Best Bank 2012: Santander storms through the Spanish crisis

On the day that two consultants published reports outlining the full extent of the problems facing the Spanish banking system, Emilio Botín was in his bank’s spiritual home.

He was in Santander, the city where the bank started and that gave it its name, for a groundbreaking ceremony for the Botín Foundation Art Centre, on the waterfront of the northern port, just a few steps from Banco Santander’s historic headquarters on the Paseo de Pereda. The new arts centre, designed by Renzo Piano, will cost €77 million and is expected to attract 200,000 visitors a year to the city.

Santander and its chairman, who even though he is well into his seventies never seems to slow down, have never forgotten the bank’s roots.

But now Botín and his colleagues are on a mission to convince the world that Santander is no longer a Spanish bank. Spain is just one of eight countries in which the bank has a market share of 10% or more. Many of those countries are in growth economies, such as Brazil, Mexico and most recently Poland.

Santander has moved to a model that the financial markets have yet to catch up with. Its shares, its CDS and its ratings move as if it were a Spanish bank – as one executive admits "the 100% correlation to the sovereign has been very damaging to us" – but it’s simply not. The bank is getting almost no credit for a diversification of earnings into growth markets and a separately capitalized subsidiary model, even though this is precisely what has ensured it has the capacity to manage through the downturn in Spain without taking a loss. What’s more, regulators elsewhere love the model that protects those local subsidiaries, each significant in their own right in their markets, and so affords systemic stability.

And although the generally assumed downside of subsidiarization is inefficiency, Santander is in fact the most efficient large bank in the world.

As Santander’s long-serving CEO Alfredo Saénz says: "The group’s international expansion in the last few years has enabled us to build a business portfolio which is better than those of other big international banks. Today we have a stronger presence in emerging markets than our major competitors. We have very strong local brands with critical mass, whilst many of our competitors have banks without sufficient scale in many markets. And this has enabled us to have a better profit mix and a more stable and recurring profit. As a result of all of that we are in an excellent position to normalize our profit."

In a strong position, yes; complacent, no: "We are taking the necessary steps to normalise our profitability," Saénz adds. "We do not base our future by trusting the economic recovery will make our profits grow. On the contrary, we are very conscious that it is up to us to define and execute the strategies that allow us to attain our goals."

When Euromoney catches up with Botín after the ceremony, his emotions are a mixture of pride and frustration.

The pride comes from the performance of his bank. He likes to trot out statistics. The first he mentions will surprise many.

Which three banks produced the highest profits before provisions in 2011? They were, in order, JPMorgan, HSBC and Santander. This is the group that the bank’s executives believe it should be mentioned alongside; not confused with domestic Spanish lenders who put all their eggs into the now distressed property basket.

Of course, it is the level of provisions – both now and in the future – that concern many analysts and shareholders. We’ll return to that later.

For now, let’s look at the headline operating earnings that provide the wherewithal to absorb them. Last year’s pre-provision profits were €24.4 billion. These are hardly the numbers of a distressed bank.

Santander hasn’t just performed in 2011. It has performed throughout the financial crisis. Since the beginning of 2010, it has produced impressive group profits in every quarter – from a high of €2.2 billion in the second quarter of 2010 to a low of €1.4 billion in the corresponding period last year. In the first quarter of 2012, the bank delivered an attributable profit of €1.6 billion.

And few banks have as diverse an earnings mix as Santander. Brazil accounts for more than a quarter of earnings. In total, Latin America delivered 52% of group profits in the first quarter this year, thanks to strong contributions from Mexico and Chile in particular. The UK generated around 13%, the US 10% and even Germany, where Santander has a leading consumer finance business, brought in 5%. Spain’s contribution to group profits was less than the UK’s, at 12%. But unlike nearly every other bank in Spain, it made a profit. As it did in Portugal in 2011, where it was the only one of the big-five banks to do so.

Santander has dramatically improved both its capital and liquidity positions. It has been a leader among Spanish banks in reducing and provisioning its real estate exposure.

