Abstract: Spain’s banks appear to have more reason for optimism in 2017 than they did in 2016 ‒ a year marked by uncertainty and market jitters since its onset. The scrutiny of the European and international institutions and the efforts made by the sector itself appear to have translated into a significant improvement in the robustness and earnings prospects of the Spanish banks, which are nevertheless still making adjustments, significant in some cases, in a market environment that still cannot be described as risk-free. Relative to the eurozone as a whole, the Spanish banks continue their ‘deleveraging’ effort in an attempt to match supply with the new demand paradigm. However, the prospects for credit are improving little by little. Spanish banks also appear to present a relative advantage in terms of their cost-to-income ratios and income-generating capabilities. Two-thirds of the gross operating income generated by the banks in the single currency area are gobbled up by their administrative and wage costs, compared to just half in Spain. Finally, the Spanish banks’ Tier 1 capital ratio rose from 11.87% to 14.96% between 2010 and 2016 ‒ somewhat below the eurozone average, but comfortably above regulatory requirements and demonstrating reinforced transparency. Going forward, both Spanish and eurozone banks face a challenging international context, mainly due to uncertainty surrounding Brexit implementation, potential spillover effects from US financial deregulation, and the upcoming stress test exercise.

• A unique effort to step up transparency (beyond the usual regulatory requirements) in a bid to dispel doubts about the quality of their assets.
• A deeper restructuring effort which has driven a bigger adjustment in supply and demand for retail banking services in Spain; this effort, moreover, remains intense.
• Application of a broad package of requirements as a result of the financial aid provided by the EU, notable among which the assumption of bail-in mechanisms, even though: a) at the time the Single Resolution Mechanism had yet to be set in motion; and, b) these mechanisms have not been applied in Italy despite being effective since January 2016.

That being said, Spain continues to display certain tendencies that are evolving in line with those unfolding in the rest of the eurozone. The most recently updated figures in the European Central Bank’s Statistical Data Warehouse enable a comparison of the Spanish banks relative to the eurozone average as of September 2016. The first thing that jumps out is the deleveraging process: total banks assets have been contracting sharply since 2015 (Exhibit 1) and although there was a brief let-up towards the end of 2016, there are few signs of a recovery that would suggest that the size of the eurozone banking sector will increase any time soon.

Where the Spanish banking sector continues to evidence the higher indebtedness of the private sector relative to the European average is on the ‘loan-to-deposit’ ratio (Exhibit 6). This simple ratio provides an approximation of how much of the credit awarded has been backed up by the banks’ main source of liquidity: Deposits. In Spain, despite the cumulative drop in outstanding credit, the loan-to-deposit ratio stood at 94.2% in September 2016, having risen from 90.9% in 2014. However, the eurozone has continued in the opposite direction, with the average falling from 102.2% in 2014 to 100.7% by September 2016.

• One of the most controversial: Brexit. The triggering of this process in March 2017 is particularly important for the Spanish financial institutions on account of their exposure to the UK market. In fact, as illustrated in Exhibit 8, the Spanish banks were the only institutions among the major European countries to increase their exposure to the UK in the year prior to the referendum of June 23^rd, 2016. Specifically, by 21.97 billion euros. This increase, however, should be viewed against the backdrop of the Spanish banks’ relative presence in the British market and their recent acquisitions. Moreover, as outlined in the last edition of SEFO, the risk of changes in the regulatory environment governing Spanish banks operating in the UK market do not appear excessive, although it is too soon to calibrate these changes.
• Financial deregulation pressure stateside: although this issue is still on his ‘wish list’ and lacks concrete form, President Trump has suggested that the regulations brought in under the Dodd-Frank Act are excessive and inappropriate and should be largely rolled back. If he were to do this, dismantling much of this legislation without introducing sufficient counterbalances, it could turn out to be an error of gigantic proportions for two reasons. Firstly, because it could lead to the assumption of inadequate risk by the US and a proliferation of ‘shadow banking’ activities. And secondly, because it would seriously damage already-tenuous international financial coordination, an effort which at least has found a certain amount of common ground and success on certain aspects, such as capital adequacy. This loss of coordination could catch the eurozone off-guard at a particularly delicate time given the evident fragility of the banking union’s financial architecture in the face of the Italian banking crisis.
• Lack of transparency benchmarks: The European Banking Authority faces a major challenge in 2017. This year there will be just one transparency exercise in the banking sector, while the next stress tests have been put off until 2018. The Italian banking crisis and lingering questions about certain institutions suggest that this transparency exercise could go in either direction. It could turn out well if sufficiently stringent and robust. But it could also turn out badly if, as until now, it overlooks important risks that end up materialising in the form of fresh episodes of bank stress, as happened with Monte dei Paschi di Siena. For the Spanish banks, this transparency exercise may prove the definitive opportunity for showing that the market is correctly assessing relative risk factors.