Earnings Call Transcript - BBVA Q2 2020

Operator, Operator

Good morning, everyone, and welcome to BBVA Second Quarter 2020 Results Presentation. I'm Gloria Couceiro, Head of Investor Relations. And here with me today is Onur Genc, Chief Executive Officer of the Group and Jaime Saenz de Tejada, BBVA Group CFO. As in previous quarters, Onur will begin with the presentation of Group’s results and then Jaime will review the business areas. We will move straight to the live Q&A session after that. And now, I will turn it over to Onur to start with the presentation.

Onur Genc, CEO

Thank you, Gloria. Good morning to everyone. Welcome and thank you for joining us. I hope that you and your families and friends are all healthy and safe in this environment. Let me also express my support to those affected by the pandemic and my deepest condolences to the relatives and friends of those who passed away. So let me start with slide number three, by updating you on BBVA’s response to this environment. As mentioned in our previous quarterly results presentation, our three priorities to navigate this crisis remain the same. So, first and foremost, to protect the health and well-being of our employees, our clients and the community, in general. This has been our number one priority from the beginning. We acted with anticipation before the official government measures were put in place, activating plans in order to have as many of our employees as possible working from home, with 86,000 of them working from home at some point. I also want to focus on the fact that in this situation, our bank, thanks to the technological investments we've been making over the years, has been performing as usual, thanks to our people and, again, thanks to our technological capabilities. Our second priority in this environment has been to continue to provide an essential service to the economies that we operate in. We are managing the branch network in a very dynamic way, based on data. As of June, 87% of our physical network is open, compared to 69% as of March. So it has been improving day by day. We have also leveraged, more than ever, our competitive advantage in the digital front. Our digital and mobile customers have reached their highest ever penetration rates of 60% and 56% respectively in this period. So, our digital channels, which we have been focusing on significantly in the past few years, we think are paying off from all those investments. The third priority has been to provide financial support to our long-standing clients. We believe banks have a powerful part of the solution to this crisis, continuing to finance the economy. So we have contributed with a full pack of measures, including especially deferrals. As of today, 4 million transactions have been deferred, which represents in value 9% of the Group's total loan portfolio. We have been very prudent in our credit admission policies, but we also tried hard to stand by our long-standing healthy clients. In the first half of the year, we have increased our total gross loans by €26 billion in constant euros. Additionally, we have provided new lines of credit and loans to our business clients through government facilities, the government support programs for a total of €20 billion. Moving on to slide number four, as highlighted in the previous slides. Once again, I would like to remark that our leadership in digital has been a significant advantage in this context. On the left-hand side of the page; you see that our relentless focus on technology and the effort BBVA has been putting over the last few years in building what we call end-to-end digital products and processes, are proving to be differential. Some examples on that side of the page. The number of visits to the BBVA app globally has increased by 20%, compared to before and after the COVID-19 crisis periods. In addition to pure digital, our high-value customers continue to interact with their relationship managers through our remote infrastructure embedded in our app. In Spain, for instance, the number of visits to 'my conversation' as we call it in the app — that functionality which allows for chat directly with your relationship manager, has increased by 68% during this period, on an apples-to-apples basis. As a result, given our capabilities to go beyond servicing and execute sales digitally, this quarter we have achieved a milestone of reaching 50% of total sales in terms of value — 50%, the tipping point that we have been aiming for. In terms of units, digital sales now represent 66% of our total sales, which, again, compared to many other peers as they are looking into this, these are uniquely differential figures. Second, on the right-hand side of the page, in this complex environment, despite all the challenges, we continue to deliver on digital tools and functionalities. Let me quickly give you a few examples: GloMo or Global Mobile app, which has been inspired by our Spanish app, as you well know, is recognized by Forrester as the world's best mobile banking app. We're extending it to several other countries. More than 240 solutions and features of the app have been developed globally and they are now reusable across regions. So any of those solutions can be plugged in plug and play in any of the countries where we operate in the future. This is a clear example of how our globality allows us to optimize costs, share best practices, and develop industry-leading solutions. The second example is we developed a very specific small- and medium-sized enterprise app, again, global, called Hammer, launched in Mexico, and it will be launched in other countries along the way. And similarly, for large corporates at the bottom of the page, you can see that given the work-from-home change in our clients, we are seeing huge traffic — a 29 times increase in the usage of technological infrastructures we have built such as digital signatures. Moving to financial results, slide number five. I would like to emphasize that in this complex, unprecedented environment, we continue to deliver strong pre-provision profit, which increased 0.7% in current euros and 17.6% in constant euros compared to the same quarter of last year, which we view as a very strong reading. From a pure bottom-line perspective, in the second graph from the left, you can see the reported net attributable profit is €636 million due to higher impairments. As I will explain later, we continue to do some extraordinary additional coverage related provisioning. Nevertheless, it’s important to highlight that net attributable profit for this quarter has more than doubled — a 118% increase compared to the first quarter of this year. The third graph from the left shows the very strong capital generation, one of our best quarters ever with a 38 basis points increase in the CET1 ratio. We now stand at 11.22% at the end of June 2020, being very close to the upper part of our target range communicated in the first quarter presentation. Finally, on the right-hand side of the page, you see that it’s important to again note that one of our core metrics to look into is the tangible book value per share. Despite the fact that currencies are significantly affected, we continue to grow our tangible book value per share plus dividends. It’s very, very important in my view. Moving to slide number six. If there are a few messages that come out from the results that we will be explaining in detail later, first, once again, resiliency in pre-provision profit increasing by 17.6% in constant euros compared to the same quarter last year. Second, very strong cost control and efficiency; we will share the detailed numbers with you in a second. But in our view, excellent management of our costs has resulted in a decrease of 4.9% in constant euros compared to the second quarter of 2019. As you know, we have significant inflation in some of our geographies. Despite this high inflation in those areas, we managed to achieve a blended cost decrease of 4.9% for the whole operation. Third, significantly improved cost of risk, now at 151 basis points versus 257 basis points in the first quarter. We’ll talk about this more in the coming slides, but cost of risk is one of the core topics that we’re giving significant management attention to continuously evolve with our expectations. Lastly, once again, one of the great news from the quarter is strong evolution in capital metrics, with fully loaded CET1 increasing significantly by 38 basis points compared to last quarter, which now stands at 11.22%. Moving to slide number seven, I would like to highlight the positive evolution of net interest income, which increased by 2% in constant euros in this challenging environment. Along with impressive performance on net trading income, which offsets the negative evolution of fee income, leading to a strong overall increase of gross income by 6.1% in constant euros. This evolution, coupled with good control of expenses I mentioned, explains the 17.6% increase in operating income. As I explained previously, however, the