and lending to agriculture, manufacturing and non-real-estate services in terms of sectors in the case of corporates. Nonetheless, total credit growth was still negative in October 2016. With private debt-to-GDP about 64 percentage points below its 2007 peak level (Figure 4), excess leverage is now concentrated mostly in a few corporate sectors for which loan repayment capacity is still weak (construction and real estate) and in households.10 Improving profit margins since the crisis have helped the corporate sector finance new investment with retained earnings, along with more debt financing by large corporates. Households proceeded in rebuilding their net wealth positions and further reduced their bank debt. At the same time, the strong economic recovery, swift employment creation, increase in disposable incomes, and low interest rates have supported borrowers’ repayment ability. Going forward, deleveraging is projected to moderate and concentrated in a few sectors.

Asset Quality

16. Asset quality of the banking system has continued to improve markedly. The NPL ratio for consolidated operations fell to 5.8 percent in June 2016 from 6.9 percent a year earlier, and is 3.6 percentage points below its peak in 2013 (Figure 7). The NPL ratio for banking business in Spain declined from 11.0 to 9.4 percent over the same period, despite the contraction of overall lending, and is now 4.2 percentage points below its peak in 2013 (almost 30 percent reduction over three years). Over the same period, the amount of foreclosed real estate assets has remained broadly stable given the balanced pace of both asset sales and new foreclosures. The NPL ratio for overseas operations has been broadly stable at around 2.3 percent.

Figure 7.Spain: Asset Quality

Sources: Bank of Spain; EBA, 2015 and 2016 Transparency Exercises; IMF, Financial Soundness Indicators database; SNL; and IMF staff estimates.

1/ Based on 14 significant Spanish banks.

17. Despite the sharp reduction the amount of legacy assets on bank balance sheets is still sizeable. For the system as a whole, the shares of nonperforming and forborne exposures are still higher than the EU-wide average, reflecting the sizeable impact that the financial crisis had on Spain compared to other countries (Figure 8).11 NPLs for banking business in Spain were €123 billion by mid-2016. The starting points of NPLs and pace of NPL reduction have differed across banks, so that a few banks still have a longer way to go than the rest to bring their level of problem assets to the EU-wide or pre-crisis levels (Figure 7).

Figure 8.Selected European Economies: Asset Quality

Sources: EBA, 2016 Stress Testing Exercise; ECB, Consolidated Banking Data; SNL; and IMF staff estimates.

1/ Based on the EBA’s 2016 Stress Testing Exercise. Credit loss is estimated based on macro-financial conditions in the baseline and adverse scenarios. The estimation is largely affected by projected macro-financial conditions (broadly similar across the EU economies) and financial soundness of borrowers at the beginning of the exercise (relatively weaker in Spain given the still high level of problem assets).

18. The decline in NPLs in Spain took place across all types of loans, with NPLs still highest in the construction and real estate sectors. Given that the housing market’s recovery has been rather weak (house prices are up by about 8 percent from the trough), NPLs in these sectors remain sizeable, amounting to 28 percent of outstanding lending to the sector and 38 percent of total NPLs (Figure 7).

19. Provisioning for non-performing exposures is generally high. The provisioning coverage of nonperforming exposures (NPEs), with provisions and collaterals accounting, was 95 percent for the Spanish banking system compared to the EU-wide average of 86 percent (as of end-June 2016; Figure 7). In fact, at that point in time each of the Spanish significant banks exceeded the EU-wide provisioning average. Similarly, Spanish banks have adequate capital buffers to cover uncovered NPEs. For significant Spanish banks overall and most of them individually, aggregated uncovered NPEs amounted to 4.1 percent of CET1 capital, well below the EU-wide level at 9.5 percent. The asset quality review in the ECB’s 2014 Comprehensive Assessment identified only small capital adjustments (the lowest among euro area members) (Figure 8).

20. Completing the NPL clean-up will take more time. If the reduction of problem assets were to continue at the same speed as observed so far (about €30 billion a year), it could take on average more than five years to completely resolve legacy assets. Following time-bound, realistic and ambitious NPL reduction plans as foreseen in the ECB Guidance to Banks on NPLs is therefore a welcome tool in the Spanish banking system’s final stretch to fully put the crisis legacies behind.

