From the perspective of the Spanish banking industry, economic conditions are improving, helped along by a recovery that began last year. A stronger economy could lead to greater activity in the banking sector and further strengthen mortgage banking, the star performer in 2003. However, the spotlight won’t be shining only on earnings results. Attention will be turning to news about Basle II, an agreement that regulates capital, as well as to the possibility of further concentration in the banking sector.


Already it’s clear that Spanish banking won’t be facing a fiscal year with as many problems as in years past. The improving global economy, along with clear signs that Spain’s GDP will grow at a rate above the European average, have raised expectations in the banking sector. According to economists, the Spanish GDP could approach a growth rate of 3% compared with rates in other euro zone countries that range from between 1.5% and 2%.


Luis Vadillo, an analyst at the Renta 4 brokerage firm, says that the driving force behind earnings in the banking sector will be “growth in the volume of business both in mortgage-banking as well as the small and midsize business sector.” Earnings growth will be “heated up by the significant growth of the Spanish economy, which has an inflation rate that is high but under control, and an improving labor environment.” Spain finished last year with an inflation rate of 2.7%.


Antonio Ramírez, an analyst at Merrill Lynch, the American investment bank, is also generally optimistic, although he defines 2003 as a year of “transition.” In his view, some negative factors could restrain the further improvement that optimists anticipate. “The strong volume of additional credit could be partially shackled by lower margins, while the anticipated increase in earnings from Latin America could be reduced by the depreciation of Latin American currencies relative to the euro,” he wrote in a recent report.


The industry’s hopes for 2004 are pinned largely on the mortgage-credit sector. In 2003, mortgage credit was the shining star, thanks to the enormous need for financing caused by Spain’s real-estate boom. The Spanish Mortgage Association estimates that in 2004, credit volume will still grow at a rate of between 15% and 18%, after increasing by more than 22% in 2003.


Whether or not mortgage credit really winds up growing could depend on another key factor – how interest rates move in 2004. Theory says that whenever interest rates rise, banks benefit. That’s because banks usually raise the rates they get from borrowers even more than they raise the rates they pay on customers’ deposits. This translates into an improvement in the margins banks earn when they act as intermediaries. In recent years, those margins have come under a lot of pressure.


Nevertheless, the influence of interest rates (on bank profits) is gradually declining, according to Juan Antonio Maroto, finance professor at the Complutense University in Madrid. “It’s a short-term situation. The banks are betting more and more on unconventional streams of revenue, and they are giving a lesser role to their traditional sources of revenue. When interest rates rise, it will make things easier for those firms that are less efficient. I would worry if I were a client of a bank whose earnings growth depended a great deal on rising interest rates. That’s a bad sign.”


It is not very clear if interest rates are going to rise in 2004. Most economists don’t expect the European Central Bank to raise the price of money during the first half of the year. Moreover, fewer and fewer experts now expect rates to rise during the latter half of 2004. The market is also acting on that presumption. The euribor, the main reference point for calculating interest paid on mortgage credits, fell in January to 2.2%. That was the lowest rate in the last six months, and very close to its historic low. Merrill’s Ramírez believes that downward pressure on the euribor “could grow during the first quarter of the year and stabilize during the second quarter. Then, it could recover a bit during the second half of the year. Over the course of the fiscal year, we expect lower margins than in 2003.”


If interest rates rise, it will be a clear signal that the economy is improving, but it will also provide a sudden jolt to consumers and business borrowers. However, if interest rates stay at current levels, or drop even further, “credit growth, especially mortgage credit, would wind up being higher than we currently anticipate. And that would help compensate for the negative impact [of higher rates] on revenues.”


The strength of the euro is the factor largely responsible for expectations that interest rates won’t rise in the medium term – or might even decline from their current level of 2%. The strong euro also affects how Spanish banks are making out in Latin America, a major business destination for Spanish banks, especially the two largest banks, BBVA and SCH. Fluctuations in Latin American currencies regularly keep pace with the dollar, which lost more than 20% of its value with respect to the euro over the past year. Experts anticipate that the dollar will depreciate by an additional 10% in 2004. If that happens, it will be an obstacle for those Spanish firms that have invested the most in Latin America and want to repatriate their revenues. According to Merrill Lynch, “The [Latin American] region contributes about 40% of the earnings of Santander (SCH) and 30% of the earnings of BBVA.”


Regardless of how currency markets evolve, prospects for the Latin American region “are slightly more optimistic for 2004,” notes Vadillo. In his opinion, the favorable factors for banks are “an environment of greater economic growth in the zone, which could amount to 4%, together with the stability of the major source of risk – interest rates that investors are prepared to pay.” Vadillo believes that banks will grow because the volume of credit and commissions will expand, yet costs will remain under control. Vadillo expects that the best markets for the banks will be Brazil, Chile, and Mexico. If Mexico does well, it will be especially good news for BBVA, which has a high level of exposure in that country.


Given those conditions, most brokerage firms predict that the major Spanish banks will expand their profits by more than 10% in 2004. Banking executives express the same degree of confidence. On January 22, Banco Popular announced that its profits grew by 13% last year, and it expects profits to grow significantly over the next three years. The bank’s target for 2006 is one billion euros, compared with its earnings of 714.2 million euros in 2003.


The Impact of BasleII

Looking beyond earnings, Spanish banks now face a combination of conditions that will change the face of the sector in coming months. The most important factor is Basle II, as the newly emerging agreement over banking capital is now called. This pact will lay the groundwork for regulating the solvency of financial institutions throughout the world.