bottom line has been negatively affected by the increase in impairments and provisioning compared to the same quarter last year. All in all, net attributable profit for the quarter is €636 million, representing a 40.5% year-on-year decrease in constant euros. Moving to slide number eight, if you turn to it, you can see the evolution in the first half of this year against the same period last year. Again, there’s a very positive evolution in net interest income, gross income expenses, and operating income. Our operating income in the first half has increased by 19.2% in constant euros — again a very strong reading even in normal times. First-quarter provisions front-loaded due to COVID-19 of €1.4 billion were accompanied by additional COVID provisions booked in the second quarter of around €0.6 billion. These have together led to a negative impact on the bottom line, but we wanted to be very prudent in our provisioning, as mentioned in the first quarter and in this second quarter, we have taken these additional extraordinary provisions. Net attributable profit for the first half of the year is €928 million, which reflects a 57.8% decrease year-over-year. If we exclude the non-cash BBVA USA goodwill impairments recorded in the first quarter of this year, if we include that impairment, the final reported net attributable profit for the half-year is €1.157 billion. Moving to slide number nine, to shed more light on revenue breakdown, also reflecting quarterly evolution. The 2% growth in net interest income has been achieved, once again, despite low interest rate environments across practically all of our markets. The performance of net fees and commissions reflects a decline of 9.5%, heavily impacted by lower economic activity, especially in card payments. The payment business contributed significantly to that figure. We have seen a clear pickup in that figure in the last months, but it has still affected quarterly overall performance. Retail loan production exhibited a decrease in insurance-related fees under fees and commissions, and there’s also a new regulation in Turkey, capping certain commissions, which has affected that figure. The performance of net trading income has been excellent, with a fourfold increase compared to a year ago, significantly supported by portfolio sales driven by volatility in sovereign yields. Overall, this robust revenue growth of 6.1% compared to the second quarter of 2019 reflects a continuing positive trend, despite the seasonality associated with the annual deposit insurance payments to the single resolution fund that occurs in second quarters. Moving to slide number ten, I have mentioned it, but it’s important we put attention here. The good performance of expenses continues to drop quarter-on-quarter and year-over-year. If you compare the year-on-year evolution, expenses dropped significantly by 4.9%. We have also maintained positive operating jaws with our core revenues increasing by 3.2% in the first half, while expenses decreased by 1.5%. In that context, this marked cost decrease clearly highlights our discipline on this topic. Finally, on the right side of the page, as a result of all of this, you’ll see an outstanding efficiency ratio of 45.8% in the first half of the year, continuing to improve by 389 basis points compared to 2019, which is again, significantly better than our European peer group. Slide number 11 shows the loan loss provisions for the quarter amounting to €1,665 million. As mentioned, part of this is extraordinary provisioning due to COVID. In the impairments line, there is also a piece under the provisions line, but in the impairments line, we have €576 million related to additional provisioning. While still significant, it is improving compared to the first quarter, where we had front-loaded provisions significantly. More specifically, the €576 million of COVID-19 related provisions include several factors. It includes additional provisioning driven by IFRS 9 macro scenarios updates and additional management adjustments relating to idiosyncratic factors, which aim to capture the expected impact of COVID-19 on specific names or sectors in certain countries that were not included in the macro adjustment. As explained in the first quarter, we took a front-loaded approach toward the full ramifications of COVID-19 based on macro estimates we possessed back in April. As of July, we have updated these macro scenarios, leading us to include additional provisions that reflect the downward revisions we are implementing. Moving to slide number 12, I talked about this macro and the additional provisioning aspects. Let me update you on GDP growth estimates forming the basis for this quarter's additional provisioning. The updated economic forecasts continue to project an incomplete V-shaped recovery for 2020, although with deeper contractions observed in some countries, indicating heterogeneous impacts across regions. That said, uncertainty remains high. In general, we are seeing downward adjustments in Spain and Mexico of around three percentage points in our point estimates. The adjustment in the U.S. is more moderate with a revision of minus 0.3 points. The forecasts for Turkey have held steady. Notably and despite its absence in the chart, as announced by BBVA Research, we are also expecting deeper contractions in South America, especially in Peru. So, we took these macro scenarios generally to mid-range and smoothed out the quarterly spikes as recommended by the OECD, readjusting our provisioning based on these new expectations. The slide number 13 displays the breakdown of impairments and cost of risk by country, distinguishing between COVID-19 related impairments and underlying impairments. From the total €1.7 billion in impairments, €0.6 billion has been attributed to extraordinary provisioning due to COVID. Out of this €0.6 billion, Mexico and Peru were particularly affected relative to expectations, as previously mentioned. In Spain, we have made specific adjustments concerning sectors hit hardest by this crisis, particularly tourism and leisure. In the U.S., we are taking additional provisions in the retail book and consumer auto loans, reflecting the evolving pandemic circumstances. For Turkey, we have incorporated the impact of currency depreciation on the provisions for foreign currency loans held in the country. From the right side of the page, you see the year-to-date cost of risk. Year-to-date total impairments indicate an annualized cost of risk of 204 basis points; this being negatively impacted chiefly by the front-loaded provisions we applied in the first quarter and second quarter. The quarter-only annualized cost of risk stands at 151 basis points, emphasizing that excluding COVID-19 related provisions, underlying cost of risk remained close to our traditional ranges at 113 basis points, which aligns with prior quarters. Our estimates for the full-year cost of risk still expect to be around 150 to 180 basis points. Given that year-to-date cost of risk currently sits at 204 basis points, we anticipate that the second half of the year will show a much lower impact compared to the initial half. Moving to slide number 14, before handing it over to Jaime, I would like to present the capital page. It demonstrates a very strong performance, one of our best quarters ever. I would like to break down the 38 basis points CET1 capital accumulation of the quarter. First, our results generation contributes 17 basis points. The decrease in RWAs in constant euros adds six basis points to the ratio. Of the 5 to 6 basis points increase due to CRR supportive factors focused mainly on SMEs and infrastructure, excluding this, RWAs added only 1 basis point to the ratio. This growth in portfolios during the quarter becomes clear through figures — a large growth in sterling credit, primarily supported by state-guaranteed loan programs, with marked improvements in market risk as well. In the waterfall displayed on the page, you can also observe the positive market slate impacts this quarter, which contributed 14 basis points, mainly driven by the marked improvements in our fixed income portfolio's mark-to-market valuation. Lastly, we include the liquidations of 3 basis points related to prudent valuation adjustments resulting from ECB decisions. Overall, our CET1 stands at 11.22% as of June, representing a substantial 263 basis points over minimum requirements. It is also worth noting that we have practically achieved our year-end guidance that targeted the upper part of our CET1 target range of 225 to 275 basis points. Furthermore, I must emphasize the high quality of our capital ratio, demonstrating our real capacity to absorb losses. We are best-in-class in terms of the leverage ratio, currently standing at 6.1%. Additionally, considering the executed and recently announced €81 million in Tier 2 transactions, we fully endowed our €81 million Tier 2 requirements post-European capital requirements — overall, this allowed us to optimize our capital base.

