Earnings Call Transcript - BBVA Q3 2021

Operator, Operator

Good morning, everyone. Welcome to the BBVA Third Quarter ’21 Results presentation. Here with me today is Onur Genc, Chief Executive Officer of the group; and Rafael Salinas, BBVA’s Chief Financial Officer. As in previous quarters, Onur will start with the presentation of group results, and then Rafa will review the business areas. Then we will move straightforward to the live Q&A session. And now I will turn it over to Onur to begin with the presentation.

Onur Genc, CEO

Good morning, everyone. Welcome, and thank you for joining BBVA's third quarter results audio webcast. As Patricia said, I'm also very glad to have Rafa Salinas here today in his first earnings presentation. So please be gentle today; it's his first as the group's new CFO. As you know, Rafa was formerly our Chief Risk Officer, with more than 30 years of experience in the group. So welcome Rafa to these meetings. Let me jump into it. Let me start with Slide number 3. On the left-hand side of the slide, you can see the performance of our net attributable profit. It continues its upward trend. I like the curve here, up to EUR 1.4 billion now in the third quarter. This figure implies a 31% increase versus the same period last year. Compared to the second quarter of this year, net attributable profit also grows 8.2%. These numbers represent one of the highest quarterly results ever reported by BBVA, bringing also our earnings per share to EUR 0.20. Let me note here on this page that for comparison purposes, all these figures exclude nonrecurring impacts such as the sale of the U.S. business or the PNC or the restructuring program in Spain, impacts which affect the baseline and previous quarters, obviously, with no impact in this quarter. The graph on the right-hand side shows our capital strength reinforced by strong capital generation of 31 basis points in the quarter, bringing the CET1 to 14.48%, again, a very powerful figure. Lastly, at the bottom of the page, I'm very happy to report that the European Central Bank has authorized our share buyback plan with a maximum size of EUR 3.5 billion, up to 10% of our shares. This is clearly one of the largest share buyback plans in Europe to date. The CET1 pro forma, considering this share buyback of EUR 3.5 billion, if you deduct it all, will still remain at a very high level of 13.18%, well above our target and minimum requirements. Going to Slide number 4, shareholder value creation and returns. Our tangible book value per share plus dividends closed at 6.55, a strong increase of 12.3% year-over-year. We are very committed to this figure that we put right upfront in all of our presentations. Tangible book value per share, 12.3%, is a very strong figure in our view. Also noteworthy is the continuous improvement in profitability metrics, with double-digit ROE and ROTE. As you can see, 11.1% and 11.7% ROTE. Despite the excess capital that we accumulated after the U.S. sale, we report very strong figures here as well. Slide number 5, top messages over the quarter, very quickly. First, strong core revenue evolution; this is the clear highlight of the quarter, in my view, explained by the acceleration of the NII and the outstanding performance of fee income across the board. Second, our leading efficiency ratio has a wide margin versus our European peers, improving in cost-income as well. Third, cost of risk continued its decreasing trend. We will talk about this in a second; very positive trends there. Fourth, strong capital generation in the quarter and the ample strategic buffer, as we just mentioned. Even after the share buyback, we still have a very strong CET1 ratio. Lastly, our outstanding progress in key strategic areas, excellent figures in new customer growth, something that we are very focused on. We are growing profitably with new customers, helped by digital initiatives, which I will explain in a second, and outperforming in our sustainable finance commitments, another clear differentiator for BBVA, one of our core pillars in terms of strategy. Slide number 6 summarizes the P&L over the third quarter, focusing on the year-over-year comparison with the third quarter of last year. The second column from the left, I would highlight the solid 5.5% increase in operating income supported again by very strong core revenues, coupled with significantly lower impairments, leading to excellent profit growth of above 30%. Also in terms of comparison with the previous quarter results, the first column from the right shows the solid quarter-over-quarter evolution in main P&L lines, again, even considering the seasonality effect which affects the third quarter, especially in Spain, but even despite that, we report very strong figures compared to the previous quarter. All in all, the third quarter reported net attributable profit is, as I mentioned, EUR 1.4 billion. Slide number 7 regarding the 9 months of 2021 versus the same period last year. Again, what stands out is the very positive evolution of gross income and operating income improving 5.6% and 4.6%, respectively. Net attributable profit for the first 9 months of the year stands at EUR 3.7 billion, excluding nonrecurring items, and EUR 3.3 billion including all. On Slide number 8, I have some more light into the quarterly revenues breakdown and evolution, one of the clear highlights of the quarter. Our net interest income increased very nicely versus last year and last quarter, driven by activity recovery and margin improvements. The recovery, which already started throughout the year, accelerated this quarter with a significant increase of 6.1% versus the previous quarter. Again, I will provide more details on this on the next page because I think it's very important. Next, on the same page, we see a remarkable evolution of net fees and commissions. We are happy to report this positive evolution across the board in all geographies. This number reflects the highest quarterly fee income figure reported in recent years. Net saving income continues to perform solidly in the third quarter, showing a 12% year-over-year increase, although there was a slight decline in the quarter because of seasonality. All in all, we see strong growth in gross income of 7.2% compared to the same period last year. On Page number 9, I was showing different versions of this page to you before. Here, we wanted to reveal the NII acceleration in the quarter, also to provide insight for the coming quarters. On the page, new loan production recovery continues. It's being translated into loan growth in both segments, retail and wholesale, but especially in the higher-margin retail portfolios, as you can see on the page. Activity in the year is particularly strong in Mexico and Turkey, again particularly in the higher-margin retail portfolios. In Spain, year-to-date activity evolution is positive, with an overall growth of 0.2%, again biased. The good news is