The pact’s Committee of Banking Supervision is presided over by Jaime Caruana, who is also governor of the Bank of Spain. By the middle of this year, the committee hopes to complete the text of the accord, which will substitute for Basle I, which is currently in effect. The current system has been criticized for its excessive simplicity. For example, it grants the same level of risk to loans provided to Telefónica (the Spanish telecom giant) as loans granted to, say, an Internet start-up firm.


Until now, Basle II has been criticized for precisely the opposite reason. Critics say Basle II regulations are too complex. The basic concept is based on three pillars. First, in order to calculate credit risk, institutions can now choose between pursuing a standard model – similar to the current one but with more sensitivity to risk – or they can draw up a their own system for risk measurement. Second, supervisors will have to perfect their own financial control systems because they will have to respond to the systems that each bank operates. Finally, the system asks for greater transparency on the part of financial institutions, so that the marketplace has total knowledge of the models that each bank is following.


The new norms will take effect by the end of 2006, and they are expected to create a revolution for financial institutions. The precise impact of the norms on each bank will depend on which [risk-management] model each bank implements. However, the impact is already developing along these general lines: Those businesses that benefit the most will be mortgage banks and private institutions, because their loans use fewer of those institutions’ resources. Meanwhile, investment banks will suffer, along with those institutions that are most exposed to risk. This includes those banks that have significant exposure in emerging markets and/or portfolios of loans to industrial firms.


Although the new regulations are still subject to major changes, analysts at Urquijo Bolsa, a Spanish brokerage house, foresee two reasons why Spanish banks will benefit. “In the first place, the rules will reduce the (level of) capital necessary to meet their mortgage risks. That’s the most important asset-based product for customers at Spanish retail banks, amounting to 46% of the total credits granted by the private sector. Second, generally speaking, the Bank of Spain’s solvency requirements are stricter than those that will be required under the international norms (set up by Basle II).”


As for the damaging impact of Basle II on Spanish institutions, Urquijo notes that the rules “will allocate a higher level of capital to Latin American risk and to industrial borrowers.” The Urquijo analysts believe that “the new accord, along with the application of new international accounting norms that toughen the treatment of earnings that derive from shareholdings, could inspire the two largest Spanish banks to continue to unload their shares in industrial and banking firms.”


According to Vadillo, Santander and BBVA could move to cash in some of their significant capital gains this year. The two banks have gains amounting to about 3 billion euros in the case of Santander, and 1 billion euros for BBVA. However, both institutions have said they intend to keep some of their major shareholding positions because of strategic considerations. That’s the case for Santander’s ownership in Royal Bank of Scotland and BBVA’s ownership of both Telefónica and Iberdrola.


It is hard to estimate the ultimate impact Basle II will have on Spanish banks, according to Maroto. The precise wording of the agreement is still being worked out, and its ultimate impact will depend on the risk-measurement models that institutions choose. But Maroto is certain that the pact “is going to lead to very important changes in the sector, since institutions are going to have to make major changes in their [risk-management] systems.” In any case, Maroto agrees that those institutions that develop their own systems will suffer the least damage. “The less efficient they are, the higher their costs are going to be.”


Will the Process of Consolidation Affect Spain?

Another major topic for 2004 is the growing concentration of the banking sector that results from the improvement in economic activity. In mid-January, the second American merger deal in barely three months was announced, the $58 billion dollar purchase of Bank One by JP Morgan Chase. Last November, Bank of America announced its acquisition of FleetBoston.


According to analysts at Britain’s HSBC bank, “these recent acquisitions have increased expectations for consolidation in Europe, whether it’s through deals made by the European firms themselves or on behalf of American banks who want to make purchases.” The market seems to be ignoring German and Italian institutions, which are in the process of restructuring. Eight of the 17 European banks that performed best on the stock market in 2003 had one of those two nationalities.  According to Beat Wittmann, investment director at Clariden, a Swiss investment bank, the current structure of the German financial system is unsustainable. “Look at Commerzbank. Its profits are so low, even those people who are interested in buying another bank aren’t asking about the price of Commerzbank.”


Very few experts believe Spanish institutions will take part in the next wave of consolidation, despite the fact BBVA has reiterated that it intends to make purchases. The experts also discount the fact Banco Popular has said it is open-minded about making new acquisitions now that it is getting strong results from its ownership in BNC, a Portuguese bank. “I don’t believe that the big Spanish banks will make a move unless they can make an acquisition that gives them an obvious leg up on their competitors,” says Maroto. “For example, BBVA would like to buy Caja Madrid, but its problem is that a bank cannot buy a ‘Caja.’ [an institution  more akin to a savings bank.] ”


Moreover, recent instability in Latin America, where Spanish banks have placed a significant share of their bets, could create doubts about the wisdom of making new acquisitions in international markets. That seems especially likely after 2003, when the major banks found out that Spain itself was the market where their business was strongest. In a recent essay, Angel Berges, professor of financial economics and accounting at the Autonomous University of Madrid, recalls a key reason why Spanish banks were losing market share in recent years. “The two big [Spanish] banks carried out their globalization gamble, which meant they abandoned local markets, relatively speaking. They allocated resources to their globalization strategy, especially Latin America.” Berges’ essay appears in the book, The Economic and Financial Integration of Spain.


According to Berges, “The major Spanish banks are confronting a dilemma of globalization – whether it makes sense to focus on globalization to the detriment of traditional markets. This situation is nothing more than a particular version of the rethinking process that major global banks are now undertaking concerning their strategies for providing a comprehensive menu of services in order to beat out those banks that are more specialized.”