Low interest rates for longer. Profitability and risk appetite in the Spanish
banking sector
15th Banking Industry Meeting/IESE
Pablo Hernández de Cos
Governor
Ladies and gentlemen, good morning:
First I would like to thank the organisers, and, in particular, Professor Juan José Toribio, for
their invitation to participate in the 15th Banking Industry Meeting.
In October the Banco de España published its Autumn 2019 Financial Stability Report. As
usual, this report identifies the main risks to financial stability in Spain and their recent
behaviour. The analysis shows that the balance of risks to financial stability has worsened
since the publication of the Spring report and identifies three main risks: the global
economic slowdown and geopolitical uncertainty, low bank profitability, and the legal risk
for banks derived from the potential consequences of the outcome of pending court action.
The worsening of the risks to the stability of the Spanish financial system in the past half
year is due in particular to the downward revision of the global economic outlook. Indeed,
this year global GDP growth is expected to be the lowest since the international financial
crisis; in addition, the balance of risks to this growth is tilted downward, mainly as a result
of the continuing high level of geopolitical uncertainty.
The downward revision of economic forecasts in the past year has been across the board,
but has especially affected the euro area and emerging market economies, and Spain has
not been immune to this trend.
In view of this situation, central banks have responded by further easing monetary
conditions. In the case of the European Central Bank (ECB), at our September meeting we
resolved to launch a package of measures which included cutting the deposit facility interest
rate by 10 basis points (bp) to -0.50%, strengthening forward guidance on interest rates and
improving the financing conditions of quarterly targeted longer-term refinancing operations
(TLTRO-III). We also decided to resume net purchases under the asset purchase programme
at a monthly pace of €20 billion as from 1 November and without a defined time limit.
Our analysis indicates that this package of monetary policy measures provides a substantial
monetary stimulus which will help to further ease the conditions of lending to households
and firms and thus assist the economic recovery of the euro area and, consequently, the
sustained convergence of inflation towards our medium-term target.
In any event, from the financial stability standpoint, the downward revision of the growth
and inflation outlook and the resultant higher expectation that interest rates will remain very
low, or will even be negative for a further period pose challenges of at least two types for
credit institutions.
First, this macroeconomic context will represent a challenge for deposit institutions to
recoup levels of profitability more in line with the cost of capital. Indeed, in the last few
months market expectations for growth of bank profits have declined.
Second, this context of "low interest rates for longer" may provide greater incentives for
economic agents to take risks, which could heighten the risk to financial stability.
Today I would like to devote my address to the analysis of these two matters, focusing on
their impact on the Spanish banking sector. I will also present the results of the latest stress
test exercise conducted by the Banco de España.
1. Low bank profitability
Profitability is one of the main variables characterising the financial position of banks
and the first line of defence against adverse shocks.
Indeed, the volume of a bank's profits determines the return its owners can earn on the
capital invested. This, duly adjusted for the risks assumed, will affect the bank's valuation.
Moreover, profit levels determine the margin these agents have to address shocks. Indeed,
low profitability reduces the possibility of generating capital internally through retained
earnings.
Note that banks' capital acts as a buffer that allows potential losses to be absorbed in
adverse scenarios, so that they can continue to offer financial services to households and
firms, thus contributing to smoothing - rather than amplifying - negative shocks to the
economy.1
Since the international financial crisis the profitability of the European banking sector has
remained very low and below the cost of capital. And this, despite a drop in the cost of
capital, mainly due to the lower risk-free interest rate of the economy, but also to banks'
improved risk profile, manifested, among other variables, in higher solvency ratios.
By contrast, US banks have managed to achieve very high levels of profitability (in 2018,
11% in the USA compared with 6% in Europe) more in line with the cost of capital (between
8% and 10% in 2018). Our analyses indicate that this is one of the reasons why the market
value to book value ratio of US banks significantly exceeds that of European banks, which
remains at values below one.
Spanish banks are no exception to this European pattern, although their profitability
at consolidated level remains above the European average. The breakdown of the return
on assets shows that the higher figures of Spanish banks compared with the euro area
average are basically due to their higher net interest income. This reflects the fact that
Spanish banks have a higher share of their business in less mature markets where margins
are higher, such as the Latin American economies. On the downside, Spanish banks have
higher expenses from asset impairment and provisions than euro area banks.
