Financial stability situation in Spain
X Financial Sector Meeting/Expansión-KPMG
Pablo Hernández de Cos
Governor

Good morning ladies and gentlemen.
Let me first thank the organisers for inviting me to participate in this tenth edition of the
Financial Sector Meeting. On this occasion my address will focus on the Banco de España's
assessment of the main factors of risk to financial stability at present, the potential impact
on deposit institutions and the tools available to the Banco de España and the other
authorities to mitigate such risk.
Assessment of the balance of risks to financial stability
The balance of risks to the Spanish financial system's stability has worsened
somewhat in the past six months. This has been due in particular to the downward
revision of the global economic outlook.
Indeed, global GDP growth continued to ease, to a year-on-year rate of 2.8% in 2019 Q2,
more than 0.5 pp lower than a year earlier. This slowdown is particularly affecting some
emerging economies and Europe.
Moreover, growth projections have been revised downwards in recent quarters in most
economies. In fact, the increase in global GDP this year is expected to be the lowest since
the international financial crisis.
This downturn in activity has likewise affected the Spanish economy. As a result, the Banco
de España revised its growth projections for our economy down last September, to 2% in
2019, 1.7% in 2020 and 1.6% in 2019.
In addition to this baseline projections scenario, a series of risks persist in the geopolitical
and economic policy areas. Should these risks materialise, they might bear down even
further on future growth.
At the global level the US-China trade conflict, prompting increases in the maximum tariffs
applicable to specific products, continues to be the main source of uncertainty. These
disputes, which feed through to all countries through global value chains and which
especially affect Europe owing to its high degree of openness, are exerting a significant
adverse impact on trade and putting back investment projects.
Regionally, the risk of a no-deal Brexit has increased and Germany is on the verge of an
economic recession. In Spain, uncertainty persists over the future course of economic
policies, a situation which should be resolved following the general elections in November.
Flatter economic activity and the potential materialisation of geopolitical risks may have
implications for financial stability through various channels.
Firstly, this may lead financial market players to reassess their perception of risk. That would
mean that the currently very compressed risk premia on financial instruments would
increase, thereby reducing asset prices and, therefore, wealth and collateral values. These
developments might affect to a greater extent the more vulnerable segments, such as that
of debt with lower credit quality, including leveraged loans and CLOs, and markets with high
valuations. And they might extend to other assets.
Secondly, agents' income flows may be affected, with implications for their consumer
spending and investment decisions. In the case of households, employment creation and
wage growth might decline. As to non-financial corporations, the rise in their profits might
diminish. The public sector would also see its balance of revenue and expenditure affected
by the operation of the automatic stabilisers. That would all mean that both private and
public levels of debt might ultimately be higher than expected, with further implications both
for spending decisions and financial markets' perception about the debt sustainability path.
Logically, the deteriorating macroeconomic context would also affect deposit institutions.
Compounding the fall in the value of some of their assets would be lower demand for credit.
Moreover, asset quality might worsen, given that the ability of their borrowers to pay would
be negatively affected. They would also face greater difficulty in continuing to jettison their
non-earning assets. As a result, their income statements would be subject to downward
pressures. This is particularly significant in a context, such as the present, in which banks
are posting low profits.
Against this background, it would be desirable in economic policy terms that, after the
elections, a stable government were formed. That would lessen uncertainty over the future
course of economic policies, give fresh momentum to structural reforms and see a
resumption of fiscal consolidation, with the aim of improving potential growth and reducing
the main sources of vulnerability in the Spanish economy, in particular high public and
external debt levels.
The added pressure of the economic environment on bank profitability is the second
element of the balance of risks that I would like to highlight. Once again, this is not
something specific to the Spanish financial system. Indeed, Spanish banks' profitability is
higher than the European average, but it remains below the cost of capital. Maintaining
appropriate profitability is crucial, among other factors, if banks are to generate capital
organically and, in this way, reinforce their solvency levels.