21. Continued NPL reduction will be beneficial in further lowering two vulnerabilities. Should Spanish banks still carry sizeable NPLs by the time that interest rates start to rise, an increase in funding costs could weigh down the typically beneficial steepening in the yield curve for bank profitability. A sensitivity analysis on banking business in Spain (with other things remaining unchanged) would suggest that an increase in interest rates by 1 percentage point could reduce the return on assets by about 0.07 percentage points based on the current level of NPLs and foreclosed real estate assets. Moreover, with the above EU average NPL levels, banks remain somewhat more exposed to credit losses. In the adverse scenario of the EBA’s 2016 stress testing exercise estimated credit losses increases for Spanish banks by 0.82 percent of risk weighted assets relative to the baseline scenario, compared with the EU-wide level by 0.58 percent of risk weighted assets (Figure 8).

Capital Adequacy

22. Banks have built further capital buffers and continuing to do so will enhance the system’s resilience to shocks. The total capital ratio stood at 14.6 percent at end-June 2016, up from 13.7 percent at end-2014. Spanish banks’ holding of such high-quality as CET1 capital exceeds the regulatory and supervisory minima, but still lags behind European peers (Figure 9). Furthermore, the EBA’s 2016 Transparency Exercise showed that the CET1 capital ratio of significant Spanish banks on the fully-loaded basis was 1.6 percentage points below the transitional basis. The lower capital position on the fully-loaded basis is related largely to intangible assets. The EBA’s 2016 Stress Testing Exercise, which covered the six largest Spanish banks, generally showed that Spanish banks display a similar resilience to adverse shocks as EU peers when measured in the reduction in CET1 capital ratios though most of the banks would end up with somewhat lower leverage ratios than the EU-wide average (Figure 11). Moreover, ongoing regulatory reforms, even if still uncertain at this stage, could imply higher capital requirements. And finally, capital buffers prepare banks to finance economic growth once credit demand picks up over the medium term, though the system as a whole already has ample room, assuming no further charges on its capital position (see Section F).

Figure 9.Selected European Economies: Capital Adequacy and Leverage

Sources: EBA, 2015 and 2016 Transparency Exercises; ECB, Consolidated Banking Data; and IMF staff estimates.

Figure 10.Spain: Capital Adequacy

Sources: EBA, 2015 Transparency Exercise and 2016 Stress Testing Exercise; ECB, Consolidated Banking Data; IMF, Financial Soundness Indicators database; SNL; and IMF staff estimates.

1/ Due to data availability, the chart shows semi-annual data through 2014 and quarterly data since then.

2/ Based on 14 significant Spanish banks.

3/ Based on entities that have been identified as global systemically important banks since 2012.

Figure 11.Selected European Economies: EBA Stress Tests and Sovereign-Banking Linkages

Sources: EBA, 2015 Transparency Exercise and 2016 Stressing Exercise; IMF, International Financial Statistics; SNL; and IMF staff estimates.

1/ Based on the EBA’s 2016 Stress Testing Exercise. The end-2018 levels of capital and leverage ratios are driven by the end-2015 levels (starting point), estimated pre-loss income during 2016-18, and estimated credit and market losses during 2016-18. These two charts thus show how the adverse scenario may affect banks, taking initial buffers and expected profits into account. Meanwhile, the chart in Figure 8 only illustrates estimated credit loss to highlight credit risk.

2/ Based on banks with total assets larger than €30 billion in each jurisdiction.

23. Spanish banks are generally less leveraged than European peers. The ratio of tangible equity to tangible assets of the Spanish banking system is broadly in line with the EU-wide average, despite the lower level of capital (Figure 9). The main driving factor is the greater risk weight intensity of Spanish banks due to the more prevalent use of the standardized approach, which tends to apply higher risk weights than the internal ratings-based approach for similar exposures. The risk weight intensity of the two Spanish global banks is higher than most global systemically important banks. Based on the EBA’s 2015 Transparency Exercise, most significant Spanish banks therefore outperformed European peers in terms of the leverage ratio (i.e., tier-1 capital to total exposures) despite somewhat lower CET1 capital ratios (Figure 10).

