The challenges to the Spanish banking industry
Conference on banking, profitability and monetary normalisation /Universidad
de Deusto, KPMG and El Correo
Pablo Hernández de Cos
Governor

Good morning. Let me first thank the organisers for their kind invitation to me to participate
in this Deusto University event. It is a pleasure to be here with you today and to share some
thoughts on the Banco España's view of the main challenges currently facing the Spanish
banking industry.
As is well known, credit institutions were greatly affected by the last crisis. This was manifest
in a strong rise in impaired assets, including both non-performing loans and real estate
foreclosures, and in a significant fall-off in profitability, which even turned negative in 2012.
To address these problems it was necessary to undertake intense recapitalisation and
restructuring in the industry. As a result, there has been a notable and generalised
improvement in Spanish banks' financial position. Also contributing here have been the
recent roll-out of an extensive package of regulatory measures and the favourable course
since 2013 of the macroeconomic setting and financial conditions, assisted by the ECB's
monetary policy measures and by other actions at the European and domestic levels.
The Spanish banking industry's improved financial position in recent years can clearly be
seen both in terms of asset quality and in its profitability and solvency levels. Thus, from
December 2013, when the deterioration in bank balance sheets was at its worst, to June
2018 the volume of non-performing loans in transactions with the resident private sector
has declined by 60%. And the amount of foreclosures has done so by 40% since its 2012
peak. The consolidated return on equity, which in 2012 stood at around -25%, has gradually
picked up to levels of 7% on data as at June 2018, and the overall capital ratio has risen
from 11.4% in 2012 to 15.1%.
Despite this notable improvement in its financial position, the Spanish banking industry
continues to face significant challenges. These are largely shared by other banking systems
in the euro area, and include i) the reduction in assets impaired by the crisis, ii) the recovery
in profitability, such that Spanish banks may draw closer to the solvency levels of other euro
area banks, iii) adaptation to the new regulatory framework and, iv) the configuration of a
new competitive setting characterised by the emergence of new technologies and
competitors.
I shall now focus on describing each of these challenges, beginning with that of the
reduction in assets impaired by the crisis.
As stated, the volume of non-performing loans has diminished significantly from its 2013
peak. This reduction has been assisted by the economic recovery, insofar as it has
favourably impacted debtors' ability to pay, and also by the disposal of impaired portfolios.
The correction in terms of non-performing asset levels is in line with what was observed in
previous cycles; but the adjustment in terms of the non-performing loans ratio is proving
slower than on previous occasions, which is attributable to the flatness of credit during the
current cycle.
Compared with the banking systems in other euro area countries that have also
accumulated a high volume of non-performing assets during the crisis, the correction in
Spain is at a relatively more advanced stage. Indeed, the non-performing loans ratio in our
country, at the consolidated level, stands at around the average for the euro area countries.
Moreover, the fall at banks is across the board, albeit sharper for those that were in a
position of greater vulnerability, the reflection of which has been a lessening of the
dispersion of the non-performing loan ratio.
Despite this progress, the non-performing assets ratio in Spain is still at a high level from a
historical perspective. Our forecasts indicate that non-performing assets will continue on a
path of correction in the coming years, boosted by economic growth, which we expect to
run into the medium term, albeit at more moderate rates than those observed in recent
years.
In the absence of an active management policy pursued by banks, the non-performing loan
ratio will continue to be relatively high in late 2020. That would be in line with international
evidence showing the general slowness of these adjustment processes and highlights the
need for such a process to be complemented by banks' active management by means of
sale agreements in respect of their portfolios of problem assets. Indeed, in 2017 and this
year there have been successive announcements by banks of agreements with asset
management companies to reduce the volume of non-productive assets on their balance
sheets. This will result in an improvement in the quality of Spanish bank balance sheets and,
consequently, in their supply of credit to the economy as a whole. In fact, the evidence
available shows that there is a negative correlation between the non-performing loan ratio
and credit growth.