And hence the frustration. Botín feels his bank is not getting the credit it deserves.

"I have never in my life seen Spain in such a difficult moment as this," he says. "We’re trying to do as much as we can for the country. The situation in the country worries me, but the situation of the bank does not. Santander is in a great position. Our subsidiaries model has been totally vindicated. The group is strong, even when one part of the group is weakened." Botín expresses his frustration that the ratings agencies don’t seem to understand the bank that Santander is today. "We’re unique among the world’s banks if you look at our business mix. We’re in Brazil, Mexico, Argentina, the UK, Germany – to name but a few. Our credit is stronger than Spain’s."

Santander is rated one notch above the Spanish sovereign by all three ratings agencies: Standard & Poor’s at A-, Moody’s at A3 and Fitch at BBB+.

José Antonio Álvarez, the CFO of Santander, takes up the theme. "The most painful impact of the situation in Spain has been the sovereign downgrades, which we are linked to – even though we are rated higher than the sovereign. But we are tied to one notch above. That doesn’t take into account the current situation of our business. We are generating profit in every market, including Spain and Portugal. Through our subsidiaries model, and the payment of dividends, that means we are generating new capital quarter on quarter."

In June, one regulator came out fighting on Santander’s behalf against the ratings agencies. Fitch had downgraded its Polish subsidiary, Bank Zachodni WBK, to BBB from A- after downgrading Santander because of the negative outlook in Spain.

The financial markets regulator in Warsaw lambasted the decision, noting that the Polish bank was ring-fenced from the parent. "Bank Zachodni has high and stable profits and is a well-capitalized, listed company," the regulator said in a statement.

It’s not just the rating that causes frustration: Santander’s CDS spreads have ballooned along with the sovereign’s. "It doesn’t really make sense," says Álvarez. "We are a core bank in all of the 10 markets we operate in. In each market, the bank is regulated locally and has autonomy in terms of capital and liquidity. So there is no reason to link our CDS to that of the Spanish treasury."

The reports from Oliver Wyman and Berger Consulting confirmed that Santander, along with BBVA and LaCaixa, would not need assistance. An examination published in June by the IMF into the stability of the Spanish financial system put the leading Spanish banks, Santander and BBVA, in a first group of their own. The IMF says that the two banks "appear sufficiently capitalized and profitable to withstand further deterioration in economic conditions. This reflects the solid capital buffers and the robust earnings of the internationally diversified operations."

Spain is of course weighing heavily on Santander, as it is on all banks with operations in that country.

Botín, as Spain’s most famous and most successful banker, must at times agonize at the terrible state the Spanish banking system finds itself in. You sense that Santander’s chairman wishes Europe’s leaders could be as decisive as his own management team.

Just before the Oliver Wyman report on the Spanish banking system suggested that, in a worst-case scenario, Spain’s banks would require an additional €62 billion of capital, Botín gives his opinion on what such a large injection of capital will mean.

"Once this money is placed into the savings banks system, within a year I can tell you that the Spanish banking system will once again be one of the safest in the world," he says.

Santander could use this moment of catharsis across the Spanish banking system to clean up its own real estate portfolio to the extent that no one can question the future earnings impact the distressed loans could have.

Álvarez says the bank has already taken important steps on reducing that exposure. "In 2008, our Spanish real estate exposure was around €43 billion," he says. "Now it is a little over €20 billion. So we have been reducing it by about 15% to 20% a year. We still have a little way to go: the bottom should be around the €14 billion level."

Even at current levels, the exposure to real estate is less than 10% of Santander’s total Spanish loan book of €210 billion. Repossessed assets are around €8.5 billion. These are provisioned at 50%, giving them a net value of a little over €4 billion.

Santander is selling these repossessed assets rapidly. Álvarez says the bank sold about 10,000 flats in the first half of the year, at a discount in the region of 30% to 40%, which he says shows that the provisioning levels are correct – especially as Santander is not in a great position as a forced seller. "Our priority is to dispose of as many of these assets as we can in the shortest possible time. But our valuations and provisioning show these are not in any way a threat to the bank, given the net position is €4.3 billion."