that it is biased towards a more profitable business mix that we can discuss when we go through the countries. Additionally, in the center of the slide, which is very important to us, our effective pricing management has led to the stabilization of spreads in Spain and clear improvements in Mexico and Turkey, as we have been guiding you in the previous quarters. All combined on the right-hand side, you can see significant improvements in net interest income in Mexico and Turkey, both year-over-year and quarter-over-quarter. The NII evolution in Spain is also clearly aligned with the guidance that we have been providing you since the beginning of the year. Slide number 10 details costs. Costs are growing 6.5% versus the first 9 months of last year, significantly affected by the normalization in variable compensation, which was especially low and even nonexistent for certain roles in 2020 due to COVID. We are returning to normalizing in this regard. Excluding the variable compensation effect, expenses would have increased 2.9%, obviously, much lower than inflation. Overall, the total cost increase in the first 9 months aggregates slightly above the blended inflation rate of 6.1% in our footprint despite the mentioned base effect in 2020, indicating that we are slightly above inflation. But if you consider a 2-year timeframe, particularly the first 9 months of 2019 as a more normalized baseline, in the past two years, total costs have increased by only 3.4% versus an 11.2% inflation rate over the same period. On the right-hand side, you can see our efficiency ratio as the lowest compared to our European peers, and more importantly, improving to 44.7% now in the first 9 months of 2021, up 83 basis points in the year. Slide number 11 addresses risk indicators. Total impairments for the quarter continue to decrease, now more aligned and even better than pre-COVID levels. This improvement is mainly explained by the positive evolution of underlying risk performance, and the underlying parameters are coming through very strongly. Year-to-date, the cost of risk continues to improve, closing the quarter at 92 basis points compared to 100 basis points in the second quarter and 150 basis points in 2020, clearly comparing positively with 2019 levels of 104 basis points. With all the positive signals we are seeing, given the strong underlying risk parameters, we are upgrading our guidance today. We expect to close the year for the group below 100 basis points. Regarding the rest of the asset quality indicators on the page, you see a decrease in the NPL ratio to 4% for the quarter, explained by the aforementioned positive loan portfolio behavior, reflecting fewer demands joining the portfolio, but also noting significant recoveries in the wholesale segment, especially in Spain and Turkey. Lastly, our coverage ratio closed at 80%, again due to this reduced NPL balance. Slide number 12 on capital. Let me highlight again the strong generation during the quarter, with 31 basis points in capital generation, leading to a CET1 ratio of 14.48% as of September. This ratio is well above our SREP requirement of 8.60%. As you all know, we have some of the lowest SREP requirements in our peer group. The waterfall chart illustrates our results generation, showing 45 basis points, dividend accrual and the AT1 coupon at minus 21 basis points, minus 3 basis points explained by growth in RWAs, and finally, the bucket of others at 9 basis points, which includes a positive impact from updates regarding credit risk parameters, market-related impacts, minority interest, and everything else. Lastly, I want to note that we do not expect anything material on regulatory impacts for the remainder of this year. Slide number 13 covers our strategic initiatives. We continue to perform exceptionally well. Our focus on building end-to-end solutions, it's a very high-level name, but very important with traditional products and processes, has proven to be differential in getting to new customers and reaching more customers. The graph on the left-hand side of the page illustrates the growing trend of new customers acquired digitally, which now represents 37% of all new customers. This translates to a 48% increase in digital customer acquisition versus the same period last year. We continue to exceed our high marks; this quarter once again being an all-time record in digital customer acquisition. Following our growth mindset, last week, we launched a fully digital bank in Italy, featuring a unique value proposition based on our award-winning app in Spain. The app in Spain has been recognized as the best in Europe for five consecutive years, marking significant achievement. On the right-hand side of the page, you can see that our digital capabilities are also enhancing our sales. In the first 9 months of 2021, digital sales now account for nearly 75% in terms of unit sales, and in relative value, which represents the economic relevance of the units sold, it exceeds 50% of total sales. Slide number 14 stresses our role as trendsetters in sustainability. This is a massive, explosive trend. We want to pioneer in this area, as we have done with digitalization. We believe we are at the forefront of the industry regarding sustainability finance commitments. We've made significant progress and have exceeded our recently doubled target for sustainable financing, aiming to reach EUR 200 billion by 2025. As of September, we have already channeled EUR 75 billion, an incremental volume of EUR 8 billion in the quarter. I'm sharing these numbers because we believe this is both a risk that needs to be managed and a great opportunity for banks. We're tapping into that potential by assisting our clients in transitioning towards a more sustainable future. Additionally, we are launching innovative solutions, such as the recently extended carbon footprint calculators. Originally developed for companies in 2020, we are now extending it for individuals. BBVA was the first bank to offer this solution via an application integrated with the mobile app. Furthermore, we continue making progress towards our commitment to net zero by 2050. In March, we announced our coal phaseout plan, which we are now advancing by setting decarbonization goals for 2030 in CO2-intensive industries. We will be sharing our commitments regarding this next week at COP26. Lastly, on Page number 15, I'm pleased to announce that we are prepared to proceed with one of the largest share buybacks in Europe, totaling EUR 3.5 billion max, equating to up to 10% of shares to be executed in several tranches over the maximum period of 12 months. We will begin executing a first tranche amounting to EUR 1.5 billion. We estimate that execution will take 3 to 4 months, launching post our Investor Day. Specific terms and conditions will be announced before the effective start of the program in due time. And now for the business areas, I will turn it over to Rafa. Rafa?

