The Spanish banking system: transformations and challenges
Opening of the seminar "Sustainable finances and their importance in the
future of the economy", Universidad Internacional Menéndez Pelayo, organised
by the Spanish Association of Economics Journalists
Pablo Hernández de Cos
Governor

Ladies and gentlemen, good morning:
It is an honour and a pleasure to be able to participate in the opening of this seminar,
organised by the Spanish Association of Economics Journalists (APIE) as part of the
Universidad Internacional Menéndez Pelayo's summer programme of seminars, being held,
once again, on this Santander soil, of which I am so fond.
I should like to begin by recalling, here in this historic Magdalena palace, that 2019 is
particularly rich in anniversaries relating to the opening up and liberalisation of the Spanish
economy. The process began with the Stabilisation Plan 60 years ago, while one of the most
important milestones was passed 20 years ago, when Spain adopted the single European
currency, the euro.
And, exactly 25 years ago, in order to reach that stage, it was necessary for the Spanish
parliament to approve the Law of Autonomy of the Banco de España, which confirmed the
Spanish central bank's autonomy and independence. By means of this law, moreover, Spain
established an institutional framework in line with the requirements for adopting the single
currency, and also put in place a fundamental pillar for a culture of stability in the conduct
of economic policy.
Accountability and transparency are essential counterparts of independence, and the media
play a fundamental role in ensuring that they are put into practice, which is why our
participation in events such as this one is so important. So I should like to thank the APIE
for organising this event and inviting us to participate.
This look back reminds us that, more than 10 years ago now, an international financial crisis
hit Spain particularly strongly, arriving at a time when the economy was suffering from
significant domestic and external macro-financial imbalances. Spain's banking system was
clearly excessively large at the time, over-concentrated on lending funds to real estate and
residential construction activities and highly dependent on international wholesale financing.
These significant vulnerabilities meant that the cost of the crisis in terms of GDP and - even
more importantly for society - unemployment, was very high and much larger than for our
main competitors. In fact, Spain's GDP returned to its pre-crisis level only two years ago.
As regards the labour market, the unemployment rate is still five percentage points higher
than in 2008 and more than 10 percentage points higher than in countries like the United
States and Germany.
And that is a reminder of the importance of strengthening mechanisms to analyse and
diagnose promptly the risks and vulnerabilities facing the economy and, in particular, the
financial system.
Many of these vulnerabilities have been corrected during the current decade, in particular
those relating to the high indebtedness of the non-financial private sector, which is now at
similar levels to those of the euro area, having fallen by 69 percentage points of GDP since
peaking in 2010. However, new vulnerabilities have emerged, such as public debt. This,
among other consequences, limits fiscal policy's future room for manoeuvre. However, I
would like to focus today on the financial sector and the challenges it will have to address.
A decade of transformation and downsizing of the Spanish banking industry
As I have already mentioned, the crisis highlighted the need to adjust the size of the banking
industry. Since non-financial private sector debt was excessive by any reckoning, its
reduction had to be matched by a slimming down of the financial sector and, thus, banks,
whose assets accounted for two thirds of the total assets of the sector. This capacity
adjustment, moreover, had to be confined to business in Spain, since business abroad was
one of the main factors behind the resilience of some institutions.
In fact, the geographical diversification of Spanish banks, especially their participation in
emerging economies, which were little affected by the international financial crisis, allowed
Spanish banks with an international presence (which accounted for almost half of total bank
assets) to limit their overall losses and to continue to cover part of their capital requirements
internally. Furthermore, these institutions played a very important role in resolving the crisis,
since they were able to take over other institutions in a weaker position.
It is not surprising, therefore, that the international presence of Spanish banks has increased
since the crisis, in contrast to that of the banks of most European countries, which have
tended to reduce their international operations. Over the last decade, Spanish banks have
increased their international exposure by 45%, while the banks of countries such as
Germany, France and Italy have reduced theirs by 38%, 16% and 15%, respectively.
On the other hand, the effort to adjust business in Spain has been highly significant.
Specifically, over the last 10 years, the total assets of business in Spain have been reduced
by 20% and employment in the industry by 32%. Also, the number of institutions has fallen
by 34%, with a decrease in the number of domestic banks1 from 122 at the beginning of the
crisis to 61 in 2018. As a result, concentration has increased significantly. Most of the
mergers and takeovers have given rise to healthier banks, with significant cost savings.
One effect of this consolidation process has been the disappearance of 43% of the bank
branches existing in Spain. However, analysis of Spanish bank capillarity shows that
between 2007 and 2017 the increase in the proportion of the population without a bank
branch nearby was 0.7%, as the closures were concentrated in areas of high branch density.
Also, the emergence of new technologies allows bank services to be offered using more
flexible and mobile methods. In any case, we should not forget that the average size of
Spanish bank branches remains small, in comparison with other European countries.
