04.10.2022
The situation of Spanish banks in the new macro-financial
environment*
V Foro Banca/elEconomista
Pablo Hernández de Cos
Governor
*lEnglish translation from the original in Spanish.
*
Good morning.
Allow me to begin by thanking El Economista for inviting me to participate, once again, in
this banking forum, which represents an excellent opportunity to discuss the present
situation of the banking industry and the implications of the current macro-financial
environment.
Our societies have been hit by several global events (the pandemic, Russia's invasion of
Ukraine) in quick succession, generating a highly complex macro-financial environment in
which the risks of a global cyclical downturn have been magnified by persistently high global
inflation, the tightening of financing conditions stemming from the widespread normalisation
of monetary policy and the heightened uncertainty prompted by a broad-based downward
revision of growth forecasts.
The question of how the banking industry could be affected by this complex setting is an
important one.
The starting point: a banking industry with lower non-performing loan ratios and
profitability above cost of capital
To answer that question, I should first emphasise that the Spanish banking sector started
out from a relatively favourable position. Allow me to illustrate this point with a few figures.
First, the quality of banks' balance sheets continued to improve through to 2022 Q2.
Nonperforming lending to the resident private sector fell by 12.4% in 2022 Q2, seeing the pace
of correction return to pre-COVID-19 levels after easing to rates of 5% following the
pandemic. The declines were also broad-based across portfolios and owed, to an extent,
to sales of impaired loans by some banks. This too is welcome news, since these markets
tend to be highly sensitive precisely to uncertainty. As a result, the ratio of non-performing
bank loans to the resident private sector in Spain reached 3.8% in June 2022, which marked
a return to recording lows following the global financial crisis.
The pace of correction in Stage 2 loans - those whose borrowers continue to meet their
financial obligations but show at least one indication of potential deterioration - has also
quickened, with a drop of nearly 10% year-on-year in June 2022. These loans currently
account for 7% of total lending to the resident private sector, still higher than pre-pandemic
figures. Naturally, vulnerability is most acute in those sectors hardest hit by the pandemic
and by the higher energy costs.
In a similar vein, forborne loans,1 most of which are classified as Stage 2 or non-performing,
were down by 7.7% to June 2022, with their share of total lending shrinking to 4.5%, again
below pre-pandemic levels.
Second, the profitability of the Spanish banking industry continued to improve in the first
half of the year, adjusting for the extraordinary profit recorded largely as a result of the
mergers that took place in 2021. Specifically, the sector's ROE stood at 10% in H1, up by
2 percentage points (pp) on June 2019. This was higher than our estimated cost of capital
for the period (7%, similar to the level estimated prior to the pandemic).
This improved profitability owed to a better performance in banks' recurring business, with
growth of more than 10% in net interest income and in fees and commissions. It is worth
noting here that banks are beginning to pass through the increase in money market interest
rates to new loans, albeit, for the time being, far more slowly than in the past. Evidently, for
variable-rate loans the impact is automatic, but it will likewise take some time.
For their part, banks' wholesale funding costs are reflecting the tightening of financial market
conditions, while risk premia are also rising. As yet, however, deposit interest rates have not
increased, and to June there has been no significant shift of funds towards term deposits.
Further, listed banks as a whole recorded a year-on-year increase in impairment losses to
June, as a result of specific contributions from business abroad, but at most banks these
impairment losses declined. In any event, impairment provisions remained slightly higher
than those recorded before the onset of the pandemic.
Third, as regards solvency, the overall common equity tier 1 (CET1) ratio of Spanish banks
stood at 12.9% in June 2022, down 50 basis points (bp) on a year earlier, but 70 bp above
the pre-pandemic level (12.2%).
The recent reduction owed to the increase in risk-weighted assets, since the numerator of
the ratio barely changed. This solvency level implies higher voluntary capital buffers than
key regulatory requirements, albeit lower than those in other major European countries.
The current macro-financial environment will heighten the financial vulnerability of
households, firms and the public sector
Clearly, the combination of inflationary pressures, tightening financial conditions and higher
uncertainty will weigh on households' consumption decisions and their residential
investment. In the case of firms, these adverse factors may also reduce their productive
investment and hiring expectations. In short, activity will face additional downward
pressures. And these factors are also having significant effects on public sector financing,
which I will turn to now.
Again, it is important to underscore the private sector's relatively benign financial position
before the pandemic, thanks to households' and firms' considerable debt reduction since
the global financial crisis. In fact, in March 2020 their debt as a proportion of GDP stood at
150.4%, slightly below the European average and down by 76 pp on the peak of June 2010.
