Banking Sector: Recovery Moving On To Firmer Footing

BMI View: The outlook for Spain's banking sector will improve further in 2014, as banks reduce their reliance on Spanish sovereign debt and ECB funding, and bolster capital buffers in the run up to eurozone stress tests. That said, the sector's recovery will be a gradual one, with ongoing household deleveraging set to weigh on profits and asset quality for some time to come.

The recovery of the Spanish banking sector looks set to continue in 2014, with the intensive restructuring and recapitalisation undertaken as part of the sector's EUR41bn bailout placing the recovery on increasingly solid ground. Against this backdrop, bank profits soared in 2013, with Banco Sabadell and Bankiter's profits rising by over 170% and 58% respectively, while Banco Popular swung from a loss of EUR2.5bn to a EUR325mn profit.

Although we expect the profitability of the sector to remain healthy in 2014, household deleveraging will dictate that this is in no part due to a revival in domestic lending ( see chart below). Indeed, the recent rise in trading profits has been largely the result of the eurozone carry trade, where Spanish banks' have borrowed money cheaply from the ECB to buy high-yielding sovereign debt from the government. Spanish banks have almost tripled their holdings of Spanish government debt since 2008, from EUR94bn to EUR272bn in at end-2013.

Carry Trade Supporting Profits
Spain - Components Of Banking Sector Assets, % chg y-o-y 12mma

BMI View: The outlook for Spain's banking sector will improve further in 2014, as banks reduce their reliance on Spanish sovereign debt and ECB funding, and bolster capital buffers in the run up to eurozone stress tests. That said, the sector's recovery will be a gradual one, with ongoing household deleveraging set to weigh on profits and asset quality for some time to come.

The recovery of the Spanish banking sector looks set to continue in 2014, with the intensive restructuring and recapitalisation undertaken as part of the sector's EUR41bn bailout placing the recovery on increasingly solid ground. Against this backdrop, bank profits soared in 2013, with Banco Sabadell and Bankiter's profits rising by over 170% and 58% respectively, while Banco Popular swung from a loss of EUR2.5bn to a EUR325mn profit.

Although we expect the profitability of the sector to remain healthy in 2014, household deleveraging will dictate that this is in no part due to a revival in domestic lending ( see chart below). Indeed, the recent rise in trading profits has been largely the result of the eurozone carry trade, where Spanish banks' have borrowed money cheaply from the ECB to buy high-yielding sovereign debt from the government. Spanish banks have almost tripled their holdings of Spanish government debt since 2008, from EUR94bn to EUR272bn in at end-2013.

Carry Trade Supporting Profits
Spain - Components Of Banking Sector Assets, % chg y-o-y 12mma

Although banks' sovereign holdings will continue supporting profits over the coming quarters, we caution that the closing spread between the ECB's cheap loans and Spanish government borrowing costs will make similar gains hard to repeat in 2014. Yields on 10-year Spanish government bonds have fallen by 4.2 basis points to 3.5% since the announcement of the Outright Monetary Transaction (OMT) programme in 2012 (where the ECB pledged to buy unlimited government debt), meaning that borrowing costs have now fallen to below pre-crisis levels.

We believe banks will be also be wary of reducing their sovereign debt holdings ahead of ECB stress tests planned for 2014. The stress tests are the prelude to the ECB assuming responsibility for the supervision of the eurozone's largest 160 banks, and we believe the 16 Spanish banks covered under the plans will be keen to loosen their ties with the government given rising investor concerns over the increasingly tight linkages between eurozone banks and their sovereign. Against his backdrop, Spanish banks sold EUR33bn of government bonds in the last two months of 2013, and further sales lead us to believe that the sector will struggle to restore potential earnings from their core banking business domestically.

Further Consolidation Ahead
Banking Sector Assets, % GDP

Sector To Shrink Amidst Deleveraging

We expect the consolidation of the banking sector ( see above chart) to continue over the next few quarters, as demand for loans is undermined by ongoing deleveraging in the household sector ( see 'Household Deleveraging To Weigh On Recovery', Feb 6). Only limited progress has been made improving households' debt-to-income ratios (which remained above 125% in 2013), implying to us that demand for new loans will remain weak for some time to come. Loan growth will also be restricted by widely-held expectations that house prices will continue falling (prices are already down over 35% from pre-crisis levels), restricting demand for new mortgages.

Against this backdrop, loans contracted by a whopping 13.9% in 2013, and we forecast loans to contract by a further 5.7% in 2014. However, we note that the slightly slower rate of contraction in 2014 will be driven by a modest recovery in demand from non-financial corporations, as the corporate sector has made more progress paying down its debts amidst unfavourable domestic and external investment conditions.

Reliance On External Funding Subsiding
Spain - Banking Sector Loans and Deposits, % chg y-o-y 6mma (LHS) & Loan To Deposit Ratio, % (RHS)

On the deposit front, high unemployment (26.1% in Q413), low wages and squeezed disposable incomes will continue limiting individual's ability to save. We forecast deposits to contract by 2.2% in 2014, noting that weaker loan demand should ensure that the sector's loan-to-deposit (LTD) ratio continues to improve ( see chart above). The LTD ratio has already fallen from 108.2 in 2006 to just 88.4 at end-2013, and we expect the sectors' reliance on less stable funding sources to continue easing over the coming quarters. Reflecting this trend, a recent report by the Bank of Spain (BdE) found that the Spanish banking sector's recourse to Euro system financing has actually fallen by over 35% since-end 2012.

Reasonably Well Prepared For Stress Tests

As well as reducing its reliance on ECB financing and sovereign bond holdings, we believe the remarkable recapitalisation of Spain's banks should ensure that the sector is well positioned to cope with closer scrutiny from ECB stress tests. Tighter credit standards have ensured that capital buffers have swelled from just 18.3% of GDP in 2007 to 39.2% at the end of 2013 ( see chart below), implying to us that the sector is now better-placed to deal with any internal or external economic shocks. Reflecting this trend, Spain's tier 1 capital adequacy ratio increased to 10.5% in Q313, from just 9.4% at end-2012, with the largest lenders having average coverage levels above that of most European peers.

Dramatic Recapitalisation Continues
Spain - Banking Sector Capital

Asset Quality Still A Risk

We believe deteriorating asset quality will pose the biggest downside risk to our improving outlook for Spanish banks in 2014. The sector's non-performing loan (NPL) ratio rose to 13.6% in December 2013, from 13.1% the previous month, as unfavourable labour market conditions continued weighing on the ability of households to repay their debts. Deteriorating asset quality is even more alarming in the context of the sector's bailout, given that the NPL ratio fell to just 10.4% in 2012 as soured real estate assets were transferred to 'bad bank' SAREB.

We expect the NPL ratio to continue creeping up over the next few quarters, forcing banks to ramp up capital provisioning and weighing on profits. However, we do not anticipate asset quality becoming a serious problem unless leading and high frequency indicators point towards a significant deterioration in household incomes in 2014, with capital buffers looking healthy and headline NPL figures inflated by the rapid contraction of banks' loan books.

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