Market Structure and Competition in the Banking Sector Finance Essay

The rapid economic convergence of Spain in the European Union in the last decade has been mirrored by an equally rapid expansion of its banking industry the Spanish banking sector's total assets over GDP expanded from 70 to 80 percent of the EU average. At the end of 2007, total assets held by the banking sector amounted to 280 percent of GDP; 110 percentage points higher than in 1997. The Spanish banking sector comprises four types of institutions: (Bank of Spain, data available at 13 April 2010) AA Commercial banks - 154 entities, accounting for 54 percent of total credit institutions' assets, of which 53 are Spanish-owned, 17 are subsidiaries and 80 are branches of foreign institutions. Domestic banks are generally market-traded entities mostly engaged in retail banking; AA Savings banks (Cajas) -46 entities, with a market share of 40 percent. They are "not for profit foundations" with strong local government and/or autonomous communities' participation. They are not listed or traded in the stock market. AA Cooperative banks - 83 entities, with a market share of 4 percent. They are organized under the umbrella of Banco Cooperativo Español. They provide services based on membership, but can also offer some financial services to third parties as do other credit institutions. AA Specialized credit institutions (SCIs) - 69 entitites, with a market share of 2 percent. Although carrying out most of the activities of credit institutions, they are prohibited from receiving repayable funds from the public in the form of deposits, loans, temporary assignment of financial assets, or other comparable instruments.

Mergers of savings banks, or cajas, are subject to respective regional governments' approval. Cajas cannot be purchased by private individuals or institutions due to their legal nature, but they can acquire other companies and credit institutions. Nevertheless, cajas' assets and branches can be purchased by individuals, private companies and commercial banks. For more details, see FSAP (2006) "Technical Note on Regulation, Supervision, and Governance of Spanish Cajas," (IMF Country Report No. 06/215). September 2010 European central bank.

Market structure indicators, such as the Herfindahl Index or the share of total assets of the five largest institutions, indicate that the d concentration in Spain, albeit increasing, has remained one of the lowest in the EU (Table AA). A number of studies have investigated banking competition in Spain and results tend to indicate that, on average, banking competition in Spain is intense, including in comparison with that in peer countries.

51. Alongside commercial banks, savings banks have been a major force in extending services and in fostering competition. Since reforms in late 1970s, savings banks have gradually reduced their regional specificity and expanded their range of activities.53 Many medium-sized savings banks have strengthened their national presence becoming solid competitors to commercial banks. Their market share has steadily increased from 35 percent in 1999 to 40 percent in 2007.

52. With the exception of the two largest players, the Spanish banking system remains essentially domestic (Table 3). After building up franchises in Latin America, Santander and BBVA have expanded in other markets as well. Santander is now a significant player in the U.K. (Abbey National PLC and Alliance & Leicester PLC),54 in pan-European consumer finance, and a smaller participant in the US (Sovereign Bank). BBVA has a non-negligible presence in the U.S., mainly through Compass Bankshare. Foreign activities are estimated to account for nearly half of both institutions' earnings in 2008. Other banks have small subsidiaries outside Spain, such as Banco Popular (Portugal and Florida), Caja Madrid (Mexico), and Banco de Sabadell S.A. (Mexico and Florida), while La Caixa (caja from Catalonia) has expanded internationally with acquisitions of Mexico's Grupo Financiero Inbursa and Hong-Kong based Bank of East Asia.

B. Main Trends

53. Convergence associated with EMU entry spurred a credit boom that abruptly ended with the outbreak of the global financial crisis in mid-2007. Interest rate convergence, both in anticipation of and since EMU membership, fueled domestic credit growth (Figure 4). Over the period 1997-2007, credit to the non-financial private sector has increased at an average of 17 percent; about two-and-half times nominal GDP growth.

54. Credit expansion was especially pronounced in the construction and real estate market. Bank activity has gradually shifted away from interbank lending and lending to the government and the manufacturing sector, to financing construction and real estate activities

(Figure 5). As of end-June 2008 exposure to real estate financing amounted to 60 percent of total credit to the nonfinancial private sector, compared to 40 percent in 1997. While savings banks have the highest exposure, commercial banks are those that most significantly reoriented their domestic activity. Increased competition for lending to real estate developers has led some institutions to take on added risks by forming joint ventures with real estate developers-banks granting loans and sometimes taking an equity stake. It is estimated thatm this type of lending exceeds the equivalent of 5 percent of Tier 1 capital on average, and can reach as high as 80 percent of Tier 1 in specific cases.55

53 As part of the deregulation process, savings banks were allowed to carry out universal banking activities starting in 1977.