24. Strong retained earnings underpinned the buildup of capital buffers in 2015. Net interest income and other net operating income boosted the capital ratio by 4.3 and 2.1 percentage points, respectively (Figure 10). Meanwhile, impairment costs reduced the capital ratio by 1.6 percentage points, down from 5 percentage points in 2012. Net capital injection (newly raised capital net of paid dividends) and change in risk weights assets barely affected the capital ratio. This experience highlights the importance of retained earnings as an organic source to strengthen capital positions and the challenges that could arise from sustained low profitability for building further capital buffers (see Section C).

F. Capacity to Support Growth over the Medium Term

25. Spanish corporates and households have continued to deleverage. This has resulted in a decline in the debt-to-GDP ratios by 49 and 18 percentage points, respectively, from the peaks. Banks’ lending has continued to fall, as amortization has outpaced new lending. The demand for credit has remained weak for various reasons, including debt overhangs and NPLs in some corporate segments (namely, construction and real estate), as well as still depressed disposable income levels, high unemployment, concentrated indebtedness among low-income households, and general need to further build up financial wealth (traditionally well below European peers). Once credit demand picks up over the medium term, would banks have sufficient capital position to expand their balance sheets and finance the economic expansion?

26. The banking system’s current capital position and previous year profitability are sufficient to meet an increase in credit demand in the medium term. Previous year’s profits could support system-wide credit growth of about 6.5–8.5 percent per year if banks used their annual profits to fulfill the regulatory capital requirement, keeping the capital ratio unchanged (Figure 12).12 The baseline estimation is based on banks’ profits during 2015H1, but profitability has declined since then. The estimation under the assumption of reduced profitability thus seems more relevant to reflect the current situation. In particular, in case profits would drop by 25 percent over the next three years, the system-wide capacity to provide additional credit would still be at 6.5 percent per year, above nominal GDP growth projected through 2021.13 This would drop to 4.4 percent annually should profits halve compared to the 2015H1 level. Some banks would have less room for credit expansion than others in these scenarios.

Figure 12.Spain: Credit Provision Under Different Scenarios

(In percent; annualized growth of total exposures over the next 3 years)

Sources: EBA, 2015 Transparency Exercise; and IMF staff estimates.

1/ The amount of credit that could be provided is estimated based on the premise that banks use additional profits to expand balance sheets. Assumes that (i) baseline profits are based on the 2015H1 level adjusted for additional credit; and (ii) no additional cleanup efforts in the baseline, with no additional provisions; (iii) no additional efforts to build up capital buffers; and (iv) the dividend payout ratio is at 25 percent and the tax rate at 25 percent.

2/ For sensitivity analysis, reduced profitability assumes declining profits by 25 and 50 percent over 2016-18 relative to the 2015H1 level.

G. Conclusions and Policy Implications

27. The banking system has gained further strength amid new challenges. Due to better asset quality, stronger capital and funding positions, and reduced debt overhangs, the system is closer to putting most of the crisis legacies behind it. However, banks have progressed at different speeds, and overall NPLs and foreclosed assets remain sizeable, though much lower than in some European banking systems. At the same time, like other European banking system, Spain’s banks face challenges arising from the low interest rate environment and new regulatory initiatives. The spillover from a less favorable macroeconomic environment in some economies where Spanish banks have a strong footprint would be limited to potentially lower profits and weaker contributions to the parents’ capital buffers.

28. Adjusting to profitability pressures is a key challenge, especially in the current macro-financial environment. Similar to other European economies, banks’ profitability in Spain is currently well below the pre-crisis level, with the return on equity lower than the cost of capital. Profitability has fallen in the past year, as for banking business in Spain reduced net interest and other income has been offset by falling impairment costs. The more difficult domestic and global operating conditions, in particular in a low interest rate environment, will put pressure on banks’ cost structure and business models. Achieving greater efficiency, in particular since Spanish banks still rely on a larger branch network than do European peers, further reducing operating expenses, and raising non-interest income will be central to addressing the profitability challenge.

29. Efforts to reduce the level of impaired assets on banks’ balance sheets should continue. Even though the reduction in NPLs has generally proceeded well, though at different speeds across banks, efforts should continue to ensure banks’ adequate provisioning and encourage the fuller use of the enhanced insolvency regime. Following bank-specific time-bound, realistic and ambitious NPL reduction plans as foreseen in the ECB Guidance to Banks on NPLs is therefore a welcome tool in the Spanish banking system’s final stretch to fully put the crisis legacies behind. This process could also benefit from the insolvency reform, which supports more efficient debt restructuring and gives a “fresh start” to individuals. However, the use of the latter has been relatively limited so far. A stock taking exercise of the framework’s functioning would thus be beneficial as certain design changes could likely help the deleveraging process.

