Spain's banks can expect a boost to revenues as the European Central Bank looks to tighten monetary policy and mitigate the impact of withdrawing a key cheap funding program.

With inflation running high, the ECB would consider raising interest rates after it completes its bond-buying program, which it hopes to do in the third quarter, President Christine Lagarde said earlier in March. Eurozone banks could pass higher rates on to borrowers, boosting margins at Spanish banks such as Banco Bilbao Vizcaya Argentaria SA and Banco de Sabadell SA, which have endured years of declining net interest income, or NII, amid negative interest rates and the economic impact of coronavirus.

"Falling NII for Spanish banks looks like it is going to be an old problem given how inflation and market interest rates are behaving, and how ECB expectations are changing," Pablo Manzano, vice president, financial institutions, at credit rating agency DBRS Morningstar, said in an interview.

Spanish banks have already voiced some confidence about the outlook for NII. BBVA expects flat to slight growth in NII in Spain in 2021, excluding targeted longer-term refinancing operations, or TLTRO, and regardless of any hike in interest rates, the bank said in an emailed statement. "Potential higher rates in Europe will be a tailwind," it said. CaixaBank SA expects NII to trough in the first quarter, CFO Javier Pano said on an earnings call in January.

Lack of interest

BBVA's, Sabadell's, CaixaBank's and Banco Santander SA's domestic businesses all have an above-average reliance on NII when compared to large European peers. For each of them, NII as a percentage of total revenue in their home market runs at more than 50%, and for CaixaBank it is almost 64%.

NII from domestic operations declined at three of Spain's four largest banks in 2021, compared with 2020. Two of the banks, Banco Bilbao Vizcaya Argentaria SA and Banco de Sabadell SA, have seen NII in Spain fall for at least six consecutive years. CaixaBank SA suffered the biggest 2021 drop, of 6.1%. NII is the revenue generated from interest-bearing assets minus the expenses associated with liabilities such as deposits.

Banco Santander SA, which like BBVA does a large part of its business in emerging markets where net interest margins are more attractive, saw NII in its home market edge up by 0.9% in 2021 to €3.99 billion. NII in Spain has been stable for Santander since it integrated Banco Popular Español SA in 2017, although it has failed to beat its 2018 NII performance of €4.09 billion in every year since. Banco Popular Español SA

Lack of interest

Net interest margins — a measure of the difference between interest received and interest paid, adjusted for the total amount of interest-generating assets held by a bank — at all four lenders' domestic businesses have shrunk in the last two years, according to company filings. CaixaBank's NIM suffered the largest contraction, dropping by 31 basis points to 0.87% in the fourth quarter of 2021 from the same period in 2019.

Banks in Spain faced a variety of pressures on NII in 2020 and 2021 beyond the record low interest rates of recent years. The Spanish government's response to the COVID-19 pandemic involved a €140 billion state-guaranteed loan scheme to help impacted businesses, which banks were obliged to offer at attractively low rates to applicants, squeezing NII, said Manzano.

The pandemic stifled loan growth as the Spanish economy struggled to absorb an unprecedented shock, and generated a surge in deposits at the banks as lockdowns and restrictions forced consumers to save. Higher deposits reduce NII for banks as they must pay more interest to depositors holding their cash at the bank, unless a lender chooses to charge negative interest rates on deposits, which some European banks do.

Some of those headwinds are likely to feed through into 2022, said Benjie Creelan-Sandford, bank equity analyst at global investment bank Jefferies. Further pressure could come from a slowdown in new lending as Russia's invasion of Ukraine impacts eurozone growth, said Manzano.

Supportive measures

Concerns that eurozone banks could face a further hit to NII from the completion of the ECB's third TLTRO program, which is due to end in June, may be alleviated by ECB action to soften the blow, according to Pau Labro Vila, director, financial institutions, Fitch Ratings.

The TLTRO programs, the first of which started in 2014, have offered banks long-term funding with attractive conditions — mostly at negative interest rates — aimed at stimulating bank lending to the real economy. The end of the program will see banks' funding costs rise while their cost of reserves due to negative rates will remain, squeezing NII. Reserves are deposits the banks must hold at the ECB.

There is market consensus that the ECB will move to exempt a larger multiple of banks' reserves from negative deposit facility rate charges, at least until it eventually raises the rate, said Labro Vila. The central bank's current deposit tiering framework exempts part of banks' excess liquidity holdings at an amount of 6x a bank's required reserves, plus required reserves themselves.

"The TLTRO effect will not be as strong as in 2021, but still we should expect some support for NII from this policy by the ECB," Labro Vila said.

Santander declined to comment for this article. CaixaBank was unable to provide a response before publication. Sabadell did not reply to a request for comment.

Euribor pickup

Further support for Spanish banks' NII in 2022 is already appearing from market interest rates. The Euribor 12-month lending rate has recovered from a record low of negative 0.518% on Dec. 20, 2021, to hit negative 0.232% on March 16, despite having dipped by around 10 basis points in the two weeks either side of Russia's invasion of Ukraine.

"Euribor, which is a key reference rate for the Spanish mortgage book, has started to increase over the past couple of weeks, which means that even ahead of formal rate hikes from the ECB, that's going to feed through into numbers in the first quarter and be a partial support," said Creelan-Sandford.

Even without an ECB interest rate rise in 2022, there is enough evidence to suggest that NII for Spanish banks will not fall any farther than it has done in recent years, said Cristina Torrella, senior director, financial institutions, Fitch Ratings. Any rise in interest rates would be a "positive add-on," added Torrella.

"Spanish banks are well positioned to benefit from interest rate rises," Torrella said.