This drive to correct the excessive size of the Spanish banking system has been
accompanied by significant restructuring. As you well know, the financial crisis led to
considerable deterioration in the quality of Spanish banks' assets. In fact, the excessive
concentration of Spanish banks on the real estate sector and the intensity of the recession
caused the non-performing loan (NPL) ratio to reach, within just five years, unprecedented
levels of around 14% by the end of 2013. Moreover, as a consequence of defaults, banks
foreclosed a considerable volume of real estate, which formed part of the collateral for many
loans. In 2014, their foreclosed assets amounted to more than €80 billion.
The lower return on assets, along with the increase in provisions for NPLs, when a large part
of the general provisions built up during the preceding expansion had been used, caused
the banking industry as a whole to post a loss in 2012. This obviously had an impact on
bank solvency, giving rise to significant capital requirements for some banks, which needed
public support to cover the capital shortfalls identified.
Since then, the situation has improved considerably, with the help of the monetary policy
measures implemented by the European Central Bank to ensure that solvent banks had
sufficient funding.
Against a background of significant decline in banking activity, banks have managed to
reduce the weight of troubled assets in their balance sheets very significantly. Specifically,
the NPL ratio has fallen by more than eight percentage points to stand at 5.8% of total
lending. Foreclosed assets, meanwhile, are only 50% of the level recorded in 2014, so that
their weight has been reduced to 3.6% of assets, vis-à-vis the resident private sector. Active
management of these assets by banks, under supervisory pressure, has played a very
important role in this process. In any event, there is still significant room for improvement;
before the international financial crisis, the NPL ratio was below 1% and foreclosed assets
were practically non-existent.
The restructuring of credit institutions is also reflected in the reduction in the weight of the
real estate sector (broadly defined),2 which stood at 52% of GDP in 2018, as compared with
99% in 2008.
At the same time, there is also evidence that these developments have been accompanied
by some degree of borrower selection for the supply of credit, so that access to funding has
improved more markedly in the case of firms in a more favourable economic and financial
situation. This has been reflected in an increase in the positive association between the
receipt of loans by firms and their productivity.
This period has also seen a significant improvement in credit institutions' solvency ratios,
with their tier 1 capital ratio rising from 7.5% in 2007 to 13.5% by the end of 2018.
Current situation and future challenges of the Spanish banking sector
Despite all these improvements, the Spanish banking sector still faces significant
challenges.
The challenge to banks represented by the task of reducing troubled assets is now greater,
because the troubled assets already sold were naturally the most attractive ones. It is thus
crucial for banks not to relax their credit standards if they wish to minimise their new bad
debts and maintain their active management of NPL and foreclosed asset portfolios.
While net interest income has held steady, the decrease in unproductive assets and
writeoffs has helped to improve profitability. Specifically, at the end of 2018 the return on equity
stood at 7.2%, the highest since the global financial crisis and also above the European
average.
Despite this, the return on equity is still below the cost of capital, making low profitability
one of the main risks facing Spanish and European banks. Improved profitability is,
furthermore, one of the requirements for banks to be able to generate capital organically
and raise their solvency.
In recent years the legal risk of Spanish banks associated with litigation has increased
significantly. Banks have been involved in a large number of legal proceedings questioning
certain contractual conditions of their mortgage exposures. In many cases they have already
paid the cost of these proceedings (for example, in relation to floor clauses more than €2,200
million was refunded to customers up to January 2019), but there are still many major legal
proceedings yet to be resolved.
Above and beyond the cost that litigation may entail for banks, a more general implication
is the loss of reputation for the banking sector. Banks must make an effort to reverse this
perception by providing their customers with necessary information in a clear and
transparent manner and affording them access to financial products suited to their needs
and financial knowledge.
All this must not distract banks from persevering in their efforts to improve their efficiency
ratios and pursue investments, particularly in new technologies, to enable them to reduce
costs in the medium term.
It should be kept in mind that in the coming years banks will have to issue considerable
volumes of debt with various levels of subordination to meet minimum requirements for own
funds and eligible liabilities. The costs of issuing these liabilities are higher than those for
senior debt and other secured instruments and, in fact, rise as they become more similar to
capital in terms of seniority. But their cost also decreases as the solvency of the issuing
bank increases.
Compared with other European countries, Spanish banks have lower solvency levels almost
irrespectively of what definition of capital is used. It is true that they comfortably exceed
minimum regulatory requirements, that stress test results suggest they are more resilient to
the risks now facing them, that is there is a certain dispersion among banks and that, in
terms of leverage ratio, they exceed the European average. However, in a highly integrated
world of competition for global financial resources, solvency is a key signal. Moreover, as I
mentioned earlier, capital is the first line of defence against unexpected losses and therefore
a means of reducing the likelihood of a systemic crisis.