The diversity of its business will allow it to go further. "Because we are so strong outside Spain, and generate such high levels of operating profit, we have the ability to make big provisions where it is prudent and necessary," says Botín.

Prudent, necessary, and big: in the first quarter of this year provisions for non-performing loans rose 51% to more than €3 billion. The NPL coverage ratio in Spain was 46%, compared with 62% for the group as a whole. That Spanish number could have some way to go, especially if Santander decides to put Spain’s real estate woes behind it once and for all. That would be a bold move, with a short-term impact on earnings. But Santander’s management is not one to shy away from bold decisions.

Faced with these headwinds, Santander has acted quickly to shore up its balance sheet, funding and capital. The group-wide loan-to-deposit ratio has fallen from 135% in 2009 to 115% at the end of the first quarter this year. Liquidity has risen over the same period to €190 billion from €154 billion.

Álvarez also says that Santander is comfortable on the funding front. As he points out, because of the subsidiary model, Santander is effectively a group of different, albeit related, credits. While the Spanish funding markets have remained shut, in the UK, for example, Santander has been active across RMBS, covered bond and senior unsecured markets. In Spain, the dependence on wholesale funding markets is naturally falling as the loan-to-deposit ratio of the bank there falls. "Loans have been falling by 5% to 7% a year; deposits have been growing by 3% to 4%," says Álvarez. "That’s a complete reversal of the situation from 2004 to 2008."

Over the past 12 months, Santander has decisively acted to bolster its capital.

Following the announcement by the European Banking Association that banks would be obliged to hold 9% Basle 2.5 core capital by June 30 2012, Santander moved to meet its requirement six months ahead of deadline. In less than two months, Santander sold 7.8% of Banco Santander Chile, reducing its stake to 67% and raising $950 million, boosting group core capital by 11 basis points. It transferred 4.41% of Banco Santander Brasil to a major international financial institution, which will deliver these shares when they mature in 2013. The bank raised €1.943 billion in fresh capital through the exchange of preferred shares for new ordinary shares. And it sold Santander Colombia to CorpBanca of Chile for $1.225 billion, generating a capital gain of €615 million. Colombia had accounted for just 0.5% of group profit. Santander’s core capital by Basle II measures is now 10.1%.

So far, Santander has avoided being asked by the Bank of Spain to take over any of the troubled Spanish banks."The government has not pressured us to buy a savings bank," says Botín. "In any case, we are answerable not to our government, but to our three and a half million shareholders."

But what of the worst-case position: that Spain’s economic woes continue to drag down its banks and its government, and a full-scale troika intervention along the lines of Ireland and Portugal takes place?

Botín says there is no scenario in which he can foresee Santander having to take direct government assistance.

Because of the spread of its business, Santander would have plenty of options to raise new capital if needed. Its ownership of the Brazilian subsidiary is currently about 76%. That could be sold down a bit more, as was done in Chile (67%), although there are no plans to do so. Santander has a highly rated bank in Uruguay, a country that doesn’t fit with the economic scale the bank usually seeks.

Santander explored strategic options for its insurance and asset management businesses in 2008 and 2009 but then decided it didn’t like the prices. Value could somehow be extracted from these – its joint venture with Zurich Financial for its Latin American insurance assets is an example.

Santander has also announced it will do all four (instead of three) of its dividends in optional scrip. Take-up of the scrip over the life of the programme has been around 75%, meaning each dividend raises close to €1 billion of new capital.

Other clouds lurk on Santander’s horizon, beyond the Spanish property market. Some economists expect a sharp downturn in Brazil’s economy in the near future. Botín doesn’t agree.

Brazil, Botín admits, has become "essential to our profits. It’s the number six economy in the world. Soon, it will be the number five. The central bank there is very good, and has taken quick and appropriate measures whenever needed. We don’t believe Brazil will suffer a major slowdown in growth."