Spanish bank profits in the first half of the year, down by 11.5% in year-on-year terms, are
a sign of the growing likelihood of this risk materialising. Contributing to this decline have
been the reduction in gains on financial operations and, to a lesser extent, the increase in
operating expenses, although a portion of this was due to extraordinary expenditure
associated with the restructuring of certain banks.
In addition, the ongoing reduction in impairment losses that began in 2012 is showing some
signs of exhaustion. Indeed, in terms of their year-on-year rate, impairment losses increased
for the first time since 2012, posting a rise of 3.9%. And we should not forget that, at present,
the NPL ratio is still significantly above that recorded before the financial crisis. Specifically,
in terms of lending to the resident private sector, in business in Spain, the NPL ratio stood
at 5.3% in June 2019, 8.7 pp down from the December 2013 high. Foreclosed assets
evidenced a further decline, standing below €40 billion in June 2019. That marks a 50%
reduction from the 2011 peak. Against this backdrop, banks should persist in their
management efforts to enhance the quality of their balance sheets, which is a fundamental
factor for the recovery of profitability in the medium term.
The other lever in banks' hands is to improve their efficiency, through a more appropriate
management of their costs that does not limit their capacity to adapt to an increasingly more
technified environment. In this respect, we should note that, in business in Spain, the
efficiency ratio at the individual level, without taking into account severance payments, has
increased (worsened) by somewhat over 9 pp since 2014, to 58.8%. As to the composition
of operating expenses, the weight of personnel costs has diminished, and that of IT and
communications, outsourced services and amortisation has increased, reflecting to some
extent the ongoing digitalisation and technological change at banks.
It should be borne in mind that operating expenses are one of the most significant levers
over which banks have direct control to increase the profitability of their business. In any
event, it should also be stressed that Spanish banks' efficiency ratio at the consolidated
level, calculated as the ratio of operating expenses to gross income, is one of the lowest
(best) in Europe.
The actual and projected reduction in the euro area economy's rate of nominal growth and,
as a consequence, the fact that interest rates are going to be at lower or even negative
levels for longer, may ultimately affect financial institutions' profitability. Indeed, in recent
months the markets have lowered their expectations in terms of the growth of European
banks' profits.
Low or negative interest rates restrict the unit interest margin banks can obtain. However,
from a general equilibrium perspective, they also increase credit, reduce bad debts and
raise the value of the financial and real assets banks hold on their balance sheets. As a
result, the net aggregate effect on bank profitability in general has so far been positive
overall. That said, this effect will foreseeably diminish insofar as the situation of negative
interest rates is prolonged over time. Indeed, a positive note regarding the most recent
developments in profitability is that net interest income has increased following years of
stagnation at low levels.
In any event, the decisions adopted by the ECB Governing Council at its meeting on 12
September, including the 10 bp reduction in the deposit facility rate to -0.5%, the
resumption of net purchases under its asset purchase programme and the strengthening of
forward guidance, have been accompanied by mitigating measures. These include the
application of a two-tier system for reserve remuneration, designed precisely to ensure the
effectiveness of monetary policy transmission through the bank channel.
There is also theoretical and empirical evidence that low interest rates transmit the monetary
impulse by encouraging banks and other financial intermediaries to take risks. Fortunately,
we currently have various macroprudential policy instruments, which I shall refer to later,
designed to mitigate the potential build-up of risks that may affect financial stability through
this channel. So far, deposit institutions do not appear to be significantly increasing their
exposure to risk, although there are some factors where we are exercising greater
watchfulness.
In fact, the total volume of lending granted by deposit institutions in Spain to the
nonfinancial private sector has continued to fall (-1.2% in June), or shows muted increases
when the construction and real estate development sectors are excluded. Moreover, the
debt ratios of the non-financial private sector have continued falling, standing at levels below
the euro area average. Specifically, the debt/GDP ratio of the non-financial private sector
was slightly above 130%, 3 pp down on a year earlier, and 2 pp less than the euro area
average, having declined by more than 70 pp from its peak during the crisis.
