Bad Debts Continue To Weigh on Sector's Recovery

BMI View: Despite the recent improvement in Spanish banks' profitability, the country's banking sector faces an uphill battle to contain growing bad debts and collapsing client loan growth. With deposits growt h likely to remain sluggish over the coming quarters, w e forecast client loans to contract by 8.1% in 2013 and 3.5% in 2014, and stress that threat of the banking sector requiring further capital injection s has not yet completely subsided.

Following the recent release of data that showed Spanish banks' profitability improved significantly in H113, we believe the risk of the sector drawing down more funds from the EUR100bn bailout agreed with the ECB in 2012 has subsided for the time being. Banking sector profits have been boosted by lower provisioning from the transfer of impaired property assets to SAREB, Spain's bad bank, which was created as a condition of the EUR41.3bn loaned to the sector by the Spanish authorities.

The bailout has helped to clear some of the backlog of foreclosed homes and bad loans clogging up the banking system after the collapse of the country's construction boom, enabling bailed-out Bankia to post a EUR200mn profit in H113, bouncing back from a EUR16.5bn loss in 2012, the largest loss of any bank globally that year. Spain's second largest bank, BBVA, posted a net profit of EUR1.2bn in Q213, from a EUR505mn loss in the same period last year, while Sabadell's profits jumped 37.0% against this backdrop.

Banking Sector Consolidation To Continue
Spain - Banking Sector Assets

Despite improving profits, we caution that the health of Spain's banking sector will be undermined by deteriorating asset quality and collapsing loan growth over the next few quarters, ensuring that the threat of further government capitalisation remains a possibility for some time to come. We expect the banking sector to continue shrinking in 2013 and 2014, as collapsing deposits and higher capital provisions restricts banks' ability to lend. This trend has been playing out in 2013, with bank assets contracting by 8.7% year-on-year (y-o-y) in June, contributing to the banking sector shrinking from 340.9% of GDP in June 2012 to 307.1% of GDP a year later.

Spain - Banking Sector Loans, % chg y-o-y (LHS)

The main driver of the shrinking banking sector will be declining client loans, which contracted 14.2% y-o-y in June, from 12.7% y-o-y in May. We revise our forecast for client loans to shrink by 8.1% in 2013 and 3.5% in 2014, from 5.1% and 1.5% previously, against the backdrop of a more significant slowdown in deposit growth going forward, which will restricting banks' ability to lend.

We forecast client deposits to contract by 5.0% in 2013 and 1.0% in 2014, as stubbornly high employment, falling real wages and collapsing disposable incomes restricts household's ability to save. In June, deposits shrunk 9.7% y-o-y, from 3.9% in January, as the country's severe economic downturn dragged on. While we expect Spain's economic recovery to begin picking up steam in 2014 (we forecast real GDP growth of -1.7% in 2013 and 0.3% in 2014), we caution that the severity of the country's economic crisis will ensure that deposit growth remains anaemic for some time to come. We expect unemployment to remain above 20% until 2018 at the earliest, and do not see real wages recovering anytime soon. We believe these dynamics will contribute to weak deposit growth weighing on bank's ability to lend, keeping a lid on profit growth and ensuring that the sector's consolidation continues over the next few quarters.

Loans Falling Faster Than Deposits
Spain - Banking Sector Loans and Deposits, % chg y-o-y

Nevertheless, as loan growth has been collapsing more quickly than deposit growth over the past few months (see above chart), the country's loan-to-deposit ratio has fallen from 94% in November 2012 to 88% in June 2013, implying that the banking sector's ability to cover any unforeseen funding requirements in gradually improving.

Deposits Weak, But LTD Improving
Spain - Banking Sector Deposits, % chg y-o-y (LHS) and Loan-To-Deposit Ratio, % (RHS)

Asset Quality To Deteriorate Further

We have long argued that asset quality would continue deteriorating in 2013, due to unfavourable economic conditions reducing the ability of mortgage holders to repay their debts, made worse by collapsing house prices. The banking sector's non-performing loan (NPL) ratio reached 11.6% of total loans in June 2013 - its highest ever level - topping the previous high of 11.4% in November 2012. The recent rise comes against the backdrop of the NPL ratio falling to 10.4% in December 2012, largely as a result of the transfer of souring real estate assets to SAREB at the end of the year. With Spain's gradual economic recovery unlikely to translate into improved household finances for some time to come, and with house prices likely to continue falling over the coming quarters (in Q213 there were 3.4mn empty households in Spain, over 14.1% of the total housing stock), we see little reason to believe asset quality will begin improving significantly anytime soon.

With banks needing to retain a significant proportion of their retained earnings as capital buffers, we believe deteriorating asset quality will prevent a more significant improvement in banking sector profitability in 2013 and 2014. Furthermore, although the banking sectors Tier 1 capital adequacy ratio was 11.0% at end-2012, we believe this figure fails to adequately recognise the level of risk stemming from the sectors declining asset quality. Rather than write down losses on many of the non-performing loans on their books, many of Spain's banks have extended or refinanced them, even in situations where borrowers are unlikely to be able to pay them back. Spanish banks have refinanced 14.0% of total loans (EUR202.2bn), with over 37% of these restructured loans classified as 'doubtful' and 21% as 'substandard'.

However, with the Bank of Spain (BDE) announcing in May that banks will have until September to reclassify all restructured loans according in accordance with tougher guidelines, we believe the NPL ratio will continue rising into H213. The rules will see banks reclassify some of these loans currently classified as 'normal', forcing banks to increase loan-loss provisions, which are likely to weigh further on loan growth and retained earnings going forward.

Risks To Outlook

Although we believe the banking sector's improving profitability has slightly reduced the risk of the sector needing to draw-down more funds from the EUR100bn bailout for now, we stress that a slower-than-expected economic recovery over the coming quarters would undoubtedly weigh on deposit growth and asset quality going forward. In such a scenario, banks would be forced to divert an even greater proportion of their profits towards loan loss provisioning and could be tempted to cut lending even further. Accordingly, we would look to downgrade our forecasts for asset and client loan growth in 2013 and 2014, and believe the need for some banks to raise further capital could force the government to draw down more funds from the total granted by the EU in this situation.

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Geography: Spain

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