The profitability of the Spanish banking system has a significant cyclical component.
In the past economic crisis profitability contracted more sharply than in other jurisdictions:
in 2012 it entered negative territory, standing at -21% in terms of equity and at -1.2% in
terms of assets according to the consolidated financial statements, which include not only
business in Spain but also international exposures. The main reason for this was the higher
losses on the loan portfolio associated with a significant rise in defaults, particularly in the
Spanish construction and real estate activity sectors, where banks had an excessive
concentration.
Subsequently, the profitability of the Spanish banking system has tended to recover in
recent years, basically because impairment losses have decreased as loan quality has
improved. A fundamental factor has been the decrease in non-performing assets, including
both non-performing loans (NPLs) and foreclosed assets.
Turning to the more recent information, in the first three quarters of 2019 the net profit
of Spanish credit institutions attributable to the controlling company decreased by
18%. The decline in profits is due to a significant fall in gains on financial assets and liabilities
(-23%), accompanied by an increase of nearly 4% in operating expenses. Thus, the fall in
net operating income amounted to 1.1%. The increase in operating expenses in the past
year was largely due to staff reduction agreements at some banks.
Additionally, impairment losses, which had been falling uninterruptedly since 2013,
increased by 10.6%. Net interest income rose by somewhat more than 3%, while net fees
and commissions grew by 2.5%.
The decline in profit was seen at nearly all banks, albeit to differing extents. As a result, ROE
decreased by more than 1.5 percentage points (pp) with respect to the same period a
year earlier and stood at 6.2%. This figure is lower than current estimates of the cost
of capital, which, subject to their characteristic uncertainty, are somewhat above 7%.
In any event it should be borne in mind that profitability levels vary considerably across
banks, both in Spain and in other European countries. This shows that profitability issues
affect the sector unevenly because of the heterogeneity of banks' business models across
countries and within each jurisdiction, and also because of the multiplicity of explanatory
factors.
Factors explaining low bank profitability
To better understand the factors behind the low profitability of Spanish banks compared
with pre-crisis levels, I intend to focus on their business in Spain. This is because
profitability figures as per the consolidated financial statements are influenced by the
growing share of international exposure in recent years, which complicates the
interpretation of earnings as they are affected by significant changes in composition.
Furthermore, only a small number of banks have significant international exposure, so the
performance figures based on consolidated financial statements may not be very
representative of the majority of the banking sector.
The profitability data based on individual financial statements of business in Spain are
also highly cyclical, even more so than those from the consolidated statements. This
reflects the greater severity of the crisis in Spain than in other economies in which Spanish
banks had exposures and highlights the benefits of diversification. Also apparent is a
marked recovery in recent years, despite which in 2018 both ROE and ROA were still
lower than before the crisis.
The breakdown of the return on assets shows that the main determinant of the current
low profitability of business in Spain compared with the pre-crisis period is a
weakening of net interest income expressed as a proportion of assets, or net interest
margin. This fall, concentrated between 2009 and 2013, was from 1.4% to 0.9%. The
indicator then steadied at around 1% of total assets. The fall was attributable to several
factors.
One factor is the increase in the relative share of non-performing assets, i.e. those
that do not earn interest, such as NPLs or foreclosed assets. Specifically, between 2007
and 2013 the NPL ratio of business in Spain rose by nearly 13 pp. It then fell gradually,
against a background of decreasing loan volume, and at mid-2019 stood at 5.3%, more
than 8 pp below the ceiling reached in 2013. However, this ratio is still well above its
precrisis level. Foreclosed assets have fallen by 50% from the high reached in 2011, but still
amounted to nearly €40 billion in June 2019.
Additionally, in that period there was a strong contraction in the bank credit portfolios,
which resulted from the sharp correction of the excessive debt built up by Spanish
households and firms in the pre-crisis years and from banks' loss of market share in the
total financing of the economy.