In this respect, over the last two years the phase-in top-quality capital (CET1) ratio has
decreased by nearly one percentage point. This indicates that banks as a whole have not
replaced to a sufficient extent the lower quality capital elements temporarily included in this
category by others with a higher loss-absorbing capacity. This has not been an
across-theboard phenomenon (many banks have raised their solvency ratios), but some have been
guilty in this respect.
Main macro-financial risks
Apart from these challenges, what are the macro-financial risks confronting the Spanish
financial system?
As emphasised in our Financial Stability Report published last May, the first of these risks is
that derived from the possibility that asset prices may undergo a downward adjustment as
a result of rising risk premia. The potential triggers of this situation are a slowdown in
economic activity and geopolitical uncertainty.
Trade tensions indeed seem to have grown and the risk of a hard Brexit now seems greater.
In addition, the economic situation in the euro area has deteriorated more than in other
areas, particularly in some countries such as Italy and Germany.
Meriting special mention are some emerging economies where Spanish banks operate,
which are undergoing difficulties associated with their high net borrowing in foreign currency
and lack of a substantial cushion of international reserves.
Thus, Turkey, which went through a recession in the second half of 2018 and has shown
weak momentum in recent months, is moreover facing a complicated political situation
which has given rise to significant depreciation of the lira in the past year.
Meanwhile, the economic plan implemented in Argentina as part of the financial support
programme agreed with the International Monetary Fund is helping to reduce its fiscal and
external imbalances at the cost of a sharp recession, but has not altered the deterioration
on the inflation front. Additionally, much uncertainty persists mainly in relation to the results
of the presidential elections to be held at the end of the year and which will define the
economic model for the coming years.
Regarding the Spanish economy, the latest forecasts of the Banco de España, published
some days ago, indicate that, although GDP is expected to decelerate somewhat, it will
continue growing above potential and the output gap will hence become progressively more
positive.
This is therefore the time to reduce some of the structural vulnerabilities of our economy,
derived partly from high external and public sector debt, which limit the room for manoeuvre
of fiscal policy and increase vulnerability to rising interest rates or risk premia.
The financial cycle of the Spanish economy also seems to be gathering impetus, although
according to our forecasts, some time will pass before it reaches the warning levels. Total
credit to the non-financial private sector has begun to increase, albeit very slightly, and it
continues to decrease as a proportion of GDP, albeit at a progressively slower pace. Only
some specific portfolios, such as consumer lending, show high credit growth, so banks
must tighten their credit standards in order to reduce the significant rise in NPLs being
observed.
However, the largest credit portfolio continues to be mortgage loans. Therefore analysis of
the real estate sector is crucial for financial stability. As I have noted on other occasions,
this market is reawakening, with an increase in transactions and rising house prices which,
even so, are still on our estimates at levels compatible with their fundamentals. However,
there is notable unevenness across geographical areas, with specific areas of the main
Spanish cities and of the Balearic and Canary Islands where housing prices are rising
sharply.
This rise in real estate activity is not resulting in an increase in the associated lending. Bank
credit to real estate and construction firms continues to fall at rates above 10%, partly due
to the sale of packages of non-performing loans. In addition, the stock of household
mortgage loans is practically stagnant. It is true that the flow of new lending is fairly buoyant,
but starting from a low level.
Furthermore, household mortgage credit standards remain prudent. Specifically, practically
all the loans granted are for an amount below the value of the real estate transaction, as
compared with only 50% before the crisis. Mortgages represent, on average, less than four
times the annual income of households, and the related debt service (repayments plus
interest) accounts for less than 20% of that income in 50% of mortgages. Also, mortgages
with long maturities, of over 30 years, represent less than 10% of the total.
In any event, it should not be overlooked that, although the credit associated with this
activity is not increasing and new household mortgages are being granted with prudence, a
potential downward adjustment to housing prices would still have a negative impact
(although logically a smaller one) on deposit-taking institutions through the effect on
foreclosed asset valuations and the indirect impact on aggregate levels of consumption and
activity.
A cyclical downturn not associated with prior excessive credit growth may also affect the
profitability and solvency levels of financial institutions. It is thus advisable to improve banks'
capital levels when the macroeconomic circumstances are propitious.
In short, to address these macro-financial challenges and risks, we need to internalise in our
decision-making what should constitute responsible and efficient management of private
and public matters: accumulating buffers in good times so they can be used in hard times.
And this applies not only to lenders, but also to borrowers and, above all, to those
responsible for managing economic policies, including myself. Contributing transparency
and rigour to the establishment of this culture of stability is part of the mission entrusted to
the Banco de España as an independent institution at the service of the community.
Thank you for your attention.