THE RECOVERY OF THE SPANISH ECONOMY AND RECENT

DEVELOPMENTS OF THE BANKING SYSTEM

Fernando Restoy

Deputy Governor, Banco de España

CENTRAL BANKS SEMINAR, CRÉDIT AGRICOLE

Madrid

26 October 2016

OUTLINE

22

The recovery of the Spanish economy and its drivers

The banking sector2

1

2.1 Challenges

2.2 Possible responses

3

1. A SUSTAINED RECOVERY

SPAIN EURO AREA

• The Spanish economy has completed three years of sustained expansion,

with growth in activity and employment above that of its euro area partners.

• Price increases have been more moderate than in the whole euro area,

allowing for sizeable competitiveness (re)gains.

SOURCES: INE and Eurostat.

-0,6

-0,4

-0,2

0,0

0,2

0,4

0,6

0,8

1,0

1,2

2013 2014 2015 2016

GDP(q-o-q growth rate)

%

-1,5

-1,0

-0,5

0,0

0,5

1,0

1,5

2013 2014 2015 2016

EMPLOYMENT(q-o-q growth rate)

%

-2,0

-1,5

-1,0

-0,5

0,0

0,5

1,0

1,5

2,0

2,5

3,0

3,5

2013 2014 2015 2016

Headline inflation rate (HICP)(y-o-y growth rate)

%

4

1. STRUCTURAL FACTORS BEHIND THE RECOVERY: COMPETITIVENESS GAINS IN LABOUR AND FINANCIAL COSTS…

• On top of some temporary elements, the recovery is explained by several

factors of a more permanent nature.

• Particularly relevant is the improvement in competitiveness, both in terms of

relative labour costs and in terms of relative financing conditions.

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0

2012 2013 2014 2015 2016

LOANS TO NON-FINANCIAL CORPORATIONS. LOANS < € 1m. SPAIN

LOANS TO NON-FINANCIAL CORPORATIONS. LOANS < € 1m. Core euro area

LENDING RATES. NON-FINANCIAL CORPORATIONS

%

SOURCES: INE, Eurostat, ECB and Banco de España.

(p) Projections of BdE and ECB.

90

95

100

105

110

115

120

2000 2002 2004 2006 2008 2010 2012 2014 2016 (p)

ULCs COMPENSATION PER EMPLOYEE PRODUCTIVITY PER EMPLOYEE

UNIT LABOUR COSTS IN SPAIN RELATIVE TO THE EURO AREA

2000 = 100

5

…THAT ARE LARGELY ATTRIBUTABLE TO RECENT REFORMS IN THE LABOUR MARKET AND THE FINANCIAL SECTOR

• The 2012 labour market reform opened new venues of internal flexibility for firms,

favouring wage moderation and supporting the recovery of employment.

• The 2012-2013 financial sector reform (balance-sheet cleaning, recapitalisation,

restructuring) contributed to a significant reduction in the banks’ cost of funding, that

they passed-through to lending rates.

0

2

4

6

8

10

12

2012 2013 2014 2015 2016

BANK SENIOR BONDS. YIELDS

SPAIN ITALY CORE EURO AREA

%

Source: Eurosystem Wage Dynamics Network Survey, 3rd wave.

Non-financial Spanish firms’ perceptions about the possibilities to adjust wages in 2013 with respect to 2010

%

Sources: Bloomberg, ECB and Banco de España

1. THE OUTLOOK

6

Projections (September 2016)

2015 2016 2017 2018

GDP 3.2 3.2 2.3 2.1Employment 3.0 2.9 2.0 1.8Inflation (CPI) -0.5 -0.3 1.5 1.6

• The expansionary phase will extend into the medium term albeit at a somewhat lower pace.

• Growth will continue to be employment-intensive and job creation will provide for further

reductions in the unemployment rate.

• GDP level pre-crisis will be achieved along 2017, but the fall in employment will be more

persistent.

SPAIN EURO AREA

85

90

95

100

105

110

2008 2010 2012 2014 2016 2018

REAL GDP2008Q2 = 100

75

80

85

90

95

100

105

110

2008 2010 2012 2014 2016 2018

EMPLOYMENT2008Q2 = 100

SOURCES: Eurostat, ECB, INE and Banco de España.

1. RISKS TO THE BASELINE AND CHALLENGES

7

Risks surrounding GDP projections: tilted to the downside

• External risks: associated with global developments: some emerging markets,

worldwide political tensions, uncertainty over the UK’s exit from the EU.

• Internal risks: uncertainty over the future course of economic policies in relation

both to the process of fiscal consolidation and to economic reforms.

Despite the progress made in the correction of imbalances, significant

challenges remain in place:

• Reducing still very high unemployment to acceptable levels

• Resuming fiscal consolidation

• Improving productivity growth

• Reducing the relatively high needs of external financing

OUTLINE

88

The recovery of the Spanish economy and its drivers

The banking sector2

1

2.1 Challenges

2.2 Possible responses

2. BANKING SECTOR: WHERE DO WE STAND?

99

• Efforts from regulators, supervisors and banks have materialised in an

improvement in capital positions: CET1 ratios have increased in practically all

European countries.

• Spanish banks show an increase similar to the EU average. In this case, the

evolution of RWA has not contributed to the increase.

• In addition, in Spain, there has been a big effort in balance sheet clean-up

(provisions) of approximately 300,000 mill.€ since 2008.

