Clean-up Champions:Spanish Banks,Problem Assets and Life After Non-Core

Spanish Cleanup in the Final Inning — Banking system clean-ups go throughthree stages: 1) recaps; 2) realistic recognition of asset quality problems (non-coreunits, bad bank creation); and 3) proactive sales and recovery of problem, non-coreassets (PA). Spain, together with Ireland, is in the third and last stage while Italy,Portugal and Greece are in stage 1?. Yet, this final stage may be the longest: weestimate it would take another 7 years to run-off PAs. At 1.5x the 2015 speed offoreclosing and selling, BKT (3 yrs), BKIA and SAB (both 5 yrs) will divest soonest;LBK (12 yrs at 8x the speed) would be last. The remaining banks would each take7-10 years. Faster sale speed may not be an option given political uncertainty andBrexit, yet lower rates and lower required investor IRR could help.

    A ?330bn Cross to Bear; Mid-caps Exposed — The Bank of Spain estimates?213bn of gross NPLs and foreclosed assets on the banks’ balance sheets (c20%GDP). On a more comprehensive definition and including Sareb, we estimate?330bn gross (c32% GDP) for 8 quoted and 5 non-quoted banks representing themajority of system assets. The eight quoted banks have 14% of their balance sheetin gross problem assets (9% net) and the five non-quoted are 17% exposed (12%net). The quoted midcaps are most exposed with POP at 27% gross, SAB 21% andLBK 20%. BKT at 7%, SAN Sp at 8% and BBVA Sp at 10% are least exposed.

    Problem Assets Handicap Profitability by 110-140 bps — On our estimates, theaverage ROE for the eight quoted banks could improve by 110 bps at the end ofrunoff and ROTE by 140 bps. POP (880 bps), SAB (380 bps), CABK (320 bps) andLBK (250 bps) improve ROTEs the most. But this would cost capital as a prolongedrunoff consumes meaningful resources such as funding, capital and managementtime: CABK would need to allocate an additional 140 bps of capital to its runoff unitwe believe while POP would need an additional 150 bps. For the rest, the capitalconsumption or benefit could be in the 30-40 bps range.

    Mid-caps Have the Largest Valuation Discrepancy vs Core ROTE — Postrunoff, POP (Neutral) could make 15% ROTE, SAB 12% and CABK 11% - all threetrade on 0.5-0.6x P/TBV today. LBK at 8.3% ROTE post runoff trades on 0.3xP/TBV. Among the large caps, BBVA and SAN could reach 13% and 12% ROTE,respectively, and they both trade on 0.9x P/TBV.

    While the Mid-caps Could Become ROTE Tigers, 7+ Years Is a Long Time;Reiterate BBVA and BKT as Most Preferred — A couple of years before theproblem assets have been dealt with, we think the midcap shares would representattractive buys. In the meantime, we stick with bank franchises that have an angleand are able to generate above-average returns. BBVA and BKT remain ourpreferred names in Spain (both Buy rated). We also have a Buy on SAN and LBK.