30. Continued efforts to strengthen banks’ capital and funding positions will enhance the system’s resilience to shocks and the capacity to support growth over the medium run. It remains important to encourage banks to increase high-quality capital through retained earnings. Bolstering banks’ capital would be prudent to safeguard financial stability and ensure adequate capital in light of new regulatory initiatives. Additional capital would also help ensure sufficient credit provision to financially-sound corporates and households as credit demand picks up. In addition, banks may need to adjust their liability structures to fulfill new regulatory requirements, such as Minimum Requirements for Own Funds and Eligible Liabilities (MREL) and Net Stable Funding Ratio (NFSR).

References

    AiyarShekharWolfgangBergthalerJoseGarridoAnnaIlyinaAndreasJobstKennethKangDmitriKovtunYanLiuDermotMonaghan and MarinaMoretti2015A Strategy for Resolving Europe’s Problem LoansIMF Staff Discussion Note (SDN) 15/19 International Monetary Fund (Washington).

    Bank of Spain2012Statistical Bulletin (MadridDecember).

    Bank of Spain2016aBanking Risks, Profitability and Solvency“ Chapter 2 in Financial Stability Report (Madrid May).

    European Central Bank2016Draft Guidance to Banks on Non-performing Loans“ (FrankfurtSeptember).

    European Central Bank2016bBanking Risks, Profitability and Solvency“ Chapter 2 in Financial Stability Report (Madrid November).

    International Monetary Fund (IMF)2015Spain’s Insolvency Regime: Reforms and Impact“ in Selected Issues for the 2015 Article IV Consultations with Spain IMF Country Report 15/233 (Washington).

    International Monetary Fund (IMF)2016aPotent Policies for a Successful Normalization” Chapter 1 in Global Financial Stability Report. (WashingtonApril).

    International Monetary Fund (IMF)2016bFinancial Stability Challenges in a Low-Growth, Low-Rate Era” Chapter 1 in Global Financial Stability Report. (WashingtonOctober).

Prepared by Phakawa Jeasakul (MCM).

Based on the FSB’s economic function-based measure, which includes (i) management of collective investment vehicles with features that make them susceptible to runs, (ii) loan provision that is dependent on short-term funding, (iii) intermediation of market activities that is dependent on short-term funding or on secured funding of client assets, (iv) facilitation of credit creation, and (v) securitization-based credit intermediation and funding of financial entities. See the FSB’s 2015 Global Shadow Banking Monitoring Report for more details.

In Spain, there are three types of deposit-taking institutions—commercial banks (bancos), savings banks (cajas), and credit cooperatives (cooperativas).

Based on net income before taxes during 2015 and 2016H1 and outstanding customer loans (which are assumed to be constant) as of 2016H1.

For more details on corporate and household deleveraging see also Figures 4 and 5 of the Staff Report.

This estimation is based on 14 significant Spanish banks. Required loan growth reflects the expansion in lending activity necessary for maintaining net interest income from lending activity as a consequence of compressed interest margins. The estimation assumes individual banks’ own experience during 2015 and 2016H1; system-wide trend is applied in the case bank-level information is not available.

For a cross-country comparison, see “Box 1.3. The Impact of Low and Negative Rates on Banks” in IMF (2016a).

Exposures are based on consolidated claims of Spanish banks, including parent entities’ claims on “ultimate borrowers” in Spain and elsewhere, as well as subsidiaries’ local claims in their operating jurisdictions.

This business model is very distinct from those of other major European banks, with the greater importance of cross-border operations carried out by the parents or through branches, as well as in the form of subsidiary operations that are primarily funded by funding from the parents.

For more details on corporate and household deleveraging see also Figures 4 and 5 of the Staff Report.

Forborne exposures are the EU term for restructured exposures.

The estimation only focuses on the availability of capital to support the provision of credit, as capital is more likely to be a binding factor over the medium term. Funding should not be an issue given that banks could obtain funding from the ECB under the new Targeted Long-term Refinancing Operations (TLTRO-II).

IMF staff projects credit to grow about 1 percent annually over the next three years.

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