SOURCE: European Banking Authority.a The comparison is made for institutions that participated in the 2016 ST (except from Hungary), taking the data for these same institutions in the 2014 ST, and clustering by country. The orange diamond shows, for each country, the total change in the CET1 ratio from December 2013 to December 2015. Theblue and dark red bars show the portion of this change attributable to changes in CET1 capital and in RWAs, respectively. Positive bars denote an inter-period increase in CET1 capital and an inter-period reduction in RWAs, changes that would result in an increase in the CET1 ratio.

-2

-1

0

1

2

3

4

SE FI NO UK DK NL BE EU ES FR AT IT DE IE PL

CHANGE DUE TO RWA CHANGE DUE TO CET1 CHANGE IN THE CET1 RATIO

PERCENTAGE POINTS CHANGE IN CET1 RATIO BETWEEN DECEMBER 2013 AND DECEMBER 2015 (a)

%

10

2.1 CHALLENGES - PROFITABILITY

• ROE for Spanish banks of 6,8%, slightly above the SSM average.

• Low interest rates, uncertain macroeconomic developments and high NPL

levels weigh down on it and, in turn, on investors expectations (reductions of the

price-to-book value ratios).

• Although clearly below 1, Spain continues having a relatively better price-to-

book ratio than European peers.

SOURCE: European Banking Authority.Risk Dashboard June 2016 (198 entities)

SOURCE: Datastream.

ROE. EUROPEAN COMPARISON. JUNE 2016

0

2

4

6

8

10

12

IE BE AT NL FR ES SSMav.

EUav.

UK DE IT

%

0.00.10.20.30.40.50.60.70.80.9

31-Dec-15 25-Oct-16

SPAIN ITALY FRANCE GERMANY EURO AREA EUROPE

PRICE-TO-BOOK-VALUE RATIO OF THE BANKING SECTOR

11

2.1 CHALLENGES - NPL

• NPLs are still high… but decreasing (at a pace of approximately 9% in the euro area and 18% in Spain, y-o-y rates)

SOURCE: European Banking AuthorityRisk Dashboard June 2016 (198 entities).

-8-6-4-202468

-20

-10

0

10

20

IT IE SSMaverage

AT ES EUaverage

FR BE NL DE

JUNE 2016 PP CHANGE: JUNE 2016 / JUNE 2015 (Right-hand scale)

EU NPL RATIOS. June 2016

pp%

47 47

12

2.1 CHALLENGES - REGULATION

i) BCBS agenda: the challenge of improving risk measurement withoutsignificantly increasing capital requirements.

ii) MREL: it is likely to be a bindingrestriction for non-listed medium sizebanks.

Regulation

0%

10%

20%

30%

40%

50%

60%

70%

DE ES FR IT NL UK TOTAL

CORPORATE PORTFOLIO SUBJECT TO IRB. RWA DENSITY

December 2015

SOURCE: EBA, Stress Test 2016 (51 entities).

OTHER

NON-SSM PARENT

STATE OWNED

COOP. AND SAV. BANKS

LISTED

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

SSM SIGNIFICANT INSTITUTIONS BY OWNERSHIP STRUCTURE (JUNE 2016)

SOURCE: Banco de España

• 60% have not issued any AT1 instrument (e.g. convertible bonds)

• 21% have not issued any T2 instrument(e.g. subordinated debt)

13

2.2 POSSIBLE RESPONSES: EFFICIENCY

• Cost-to-income ratios have beenrelatively stable over the last years. Thereappears to be room for improvement.

• New technological developments shouldallow further gains in efficiency. Proximity to customers is less dependent on face-to-facecontact.

SOURCE: SNL. Significant institutions on which data are available each year; in the case of UK, the 5 biggest banks, in terms of total assets.

SOURCE: ECB (Structural Indicators), World Bank and Eurostat. a Data refer to 2014.

0

10

20

30

40

50

60

70

80

90

SPAIN SSM ITALY FRANCE UK GERMANY

2012 2013 2014 2015

COST-TO-INCOME

0.00

0.20

0.40

0.60

0.80

1.00

1.20

FRANCE GERMANY ITALY SPAIN UK (a) TOTALEUROAREA

2007 2011 2015

NUMBER OF OFFICES PER ONE THOUSAND INHABITANTS

14

• Room to improve fee income.

• Fintech is a challenge but also an opportunity for banks.

2.2 POSSIBLE RESPONSES: NEW PRODUCTS AND SERVICES

SOURCES: SNL (significant institutions on which data are available each year; in the case of UK, the 5 biggest entities, in terms of total assets) and Banco de España.

0

5

10

15

20

25

30

35

40

SPAIN SPAIN(Business in

Spain)

GERMANY ITALY FRANCE SSM UK

2013 2014 2015

NET FEE INCOME TO TOTAL OPERATING INCOME%

15

• The need to continue reducing costs will encourage mergers and acquisitions withineach country.

• In accordance with the HHI index, there seems to be room for consolidation in thelargest European countries.

• In any case, what is desirable is to have cross-border mergers and truly pan-European banks.

2.2 POSSIBLE RESPONSES: CONSOLIDATION

SOURCE: ECB (Structural Indicators)The euro area average is calculated as the average of the Herfindahl-Hirschman indices of each of the euro area countries, weighted by their total assets

0

500

1,000

1,500

2,000

2,500

3,000

DE AT UK IT FR IE Euroarea

average

ES BE PT NL GR FI

HERFINDAHL-HIRSCHMAN INDEXDecember 2015

Low concentration

Moderate concentration

High concentration