During those years, banks cushioned the balance sheet effect of this fall in their credit
portfolios by increasing their exposure to other assets, especially through government
debt purchases. As these debt securities provide lower returns than lending to households
and firms, in the long run this portfolio rebalancing resulted in a fall in the average return on
assets. However, when the sovereign debt crisis came to an end, the increase in value of
these debt securities provided a positive, albeit short-lived, boost to profitability. This effect
fades gradually once interest rates stop falling and, furthermore, in recent years banks have
substantially reduced their holdings of these securities in the available-for-sale portfolio,
which, since it is measured at market prices, is where these gains are recorded.
On our estimates, the overall effect of these changes in asset composition - associated
with the increase in non-performing loans and the decrease in the relative share of
credit on balance sheets - would explain some 70% of the decline in net interest
margin in the Spanish banking system between 2007 and 2018.
The fall in market interest rates has also played its part in narrowing the net interest
margin, since the cost of liabilities, and especially of deposits, which are the main source
of funding for Spanish banks, tends to be less sensitive to changes in market returns
than the remuneration of assets.
Indeed, regarding assets, the remuneration of variable-rate loans, which make up most
of the stock of outstanding credit in Spain, adjusts to the new market prices as the
reference indices are updated (which generally occurs with a lag of less than one year).
Further, interest rate falls also pass through to new lending, which likewise gives rise to
a cut in the average remuneration of assets.
Regarding liabilities, the zero level of interest rates has acted as a lower bound for the
cost of deposits. The reason for this downward stickiness in the cost of deposits is that
negative interest rates in these instruments could reduce the supply of funds, especially in
the case of households, as they may prefer to hold cash, which has zero but not negative
remuneration, rather than deposits.
However, as regards other bank liabilities, such as debt securities, interest rate
decreases pass through to their cost without the zero level acting as a lower bound.
Indeed, the average cost of some financing instruments, such as covered bonds, fell to
negative values in the summer. The impact on costs is particularly important against a
background in which banks have to meet regulatory MREL requirements. Since these
instruments can absorb losses in the event of difficulties, their interest rates upon issuance
are usually higher than those of ordinary debt instruments, so there is much more room for
them to decrease, particularly in comparison with deposits.
Analysis of the average loan-deposit spread, in terms of outstanding balances, shows
that there is indeed a historically positive relationship between this variable and the
level of market interest rates.
However, since 12-month EURIBOR turned negative in February 2016, not only has this
spread not narrowed, but it has actually widened. There are three reasons for this.
First, average loan remuneration has been underpinned in recent years by the decline
in non-performing loans, which has lowered the proportion of loans that do not generate
any interest.
Second, banks have to a certain extent rebuilt their portfolios, focusing more on
business such as consumer lending that provides higher net interest income, albeit at
the expense of increasing the risk profile of their credit portfolios.
Third, in February 2016 there was still some room for a further decline in the cost of
deposits which averaged 0.35% for outstanding balances and 0.20% for new business.
Since then deposit rates on new business have fallen by an amount similar to the decline in
average loan remuneration. However, the cost of deposits is currently very close to zero, so
it will be more difficult to pass through any further falls in loan remuneration.
It is often argued that banks' net interest income is being adversely affected not only by
the low level of interest rates but also by the flattening of the yield curve observed in
recent years. This effect depends, first, on the extent to which there are positive differences
between the maturities of banks' assets and liabilities, in other words, what is known as
maturity transformation. However, in order for the flattening of the yield curve to have a
negative impact on banks' net interest income, in addition to maturity transformation, there
also needs to be lending at fixed interest rates. If the loans granted are variable rate, their
remuneration will generally be linked to short-term yields, and will therefore not be affected
by changes in the yield curve.
In the case of Spain, although banks perform maturity transformation, the bulk of long-term
lending is variable rate. In consequence, the flattening of the yield curve in recent years
should have had less impact on Spanish banks' net interest income than on the net
interest income of banks in other European jurisdictions where fixed-rate loans
predominate, such as Germany and France. However, in recent years a significant volume
of new fixed-rate mortgage lending is starting to be observed, so these effects could
become more significant in the future.
In any event, to assess the overall impact of interest rates on banks' profitability, it is
important to note that interest rates affect not only net interest margin but also other
income statement items.
In particular, lower interest rate levels help reduce losses on credit portfolios, thanks to
the favourable effect they have on borrowers' ability to repay their loans, associated both
with lower loan costs and with the higher income and lower unemployment levels linked to
the positive macroeconomic impact of lower interest rates.