The outbreak of the pandemic and the measures adopted to mitigate its effects, such as
the moratoria on financial obligations and the public loan guarantee scheme, underpinned
and galvanised credit in 2020, putting that debt at 157.8% of GDP. However, the overall
cumulative growth in the stock of loans has been moderate, with bank lending to the
resident private sector in Spain increasing by 4.2% since 2019.
In the case of firms, business turnover appears to have continued to recover in nominal
terms during 2022 H1, leading to an improvement in most firms' economic and financial
position, particularly those in the sectors hardest hit by the pandemic thanks to the lifting of
the restrictions on movement. The exceptions are firms in the sectors most exposed to the
rise in energy prices and that were not greatly affected by the pandemic, whose economic
and financial situation now appears to be deteriorating somewhat.
Against this background, the latest bank funding data suggest greater buoyancy in business
lending, with the total stock of loans growing year-on-year in recent months, contrasting
with the declines recorded in 2021. This performance seems to owe both to firms covering
their financing needs and to a precautionary motive, since the growth in their bank deposits
is also accelerating.
In any event, the rise in interest rates is beginning to affect new lending. The simulations
recently conducted by the Banco de España suggest that a rise in market interest rates in
line with that observed to date (around 300 bp) would, in the short term, drive up the median
debt burden ratio (the ratio of financial costs to gross operating profits plus financial
revenue) by between 2.5 pp and 5.6 pp (from a starting point of 11.6%), depending on the
percentage of debt and loans that are refinanced in the near term.
To put this into perspective, the percentage of employment accounted for by firms under
high financial pressure2 would rise by 1.6% following the interest rate increase, from 9.1%
before the hike.
Household income is primarily being supported by labour market developments - given the
year-on-year increase of 3.6% in the number of persons employed and of 5.1% in hours
worked - and, to a lesser extent, by the government policy support measures. However,
high inflation is driving a significant decline in real disposable income. Indeed, in 2022 H1
households' disposable income increased by 4.2% year-on-year in nominal terms, which
transforms into a 3.1% fall once developments in the private consumption deflator are taken
into account.
Bank lending to households has held stable in recent months. However, a distinction can
be drawn between the performance of mortgage lending (growing consistently at rates of
just over 1%) and that of consumer lending (shrinking at rates of around 4%).
Unlike firms, in 2022 households are not accelerating the growth of their bank deposits,
which have been on a sustained growth path (above 5%) since 2021. Together with cash,
they account for 40% of households' total financial assets.
Simulations have also been carried out on the potential impact on household income of the
rise in energy prices and interest rates, which is notably uneven across income percentiles.
The upturn already observed in energy prices would generate an increase in the median
household's energy expenditure as a proportion of its budget from 10% to more than
12.5%. By way of comparison, energy expenditure represents around 7% of the budget of
higher-income households and the increase would be proportionally lower.
As regards the effect of the surge in interest rates, an increase of 300 bp, in line with that
observed to date, would generate a 3.9% rise in the proportion of households with a high
financial burden3 (to 13.8% of the population).
Special attention should be paid to the residential real estate market, which is closely related
to households' situation, where some exuberance has been observed in recent quarters.
Specifically, house purchases posted growth rates exceeding 20% in 2022 H1 and new
lending for house purchase rose by 15%. Also, the rate of change in house prices
accelerated to 8%, confirming the degree of price overvaluation that we estimated in
previous quarters.
However, counter to the argument that there is exuberance in the real estate market, loans
to the construction and real estate sectors continue to decline, the percentage of GDP
represented by the stock of lending to households for house purchase stands at 39.7%
(21.3 pp less than at end-2010) and mortgage lending conditions in the wake of the global
financial crisis remain at prudent levels, with warning signals only observed in the interest
rate spreads on loans granted at a fixed rate, which stood at record-low levels.
Nonetheless, the most recent data could suggest a change in trend in this market stemming
from the macro-financial setting that I have described. Specifically, housing transactions
contracted in July, which is significant given that this month usually has a positive seasonal
component. Also, house prices ceased to accelerate in Q2, posting growth similar to the
first three months of the year. In any event, we will have to wait for new information to assess
this behaviour more accurately, meaning we will need to keep a close eye on this market.