Rafael Salinas, CFO

Thank you very much, Onur. Good morning, everyone. Starting with Spain on Slide 17. Loans have increased by 1.1% year-on-year, driven by strong growth in the most profitable segments. A strong performance on consumer, 8.9%, where we continue gaining market share as well in SMEs with 8.5%, while mortgages devaluated at a lower rate, thanks to a strong new loan production, offsetting a bit of the leverage that we are seeing in the corporate and CIB portfolios. Moving to P&L in the first 9 months, Spain delivered an outstanding pre-provision profit of EUR 2.3 billion, growing at 9.2% versus last year, mainly driven by strong core revenue growth of 4.7%, supported by strong fee performance, up 18%, led by the recovery of activity and the robust growth in banking services, credit cards, asset management and insurance fees, and a significant increase in net trading income, thanks to the group performance of the global market unit in 2021. Expenses decreased by 1.7% year-on-year, thanks to our continued cost control efforts and despite comparatives against exceptional low 2020 figures significantly impacted by COVID, resulting in a significant improvement in our efficiency ratio to 49.3% in the first 9 months of '21 versus the 54.6% of December '20. For the whole of 2021, we foresee expenses to decrease at the same rate as we have seen in the first 9 months of the year. Additionally, net attributable profit is also positively impacted by the significant reduction of impairments, mainly explained by the good performance of the portfolio and the front-loading of COVID-related provision that we did in 2020. These group underlying trends lead to a better-than-expected cost of risk that stands at 32 basis points for the first 9 months of the year, which leads us to believe that we will end the year at around 30 basis points cost of risk. All in all, very good results with a net attributable profit of EUR 1.2 billion for the first 9 months. Moving to Mexico, Slide 18. Looking into BBVA Mexico, in terms of activity, the loan portfolio grew 1.3% quarter-on-quarter, achieving a 3.4% year-to-date growth rate. This growth is attributed to the dedication shown by retail segments, which have grown by 6.3% year-to-date, especially in mortgages, credit cards, and SME, while commercial segments also registered positive territory. For 2021, we continue to expect mid-single-digit loan growth. In terms of P&L, BBVA Mexico's net attributable profit increased by 47% year-to-date compared to last year, driven mainly by excellent core revenues and significant reductions in impairments. Core revenues as of September are improving by 5.9%, driven by solid growth in both NII and fees. NII increased by 4.1% due to improving customer spreads, thanks to our efforts to reduce funding costs in customer deposits and also lower wholesale funding costs, as well as improvements in loan yields favored by a better loan mix with new loan production directed to retail segments. For 2021, we feel confident in mid-single-digit NII growth. Fees continued showing a strong performance, increasing by 15.5% year-to-date, mainly due to higher activity. Expenses have increased by 9.5% due to a higher inflation environment and certain normalization of expenses as activity recovers. As of September, our cost-to-income ratio remains very strong at 35.1%. Good dynamics in asset quality, as we mentioned before, exist in both the retail and wholesale segments, leading to further improvement in the cost of risk, which stands at 270 basis points in the first 9 months of the year. We now expect the cost of risk to end 2021 at levels below 300 basis points. Turning to Slide 19. In terms of activity, the TL loan portfolio grew close to 30% with double-digit growth in both retail and commercial segments, while foreign currency loans continued decreasing by more than 11% year-on-year, in line with our strategy in this segment. In the third quarter, TL loan growth remained strong at 8.3% quarter-on-quarter. In this sense, we expect TL loans to grow above 20% in the full year. In terms of P&L, gross income in the 9 months of the year grew by 7.6%, supported by excellent performance of fees and net trading income. Net interest income continues to trend positively and grew significantly by 19.7%, thanks to strong TL growth, the improvement in customer spread in TL, and the higher contribution from the CPI-linked portfolio due to rising inflation expectations. We also expect this improving NII trend to endure into the fourth quarter, ending 2021 with a high single-digit increase. Net fees and commissions grew by nearly 45% year-on-year in the first 9 months of the year with growth across the board. While expenses grew by 18.5% year-on-year, exceeding the 12-month average inflation of 16.4%, negatively impacted by TL depreciation and rising personnel expenses. The efficiency ratio, however, remains strong at 30.4%. Impairments decreased significantly due to better underlying trends and singular recoveries in the wholesale portfolio, resulting in a cost of risk of 18 basis points in the first 9 months of the year, exceeding expectations. Overall, we experienced a strong set of results, with net attributable profit in the first 9 months of the year up by 48.4% year-on-year in constant terms and 16.1% in current euros. Lastly, regarding South America, Slide 23. In Colombia, loan growth is up 5.7% year-on-year after a strong quarter in both retail and commercial segments, driven by improving economic conditions. Net attributable profit increased by 65% to EUR 159 million in the first 9 months of the year, thanks to strong core revenues, which increased by 6.1%, and lower impairments. In Peru, loan growth is up 4.1% year-on-year with positive performance in both retail and commercial segments. Pre-provision profit increased by 10%, driven by strong growth in income and improvements in impairments. This led to a net attributable profit growth of 22% to EUR 79 million in the first 9 months. Finally, Argentina recorded a positive net attributable profit of EUR 42 million in the first 9 months of the year, even after a high inflation adjustment. Now I will hand back to Onur for the final remarks.