These effects have been especially significant in countries such as Spain where the
banking system had a high level of non-performing loans and where short-term and
variable rate lending predominates, since this means that changes in market yields are
rapidly passed through to the cost of outstanding debt. This effect thus explains part of the
decline in the NPL ratio in recent years.
In addition, lower interest rates help drive up the prices of financial and real assets.
This effect is immediate in the case of debt securities, especially long-term ones, as their
prices are more sensitive to yield changes. The prices of equities and real assets, such as
housing, are also boosted by lower interest rates, owing to their effect on the discount
factor, although these prices are also affected by other factors, such as macroeconomic
expectations.
All this entails capital gains for banks exposed to these financial and real assets. It
also increases the value of loan collateral, which enhances the credit quality of loans and,
therefore, reduces losses on the credit portfolio. That said, it is true that these capital gains
become exhausted once interest rates cease to decline and remain at low levels.
In addition, low interest rates and, in general, more accommodative financial
conditions naturally have a positive impact on economic activity and employment and
help stimulate the flow of credit, thus also driving up banks' profitability. Indeed, this
is the key rationale behind an expansionary monetary policy such as that implemented in
the euro area in recent years. As an illustration of these effects, according to various ECB
studies2 and the Banco de España's own estimates, the set of monetary policy measures
adopted since mid-2014 will have an overall impact on real GDP growth in the euro area of
around 2 pp in cumulative terms between 2016 and 2020. Moreover, these estimates do not
include the measures agreed in September which, according to the Banco de España's
estimates, could add up to 0.4 pp in cumulative terms to euro area GDP growth by 2021.
In any event, it is fair to say that there is evidence that, since the ECB's deposit facility rate
fell below zero, negative surprises in short-term interest rates have been accompanied by
falls in European banks' stock market valuations.
Given the endogenous nature of the monetary policy response to projected economic
developments, this response by bank share prices to monetary surprises may reflect, on
the one hand, the negative impact of less favourable projections for the future
macroeconomic setting and, on the other, the market view on the direct negative effect
of further interest rate cuts on banks' future profitability against a backdrop of a
prolonged period of negative rates.
In short, although there is no conclusive evidence that low or even negative rates have
adversely affected the supply of bank credit to date, we cannot rule out the possibility
that if rates remain at very low levels for a further - potentially extended - period,
there could ultimately be certain negative consequences for the bank-based
transmission of monetary policy.
For this reason, the decisions adopted by the ECB Governing Council at its meeting
of 12 September were accompanied by mitigating measures, such as the introduction
of a two-tiered reserve remuneration system (to ensure that the negative deposit facility rate
is not applied to part of the surplus liquidity held by banks). These measures are intended
to soften the potential negative impact on banks' profitability of the latest interest rate
cut, and thus to ensure the effective transmission of monetary policy through this channel.
Similarly, the reduction in the interest rate applicable to the third round of TLTRO operations
and the increase in their maturities will cut the cost of banks' liabilities.
Lastly, allow me to refer briefly to the role of regulation. On occasions it has been argued
that the higher regulatory pressure on banking activity in recent years, together with the
future regulatory requirements pending implementation following finalisation of the Basel III
agreements, have negative effects on banks' profitability.
Irrespective of this, it should be recalled that the Basel III reform package aims to address
the shortcomings identified in the regulatory framework in place prior to the global
financial crisis and to strengthen regulation, supervision and banking practice
internationally in the interest of financial stability.
In accordance with this aim, the Basel III reforms have significantly strengthened the
resilience of the global banking system. Specifically, since 2011, internationally active
banks' common equity tier 1 (CET1) capital has risen by 91% to over €3.7 trillion. In addition,
the average risk-weighted CET1 ratio has risen from 7.2% to 13%, while banks' average
tier 1 capital leverage ratio has risen from 3.5% to 6%.
Moreover, these figures will likely continue to rise in coming years, given that some of the
Basel III reforms will not be fully in place until 2022. Indeed some, such as the output floor,
which limits the difference between risk-weighted assets (RWAs) under the standardised
and IRB approaches, have a transition period that may continue up until 2027.