In the case of non-financial corporations, overall external financing has continued to expand
at year-on-year rates of close to 2%, with significant growth in bond financing and a fall-off
since the start of the year in new bank lending extended to non-financial corporations.
Overall, the reduction in the deleveraging of non-financial corporations exceeds 50 pp of
GDP, from the peak reached during the crisis. Further, in recent years banks appear to be
setting greater store by variables such as productivity in lending standards, which results in
a more efficient allocation of credit. Nonetheless, some firms still show a certain degree of
financial fragility.
In the case of households, the credit terms of mortgage loans are much stricter than those
observed pre-crisis, and in recent quarters no signs of easing have been perceptible. For
example, in the case of the loan-to-price ratio (LTP), there has been a reduction in the weight
of more leveraged transactions (with an LTP of over 80%) compared with the crisis years.
Moreover, the average LTP is also lower. By way of exception, consumer lending and its
attendant bad debts quickened once again in the final quarter to year-on-year rates of 12%
and 26%, respectively, slightly raising the NPL ratio of this business segment to 5.6%. And
this against the background of the considerable slowdown in private consumption in the
economy.
In terms of solvency, from June 2018 to June 2019 the CET1 ratio increased by somewhat
over 30 bp to stand slightly over 12%. The rise was based essentially on an increase in
reserves. This improvement in solvency was concentrated in the biggest institutions which
are, precisely, those showing lower levels. Moreover, the bulk of the capital materialises in
instruments with the biggest loss-absorption capacity.
Compared with the other European countries, Spanish institutions have a top-quality CET 1
capital ratio almost 3 pp below the European average, whereas in terms of the leverage
ratio, Spain stands slightly above the same average.
It is well-known that this difference in Spain's relative position in respect of these two
solvency measures is due to the fact that the density of risk-weighted assets is higher in
Spain. This greater density is linked to the higher use in Spain of the standard approach
when calculating risk-weighted assets and to the very risk profile of the portfolios. In fact,
for banks and portfolios for which the IRB approach is used, no appreciable difference in
the density of risk-weighted assets is discerned, on average, compared with other Single
Supervisory Mechanism (SSM) banks and countries.
In any event, precisely to limit variability between weightings obtained through the IRB
approach and the standard approach, the final phase of the Basel III reform includes the
socalled output floor. Here, the density of the risk-weighted assets of institutions' aggregate
portfolio may not be lower than 72.5% of that obtained applying the standard approach.
Accordingly, this constraint should affect Spanish banks to a lesser extent. However, the
set of reforms pending implementation will foreseeably have some impact on banks' capital
requirements in the coming years. In this respect, the bigger the capital buffers Spanish
institutions have, the greater their capacity to cushion the impact of the full adoption of the
reforms and their pass-through to European regulations.
Beyond the need for compliance with regulatory requirements, the level of solvency is
particularly significant in a financially globalised world. Thus, there is empirical evidence that
the cost of financing with instruments convertible into capital falls significantly the greater
banks' level of solvency. And we should remember that banks, owing to MREL
requirements, will have to issue a lot of these instruments in the coming years, a task that
has been made easier in recent months by the ECB's monetary policy. In addition, there is
evidence that banks with higher solvency levels are those best adapted to uphold their
profitability against a background of negative interest rates.
One way of evaluating the suitability of banks' solvency levels involves subjecting
them to stress tests. The Banco de España performs such exercises annually on all
Spanish institutions. To do so it takes as a starting point highly granular data from the
balance sheets of banks at the close of the previous year and defines a baseline
macroeconomic scenario which coincides with the forecasts of the Banco de España
available at the time the exercises are performed. It then takes another, stressed scenario,
which seeks to reflect the effect of the risks identified previously materialising. The
difference between both scenarios reflects the degree of stress of the exercise which, in the
test this year, is slightly higher than that of the previous year owing to the intensification of
the risks mentioned in the first part of my address.