Onur Genc, CEO

Thank you, Rafa. In conclusion, let's jump into the questions, but briefly, in conclusion, we see excellent results in our view—all-time high quarterly results driven by strong core revenues and solid underlying risk performance. The second point is that we are continuing to advance in our strategy. We are leveraging our leading digital capabilities to better serve our customers but also to acquire new clients. In this quarter, we reported an all-time record in digital customer acquisition once again, increasing 48% year-over-year. Third, we remain committed to sustainability, helping our clients transition towards a more sustainable future. We have already channeled EUR 75 billion, outpacing our recently doubled 2025 pledge on the topic. Finally, we have observed strong capital generation in the quarter—31 basis points—resulting in a new level of capital strength that allows us to grow profitably and to increase shareholder distributions, which includes the launch of one of the largest share buyback programs in Europe. Additionally, I would also like to remind you of the Investor Day on November 18; we are expecting all of you to join us. We plan to share more details about our strategy and future goals. If you need any assistance regarding this, please reach out to Patricia and the Investor Relations team. Now, back to Patricia for moderating the Q&A.

Operator, Operator

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

Operator, Operator

Our first question comes from Francisco Riquel from Alantra.

Francisco Riquel, Analyst

Let me start with Mexico, 5% quarter-on-quarter growth in NII, with a flat loan book. So I wonder what is driving this NII growth. Is it freight hikes and the loan mix, the ALCO portfolio? If you can please elaborate on all these trends, and update the mid-single-digit growth guidance for the year. Also, I'd like a second question on Turkey, which is the market's current focus. These days, I still observe fast loan growth coupled with a few provisions despite the macro and currency challenges. Can you please comment on your risk appetite, loan growth, and the outlook for the cost of risk going forward? Also, on the currency sensitivity front, I see that the impact on the CET1 is negligible. So it seems that you are fully hedged; if you can please elaborate on the currency risk.