From another perspective, the swift progress in correcting the high levels of bad debts in
Spain and in other euro area countries is crucial for easing the way to finalising the Banking
Union project in respect of its remaining pillar, which is none other than the definitive
creation of a pan-European, pooled and sufficiently backed deposit guarantee scheme.
All the foregoing justifies the special interest we have as economic and supervisory
authorities in credit institutions taking the appropriate measures to expedite the ongoing
reduction in the volume of impaired assets. One of the most significant initiatives here is the
package disclosed by the European Commission in March. It includes a proposal to review
capital requirement regulations with a provisioning calendar for non-performing loans, a
draft directive for the creation of a secondary market in this type of asset and an
extrajudicial mechanism to speed the recovery of collateral, and the publication of guidelines
supporting the development of asset management companies. For its part, the Single
Supervisory Mechanism published guidelines in March 2017 for the management of
nonperforming assets and, more recently, it has released an addendum to this in which it sets
out explicitly its supervisory expectations on provisioning, both for newly-arising
nonperforming assets and for the existing stock, as part of the supervisory review process.
Restoring profitability levels is another of the main challenges the Spanish banking industry
faces. While the profitability of Spanish banks has returned to positive figures and stands
somewhat above average EU levels, it continues to be down on pre-crisis levels and below
those observed in the banking systems of other developed economies such as Australia,
Canada, the United States and Sweden.
The current low level of the average profitability of Spanish banks is particularly apparent in
business in Spain, which was the area most affected by the crisis. The international activity
of Spanish banks, concentrated in a very small number of institutions, was a major source
of risk diversification during the crisis since it enabled them to counter the downturn in
Spain's situation with the sound economic progress in other areas. In any event, this
business segment is not free from challenges, especially at present when some of the
economies to which our banks are exposed, such as Turkey and Argentina, are undergoing
significant difficulties. Against this background, the international business model of Spanish
banks, based primarily on activities conducted through subsidiaries operating in a
decentralised fashion, with financial independence and engaging in traditional banking
activities, is a mitigating factor that should be borne in mind. That said, and despite the
conjunctural difficulties facing some of the countries in which Spanish banks are present, I
would like to underscore the undoubted importance of geographical diversification as a
source of medium and long-term value added and stability for these banks.
The low profitability of the banking business in Spain is attributable to a combination of
factors, some cyclical and others more structural. First, the high level of non-performing
assets ensuing from the effects of the crisis adversely affects banks' income statements
both through the decline in interest received and, especially, the increase in the attendant
asset impairment losses. The volume of these losses for Spanish deposit institutions as a
whole peaked in 2012 and has subsequently tended to fall, although these losses continue
to consume a large portion of revenue, meaning that pre-crisis levels have not been
restored. Specifically, in terms of assets, these losses were, between 2015 and 2017, double
those recorded between 2003 and 2005.
Another telling determinant of the low profitability of the banking business in Spain is the
significant decline in income since the outbreak of the crisis, associated with the strong
reduction in the size of bank balance sheets. During the upturn prior to the crisis, against a
backdrop of high demand for bank lending and of very easy financing conditions, banks
expanded their balance sheets notably, the reflection of which was a strong increase in
typical revenue in the banking business. To cater for this surge in activity, banks increased
their capacity by means of increasing the number of offices and staff, thereby raising
operating expenses; but given that such expenses grew more moderately than income, the
operating efficiency ratio underwent no erosion and results improved.
With the onset of the crisis it became clear that the aggregate debt levels of Spanish
households and firms were unsustainable, which triggered an intense and lengthy process
of deleveraging. The ensuing reduction in the size of bank balance sheets has undoubtedly
affected net interest income.
Banks reacted to this contraction in activity and in operating income by cutting back their
capacity, both in terms of offices and of staff, a correction which was assisted by the
ongoing concentration in the banking industry. Despite the notable adjustment in productive
capacity, operating expenses declined to a lesser extent than operating income, the result
of the existence of certain overheads and of the expansionary behaviour of certain items.