While the results of these tests will be published in greater detail in the forthcoming Financial
Stability Report, allow me to offer you in advance some of the main conclusions.
The results obtained in relation to the resilience of Spanish banks as a whole are, in general,
positive. The capital needs arising under the adverse scenario are moderate at the
aggregate level, although there is considerable heterogeneity across banks. Specifically, the
reduction in the CET1 capital ratio for large institutions with a significant international
presence is 0.4 pp, standing at 2.7 pp for other SSM-supervised banks and at 0.6 pp for
less significant institutions.
The difference obtained between internationally active institutions and other institutions
supervised by the SSM shows the significance of geographical diversification in absorbing
shocks. The lower decline in the capital of the less significant institutions is largely due to
their lower credit risk and the lesser weight of their exposure to the real estate sector, i.e. to
their better asset quality.
The results obtained are generally more favourable than last year. This is because banks
have made use of the past year to lessen their exposure to changes in the prices of certain
assets, such as foreclosed assets. Specifically, banks have offloaded considerable
packages of foreclosed assets during 2018 and in 2019 to date.
Turning once more to the main sources of risk to financial stability, the last such source I
wish to mention relates to financial institutions' operational risk. Operational risk
accounts for 9.3% of Spanish deposit institutions' volume of risk-weighted assets, slightly
below the European average (10.5%). In any event, the deterioration of solvency associated
with an operational risk event may be high based on past experience. Indeed, for European
banks affected by big operational events, this deterioration has stood at over 1.25 pp of
CET1 in the past five years, with a rise to 2.1 pp in 2018.
In Spain's case, the potential materialisation of costs associated with legal risks
continues to contribute to deposit institutions' operational risk. The processes linked
to past litigation such as that of the floor clauses have had an estimated cost for the sector
of over €2.2 billion to June 2019. Moreover, there are other significant legal processes still
pending resolution.
In any event, legal risk and certain other factors relating to banks' conduct have had a
considerable impact on the reputation of the banking sector, and not only in Spain. It is
worth recalling here that reputation and customer confidence are fundamental to the
banking business. Therefore, institutions should strive to reverse this tendency by providing
their customers with financial products and services suited to their needs and capabilities,
and they should likewise supply the relevant information clearly and transparently.
Lastly, in relation to the systematic assessment of the balance of risks to financial stability
that we regularly make at the Banco de España, we are including other elements, whose
materialisation could occur over a longer horizon. I refer here to the potential changes
technological innovation may entail for the market structure of the financial sector,
and those arising from climate change. The importance banks give to these changes
will have to increase accordingly.
Macroprudential policy
As you all know, a macroprudential authority (AMCESFI) has been in place in Spain since
the start of the year. Its main task involves contributing to the coordination and exchange
of information on financial stability-related aspects between the Banco de España, the
Ministry of the Economy and Enterprise, the National Securities Market Commission and
the Directorate General of Insurance and Pension Funds.
In parallel, the supervision of the financial system as a whole has been bolstered by the
extension of the macroprudential tools available to the sectoral supervisory authorities.
Some of these new tools, in particular those of the Banco de España based on borrowers'
ability to pay, aim to prevent an excessive easing in lending standards on the part of banks
and to contribute to the sustainability of household and corporate debt. These new
instruments complement those already being used by the Banco de España: the
countercyclical capital buffer, the systemic risk buffer and the buffer for systemically
important institutions, among others.
Overall, this new institutional framework and the attendant powers mark progress and the
strengthening of financial stability in Spain. In fact, in my opinion1, the introduction of
macroprudential policy instruments to complement monetary and fiscal policy is probably
one of the most significant advances in the wake of the international financial crisis. For
countries which, like Spain, belong to a monetary union, these tools are particularly
important. They are some of the few instruments available in the national realm to ensure
the stability of the domestic financial system.