Onur Genc, CEO

Thank you, Francisco. In Mexico, very quickly. It's both activity growth and margin improvement. We have presented this to you on the page. In terms of quarter-over-quarter growth in loan balances, our retail segments have grown by 2.9% quarter-on-quarter. You see all the year-over-year figures, indicating that consumer is catching up. For example, if you refer back to last quarter's presentation, the previous number was much more negative. Now we are recovering because we paused production during COVID, but now we are back on track. What you're seeing is credit card growth of 7%. The overall quarter-over-quarter growth in retail loan activity and balances stands at 2.9%. Along with this, our customer spread has increased. The second quarter was 9.99%; now the spread is improving in Mexican pesos, which obviously helps. So we have both activity growth and the spread improvement. Regarding Turkey, loan growth is fast, yes. However, as you all know, we maintain a conservative approach to growing our book in general, especially as we have said before; we plan to reduce our balances in the FX book. We believe the risks are more concentrated on the FX side. Thus, we have been steadily planning to reduce this, and this trend has persisted over the last five years, especially this year. Our FX loan book has continued to decrease; you will see this reflected in the documentation as well. Our FX book year-over-year, September year-over-year, declined by 11%. We will remain very conservative in FX but will grow in TL portfolios as we see good client behaviors and normal cost of risk trends. On the hedging question regarding sensitivity, we have always been prudent on that one, and it has proven to be the right approach. 75% of our P&L is hedged in Turkey, and 100% of our capital is hedged. That's why you observe a 0% sensitivity to further devaluation of the Turkish lira; we've made the right decision.

Operator, Operator

Our next question comes from Benjamin Toms from RBC.

Benjamin Toms, Analyst

The first one on cost of risk, please. It's another quarter of a lower-than-expected cost of risk. Can you just remind us how much of your impairment overlay remains in place? I think previously, you said it was something like EUR 1.4 billion to EUR 1.6 billion. And I know that you say that cost of risk will be below 100 bps this year, but presumably next year could also be significantly below through the cycle. Secondly, can you just give us some color on what your longer-term aspirations are in Italy? You tend to aim to be market leader in the geographies where you operate—in this case, does this fit your existing strategy? Is the concept to own the digital banks in Italy, or do you have aspirations to potentially acquire there?

Onur Genc, CEO

Okay. Thank you, Benjamin. Regarding the impairment overlays, because we discussed these provisions in previous calls, the current numbers you are seeing today do not affect that buffer because a significant part of that buffer is reserved for Spain. We want to maintain that buffer until at least the end of 2022 before we can consider releasing any portion of it. Our guidance for the cost of risk is below 100 bps now, based on our assessment of the underlying risk profile, which appears strong. The 92 basis points I've provided, which is the annualized cost of risk year-to-date for the third quarter, reflects this. If we assess the underlying parameters, the situation looks even better than that. That is why we upgraded our guidance to below 100 bps, given the robust underlying positions. However, I would stress again that we are not releasing from the provision buffers we built up during COVID, mostly reserved for Spain, until we see the evolution in that market. Our risk management approach remains conservative and prudent. Regarding Italy, as you mentioned, we prefer to be market leaders, and we believe scale is vital in our core traditional banking business. That's why having a leading position and good market share is crucial. However, this digital model has a different cost structure—it's purely digital. We do not aspire to necessarily be the first in everything. Our objective is to create long-term value with an excellent cost structure compared to incumbents and a compelling value proposition. We've spent five years developing a leading mobile application. Why wouldn't we leverage this competitive edge in another country with a much lower cost structure than traditional banking? Our first-year goal for the Italy project is to ensure we provide the best possible customer experience, with the focus on ensuring we outperform all competitors in customer satisfaction. If we achieve that, then we can consider growth in customer numbers but remember we will not compromise value just for metrics.

Operator, Operator

Our next question comes from Sofie Peterzens from JPMorgan.

Sofie Peterzens, Analyst

Sofie from JPMorgan. My first question would be related to the previous one. Can you discuss why you chose Italy for expanding your digital bank and not another European country? What key considerations were made? How should we think about potential penetration elsewhere in Europe on the digital side? If yes, which countries would you consider? Secondly, on excess capital, your capital position is very solid. Even after the 10% share buyback, you have a 13.2% core equity Tier 1, which is well above your target of 12%. How should we conceptualize the deployment of excess capital once the 10% share is fully utilized? Will it be more share buybacks, more M&A, or organic growth? Lastly, a quick follow-up on a previous question. How much do you spend annually on FX hedging? When do the Turkey FX hedges roll off?