The upshot has been a decline in the profitability of the banking business.
Given that the outstanding balances of lending in the short and medium term are not
expected to grow in a similar way to how they did in the expansion prior to the crisis and
such that they may offset the reduction in net interest income, the recovery in bank
profitability will have to be based on the continuing adjustment of expenses, on the search
for alternative sources of income and on improved efficiency.
In any event, in the search for profitable business, banks cannot ease off in their vigilance
regarding lending standards. In the current setting, very high rates of credit expansion, as
is occurring in the household bank lending segment for the purchase of consumer durables,
might be indicative of an easing of risk acceptance and selection standards which, as past
experience shows time and time again, ultimately translates into notable increases in
nonperforming loans. Despite the limited weight of this business segment in Spanish banks'
overall credit portfolio, the rise in the volume of non-performing assets in this activity as a
result of overly rapid credit growth should strike a note of caution: from being an alternative
source of income it should not become a potential source of losses.
Low interest rate levels have contributed to compressing banks' net interest income given
that, with zero proving an effective floor for the remuneration of most deposits, once that
level is reached banks have not been able to continue reducing their funding costs in a
setting in which risk-free returns have come to stand at negative values. In any event, the
evidence available indicates that this negative effect on net interest income has been partly
offset by a lesser pass-through of market movements to the interest rates on the
outstanding balance of lending.
It should be borne in mind, moreover, that the reduction in interest rates also has some
positive effects on bank profits via various channels. On one hand, the expansionary
monetary policy has a favourable impact on economic activity, boosting the demand for
credit and for other banking services. On the other, the decline in the return on risk-free
assets tends to raise the value of assets by reducing the discount factor implicit in their
price, which translates into capital gains for the banks. Lastly, the decline in interest rates is
conducive to a decline in loan default losses, as it reduces the debt burden and raises
borrowers' income as a result of the boost to economic activity it entails.
Overall, the above points suggest that the net final impact of the low interest rate levels on
bank profitability has been comparatively low compared with the other above-mentioned
factors.
I will now move on to the third major challenge the Spanish banking industry faces. This is
associated with the adaptation to a more demanding regulatory framework that involves
higher requirements in respect of own funds and liquid assets, along with other additional
demands derived from the new resolution regulations.
These regulatory changes, which have been introduced globally, are the response by the
economic authorities to the shortcomings highlighted by the international financial crisis.
Their essential aim is to increase banking systems' resilience in the face of adverse shocks
and to prevent taxpayers from having to bear the cost of the resolution of ailing banks.
The first raft of reforms, known as Basel III, which was designed between 2010 and 2011,
focused on increasing the volume of bank capital and improving its quality, and on the
introduction of new minimum liquidity requirements and counterparty exposure limits, and
of macroprudential instruments, such as the so-called countercyclical capital buffer. All
these requirements will be effective, practically in their entirety, in late 2019.
Spanish banks have already largely adapted to these new requirements, with their liquidity
and capital ratios currently standing above the minimum levels stipulated. In any event, as
regards the CET 1 and Tier 1 solvency ratios, their aggregate levels - albeit with significant
dispersion across banks - are, as at March 2018, low compared with those of the euro area
banking systems, according to data from the European Banking Authority.
This once again highlights the need for Spanish banks to adopt capital-strengthening
strategies. With regard to the solvency regulatory measure, which does not take into
account risk weightings, i.e. the leverage ratio, the Spanish banking system as a whole
shows, on the contrary, slightly higher levels than the euro area average. Also, Spanish
banks evidence, overall, a sound liquidity position, with their LCR ratio above the European
average.
Regarding the resolution of institutions, in recent years a number of regulations have been
approved in Europe establishing a common framework for the EU, and defining the
circumstances in which banks with financial difficulties should enter wind-up or resolution
processes. In this setting, a new category of senior non-preferred debt instruments has been
created, which ranks below senior debt in the payment priority of insolvency proceedings,
with a view to facilitating compliance with the minimum requirements for own funds and
eligible loss-absorbing liabilities, known as MREL. The MREL requirements that the Single
Resolution Board has started to set for significant European institutions are an added reason
for Spanish banks to strengthen their capital in the present environment of recovering
profitability and an economy that is growing at a significant pace.