Jaime Saenz de Tejada, CFO

Thank you very much, Onur, and good morning, everybody. Let me begin with Spain. As Onur said, GDP expectations for 2020 have been revised downwards, with BBVA Research anticipating a GDP contraction between minus 10 and minus 15%, due mainly to a longer and more intense lockdown than initially expected. However, expectations for 2021 have been revised upwards, with BBVA Research now forecasting growth between 3% and 9%. In terms of activity, loans have increased by 2.7% year-to-date, better than anticipated due to strong growth across commercial segments and small businesses, supported by government programs. This more than offsets the negative impact of the lockdown on retail portfolios. For 2020, we now expect total loans to increase slightly versus the slight decrease previously predicted. In the first half, BBVA Spain delivered an outstanding pre-provision profit, growing by nearly 20% compared to last year, despite the challenging environment. This performance is attributed to card revenues, which grew 3.6% year-on-year in the half-year results, driven by significant growth in fees up almost 7.5% from higher fees in corporate investment banking and asset management. Net interest income (NII) grew by 1.7% mainly due to lower wholesale funding costs and higher contributions from global markets and the ALCO portfolio. For 2020, we now expect NII to increase slightly in line with activity compared to the earlier expected slight decrease. Notably, net trading income is reported to have increased almost 80%, mainly driven by ALCO portfolio sales. Furthermore, we observed a remarkable decrease in operating expenses, which fell over 6%, surpassing expectations. For the full year 2020, we now anticipate expenses to decline by more than 5%, and potentially even better than this initial half of the year. This strong performance of operating income has enabled us to absorb the increasing loan loss provisions compared to the previous year, primarily influenced by the base effect previously noted by Onur, specifically, due to provision releases from a mortgage portfolio sale last year. Additionally, significant front-loading of COVID-related provisions was performed in Q1, in addition to the €64 million of additional provisions recorded in Q2, mainly linked to the sectors most impacted by the crisis, such as leisure and transportation. Having said this, the cost of risk improved significantly from 154 basis points in Q1 to 100 basis points still year-to-date, aligning with expectations. For 2020, we now foresee the cost of risk to remain significantly below first-half levels. Moving to the U.S., GDP expectations for the U.S. in 2020 are currently in the range of minus 4% to minus 7%, with recovery forecasted at between plus 2% and plus 5% in 2021. While this segment is projected to experience a more negative growth this year, we believe its dynamism will allow the region to catch up with the U.S. recovery in 2021. Loan growth has risen by nearly 13% year-on-year, driven by commercial segments supported by the drawdown of credit lines in Q1 and the €3 billion provided under the Paycheck Protection Program in Q2. For 2020, we expect loan growth to fall within the mid-single digit range. As for the P&L, the U.S. contribution has improved clearly this quarter, delivering €126 million in net attributable profit versus a €100 million loss in Q1, due to our resilient pre-provision profit alongside lower impairments. In comparative terms to last year, we observed a 9% decline in net interest income, mainly attributable to lower interest rate levels. However, a significant NII increase of nearly 6.5% is noted against the previous quarter, reflecting better contributions from the securities portfolio and loan origination fees received from the PPPs. Moreover, I would emphasize the lower funding costs, owing to an improved deposit mix, with demand deposits comprising 84% of the total, and a favorable price management strategy, driving deposit costs down by 39 basis points over the quarter. For 2020, we now anticipate a continuation in the reduction of deposit costs, expecting NII to decrease within low single digits, improving from the first-half trends. We've also dealt with increasing impairments year-to-date, primarily attributed to the front-loading of COVID-related provisions in Q1, indeed increasing 56% compared to the first quarter. However, cost of risk has decreased quarter on quarter, currently guided from 260 basis points in Q1 down to 180 year-to-date. In 2020, we now expect cost of risk to remain significantly below the first half. These two headwinds are partially mitigated by a strong performance in both expenses and net trading income. Expenses have decreased by 2.5% compared to last year, and we also expect to maintain this trend throughout the year. Our net trading income rose by over 80% from last year, aided by sales in the securities portfolio and supporting better results from the global market division. In summary, we see a robust performance from the U.S. franchise, despite navigating lower rates and a challenging environment. Moving to Mexico, TL loans have increased by 9.5% year-on-year, or 6% when excluding the FX impact, driven by corporate clients drawing down lines, particularly in Q1, with mortgages growing in Q2 due to pent-up demand. Operating income for the half has remained relatively flat in constant euros against last year, demonstrating resiliency supported by strong net trading income, along with operating expenses growth remaining below inflation. Net trading income is at over 85%, supported by positive performance in global markets and the insurance business. Expenses are up by 2.6% and remain below inflation, allowed by lower personnel expenses after variable remuneration adjustments. Consequently, we expect 2020 expenses to perform better than initially anticipated, increasing at rates below inflation. Net interest income in Mexico is down by 1.5% compared to last year, primarily impacted by lower customer spreads in both Mexican pesos and U.S. dollars, due to considerable rate reductions by Banxico of 325 basis points since last June, along with a changing mix effect as loan growth leaned toward commercial segments, which present lower yields. Additionally, the deferrals on credit cards and SMEs, which do not accrue interest during the grace period, are also worth consideration, as they caused a one-off effect of that €107 million on NII in Q2. For 2020, we forecast NII to remain flat against last year. Our resilient pre-provision profit has allowed us to absorb the growing impairments. The cost of risk improved slightly from 530 basis points in Q1 to 495 basis points year-to-date, as impairments declined by 5.1% quarter-on-quarter. Looking ahead, and accepting the persistence of uncertainty, we believe the 2020 cost of risk will align with or dip slightly below first-half figures. Now focusing on Turkey, our GDP expectations for 2020 and 2021 remain largely unchanged, assuring BBVA’s significant growth in TL loans, exceeding 30% year-on-year, primarily driven by the commercial segment, supported by the credit guarantee fund in Q2. Foreign currency loans have seen a near 6% decrease year-on-year. For 2020 as a whole, we predict TL growth around 25%, with a minor reduction in foreign currency loans. Transitioning to the P&L, pre-provision profits for the half-year have grown by 45% compared to last year in constant terms, benefiting from strong revenue generation and continuous focus on efficiency. NII rose by 28%, primarily due to heightened activity levels and a notable improvement in TL customer spreads, despite a lower contribution from the CPI-linked portfolio. For 2020, we expect NII to grow in the high teens range in constant euros. We also experienced promising NTI performance from FX results, gains on security sales, and contributions from our global market's salary. Operating expenses rose 6.6%, which was significantly below inflation, which hovered around 12%, lowering our efficiency ratio to a historic level of 28.7%. These pre-provision profits enabled us to manage provisions related to COVID-19, with impairments witnessing a substantial reduction of 37% in Q2 compared to Q1. As a result, cumulative cost of risk has decreased from 380 basis points to 271 in the half-year. For 2020, we anticipate the cost of risk to remain significantly below first-half levels. Overall, we are reporting a robust set of results that continue to prove BBVA’s earnings resiliency, with a net attributable profit rising by 6.3% year-on-year in constant terms. And let’s conclude with South America. In Colombia and Peru, BBVA Research significantly downgraded GDP growth expectations for 2020 to ranges between minus 5.5% to minus 10% for Colombia, and minus 12% to minus 18% for Peru, followed by an incomplete V-shaped recovery for 2021. In Argentina, the ongoing debt renegotiations appear to be progressing in a favorable direction. In Colombia, NII has demonstrated high single-digit growth year-on-year in constant terms, buoyed by activity growth of 12%. The cost of risk has improved quarter-on-quarter, from 401 basis points down to 337 basis points over the half-year, following significant provisions taken in Q1. Together with commendable NTI performance and expense management, this has driven an overall improvement in net attributable profit. In Peru’s second quarter, the net attributable profit recorded was only €3 million, impacted heavily by provisioning-related charges against deteriorating GDP estimates. The NII drop is attributable to lower loan yields. Lastly, in Argentina, we witnessed a net attributable profit of €39 million in Q2, reflecting considerable progress since the previous quarter due to favorable inflation adjustments and release of provisions from our securities portfolio. Now back to Onur.