54 Amid the U.K. banking crisis, Santander also bought the branches and deposits of Bradford & Bingley. 39

55. Since growth in customer deposits has not kept pace with domestic credit expansion, banks have increasingly tapped international capital markets. Between 1997 and end-2007, domestic deposits grew at an average rate of 12 percent, thus financing only part of the credit expansion of 17 percent. As a result, the loan-to-deposit ratio climbed welln above the Euro-area average. Securitization facilitated access by credit institutions to foreign savings (Figure 6). Credit institutions have established securitization funds, which in turn have issued their own securitization bonds, mainly covered mortgage bonds (cédulas hipotecarias, CH). Given the soundness of the issuer, the quality and size of the mortgage portfolio, and the level of over-collateralization, resulting from sound regulation, these securities were attractive to foreign investors.56 Outstanding balances of Spanish

55 Moody's April 2008.

56 The new Mortgage Law (Law 41/2007) further strengthens the regulatory framework of CH; in particular:

1.  it creates a special register for all mortgage loans and credits forming the collateral;
2.  it reduces the loan-to-value ratio for commercial mortgage loans from 70 to 60 percent while keeping the one for housing loans at 80 percent (both ceilings may rise respectively to 80 and 95 percent if there are appropriate and sufficient additional guarantees);
3.  it increases the minimum legally required over-collateralization from 11 to 25 percent; and
4.  it provides for the possibility of including specific liquid and low-risk assets in the pool of collateral underlying the CH issue (up to 5 percent) from 18 billion (3 percent of GDP) in 2000 to 350 billion (33 percent of GDP) in 2007. 

57 Spanish CHs currently represent the second biggest Jumbo segment in European covered bonds after the German pfandbriefe.

58. In recent years, the Spanish banking industry has enjoyed significantly higher profitability than EU peers, despite lower leverage (Figure 7). While high volumes of intermediation have contributed to this result, higher trading and fee income as well as enduring cuts in operating costs have been important drivers.

57 It is important to note that the Bank of Spain has adopted stringent criteria regarding risk transfer and control of special purpose entities. Both steps have reduced drastically the incentives for off-balance sheet securitization and the resulting capital relief opportunities.

58 Jumbo issues amount to at least a billion euros.

57. To gauge the contribution of different factors, an algebraic breakdown of banks' return on equity (ROE) has been undertaken (Box 2, Figure 8). The results indicate that while savings banks' financial strength (net income over net operating income) has remained broadly unchanged, commercial banks and cooperatives have experienced some decline in this indicator in the last years, mainly reflecting provisioning expenses and write-downs. In the case of commercial banks, this development has been partially compensated by continuous improvements in cost efficiency whereas savings banks and cooperatives have witnessed some increase in the burden of their administrative expenses, consistent with the expansion of their branch networks. While increasing leverage ratios may have weighed on credit institutions' vulnerability to shocks, improving (or undiminished) risk-adjusted asset productivity, more prudent risk strategies (as indicated by declining risk-weighted to total the impact of the ongoing global financial turmoil

59. The outbreak of the financial crisis in summer 2007 has severely affected the operating model of the Spanish banks. With wholesale funding drying up, Spanish banks have started restructuring their balance sheets. On the asset side, credit institutions have slowed lending growth and tightened credit standards. On the liability side, they have tapped more extensively ECB refinancing facilities by doubling access from A¢”šA¬22 billion in the pre-crisis period to A¢”šA¬49 billion recently. Since other banking systems also expanded their recourse to the ECB, Spain' access has remained broadly in line with that of Euro-area total assets (Figure 11). Banks have also competed fiercely for customer deposits, largely at the cost of redemptions from mutual funds.

60. Banks' operating environment has deteriorated more rapidly and severely than expected. Given their retail-oriented nature, Spanish banks have not been directly affected by the US subprime crisis and its ramifications.60 Nevertheless, they have to face with the bleak economic situation. Domestic economic slowdown and banks' deleveraging have been mutually reinforcing. Households and the corporate sector are highly indebted. Unemployment is rising. The housing market is rapidly cooling off. The corporate sector is facing increasing cash-flow and liquidity problems. Several large real estate developers have filed for bankruptcy. Against this environment, NPLs have increased rapidly but from a very Spanish banks' total direct gross exposure to Lehman was estimated at US$700 million, with BBVA having the largest exposure with US$100 million. However, both Santander and BBVA were caught off guard by the Madoff fraud scandal. While Santander's direct exposure was reportedly minimal (17 million), Santander's clients who invested in the bank's Optimal Strategic hedge fund, had an exposure of 2.3 billion. BBVA reported  300 million losses from its activities related to Madoff Investment Securities low base.