A document published by the Basel Committee3 in June reviews the recent academic
literature on the macroeconomic benefits and costs of higher capital requirements.
According to the literature, the Basel III reforms give rise to capital levels within the range of
estimates that point to positive net macroeconomic benefits for society as a whole, as a
result of the greater financial stability and enhanced shock-absorbing capacity they provide.
In short, there is no evidence to suggest that we have gone too far in calibrating the
Basel III capital requirements.
The priority, therefore, should be for jurisdictions now to apply these standards in full,
consistently and within the periods agreed. This is the message reiterated by the G20
leaders, and banks are required to adapt to this new regulatory environment. We must fight
against what has come to be known as the "regulatory cycle", according to which (and there
is empirical evidence to confirm this), over time, memories of crises and of their negative
effects tend to fade, the pressure of individual interests grows and the temptation to ease
regulatory standards increases.
Clearly, a different question altogether is the need to ensure a level playing field. In
particular, it is important to ensure that the risks associated with the non-bank financial
intermediation sector, and those stemming from its interconnectedness with the
banking sector, are properly regulated and supervised. This requires, among other
things, close monitoring of the regulatory perimeter of the whole financial system, to ensure
that market participants operate under the principle of regulatory neutrality.
Responses to the low profitability environment
In recent years, Spanish banks have partially cushioned the fall in net interest income
by means of various strategies. To address the current low profitability environment, they
should persevere in some of these strategies and embark on others.
First, as I mentioned earlier, banks have made great efforts to reduce their
nonperforming and foreclosed assets. But the non-performing loan ratio still stands at
5.3% for business in Spain and foreclosed assets amount to around €40 billion, in both
cases well above the pre-crisis levels.
Banks should therefore persevere with this strategy. To illustrate the room for
improvement that still exists in connection with these non-performing assets, if the level of
provisioning of average total assets were as low as in 2005 (which, at 0.26%, was the lowest
level recorded since 2000), it is estimated that Spanish deposit institutions' annual
consolidated profit would increase by €1.7 billion. This would raise average ROA by 10 bp
and ROE by 1.3 pp.4
Second, banks have diversified their revenue generation and in particular there has
been an increase in fee income. Among these fees, the relative increase in those linked to
the marketing of products such as investment funds stands out, in a setting in which
demand for these products has risen, boosted by households' search for more profitable
investments, given the low level of return on deposits. This has meant that gross income,
which includes fees and net interest income, has declined by less than the net interest
margin. Likewise, as I indicated earlier, banks have tended to increase the share of business
in their portfolios that provides higher net interest income (such as consumer lending), albeit
at the expense of increasing the risk profile of their credit portfolios.
Third, banks have also made great efforts to cut their operating expenses through
branch closures and staff reductions. Specifically, the number of branches has decreased
by more than 40% (by some 20,000), while staffing levels have been cut by more than 30%
(some 90,000 fewer employees).
Nevertheless, to date these cuts in expenses have been more moderate than the
decline in gross income, as reflected in a constant increase, up to 2017, in the ratio
between the two (the efficiency ratio), which reveals the deterioration in efficiency in this
period. Overall, in business in Spain there has been a significant increase (deterioration) in
the efficiency ratio at the individual level, of around 9 pp since 2014, which took it to 56.2%
in June 2019.
In terms of assets, operating expenses in 2018 were similar to their pre-crisis levels. Yet
in a setting where credit accounts for a significantly lower proportion of assets than it did
then, these expenses should also be lower given that the costs associated with the
management of non-credit assets are lower.
The consolidated statements show that, despite the deterioration in efficiency levels, the
Spanish banking system's efficiency ratios remain better than those of the main European
banking systems and also than those of banks in the United States and Japan, although
they are worse than those observed in other jurisdictions such as, for example, the Nordic
countries
Once again, to illustrate the potential gains, in terms of rates of return, of an improvement
in efficiency, in a scenario in which banks achieved their best (lowest) efficiency ratio since
2000 (43.2% in 2009), it is estimated that the profit attributed to the dominant institution
would have been almost €3 billion higher than the figure actually recorded in June 2019. In
consequence, ROA would have increased by 17 bp and ROE by 2.2 pp.