Onur Genc, CEO

To close the session with final remarks, I would first reiterate the resiliency of our operating income, our successful crisis management, and the clear message from our differential digital capabilities this quarter. Our focus on cost control and efficiency has become quite evident from the figures. Thirdly, we have witnessed a significant improvement in our risk indicators, allowing us to provide for provisions highlighted in the first quarter. We expect to see even more improvements, particularly in retail loan segments as we progress. Lastly, strong capital generation during the quarters has seen us achieve our year-end targets ahead of schedule. With this, I conclude the presentation. Gloria, back to you for the Q&A.

Operator, Operator

Thank you, Onur. We are now ready to move into the live Q&A session. So first question, please.

Operator, Operator

The first question today comes from Francisco Requel from Atlanta. Francisco, please go ahead.

Unidentified Analyst, Analyst

Good morning. Thank you very much for the presentation. I will start with Mexico. I have two questions. First, regarding asset quality, I noticed from the presentation that 25 to 40% of household loans are currently under payment holidays. Can you provide more details on the portfolios, specifically how many of the claims are on furlough? Have you managed such a high level of moratoria in the past? The 5% cost of risk that you are projecting for the full year is close to the historical peak. Why do you believe this will not change? Additionally, I see that the top line in volumes shows that you are still engaged, but are you still willing to meet strong loan demand considering the lack of state support, or are you planning to adopt more cautious risk criteria? Finally, about the outlook for the NIA, it seems that the four-month moratoria will not be extended, and the borrowers are prepared to resume loan payments. Could you elaborate on the dynamics concerning volumes and margins? Thank you.