61 Loans to the construction and real estate sectors have witnessed the most marked deterioration (Figure 12). As a result, savings banks have been most affected owing to their large exposure to the real estate sector. While banks' provisions are still at a comfortable level, the extra cushion provided by dynamic provisioning is falling rapidly.

61. As a consequence, and despite broadly positive results in 2008, market sentiment on Spanish banks has turned mixed. While Santander and BBVA continued to record high net income in line with market expectations, their stock prices have declined significantly, reflecting generalized market risk aversion and in anticipation of very difficult market conditions yet to come (Figure 13). When the financial turmoil heightened in the autumn, their CDS spreads trended above those of (retail) peers (investment banks fared much worse), 61 As of end-2007, NPLs amounted to less than 1 percent of total loans; half of the EU average mainly owing to the sharp deterioration in the Spanish economic outlook and their large exposures to emerging markets, especially in Latin America. Since then, however, CDS spreads have returned in line with those of retail peers, in part helped by the two institutions' successful market-based capital increases.62 Small banks and savings banks have been

62. Like other European countries, the Spanish government has taken a number of exceptional measures to shore up confidence in the financial system (Box 3). As part of the package, the Spanish government established a  30 billion fund (which may be raised to 50 billion) Fondo para la Adquisición de Activos Financieros (FF)-to provide liquidity to the banking sector by purchasing, on an outright or temporary basis, high quality bank liabilities (asset-backed securities with 3-5 year maturity).

Box 3. Spanish Government Assistance to Banks

Following the common framework agreed by euro-area countries, the Spanish government has taken the

following exceptional measures:

 The limit of the deposit guarantee was raised from  20,000 to ¬100,000.1/  30 billion fund (which may be raised to  50 billion) was established to purchase high quality asset-backed securities issued by credit institutions: the FF.2/ The operations can take the form of outright purchases or long-term swap operations (12 months or longer). Asset eligibility is slightly different in the two cases. In particular, outright purchases can be carried out for CHs and securities backed by CHs issued before October 10, 2008, traded (or in the process of being traded) in a regulated market, carrying a triple-A rating, and with a maturity no longer than the one specified in the auction. In the case of swap operations eligible assets comprise CHs and securities backed by CHs, or credit to individuals or non-financial companies and institutions provided that these securities have been issued after August 1, 2007, meet the ECB's eligibility requirements, and carry at least a rating of double-A. The FF consists of two separate portfolios; one for each type of operations. To safeguard a sufficient diversification, the FF cannot allocate more than 10 percent of its resources in each portfolio to a single entity. The FF's operations are conducted through an American-Type Auction; a fraction may also be allocated through non-competitive auctions. In each auction, individual allotments cannot exceed the lowest between the above-mentioned 10 percent limit of FF's portfolio and the result of the product between 2.5 times a credit institution's share in total credit to the domestic non-financial private sector and the amount offered.

 Government guarantee may be provided for credit institutions' new debt issues. The amount of the scheme approved in 2008 is  100 billion to be used by mid-December 2009.3/ A possible additional  100 billion might be allotted in 2009 if market conditions do not improve. As agreed within the EU, the pricing depends on debt maturity, CDS spreads, and rating of the originators: Table 4. Spain: Pricing of the Government Guarantee Maturity Commission Fee Less or equal to 1 year Flat fee of 50 bp.Greater than 1 year Flat fee of 50 bp plus: For beneficiary institutions with CDS data; the lowest between:

1) the median of the 5 year CDS spreads calculated over the period January 1,2007 - August 31, 2008;

2) 36.5 bp for institutions with  rating;

3) 44.8 bp for institutions with A rating. For beneficiary institutions without CDS data, or without representative CDS data, but with a credit rating:

1) 36.5 bp for institutions with  rating;

2) 44.8 bp for institutions with A rating.

For beneficiary institutions that are not comprised in the previous two categories, 44.8 bp plus a supplementary annual fee of 10 bp.  If necessary, credit institutions' re-capitalization may be carried out through the government's acquisition of non-diluting instruments such as preference shares.3/

1/ Royal Decree 1642/2008, October 10, 2008.

2/ Royal Decree Law 6/2008, October 10, 2008.

3/ Royal Decree Law 7/2008, October 13, 2008.

