DBRS Confirms Ratings of Banco Popular Español at A (low); IA Lowered to BBB (high)

DBRS, Inc. (DBRS) has today confirmed the ratings of Banco Popular Español, S.A. (Popular or the Group), including its Senior Unsecured Long-Term Debt & Deposit rating at A (low) and its Short-Term Debt & Deposit rating at R-1 (low). The long-term ratings have a Negative trend and the short-term ratings have a Stable trend. These ratings were previously lowered to A (low) in August 2012 after DBRS’s downgrade of the Kingdom of Spain to A (low) with a Negative trend. Along with today’s confirmation, Popular’s intrinsic assessment (IA) has been lowered to BBB (high) from A (low).

DBRS views Popular as a Systemically Important Bank (SIB) in Spain. As Spain’s sixth largest banking group, a major provider of financial services to the business and financial sector and a key participant in the financial markets, significant distress for Popular, if not addressed promptly, could materially affect Spain’s financial system and the country’s payment mechanisms. DBRS maintains its SA-2 support assessment for Popular, which indicates an expectation of timely systemic support in case of need. DBRS views the ability of the government to provide support as having been enhanced by the agreement with the EU/EC/IMF that provides EUR 100 billion of resources to strengthen the capital base of Spanish banks, of which approximately EUR 40 billion has been used. DBRS notes that Popular has not utilised any capital support from the State. The SA-2 designation results in a one-notch uplift from Popular’s IA of BBB (high) to the final rating of A (low).

In lowering the IA by one notch to BBB (high), DBRS considers the elevated level of provisions which are expected to continue going forward given the continuing deterioration in credit quality due to the ongoing weakness in the economy. In addition, the adverse interest rate environment continues to weigh on underlying earnings, as lower interest rates have reduced yields on assets by more than funding costs despite maintaining higher margins than peers. While Popular’s franchise strength has helped it to lessen the impact on its net interest margin (NIM), and its net interest income is showing signs of stabilizing, the risk of further deterioration remains significant, as the financial markets remain unsettled. Given Popular’s sizable amount of nonperforming loans (NPLs) and acquired real estate assets, elevated provisioning is likely to remain a burden that pressures the intrinsic strength of the Group. While Popular has utilized one-off capital gains to absorb these provisions and strengthen capitalization, the resources that are available to offset these provisions have become more limited. After the successful sizable rights issue of EUR 2.5 billion in December 2012 that increased Popular’s capital position, DBRS views the Group as having a reduced capacity for further significant capital increases, if needed, although it has other ways to adjust to meet capital requirements.

Reflecting the lower IA, DBRS has also downgraded the rating of Popular’s Preferred Shares issued out of Popular Capital S.A. to BB (low) from BB (high). The two notch downgrade reflects the combination of the one notch reduction in Popular’s IA and the wider notching from the IA for banks in the “BBB” rating category, which widens from to 5 notches from 4 notches for the “A” rating Category, to reflect the greater expected probability of nonpayment of preferred shares implied by an IA of BBB (high) under current DBRS methodology.

The Negative trend on the long-term ratings reflects the challenges posed by the weak economic conditions in Spain, uncertainty in the outlook for the Eurozone, and evolving regulatory requirements. This negative external environment is expected to continue to pressure Popular’s earnings generation ability going forward, at a time when its contingency resources are more scarce than at the beginning of this sustained crisis. Significant weakening in earnings generation ability combined with a more rapid deterioration in credit quality, particularly in Popular’s core business of lending to SMEs and corporates, could put downward pressure on the rating. DBRS notes that further negative action on the sovereign rating (Kingdom of Spain current rating A (low), Negative trend) would likely impact the A (low) rating of Popular, as such action would likely signal further deterioration in the domestic environment.

DBRS views Popular as maintaining a strong franchise in Spain. As the 6th largest domestic bank, the Group maintains solid market positions throughout its domestic market, with more sizable market positions in Madrid (7.1%), Galicia (20.0%), Castilla Leon (9.0%) and Andalucia (8.3%). In segments where the Group’s business is more focused, such as lending to SMEs and corporates, Popular has larger market shares. The acquisition of Pastor, which was based in Galicia, helped Popular to increase its scale, depth and presence, allowing it to better compete in an increasingly consolidated and competitive market. DBRS notes that Popular’s acquisition of Pastor did not involve any support from the State.