Onur Genc, CEO

Okay. Thank you, Francisco. So, asset quality, 34% of our payments are under holidays. Yes, that is high. However, this is also in line with some other countries, which you might see in the appendix of the presentation that provides details on the different portfolios by countries. This is relatively on target compared to some of the other countries you may be observing, and this is what is demanded in the market. I will look into this payment holidays further. Most of these deferrals are payment holidays. These will become due in late July — mostly in August. Hence we will see the first signals we are receiving are not bad at all. The initial signals we are seeing are some customers already closing their loans, or paying installments in terms of their consumer loans and mortgages, etc. I want to highlight regarding Mexico that close to half of the deferred portfolios are mortgages — close to that in retail. Hence, there is clear collateral value we should be accounting here. Therefore, we are guiding asset cost of risk for Mexico to decline slightly only from what we have seen in the first half. In every other country, we also expect significant declines in the second half or the cost of risk. What differentiates Mexico? Firstly — the pandemic continues, in terms of new cases and so on. Secondly, government support is not as strong as in other countries. Therefore, we do foresee some impact, but our projections are all accounted for in our figures. The early signals we have seen are positive, but we need to navigate through August to truly gauge how it will pan out. On the top line values, given this lack of state support, Francisco, do we intend to lend? We are willing to lend to any credible and healthy candidate. We have established the best franchise in Mexico, in terms of clients, staff, systems, and on. You would have noted in the second quarter that we are gaining market share in deposits, 120bps more. Hence, there is some flight to quality occurring in Mexico as well. So, we will continue to lend prudently, but we will do so. In the appendix of this presentation, you can observe the progress of new retail products in mortgages and consumer loans. As mentioned, mortgages basically have fully recovered, indicating a V-shape. You can see that in the metrics; in April, this was at a level of 70, now back to 100 for mortgages. For consumer, it was around 30% in April, and now it's risen to 60%. This data encapsulates our cautiousness. So we will see some volumes, but we will proceed with caution at least in these next months. Regarding the NII, our outlook for NII expectations? First, if we look at the simplified P&L of ALCO, you will see that in net interest income for Q2, we recorded a minus 7.3% decline. This decline shouldn't be projected into the second half of the year. Why? That minus 7.3% is influenced by multiple elements. But primarily, rates within the market, were cut by 225 bps since the beginning of the year. This has impacted obviously on lending yields and affected deposit costs. As these rates, the recovery from these rate declines comes into play, it results in a lag. We are seeing this in the second quarter; however, we expect to see this trend elevate even more in the upcoming quarters with cost of funding. Thus, such lag with the lower rates from Banxico will improve the situation in the second half. Additionally, in the second quarter, some of the impacts from payment deferrals were without interest, which should not result in being considered for extrapolation. Thus, we anticipate recovering from August. Considering those factors, we are guiding for Mexico in terms of NII to be flat or see only a slight decrease — rather than the minus 7% you observe in the table.

Operator, Operator

Thank you, Francisco. Next question, please.

Operator, Operator

The next question comes from Carlos Cobo, Societe Generale. Carlos, please go ahead.

Carlos Cobo, Analyst

Hi. Thank you very much for the presentation. A couple of questions for me. One is on the site assets. We have a couple of different approaches to these, well, lower quality assets perhaps over the last couple of years from peers. And I would like to ask you about, your total exposure to DTAs. It’s true that tax loss carryforwards are slow, but what do you think about the quality of other timing differences on grantee DTAs? And if you have conducted any updated absorption tests on those DTAs and is there any chance of seeing impairments here, like to see your views. My second question is, if you could update us on your CET1 target for the end of the year. Capital progress has been better than expected and now you're close to the high end of the range, as you said. So, are you raising the target or capital formation in the second half? That’s great. Thank you.

Onur Genc, CEO

On DTAs, Jaime?

Jaime Saenz de Tejada, CFO

Okay. First off, we currently have guaranteed DTAs of €9.4 billion, which are guaranteed by the state. These do not have expiration dates nor depend on future results. We pay a fee for them quarterly, which is roughly €17 million net of taxes, reflected on the corporate center income statement. Additionally, we also have 4.8 billion of non-guaranteed DTAs that are currently deducting 67 basis points from our CET1. For these, we need to do projections, and we consistently update them every quarter. Significant changes in late 2019 led us to increase the years used for evaluating DTA from a 10-year to a 15-year P&L forecast after realizing peers were utilizing longer periods. We firmly believe that we will generate enough taxable revenue in the years ahead, even after the drop in income expectations, particularly for Spain in the upcoming years, to recover these non-guaranteed DTAs. Based on present circumstances, we do not foresee, unless there's a significant change, any impairments arising from these DTA numbers.

Onur Genc, CEO

Carlos, regarding CET1, we are likely to be above our target range by the year's end. We are all aware of certain corporate transactions that have been announced some time ago, namely Paraguay and our partnership with Allianz in insurance. These will yield around 13 basis points when finalized. There are also regulatory impacts that we will benefit from, particularly related to software treatments, our expectations for which are roughly 12-13 basis points. Accounting for these additional influences, we expect to be above our target range by the end of the year. That said, we don't plan to raise our goal of 225-275 basis points, as stated a quarter ago. per ECB recommendations, our Board of Directors previously committed to refrain from any dividend payments for 2020 until uncertainties arising from COVID-19 have dissipated, and in any case, we won’t distribute dividends before the end of the 2020 fiscal year. We remain dedicated to this plan but intend to recommence dividend payments as soon as uncertainties around COVID are resolved, as we had discussed before the crisis. Additionally, we will explore other shareholder remuneration methods, such as share buybacks. But, at present, we do not have plans to raise our target.

Operator, Operator

Thank you, Carlos. Next question, please.

Operator, Operator

The next question comes from Alvaro Serrano of Morgan Stanley. Alvaro, please go ahead.

Alvaro Serrano, Analyst

Thanks for taking my questions. Good morning, everyone. Can you hear me, okay?

Operator, Operator

Yes. Alvaro, we can hear you well.

Alvaro Serrano, Analyst

Yeah. Thanks. I have follow-up questions regarding Mexico and cost. On Mexico, Jaime indicated that the effects from payment holidays were €107 million in the quarter. I wonder how confident you are regarding the NII recovery in the second half and the visibility you have on that NII recovery. Is that €107 million? I mean, you mentioned that August will show the largest rollover — what timeframe do you envision for that to sufficiently return? How sure are we that most of these factors will recover? Also on loan production, it seems to be recovering from the lows, but remain significantly lower, and you're indicating that retail loans are still 40-50% behind in volumes up until June. So I would expect any insight you might share on recovery points for NII and overall volumes? On the other question regarding costs, your performance appears exceptionally impressive, 7% above consensus in the quarter! Qualitatively, how are you achieving this? I understand you’ve allocated guidance by division, but conceptually, what areas are you targeting for cost reductions, and how sustainable do you view this trend moving forward? Is Q2 the right run rate or is there an extraordinary influence from COVID? I'm curious about long-term trends and next year's projections. I recognize that you refrain from providing guidance. Still conceptually; in your view, what portions are due to COVID and what parts are projected as sustainable moving forward? Thank you.