In relation to this macroprudential policy, the Banco de España is responsible for setting
quarterly the so-called Countercyclical Capital Buffer (CCyB). The CCyB is a
macroprudential instrument that leads to credit institutions building up a capital buffer
during expansionary periods so that this buffer may be released during a subsequent
contractionary phase. In this way, the CCyB strengthens the banking system's solvency
during growth phases, which is when risks usually build up, and helps mitigate the decline
in the flow of new lending to the economy when these risks materialise. Consequently, the
CCyB contributes to smoothing credit cycle fluctuations, and to increasing credit
institutions' capacity to withstand potential future losses.
During 2019 Q3 and Q4, the Banco de España has kept the CCyB percentage at 0%. This
decision is underpinned by a technical analysis of quantitative indicators mixed with
qualitative information.
The set of quantitative indicators shaping decisions on the CCyB include indicators that
seek to capture developments in the credit cycle of the non-financial private sector and its
excessive growth, the potential overvaluation of house prices, the effort entailed for
households and firms in paying interest and repaying the principal of loans (debt service),
the external deficit and the macroeconomic environment.
The technical analysis assesses the recent trend of the indicators, their current status and
also their expected behaviour in the coming quarters consistent with the macroeconomic
forecasts prepared quarterly by the Banco de España. The forward-looking analysis is
particularly relevant in this context since, in the event of the CCyB being activated, banks
have 12 months to comply with the requirement.
According to these indicators, the credit cycle continues to show values below the activation
thresholds (having regard to the credit-to-GDP gap, which remains below its long-term trend
value), although it is progressively converging on the long-term equilibrium level. In fact,
forecasts as to how it will trend in the coming years indicate that this indicator will turn
positive towards 2021 Q1 and might exceed the activation threshold in 2021 Q2.
Some complementary quantitative indicators are along the same lines. This is particularly
the case for credit intensity, which shows the weight of the change in credit relative to GDP,
and the overvaluation of house prices currently show values close to equilibrium, with an
upward trend that is forecast to continue over the next two years. Non-financial
privatesector debt service, for its part, has maintained the reduction that marked its path at the
start of the global financial crisis. Foreseeably, this reduction will continue, albeit more
moderately so over the coming two years, given that the process of debt reduction has
eased significantly and interest rates have less margin for further cuts. Finally, the current
account balance continues to be slightly in surplus and is expected to remain relatively
stable over the coming years.
The output gap in the economy has, since the start of the year, been in positive figures, and
forecasts about its future course retain the prospect of the gap widening. Bear in mind that,
moreover, set against the current recovery in the Spanish economy, the business cycle has
tended to be a leading indicator of the credit cycle.
Overall, the analysis performed warrants holding the CCyB at 0%. However, if the baseline
scenario forecasts for the Spanish economy hold, in early 2021 several reference indicators
would exceed the activation thresholds. If this macroprudential instrument is activated, the
credit institutions concerned would have 12 months in which to comply with the
requirement. This analysis, however, is conditional upon fulfilment of the baseline scenario
forecasts which, at present, as I stressed earlier, are subject to numerous downside factors
of risk. If such risks were eventually to materialise, with a significant impact on Spanish GDP,
the former diagnosis would consequently be altered.
Allow me to conclude. The downward revision of global economic prospects is the main
argument warranting some deterioration in the balance of risks to the stability of the Spanish
financial system. This flatter economic activity may have adverse implications both for
financial and real asset prices and for agents' incomes, raising their levels of debt. Further,
in this macroeconomic environment, which also makes the prolongation of the period of low
interest rates more likely, banks' profitability will be subject to additional downward
pressure. Against this backdrop, financial institutions should strive to improve the quality of
their balance sheets, to raise efficiency and solvency levels and to increase their efforts so
as to enhance their reputation. Economic policies should focus on reducing the
vulnerabilities still in place in our economy, such as public and external debt, and on raising
medium and long-term growth through the implementation of appropriate structural
reforms. Lastly, macroprudential policy should concentrate on mitigating the potential
generation of risks that may affect financial stability and on the accumulation of buffers for
use, when needed, in more adverse macroeconomic scenarios.
Thank you for your attention.