Onur Genc, CEO

So let’s look for a large European country, and Italy is certainly among them, but our key selection criteria were based on how rapidly the country is embracing digitalization. We examined several parameters, but the top three are mobile banking transactions, e-commerce transaction growth, and card electronic payment transaction growth. Italy is demonstrating clear double-digit growth across these metrics. Additionally, there is significant momentum from the Italian government and policymakers pushing for reduced cash utilization, which further reinforces our conviction that these numbers will continue growing, even at high double digits. What's next? Other countries are a possibility, but we are not in a rush to expand. We first need to demonstrate value creation in Italy before exploring options in other countries. Thus, our focus remains solely on Italy. The entire team is dedicated to ensuring we are the best digital bank in the Italian market. Once we achieve that, we will consider future expansion, but we do not view Italy as a test market. We are fully committed to entering and remaining in this market long-term. Regarding excess capital, we will discuss this more at the Investor Day. So let's reserve that topic for then. Nothing new to share; we have expressed that our plan for excess capital includes profitable growth and more shareholder distributions. We are not correlating M&A with excess capital; we don’t adopt a mindset of M&A being necessary when excess capital exists. M&A is a project that must make sense on its own. If it does, capital can be sourced from the market even if we have excess capital. We will continue to explore opportunities, but it must have clear value creation. As for the FX hedges, Rafa, would you like to address that?

Rafael Salinas, CFO

On the FX hedges, as a reminder, our policy reflects that we hedge between 30% and 50% of net attributable profit. Concerning excess capital in various currencies, we usually hedge 70% of that position. The cost of these hedges, which varies based on the year's circumstances and the market's valuation of different currencies, is EUR 28 million for the first 9 months of this year. The only rule I would emphasize is that we use the forward curve for FX as the reference point for our hedges. Ultimately, effective percentages depend on both the cost of the hedges and our expectations regarding currency movements.

Onur Genc, CEO

The EUR 28 million reflects our hedging program; if you're asking about costs, it represents the cost of carrying—I must stress that. Should the currency perform better than what the forward curve suggests, this results in a profit from the hedge. If not, it fulfills the purpose of the hedge. The raw cost of hedging is minimal.

Operator, Operator

Our next question comes from Fernando Gil from Barclays.

Fernando Gil, Analyst

Welcome, Rafa, to these meetings. Just two questions, please. First, you mentioned that from a regulatory perspective, you don’t expect any material impact for Q4. Could you please give guidance on what to expect in 2022? For my second question on Spain, could you comment on costs? Additionally, can you remind me how the cancellation policies regarding the Merlin agreement are structured, or if there’s anything that could allow you to cancel branches more quickly?

Onur Genc, CEO

Fernando, I couldn't catch the second part regarding the cancellation process or what you mentioned. Sorry about that.

Fernando Gil, Analyst

Yes, I apologize. It's about the margin agreement related to the branches. What are the terms for potentially canceling these branches with them more quickly?

Onur Genc, CEO

On the first front, capital expectations, as mentioned, we don't foresee any regulatory effects in Q4. For 2022, we discussed this in the previous call. We expect PD-LGD to be fully accounted; the only remaining component will be the LGD part, which should be around 15 basis points. That’s the only concern moving forward for many of the regulatory changes we’ve faced in recent years. The reason for that timing in 2022 is also because of Basel III. BBVA will be one of the least affected banks from this transition, as I mentioned. Nonetheless, regarding specific guidance, you can expect approximately 15 basis points. As for costs, I believe your inquiry was about branch mergers and sale and leaseback processes. That sale and leaseback process does not constrain us from making decisions as we have sufficient flexibility in those contracts. We can swap locations with the counter-party, which allows us to close branches as necessary. We've announced, if you remember, plans for 480 closures in Spain, and as of September, we had already completed 260. More closures will be occurring in October; most of the closures will be completed by year-end, independent of the process you mentioned.

Operator, Operator

Our next question comes from Ignacio Cerezo from UBS.

Ignacio Cerezo, Analyst

I have two questions. The first one, in Spain, regarding TLTRO. Could you please provide insight on the eligible book? How is it performing compared to the third quarter last year? How comfortable are you in meeting the benchmark? Secondly, in Mexico, regarding the lending book, could you separate the progression of the retail portfolio and the corporate lending portfolio moving forward? In retail, do you expect an acceleration in growth?

Onur Genc, CEO

Very good. On the first question regarding our comfort level with meeting the TLTRO benchmarks, we feel very confident that we will achieve it, with no issues expected. Moving on to Mexico, activity in the production scenes is accelerating. This will translate to significant growth in the retail stock, especially in the consumer book, which is notably high-margin for us moving forward. This suggests positive dynamics in retail. You asked about the wholesale side. The recent production numbers aren't bad either, yet during COVID, many enterprises have leveraged their capabilities to confront the crisis with enhanced liquidity. The deleveraging trend we've witnessed, however, resulted in a slight downturn in stock. I'm optimistic that corporate growth will return as we move into next year.