Onur Genc, CEO

Thank you, Alvaro. Regarding the Mexico question, the €107 million impact on NII from the payment holidays will dissipate as Jaime indicated, starting in August. The €107 million was essentially for the quarter, so you should see quite minimal impact extrapolated in the second half. As for loan production and volumes, we expect mid-single digit growth, primarily led by wholesale portfolios. There is noticeable softness in retail production, and as I've mentioned, it’s a partial move to a cautious stance. These are indeed prudent measures during these times, which is why we are managing the firm accordingly. While we're still seeing significant retail loan activity, we’re proceeding with a level of caution. Thus far, we are witnessing increases for mortgages going back to pre-COVID levels, showing a recovery trend in that V-shape recovery. Consumer loans, however, are still around 30% in April, and have been gradually rising to 60%. Hence regarding volumes, we will continue proceeding cautiously at least for these upcoming months. Looking ahead for NII, our outlook does suggest that the second-quarter results shouldn't be seen as reflective moving forward. The additional impacts exerted from payment deferrals in Q2 saw some and should not be projected as extending into future quarters. Hence we expect recovery moving forward as of August. The prospect for Mexico allows for a flat to slight decline moving forward rather than extending beyond the minus 7% seen in today’s data. Regarding the costs — we are addressing this significantly. It's become one of our short-term focal points. We’ve established considerable plans with individual business units over all countries, scouring through line-by-line expenses, working toward appropriate prudence in our operational expenditures.

Jaime Saenz de Tejada, CFO

Yes, once you compile all the guidance I've provided concerning expenses, you will be able to see that what Onur has said has weight. I want to emphasize that we anticipate better overall pre-provision profits in the second half of the year for the group, particularly supported through better performance in both Mexico and Latin America, which have faced more challenges in Q2.

Operator, Operator

Thank you. Thank you, Alvaro for your questions. Next question, please.

Operator, Operator

The next question comes from Marta Romero of Bank of America. Marta, please go ahead.

Marta Romero, Analyst

Good morning. Thank you very much for taking my questions. I've got three quick ones. The first one on dividends, your message is very clear — nothing until we get more clarity on the effects of the pandemic. When time comes for you to redefine your dividend policy, I wonder whether you may consider bringing the script dividend back, or if you’re comfortable to leave that script behind. My second question is a follow-up on Mexico’s top line. Your fees in local currency are 17% below last year. How quickly or to what degree do you expect the fee line to recover? How much of it is due to volume and how much of it is attributable to lower prices? Are you observing any political pressure to keep the prices low, given the current situation? And lastly, regarding your coverage ratios by stages, Stage 1 loans exhibit coverage of 66 basis points. Historically, your cost of risk has lingered around 100 basis points. Shouldn't you have at least a coverage of 100 basis points for Stage 1 loans or am I approaching it wrong? Thank you.

Onur Genc, CEO

Regarding the dividend question, let’s keep it short and clear: Will the script return? The answer is no. We previously communicated a consistent, predictable approach to dividend policy — it must be in cash and the percentages are clear. Hence we’ll maintain this approach moving forward. On Mexico's numbers, I didn’t entirely catch what you were asking, but concerning fee income, the minus 17% reflects three main factors that drive it. First, the payment systems, the payment business in Mexico is more crucial than in many other areas, including cards, credit, and merchant acquiring businesses. This has driven much of that decline. My perspective is tied to economic activity. If we analyze overall spending observed on cards versus our terminals, there are notable decreasing indices. In the week of April 12, the index was around 68, while in early July the same index had once again risen to 96, indicating recovery. This trend should see fee and commission recovery moving forward into second half gradually. The second contributor to lower fee income was insurance. Notably, mortgage production last year was favorable at around 7% growth rates, which again had a significant role in decreasing fees presently. We are certainly back on that either way. The 17% that you pointed out will see improvement as long as we avoid substantial lockdowns. The last point regarding your question about the coverage ratio of Stage 1 loans at 66 basis points — historically you are right, costs of risks lingered between 100. However, it’s essential to view it from multiple perspectives. We cannot just observe Stage 1 alone but must integrate Stage 2 and Stage 3 into the overall picture. The blended total must be used to accurately gauge the cost of risk factors as the transition likelihood from Stage 1 to Stage 2 and Stage 3 yields to what coverage looks like. Our data shows that we’re maintaining a coverage rate of about 165% concerning our NPL ratios actively. The fact is that the likelihood of transition from Stage 1 to Stage 2 and 3 is incredibly constrained, reflected firmly in our portfolio balance. The stable portfolio metrics convey that message well.

Jaime Saenz de Tejada, CFO

Yes, this point is crucial. In the yearly cost of risk related to underlying concerns, we have included not solely provisions for the Stage 1 portfolio but also for the Stage 2 and 3 segments, as previously stated by Onur.

Marta Romero, Analyst

Very good.

Operator, Operator

Thank you. Thank you, Marta for your questions. Next question, please.

Operator, Operator

The next question comes from Ignacio Ulargui from Exane BNP. Ignacio, please go ahead.

Ignacio Ulargui, Analyst

Hi. Hi, good morning. Thanks for taking my questions. I just have two questions. One, if you could give us some detail on the performance of those payment holidays that have expired in Mexico and in South America. I see that in Mexico, €1.1 billion of moratoria have expired so far. How this has performed? Whether clients have been paying or not, to get a sense of how we could expect those. The second thing is, on the NII guidance that you've given in Mexico, I assume this in local terms. Thanks.

Operator, Operator

Ignacio, yes, NII guidance is in local terms.

Onur Genc, CEO

On the deferrals, Ignacio, it is again — most of them are expiring, actually, this week. We're currently observing it daily. Most of the expirations occur in August. The pieces that we have tracked indicate that our return to payment ratio is improving weekly and monthly. Keep in mind that the deferral period fluctuates depending on the loan's status when deferred. For instance, a loan that was 30 days late might only qualify for three months of deferral, while a loan 60 days late would only see a two-month deferral offered. Therefore, the loans that are expiring represent those that were initially somewhat problematic. Starting from early June with a small base of deferral returns, we’ve seen significant improvements over weeks. We initiated around a 20% ratio, and we’re nearing 60-70% averages across specific equity portfolios, specifically towards consumer series. The loans expiring at present tended to be the most troubled. Consequently, as we start in terms of perceptions in August, we expect that return rates will rise significantly higher. While initial indications are very favorable, we still need to navigate through weeks ahead for clearer assessments.

Operator, Operator

Thank you, Ignacio. Next question, please.

Operator, Operator

The next question comes from Adrian Cighi of Credit Suisse. Adrian, please go ahead.