Like all eurozone banks, Santander has large overall exposure to the government bond market. According to a European Banking Authority report published earlier this year, its exposure totalled around €58 billion. Of this, the majority was in Spanish government bonds: around €35 billion. Álvarez says this exposure is more than manageable: "Our exposure to Spanish bonds is less than 3% of all of our assets and around 8% of our assets in Spain," he says.

Then there’s the threat of lawsuits surrounding the sale of €7 billion of convertible bonds to fund the acquisition of Santander’s part of the ABN Amro takeover in 2007.

The bonds are due to mandatorily convert to common stock this year, at around a third of the price at which the bonds were issued.

Álvarez says: "More than 30% of our shares are held by individuals. In Spain, we have more than 1 million private shareholders. Many of them took up the bonds. They were fully aware of what they were buying. We expect some complaints, but out of 129,000 bondholders we have received only a handful and we have already successfully converted €1 billion into stock."

Then there are questions about how the mortgage and SME-lending books could cope with a prolonged economic downturn. And perhaps the biggest threat of all is that the Spanish government will impose burdensome new taxes on its banking sector to help pay for the bailout. That would likely hit the biggest banks – Santander and BBVA – hardest.

Saénz is confident that Santander can withstand anything thrown at it. "I would like to transmit a clear message," he says. "The results we presented in 2011 do not represent our group’s potential pace of profit generation. Over the next two or three years we will recover levels of profitability and growth that reflect the potential of our businesses. A vital first step in this process is to absorb, in 2011 and 2012, the regulatory and economic cycle impact. Once this has been done, we can return to the profit levels the group was at before."

There are two further reasons why Santander is confident in its ability to cope with whatever is thrown its way: experience and efficiency.

Experience comes in the form of a management team that has been together for many years, has been through many a crisis together and, frankly, has a lot more miles on the clock and years in the trenches than most of its global competitors.

As well as the septuagenarian chairman, chief executive Saénz is 70 this year. Álvarez, a relatively youthful 52, has been CFO of the group since 2004. Before that, he was CFO of arch-rival BBVA. Two other key executives, the Rodríguez Inciarte brothers Matías and Juan, also bring huge experience: Matías was a former Spanish government minister and joined the board in 1988; Juan, who joined the firm in 1985, has been intimately involved with every large takeover that Santander has done.

They’ve seen this before, in Argentina for example, where Santander Río is arguably the leading bank. In 2001, the government uncoupled the peso from the dollar and imposed a corralito, effectively freezing bank accounts and thus the payment of debts to banks, while maintaining the banks’ liabilities. Santander ran the consequent losses through its accounts in 2001 and early 2002, bringing the book value of the unit at the time to zero and in effect ring-fencing the rest of the group from any contagion. Slowly, as business returned to normal, Santander was the first bank to start lending again. More recently, and more relevantly, Santander has seen first hand the effects of the Eurogroup troika’s intervention in Portugal in March last year. The troika has been imposing a harsh austerity programme since. The economy shrank 1.6% in 2011 and is expected to contract by another 3.4% this year. In the banking sector, the troika has instructed banks to get their loan-to-deposits ratio to 100% or below, so that they can fund their books through deposits and without recourse to the European Central Bank.

"The troika came in and looked at our position in Portugal a year ago and said that they saw no need for us to have more provisions or capital there," says Álvarez.

Net profit at Santander Totta, the country’s third-largest and most profitable bank, fell by 62% to €174 million in 2011, and was down 64% to €33 million in the first quarter. The bank has been deleveraging, bringing loans to 119% of deposits in March 2012, down from 136% a year earlier. Perhaps most important, though, NPLs were 4.59% at the end of March – up but not dramatically so. Santander management has been looking at the experience in Portugal as a sort of trial run of what performance in an intervened Spain, should it come to that, could look like.

As for efficiency, Álvarez is quick to point out where Santander’s strength and ability to generate those profits before provisions is.