Operator, Operator

Our next question comes from Carlos Cobo from Societe Generale.

Carlos Cobo, Analyst

Most of my questions have already been addressed, but may I ask a couple of follow-ups on Spain? Loan demand seems to be weakening across the board alongside consumer liquidity buffers. How do you perceive this to evolve? What underlying lending growth do you expect? Should we anticipate another deleveraging mode like before the pandemic? Additionally, regarding TLTRO, what are your base case expectations for a roll-over or replacement with alternative compensation measures in the low-rate environment? Are you assessing a view that spans from mid-2022 onwards, as some banks are reflecting in their base cases? Lastly, on costs, consensus approximates your drivers for quarterly growth. Is there any viable compensation catch-up? Could you elaborate on the drivers of the 4% total cost increase? Historically, you've demonstrated commendable cost discipline, so if you could touch on that aspect, it would be helpful.

Onur Genc, CEO

On the growth for Spain, our research and operations teams expect that growth will continue in 2022. While we’re not providing specific guidance for the year at this moment, particularly let's note that we foresee ongoing growth in several portfolios. As noted in the figures we have shared, the consumer portfolio has grown 8.9% year-over-year in Spain, and we anticipate that growth will persist. We also see solid production dynamics in mortgages; comparing this year's third quarter to that of 2019—as 2020 was largely suppressed—we've seen a 75% increase in mortgage production. Regarding production trends for enterprises, we note that while we see some signs of deleveraging, there's also a positive outlook due to liquidity built up during COVID. Overall, we're optimistic about loan balance growth in 2022. In relation to costs, you are inquiring if they pertain to the merger of branches and the sale and leaseback process. The sale and leaseback process does not restrict us when making these decisions, as we have flexibility in our contracts. We can swap branches with the counter-party and close those we no longer need. We've announced plans to close 480 branches, and we've already achieved 260 closures as of September, further closures happening soon. Therefore, most closures will take place by year-end without hindrance from the processes you mentioned.

Operator, Operator

Our next question comes from Ignacio Ulargui from Exane BNP Paribas.

Ignacio Ulargui, Analyst

I have two questions. First, regarding costs. If I analyze your expenses, they appear slightly above inflation. Given this year's insights and your good understanding of a two-year outlook, moving forward, are there strategies you can implement in emerging economies to better contain inflation trends? This stems from experiences you've had in Turkey that may aid in containing cost growth below inflation. If not, is there potential for further measures in developed economies like Spain? My second question pertains to Mexico. It seems to me that activity has normalized significantly there, and we can expect incremental lending growth from this point. You emphasize the growth in consumer credit; however, do you perceive escalating competition in this segment? Is there a risk that could challenge consumer lending growth from Mexico? Also, a brief inquiry on sensitivity rates with respect to interest rates in Mexico—will you be updating these?

Onur Genc, CEO

On cost growth, our original guidance suggested that we plan to keep cost growth below blended inflation rates this year. We will stand firm in that before the end of the year. For the coming years, maintaining this plan will still be our focus. A considerable effort has gone into our digital transformation journey — we've been pioneers in this space. Our target customer segment, which we define as our most engaged clients, increased its numbers significantly, growing 70% over the past five years, with branches decreasing by 6%. We are serving many more customers with less infrastructure, which allows us to keep costs growing less than inflation. We are keen on enhancing our cost-to-income ratio and aspire to keep improving this because we are presently regarded as the best bank in Europe concerning this ratio. We will either serve a greater number of customers with the same level of infrastructure, a smaller infrastructure, or optimize the infrastructure altogether. Regarding the consumer portfolio in Mexico, it is crucial for us. As you rightly pointed out, competition exists everywhere; however, a significant portion of our consumer book comprises what we refer to as payroll loans, where payments are directly deducted from salaries. We hold nearly a 40% market share in this area. Our strength in consumer lending stems from this transactional relationship with customers, giving us a key advantage over newcomers. As long as we maintain high customer satisfaction, and knowing we have far superior digital capabilities, we foresee continued growth in our consumer lending business. On the sensitivity to rates in Mexico, a 100 basis point increase would result in a 3% shift over a 12-month period. Specifically, if we consider local currency sensitivity—where you increase rates by 100 basis points—this would prompt an NII rise by 1.7%. The dollar sensitivity figures at 1.3%. Thus combined, yields a total sensitivity of 3%.

Operator, Operator

Our next question comes from Benjie Creelan-Sandford from Jefferies.