The impact of the credit system

The real estate crisis has had an inevitable impact on the banking system. At the end of 2009, loans to this sector were classified as a bad debt of 9.6% of loans ( 43 billion), but still far from a high incidence reached 13% in 1993. A special investigation by the Central Bank, however, stressed that to have a complete picture of the situation must also add to the suffering of  59 billion of other loans uncertain recovery,  60 billion of real estate acquired by banks in payment for loans in the past and  4 billion of loans already written off entirely (write-offs). In short, the downturn in the property sector is thus weigh on the banking sector to  165 billion, 37% of total loans to this sector. Although this is a significant amount, it should not result in system-wide problems of stability since the specific provisions covering these loans to 26%, rising to 35% if you add the general provisions available. The Bank of Spain also estimated that the overall coverage may be increased to 70% if the operating income in 2010 was only equal to that of the previous year. With the exception of finance companies in the real estate sector (about 18% of the loan portfolio), the quality of the portfolio of Spanish banks as a whole appears reasonable given the severity of the economic situation.

A crisis manageable

According to the research department of BNL, "the situation of Spanish banks is attracting too much attention, perhaps especially when compared with the weakness shown by other European banking systems, such as is the case of Germany." Despite an increase of 65% of provisions, the Spanish banking system ended 2009 with net profits (nearly 20 billion) in limited flexion (-20%), achieving a non-marginal increase of the two main indicators patrimonalizzazione (tier 1 to 9.7% an increase of 1.3 percentage points to 8.1% core tier 1 an increase of 1 percentage point). Detail is not secondary, the increase of these two reports is due entirely to increase the number (net worth +13%) compared to a denominator (risk-weighted assets) remains unchanged. Even the effect of this increase, ROE (Return on Equity) fell by almost three percentage points, ranking still 9%, the highest level in Europe (3.6% in the case of Italy).

La crisi del settore immobiliare ha avuto un inevitabile impatto sul sistema creditizio. A fine 2009 i prestiti a questo settore classificati in sofferenza risultavano pari al 9,6% dei prestiti erogati ( 43 mld), un'incidenza elevata ma comunque lontana dal 13% toccato nel 1993. Una apposita indagine della Banca Centrale, tuttavia, ha messo in rilievo che per avere una completa rappresentazione della situazione bisogna aggiungere alle sofferenze anche  59 mld di altri prestiti di incerto recupero,  60 mld di proprietà immobiliari acquisite dalle banche in pagamento per prestiti concessi in passato e  4 mld di prestiti già interamente svalutati (write-offs). In definitiva, la sfavorevole congiuntura del settore immobiliare risulta così pesare sul settore bancario per  165 mld, il 37% del totale dei finanziamenti a questo settore. Seppure si tratti di un importo rilevante, non ne dovrebbero derivare a livello di sistema problemi di stabilità considerato che gli accantonamenti specifici coprono questi prestiti al 26%, percentuale che sale al 35% se si aggiungono gli accantonamenti generici a disposizione. La Banca di Spagna, inoltre, calcola che la copertura complessiva potrebbe essere portata al 70% se nel 2010 il risultato operativo fosse solo pari a quello dell'anno precedente. Se si escludono i finanziamenti alle società del settore immobiliare (il 18% circa del portafoglio prestiti), la qualità del portafoglio delle banche spagnole appare nel complesso discreta considerata la gravità dell'attuale congiuntura economica.

Una crisi gestibile

Secondo l'ufficio studi di Bnl "la situazione delle banche spagnole sta attirando un'attenzione forse eccessiva soprattutto se confrontata con la fragilità evidenziata da altri sistemi bancari europei, come ad esempio è il caso della Germania". Malgrado una crescita del 65% degli accantonamenti, il sistema bancario spagnolo ha chiuso il 2009 con un utile netto (quasi 20 mld) in limitata flessione (-20%), conseguendo anche un aumento non marginale dei due principali indicatori di patrimonalizzazione (tier 1 al 9,7% in aumento di 1,3 punti percentuali e core tier 1 a 8,1% in aumento di 1 punto percentuale). Dettaglio non secondario, l'aumento di questi due rapporti è dovuto interamente all'aumento del numeratore (risorse patrimoniali +13%) a fronte di un denominatore (attività ponderate per il rischio) rimasto sostanzialmente invariato. Anche per effetto di questo incremento, il RoE (Return on Equity) è sceso di quasi tre punti percentuali, posizionandosi comunque al 9%, livello tra i più alti in Europa (3,6% nel caso dell'Italia).

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