Adrian Cighi, Analyst

Hi, there. Adrian Cighi from Credit Suisse. Thank you for taking my questions. Three quick follow-ups, please. On the cost of risk, you reiterated the guidance for this year. Do you perceive some elevated costs of risk could potentially shift into the next year, considering that moratoria exist in numerous geographies? Alternatively, do you expect sharper declines toward normalization into next year? My second question relates to capital. You’ve mentioned corporate transactions alongside software intangibles, yet do you observe other possible headwinds, or other impacts from TRIM or other regulatory developments? Finally, just a follow-up on costs. You’ve mentioned numerous cost measures have been enacted. Viewing this quarter or this year, do you expect some of them to be temporary based on the projections for 2021? Or do we classify these as permanent cost reductions? Thank you.

Onur Genc, CEO

On cost of risk we expect this to trickle down to next year. Conversely, in retail, the essential portfolios will face moratoria expiring in the next three months — primarily in August. Hence, this aspect for retail concerning our expectations for the cost of risk appears significantly less in retail portfolios. There are possibilities in corporate wholesale portfolios where some trickling might occur through 2021 and so forth, but we’re currently monitoring it closely. As for TRIM, they have been postponed to 2021. As you’re aware from our last quarterly presentation, TRIM’s impact needs addressing, especially concerning low-default portfolios, with an approximate impact of 10 basis points in 2021. Concurrently, you might also expect further 5 basis points from other regulatory aspects. However, we anticipate neither supervisory nor regulatory impacts influencing the numbers in the latter half of 2020.

Jaime Saenz de Tejada, CFO

Yes, concerning costs, you should indeed expect a mix of both structural reductions alongside temporary components moving forward. Generally, about one-third of the reductions circling around variable compensation, positioning variable compensation subject to this fiscal year’s considerations without promises for future impact into next year. Furthermore, hiring freezes during the June period successfully achieved a decline of roughly 15%-20% in holding costs. By the end of June, we had selectively opened up hiring again—for networks, customer service, and sales positions. However, corporate services continue on hold.

Operator, Operator

Thank you, Adrian. Next question, please.

Operator, Operator

The next question comes from Sofie Peterzen of JP Morgan. Sophie, please go ahead.

Sofie Peterzen, Analyst

Yeah, hi. It's Sofie Peterzen from JP Morgan. I was just curious to know about your NPL uplift when I look at your NPL as they grew as you can see in this quarter or for many quarters increased from 3.6% to 3.7%. So, my question would be when do you expect NPLs to peak? One more simple question would be on growth. I wondered if you can see additional pricing being unlocked, as premiums have gone up. Is this something that we could expect?

Onur Genc, CEO

Well, Sofie, we apologize for interrupting, but your line is entirely broken. We couldn’t fully gather your thoughts or questions. Perhaps you can reconnect with a different line because it’d be unfortunate to miss your insights. First and foremost, regarding the NPLs, as much as you have observed their slight rise in the second quarter, this was mostly due to a wholesale client in Turkey — therefore we don't foresee general NPL increases imminently. Note that due to deferrals and ongoing government support programs, we are proactively managing the situation quite well. It’s key to recognize that while we instituted those deferrals, these steps were taken at the behest of the clients as we’ve integrated a proactive approach. This signifies good willingness to pay, support solid lines overall, indicating our readiness to navigate through the upcoming months. Therefore, when observing deferrals, one shouldn’t lose sight of the overall context surrounding NPLs, aiding us in strengthening these portfolios. This structured monitoring helps us preempt potential escalations in NPLs as we proceed through these challenging times.

Jaime Saenz de Tejada, CFO

I concur with Onur about remaining mindful of evaluating good financial health across these parameters. As you perceive, overall, there remains lesser prospects for NPL upticks concerning our factions.

Operator, Operator

Thank you, Sofie. Next question, please.

Operator, Operator

The next question comes from Daragh Quinn of KBW. Daragh, please go ahead.

Daragh Quinn, Analyst

Hi, good morning and thanks for the presentation. I have a question regarding Spain about corporate loan growth — what do your projections include for demand there once ICO loans have been fully dispersed? Also, regarding how the business has performed in lockdown, has this shifted your perspective about how quickly you can reduce the physical distribution of your branch network? Do you think recent comments or changes in approach could trigger a reevaluation of consolidation opportunities in the Spanish market?

Onur Genc, CEO

On Spain's loan growth, we expect growth trends to continue. BBVA research estimates for the industry are in lower single digits, lower-end certainly, and we plan to align with it. Most growth driven with the Euroloan segments notably from the ICOs is performing, as previously mentioned, which we'll continue through Q3. Overall, supportive of this trajectory, we expect corporate and wholesale segments to remain robust, with mortgages expanding slightly, whereas consumer segments may face minor contractions. The branch closure velocity is concerning; our digital advancement saves infrastructure. We’ve long been advocates that transition toward digital platforms will give a competitive edge. While we invested resources in improving digital channels for a few years now, a positive trend via increased efficiency can still incorporate working branches. We see a gradual reduction of physical branches for the future; thus, we're already managing plans accordingly. The pace indicates we might close approximately 160 branches this year — there might be a potential acceleration in future periods for further reductions. Opportunities for consolidation in Spain have always been considered, and BBVA actively evaluates it. However, our priority remains on organic growth to foster value creation. We remain committed to our organic market share strategy focusing on our digital approach to strengthen market positioning. However, we will always assess opportunities as they arise.

Operator, Operator

Thank you, Daragh. Next question, please.

Operator, Operator

The next question comes from Andrea Filtri of Mediobanca. Andrea, please go ahead.

Andrea Filtri, Analyst

Yes, thank you for taking my questions. Two questions; one on capital and one on the cost of risk. On capital, I want to understand better in a dynamic context — how much risk-weighted asset inflation do you anticipate will arise from migration, and when can we expect it to commence? At what point would you be prepared to adjust your CET1 targets or elevate them in order to alleviate concerns around your headline numbers? On cost of risk — what do you see as the primary factor that could provoke further material coverage charges in your view?

Onur Genc, CEO

Let’s discuss the RWA and impact — we’re already observing effects from RWA migration. While small impacts emerged in Q2, we anticipate a slight acceleration through the second half — more sharply toward 2021 as some of these factors firm up. Yet it must be said that a large part of our RWAs, citing the two-thirds calculated on standard models, mitigates impacts and allows us to buffer volatility in exposures.