More recently, December 2017 saw the completion of the second phase of reforms in the
Basel III framework. The reforms include, inter alia, the improvement of the standardised
methods for calculating credit and operational risk, restrictions on the use of internal models
and changes in the leverage ratio. These changes will be implemented in two phases that
will conclude in 2027.
Therefore, although Spanish institutions have already largely adapted to these regulatory
changes, there are still some outstanding reforms to be applied, which will require them to
make further adjustments.
Lastly, the main medium-term challenge lies in the new competition framework derived from
the new technologies and progressive financial disintermediation.
New technologies can quickly change the competitive framework by increasing competition
in some segments. That will oblige institutions to anticipate changes and adapt to the new
environment, even though this entails a rise in costs in the short term, which will be difficult
to manage in an environment of low profitability. One of the areas where the highest degree
of penetration by new entrants has been observed is payment services, particularly retail
payments, which is causing a decline in income from transactional services.
Furthermore, adapting to these technologies may involve greater operational, and even
reputational, risks, with aspects such as cybersecurity gaining in importance.
But new technologies also entail fresh business opportunities for banks. On one hand, these
technological changes allow immediate remote access to a broad range of financial
services, which may enable general administrative expenses to be reduced. The relatively
scant penetration of digital banking in Spain suggests that there is ample scope for this form
of banking to grow, providing Spanish banks with an opportunity to expand their business.
The application of artificial intelligence and the use of large databases with real-time
information (known as big data) may also provide for significant efficiency gains.
Continuing financial disintermediation also involves increased competition for credit
institutions. It is well known that, if trade credit is excluded, the bulk of borrowing by Spanish
non-financial corporations has traditionally been in the form of bank loans. This funding
structure is similar to that observed in other European countries, such as Germany or Italy,
but contrasts with the greater weight of financial markets in other economies such as the
United States and the United Kingdom.
Following the outbreak of the most recent crisis, a gradual increase in the weight of business
funding raised on financial markets through the issuance of fixed-income securities has
been observed in Spain and in other developed countries. This phenomenon especially
affects large corporations. Among the factors potentially contributing to this development
are the regulatory changes in the financial arena, imposing stricter requirements on banking
activity, as mentioned earlier, and the corporate sector purchase programmes by central
banks, which has reduced the cost of issuing these assets.
Looking ahead, this trend towards the expansion of capital markets might continue if
progress can made on the European project to create a capital markets union. Also, a
potential increase in long-term savings linked to the ageing of our society could also
contribute in the same direction.
Although a greater diversification of financing sources could potentially be positive for
nonfinancial corporations, making them less vulnerable to adverse shocks affecting a specific
financing channel, for credit institutions it could entail a reduction in business volume and
income. This is particularly relevant in the current setting of low demand for financing in
Spain, in which this trend could contribute to further eroding the net interest margins in
some market segments.
To conclude, let me sum up the key messages I would like to convey. In recent years,
Spanish credit institutions have made sterling efforts to overcome the problems stemming
from the crisis and to adapt to the new and stricter regulatory requirements. This has been
reflected in the significant improvements in their solvency, profitability and asset quality.
However, despite these improvements, Spanish banks continue to face major challenges,
largely shared with other euro area banking systems. These include, most notably: (i)
stepping up sales of non-productive assets (ii) the need to strengthen capital, (iii) addressing
profitability challenges without unduly easing credit standards and, lastly (iv) harnessing new
technologies in a competitive environment of potential new competitors. In an economy as
highly banked as Spain's, overcoming these challenges is key to the banking industry
gaining a sufficient position of strength from which to contribute to economic growth and
job creation.
Thank you for your attention.