If we combine this hypothetical scenario with that of the non-performing loan ratio at record
lows, annual profit could have been almost €5 billion higher than the actual figure, with ROA
27 bp higher and ROE 3.5 pp higher. Thus, ROE would be comfortably above the
statistically viable upper range for estimation of the cost of equity.
Clearly, these estimates are only illustrative and should be understood as a ceiling for the
actual effects, as it is probably difficult to achieve such a low non-performing loan ratio in a
setting of lower indebtedness and with significant changes in credit portfolio composition.
And also because part of the increase in banks' costs are the result of technology
investments, which are allowing banks to adapt to the new environment and are therefore
essential. They are also indicative of the measures that banks should be prioritising.
Fourth, the role that consolidation can play as a mechanism for harnessing economies of
scale and improving efficiency and, therefore, for increasing profitability, is regularly
discussed. Added to this is the cost pressure associated with the high IT investments being
made to address changes in a competitive environment with new competitors. And also the
need for banks to have preferential access to international capital markets to be able to
respond efficiently to the implementation of the new post-crisis banking regulations and,
especially in Europe, to comply with the MREL requirements.
In the last decade the Spanish banking sector has already undergone a very significant
consolidation process. Specifically, since 2009 the number of banks has fallen by more
than 30%. Looking ahead, potential future consolidation processes should be led by
the market, in other words, by value creation for shareholders, while we supervisors
should ensure that these processes do not undermine financial stability.
Fifth, we cannot overlook the potential role of international diversification, as shown by
the part it has played in some of the largest Spanish banks in the last decade. Thus, over
that period, the Spanish banking sector has increased its international exposure by 45%,
while banks in countries such as Germany, France and Italy have reduced their international
exposure by 38%, 16% and 15%, respectively.
Despite the risks associated with business in emerging market economies, international
diversification of banking business, especially when focused on retail business and
organised in a decentralised manner, brings important benefits, in terms of greater diversity
of business models and revenue sources, as was seen during the last crisis. In addition,
there is evidence that the lower the level of synchrony between the economic and financial
cycles of the countries in which banks operate, the greater these benefits.5
In this respect a profound reflection at the European and the international level on the
regulatory treatment of diversification in the banking business may be appropriate, so
that, in conjunction with the greater complexity it may entail, some of its beneficial effects
on banks' risk profiles may be afforded better recognition.
Sixth, nor should we overlook the importance of operational risk being correctly
managed by banks.
Operational risk accounts for 9.3% of the risk-weighted assets of Spanish deposit
institutions by volume, slightly below the European average (10.5%). In any event, we know
on past experience that the deterioration in solvency associated with an operational risk
event can be high. Indeed, for European banks affected by the most serious operational
events, this deterioration has remained over 1.25 pp of CET1 in the last five years, rising to
2.1 pp in 2018.
As I mentioned in my introduction, in the case of Spain, potential costs associated with
legal risks continue to contribute to operational risk at deposit institutions. The
processes linked to past litigation, for example over floor clauses, have had an estimated
cost for the sector of more than €2.2 billion up to June 2019. Moreover, there are other
significant legal processes still pending settlement.
In addition, legal risk and certain other factors relating to banks' conduct have had a
significant impact on the reputation of the banking sector, and not only in Spain. In this
respect it is important to note that reputation and customer confidence are fundamental to
the banking business. In consequence, and also from a purely economic standpoint, given
that in the long term litigation costs are far higher than the possible benefits that some banks
may have obtained in the short term as a result of questionable behaviour, banks should
strive to reverse this trend, providing their customers with financial products and
services suited to their needs and capabilities, and also supplying the key information
in a clear and transparent manner.
Similarly, banks should address the technology risk stemming from the impact of the
adoption of new technologies on, for example, the probability of suffering
cyberattacks, with extremely high potential effects on operational risk and banks' own
reputation.
Lastly, climate change and the transition towards a more sustainable economy pose
another key challenge. Although this affects all economic agents, it is particularly important
in the financial sector. Banks face two types of risks in this area: "physical" risks linked to
the direct effect of climate change on their asset values, and "transition" risks linked to the
process of technological and regulatory transition to a more sustainable economy. In
coming years