Jaime Saenz de Tejada, CFO

On capital matters, I want to add that our distance to MDA — calculated on a phased-in basis, sits at 304 bps — arguably among the best in Europe for large banks. This figure likely invites little visibility in general discussions. Nevertheless, we maintain our caution towards target evaluation. We do not see the necessity to modify our existing target of 225-275 basis points at this moment.

Onur Genc, CEO

With respect to cost of risks, the primary factor that could trigger additional COVID-related provisioning is, in my opinion, lockdowns. We've seen patterns across various states where stringent lockdowns directly correlate with declines in growth, suggesting that every week of strict measures corresponds to a further decline in GDP by 0.5-1%. Hence, if stringent lockdowns return to countries, we should anticipate repercussions in fees and risk costs. However, as it stands now, we have started to collectively learn to coexist with the situation. Thus, you may observe credit card-related spendings in several regions going beyond index 100 temporally — suggesting signs of usual economic activity.

Operator, Operator

Thank you. Thank you, Andrea. Next question please.

Operator, Operator

The final question comes from Britta Schmidt of Autonomous Research. Britta, please go ahead.

Britta Schmidt, Analyst

Yes. Hi there. I have three quick questions please. The first one is to follow up on M&A. Those who comment also hold for other geographies, for example, the U.S. The second one is on the U.S. Could you detail how much PPP fees were net interest income? And what sort of delta we should expect there for the coming quarter? Finally, could you provide insight into inflation as it relates to the Turkish CPI expectations for the year?

Onur Genc, CEO

On the M&A, my feedback remains that the sentiment applies across geographies — we will continue to watch for opportunities relative to value creation for our stakeholders.

Jaime Saenz de Tejada, CFO

I can clarify that we've not shared that number specifically; however, we have disclosed that we disbursed €3 billion in PPP loans during Q2. The fees standard can be computed accordingly. In essence, we've registered approximately €70 million in fees related to those in Q2. On inflation, we began 2020 with around 8.5% in Q1, declining in the second quarter down to 7.5%. Hence, our average in the first half is 7.8%. Our present expectations for year-end inflation hover around 10%, which suggests a year-on-year impact of approximately €75 million affecting NII for the first half, which clearly indicates better second-half performance than the first half numbers, and this will express an improvement over the second half of 2019.

Operator, Operator

Thank you, Britta. Next question, please.

Operator, Operator

The next question comes from Stefan Nedialkov of Citigroup. Stefan, please go ahead.

Stefan Nedialkov, Analyst

Thank you. Hi guys. Good morning. I have a couple of questions in mind. First, on the cost of risk; the 150 to 180 guidance. Last quarter, you conveyed the upper limit refers to a second wave, so I want to acquire more insights about that. Have you reassessed your second wave estimates? Does the reiteration of the 150 to 180 extend from your increased confidence in predictions that no additional wave occurrence will take place? My second question focuses on Mexico. You mentioned that NII is significantly driven by threats rather than rates. Can you discuss how much repricing flexibility we have on new loans? Also, what the breakdown is in terms of the percentage of floating versus fixed loans? Circularly, in Mexico, with the cost of risk guidance of roughly 500 basis points this year, could you provide additional insights into how many of your payroll-backed consumer loan customers are employed by ratings, and what levels we should be monitoring? Are we talking about B ratings individually or more about BBBs or below? Any clarification would be greatly appreciated.

Jaime Saenz de Tejada, CFO

Sure. Regarding the cost of risk guidance of 150-180, our commentary from last quarter signified the uncertain environment rather than explicitly connoting a second wave. We did speak broadly about the uncertainty surrounding the recovery’s trajectory but, presently, we feel more confident navigating the overall recovery shaping within countries. Nonetheless, we still have remnants of uncertainty surrounding the environment. Thus, we reiterate our guidance without direct correlation to a second surge.

Onur Genc, CEO

Noting the situations from the prior question about COVID — if strict lockdowns pose potential ruptures, we do need to remain agile to respond dexterously. So our overall outlook gravitationally converges towards effective management of risk. In Mexico, we are optimistic about new production leading to repricing. Most retail loans are fixed, while corporate investments vary. The data shows that although student loans are quite variable, retail loans tend to be more stable. We maintain our guidance for the cost of risk at below 500 basis points this year. Consequently, composition is mainly determined and performance in the most vulnerable areas regarding consumer changes are important areas where we will see flexibility adjust according to established business frameworks rather than overly cautious ratings. We will continue to manage based on those terms.

Operator, Operator

Thank you, Adrian. Next question, please. The final question comes from Carlos Peixoto of CaixaBank. Carlos, please go ahead.

Carlos Peixoto, Analyst

Hi, good morning. Thanks for taking my call. Carlos Peixoto from CaixaBank BPI. My question would actually be on the fees — just a one in particularly in Spain, basically in the release information that was some coming back from corporate transactions in the quarter. I was wondering how much of this could be seen as a one off effect in the pulling, and what type of expectations do you have for fees throughout the full year? Thank you very much.

Jaime Saenz de Tejada, CFO

For net fees and commissions, we expect a slight decrease for 2020 versus 2019 overall, largely driven by reductions in asset management fees and lower activity levels stemming from lockdown consequences. As we’ve noted, during times of restricted consumer activity transactional levels tend to drop sharply. Our corporate investment banking has remarkably excelled, enabling us to mitigate part of these losses. Therefore, if there are no additional lockdowns, we could see a better second half of the year overall.

Operator, Operator

Thank you, Onur. We appreciate everyone's engagement in today's call. I’d like to remind everyone that our entire IR team is available to address additional questions you might have. Onur, would you like to close?

Onur Genc, CEO

I want to extend my empathy and sympathy to all of you on the line. The current period remains difficult to interpret numbers, and we aim to be as transparent as possible with our communication to provide a perspective on the business and numbers as they evolve. We have an excellent IR team; please do connect should you require further details. The broader message is positivity for our future outlook. Thank you, very much, for your time and participation.

Jaime Saenz de Tejada, CFO

Have a wonderful summer.

Onur Genc, CEO

Have a wonderful summer. Exactly! Thanks so much. Bye-bye.