As for the public sector, fiscal policy has clearly played a key role since the outset of the
pandemic to soften its impact on household and corporate income, thus avoiding more
persistent negative effects. The corollary of this has been a significant increase in public
debt relative to GDP, which was already high before the pandemic. This high government
indebtedness and the likewise high structural budget deficit evidently represent
vulnerabilities when faced with a tightening of financing conditions, as is the case at present,
and reduce fiscal policy headroom to respond to future shocks.
Mitigating factors include most notably the higher-than-initially-forecast reduction in public
deficit in 2022 and the significant lengthening of the average government debt maturity in
Spain, which stands at more than eight years and delays the impact of interest rate
increases on the public debt burden.
In any event, Spain's annual public sector financing requirements stand at high levels,
around 20 pp of GDP. Also, if the current expectations for rising interest rates are
incorporated, the public debt burden will increase from 2.2% of GDP at end-2021 to 2.7%
in 2024.
Against this backdrop, allow me to repeat the recommendation I have made on numerous
occasions to adopt a medium-term fiscal strategy. This should include immediately setting
out a multi-year fiscal consolidation plan for implementation once the economic impact of
the pandemic and of the war in Ukraine has been overcome. The plan should have broad
political consensus and be accompanied by an efficiency review of public spending and the
tax system, including all tiers of general government. Defining the plan early on would
generate greater certainty and trust, which is particularly important against the current
backdrop of monetary policy normalisation.
The potential impact of the current climate of uncertainty on the banking sector calls
for exercising extreme prudence
Estimating the impact of the current setting on the banking sector's profitability and
solvency is more complex. First, the rise in interest rates will mean higher returns on new
loans and likewise on existing loans at a floating rate. Thus, although the volume of credit
will presumably moderate in the current setting, gross income will likely increase, particularly
in the near term.
However, financing costs will also be pushed up. This includes those relating to debt
instruments issued in the financial markets and, albeit to a lesser extent, deposits. The
volume of deposits can also be expected to rise owing to their higher remuneration and the
climate of uncertainty.
Second, interest rate rises also immediately translate into a downward revision of the
valuations of public and private debt securities in institutions' balance sheets. However,
these lower valuations are only recognised in institutions' income statements when such
assets become available for sale, but not if the institutions intend to hold them on their
balance sheets to maturity. In this latter case, it should be borne in mind that institutions'
returns on these securities will be lower than on any new issues that are put into circulation.
Less than half of Spanish institutions' debt securities' holdings were classified as available
for sale at end-2021.
The adverse effects of the current and foreseeable setting - which I have referred to
previously - on households' and firms' ability to meet their financial obligations will chiefly
become manifest over a broader horizon (one or two years forward). As a result, institutions
will have to increase their provisions to cover the potential losses. Inflation could also drive
up their operating costs.
Under certain scenarios, the net impact of all these channels for transmission of the new
macroeconomic situation could be negative for institutions over a three-year horizon.
The latest Financial Stability Report, published in May 2022, includes simulations of the
impact on institutions of a scenario in which some of the current risks materialise.
Specifically, the scenario assumed additional energy price increases and more persistent
bottlenecks in global trade, generating fresh upturns in inflation and a further tightening of
monetary policy, alongside a deterioration in agents' confidence and greater risk aversion.
These were very severe stressed scenarios, since they entailed cumulative deviations from
the baseline GDP growth in 2022 and 2023 of between 2.8% and 5.4%.
The results show that the sum of the different transmission channels in these stressed
scenarios would generate a negative impact on bank solvency of between 1.8 pp and 3 pp
for Spanish banks as a whole. By component, while net interest income would increase, the
worsening of the credit quality of loans to the private sector would lead to greater losses.
Moreover, the simulated interest rate hike entails a slight reduction in the value of bond
holdings on banks' balance sheets.
There is nonetheless some heterogeneity across banks, owing to differences in factors
such as the weight of short-term and/or variable-rate lending, the accounting classification
of debt securities, their international presence or the extent of their lending under the ICO
programme.
Concluding remarks
In short, we are in the midst of a highly complex macro-financial situation, characterised by
high inflation, a tightening of financing conditions and greater uncertainty, which has already
triggered a slowdown in economic activity in Q3 and a widespread downward revision in
the growth outlook for the coming quarters.
Against this backdrop, although the banking sector's starting point is positive, it is
necessary to exercise the utmost prudence and to closely monitor risks, which may rapidly
take a turn for the worse, making it necessary to consider new stress scenarios. All of this
leads us to recommend that banks be very careful in their provisioning policy and their
capital planning over the coming quarters.