Popular’s results continue to demonstrate the significant headwinds still facing the Spanish banking sector. While Popular’s impairment costs remain elevated, the Group is having some success in offsetting these costs by sustaining pre-provision profit, or IBPT, which was EUR 2.0 billion in 2012 up from EUR 1.6 billion in 2011, as Popular benefited from the Pastor acquisition. Looking at the quarterly trajectory, Popular’s IBPT has been improving, reaching EUR 568 million in 2Q13, up from EUR 405 million in 1Q13 and EUR 377 million in 4Q12, indicating an improving trend despite margin pressures and declining volumes. The Group maintained a low cost/income ratio of 39.3% in 2Q13; although higher than in the past, Popular’s ratio remains well below Spanish banking peers and helps support IBPT with a greater share of revenues passing through to the bottom line.

Continued asset quality weakness is evident in Popular’s elevated NPL ratio of 10.8% at 2Q13, a significant jump from 7.0% a year ago, but still below the sector average of 11.2% (or 12.8% when including SAREB). With sizable NPLs of EUR 15.4 billion, it’s important to note that net new entries to NPLs are showing a declining trajectory, indicating improving credit trends. While DBRS views further asset quality deterioration as likely, it appears that the pace of credit deterioration is slowing. Also contributing to asset quality weakness is the Group’s sizable exposure to foreclosed real estate assets of EUR 6.0 billion, net, or 3.7% of total assets, as of 2Q13. DBRS views positively the Group’s enhanced efforts to sell these assets, with an increased pace of asset sales in 1H13. Importantly, with its significant provisioning effort in 2012, Popular increased its coverage of nonperforming assets (NPAs) to 57% at the end of 2Q13 from 45% at the end of 2011.

Popular’s access to market funding has improved in recent quarters, as market concerns about the liquidity and capitalisation of some Spanish financial institutions and the position of the Spanish sovereign are receding. Demonstrating its access, Popular issued EUR 954 million in senior unsecured bonds and EUR 1.3 billion in covered bonds in 1H13. As a result of its strategy to reduce its reliance on wholesale funding, the Group’s loan-to-deposit (LTD) ratio improved to 118% at 2Q13, as compared to 135% at the end of 2011. These actions have contributed to Popular’s ability to repay a sizable portion of its LTRO funding (EUR 5 billion in 2013 YTD) with EUR 12.2 billion remaining. With EUR 13.4 billion of available, unencumbered collateral and continued progress on its funding strategy, the Group has significant excess liquidity coverage over its unsecured debt maturities.

From a capital standpoint, Popular remains well positioned with a core capital ratio based on EBA standards of 10.3% at 2Q13, up from 7.4% at the end of 2011. The Group also calculates its tangible equity capital (including mandatory convertible notes) at 5.9% of tangible assets as of 2Q13, which DBRS views as sizable. Popular successfully completed a EUR 2.5 billion capital raise in 4Q12 enabling it to meet the increased regulatory requirements that were based on the more severe adverse scenario of the Oliver Wyman stress test results. DBRS views positively the Group’s successful completion of its rights issue that was accomplished without support from the State and allowed the Group to grow its capital base even as it cleaned-up its balance sheet.

Notes:
All figures in Euros (EUR) unless otherwise noted.

The principal applicable methodology is the Global Methodology for Rating Banks and Banking Organizations. Other methodologies used include the DBRS Criteria – Intrinsic and Support Assessments, and DBRS Criteria: Rating Bank Capital Securities - Subordinated, Hybrids & Preferred Securities. These can be found on the DBRS website under Methodologies.

The sources of information used for this rating include the issuer, SNL Financial and the DBRS rating of the Kingdom of Spain. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

This rating is endorsed by DBRS Ratings Limited for use in the European Union.

Lead Analyst: Lisa Kwasnowski
Rating Committee Chair: Alan G. Reid
Initial Rating Date: 11 October 2006
Most Recent Rating Update: 10 August 2012

For further information on DBRS’ historic default rates published by the European Securities and Markets Administration (“ESMA”) in a central repository see http://cerep.esma.europa.eu/cerep-web/

The conditions that lead to the assignment of a Negative or Positive Trend are generally resolved within a twelve month period. DBRS’s trends and ratings are constantly under surveillance.

For additional information on this rating, please refer to the linking document under Related Research.