"There are two components to operating profits: revenues and efficiency," he says. "Sometimes it is hard to differentiate your bank on revenues. Competition is tough. We are selling commoditized products. It’s hard to win business on price. And if the market is falling, then everyone’s revenues are likely to be declining. So where you can make a difference is in efficiency. If our cost-income ratio is 45% but our competitor’s is 60%, then it makes a huge impact on your ability to generate earnings."

Santander’s group-wide cost-income ratio is 44.7%, the best of any big international bank. The group’s management says much of the efficiency comes from a state-of-the-art IT platform that the bank is constantly investing in. "We believe that in every market that we operate in, we are among the three most efficient banks," says Álvarez.

As well as technology, the other thing that drives efficiency is scale. "You can’t have a 2% market share and expect to deliver a cost-income ratio of 40%," says Álvarez. "Our rule of thumb is that you need market share of 10% or more."

The one market in which Santander does not have this scale is the US. There, its Sovereign Bank is a small player on the eastern seaboard, operating from Boston through New York to Pennsylvania. Álvarez says that, under Santander’s ownership, its market share in this geography has grown from 1% to around 5%. The US business generated nearly €150 million of profits in the first quarter. That’s not far off 10% of the group. But it’s still not enough.

Two years ago, Santander came close to merging Sovereign with Buffalo-headquartered M&T Bank, which would have made the combined group the ninth-largest deposit-taking institution in the US. In the end, the talks came to nothing. But Santander is unlikely to sit still over its Sovereign stake over the long term.

Botín and Juan Inciarte certainly still have an eye for a deal. There aren’t many banks that are supposed to be on their last legs that look to make growth-driven acquisitions for a top price. In fact, Santander was the only bank in western Europe to do this over the past 12 months.

Santander first entered Poland in 2003 with the acquisition of a medium-sized auto-finance company. The bank used that company as a platform for getting to know Poland very well. When Bank Zachodni, the third-largest bank in Poland, came up for sale as Ireland’s AIB was forced to raise capital in 2010, Santander knew it wanted it.

As usual with Santander, the due diligence on the purchase went far beyond the pure numbers. "We sent a special team in to Poland to look at the branches, not just of the bank we were interested in buying but of its competitors as well," says Botín. "We spent a long time getting to know the country’s politicians and business leaders, and we know the economic potential of the country. Before we even thought about the cost, these were the most important factors in our decision to buy."

Santander had also looked closely at buying Turkey’s Garanti Bank. Senior management says it was attracted by the growth prospects in that country, as well as a very well run bank, but that it knew the Polish market better.

Did Santander pay too much for a bank being offloaded by a forced seller, at a time when there were few banks looking to make whole-business acquisitions? "This bank is very special, and gave us the position we needed to build more in Poland," says Botín. "We needed to put a proper price on it."

That price, in the end, was around €3.1 billion. As Botín says: "We knew the markets, we knew the banks, and we wanted that one. That’s why in the auction we made what knew was a high bid – probably about €300 million too high – to make sure we won."

This February, Santander brought off another acquisition in Poland that will enable the bank to hit the magic 10% market share number. Belgium’s KBC Bank was also a forced seller of its subsidiary, Kredyt Bank. In this case, because Zachodni was locally listed, Santander was able to complete an all-share merger. The value of the transaction was in the region of €1.1 billion.

Botín says: "We’ve invested in total around €5 billion in Poland now, and we’re delighted – we have a high expectation of profitability."

Market conditions could hamper Santander’s plans to launch IPOs of its businesses in the UK and in Mexico. The UK share sale had originally been mooted for 2011; the Mexico plans were announced earlier this year. The current line on both is that the UK deal will continue to depend on the markets; it is hoped that the Mexico deal could go ahead in the second half of this year.

Álvarez stresses that the listings are not designed to generate capital for the parent. "We like to list our largest franchises in our core countries," he says. "It links them to the local financial community. It gives us access to local capital markets. If you are 10% of a market, you should be listed there. Regulators seem to like the strategy."

Unsurprisingly, Botín likes Santander’s strategy too. He just wishes more people would notice it. "Our model is working better than ever," he says.