Fitch Ratings says in a report that the Spanish banking system has weathered the global financial crisis successfully to date with no need for capital support from the state. This is due to its retail banking focus, prudent regulation and limited exposure to structured products and complex instruments. However, the strong economic adjustment that Spain is experiencing, the sharp rise in unemployment in a short period and a large exposure to the Spanish property sector have had knock-on effects on revenue and domestic loan quality, affecting the banks' H109 operating profitability.

"The impact is nevertheless mixed, as the large, systemically important banks have easily absorbed a high level of credit costs while maintaining sound operating profitability due to diversification and/or niche franchises. And despite challenges from the current downturn, the large banks should maintain sound performance," says Carmen Munoz, Senior Director of Fitch's Financial Institutions group, "However, other players, particularly some of the small to medium-sized savings banks, have suffered a sharp fall in operating profitability in H109. They will continue to suffer substantial pressure due to weaker revenues, a high cost base and higher credit impairment charges, although some institutions should hold up well."

A key challenge facing Spanish banks is managing the sharp deterioration in asset quality as a result of their large exposure to the troubled domestic property sector.. Other near-term challenges include revenue pressure from the recession and low interest rates, the need to deleverage and rebalance funding structures towards customer deposits and an improvement in the level and quality of the capital at some institutions. Fitch will address the impact of all key challenges faced by the Spanish banking sector in a separate upcoming comment.

Banco Santander (Santander) and Banco Bilbao Vizcaya Argentaria (BBVA) face the complex operating environment from a strong position. Their focus on retail banking and the diversification of their franchises internationally have supported recurrent revenues which, together with cost control and proactive risk management, have enabled them to absorb asset quality deterioration in Spain, Latin America and the US and yet report solid operating performance. Although performance pressures will persist, the banks should be able to continue reporting sound profitability, given their critical mass in core markets.

Given the close correlation of their performance to the Spanish economy, as in H109, Caja de Ahorros y Pensiones de Barcelona (La Caixa), Caja de Ahorros de Madrid (Caja Madrid) and Banco Popular Espanol (Popular) will continue to see their operating profitability come under pressure from the weakened Spanish property sector, the recession and lower interest rates. However, substantial generic reserves and good cost efficiency should help alleviate pressure on performance.

Except for Caja Madrid which reported a regulatory core capital of 6.5% at end-H109, the other four large Spanish banks reported a ratio of around 7% and above. Following the recent capital-raising initiatives that include the IPO of around 16% of Santander's Brazilian operation, the issuance of mandatory convertible securities by BBVA and Popular, and the share capital increase by Popular the regulatory core capital ratio for these three banks should increase to about 8% by end-2009.