Benjie Creelan-Sandford, Analyst

Yes, I think most of my questions have been answered. Perhaps just a quick follow-up regarding the interest rate sensitivity you've mentioned in Mexico. You've communicated continued efforts to reduce funding costs there. Can you discuss that further in light of the rising rate environment and whether that might add to the interest rate gearing? For a brief follow-up, could you comment on asset quality? The trends in Spain appear relatively benign, but I've noticed Stage 2 balances ticked up slightly quarter-on-quarter. I'm curious if there's anything specific to address there or if you're apprehensive about future provisions in Spain.

Onur Genc, CEO

For Mexico, Benjie, you can see this reflected on the page we shared. The latest numbers show that demand deposits have increased by 9.8%, while time deposits are down by 12.7%, which showcases our strategy to optimize funding costs by focusing on a transaction-focused customer base, as it's cheaper. The average funding cost in Mexico is now around 0.9%, while the industry average is 1.8%; we are achieving this with almost half the funding cost due to our emphasis on transactional cash flows. Regarding Spain's cost of risk, Rafa, would you like to comment on that?

Rafael Salinas, CFO

Our guidance regarding cost of risk has been upgraded to 30 basis points overall. The noticeable uptick in Stage 2 exposure you mentioned results from some exposures in Stage 3 moving to Stage 2 in the wholesale portfolio. To clarify, this is related to specific cases where we have observed improvements and recoveries in that geography.

Onur Genc, CEO

For Spain, regarding cost of risk, I would add one point. The summer period proved to be a good asset test for us. There was the potential for Eco holders to apply for participative loans or reductions in the principal of their loans, so we anticipated high interest from customers. However, we only received around 100 applications, which is substantial considering we have more than 100,000 on these loans. This served as a good asset test, reflecting that the companies in our Eco portfolio are doing well and are not experiencing financial pressure.

Operator, Operator

Our next question comes from Marta Romero from Bank of America.

Marta Romero, Analyst

I've got a couple of follow-ups on Mexico. You're operating Mexico with negative margins this year; when do you expect this trend to reverse? Could you provide more specificity on your outlook for costs in Mexico? Are you targeting a specific cost-to-income ratio? You're running now at 35%. Also, are you transferring costs from the corporate center into Mexico, Turkey, and LatAm? If you are, how much more could we expect? Lastly, just a follow-up on Mexico's commercial loans. The book wasn't progressing well before the pandemic; what do you believe is driving this? Do you think policy risk has continued to impact corporate risk appetites in Mexico?

Onur Genc, CEO

Marta, could you reiterate the third question again? I didn’t fully catch that.

Marta Romero, Analyst

Yes, certainly. It's about whether you're transferring costs from the corporate center into the divisions.

Onur Genc, CEO

No, that's not a significant driver. We do transfer costs only for specific projects developed for certain countries, which is intergroup billing. However, the immediate increases or changes therein aren’t affecting overall figures noticeably. The notable decline in total corporate center expenses that we've seen in the past two years is indicative of our plan to downsize that center. Previously, we discussed the intention to scale back the corporate center, and this process is currently underway.

Operator, Operator

Our next question comes from Stefan Nedialkov from Citi.

Stefan Nedialkov, Analyst

Welcome, Rafa. I have a couple of questions. Concerning Italy, as you know, a major Dutch bank has been operating there in a nearly digital-only capacity with a few branches. Their success has been somewhat mixed. What makes you believe you can perform better? Did you analyze their case? What conclusions did you reach before entering this market? Also, how long did it take to launch operations in Italy from conception to execution? On a related note, about ESG; I saw you now offer a carbonization calculator—that sounds interesting. Yet regarding the Scope 3 emissions disclosed, I see you're not clarifying your loan book emissions. When can we expect those numbers? Additionally, would you consider that an increased focus on green and brown assets could penalize you due to geographic exposure and significant representation in emerging markets? I understand it's early, but do you see that becoming an obstacle?

Onur Genc, CEO

Great questions, Stefan. Regarding Italy, compared to other digital competitors which may be free value propositions, they lack depth in product offerings. Our analysis shows that we have a unique competitive position: we can replicate low-cost propositions while retaining the product depth and trust of incumbents. We effectively provide a combination of low-cost operations with a comprehensive product suite—a middle ground. Regarding the timeline for Italy, post-decision, it took about a year to tailor the Spanish platform to Italy, involving a team of approximately 100 individuals. On carbonization and sustainability: we will provide more detail on our Scope 3 emissions at COP26 next week. This will include our sector-by-sector goals, comprising client portfolio emissions as well. Addressing your broader point on emerging markets, we anticipate that the acceleration in developed regions will influence developing countries positively. While support is necessary, this is already unfolding as a trend—our consumers will demand green innovations similarly to those in developed economies, and we see the value in transitioning our diverse client base early.

Operator, Operator

Our next question comes from Mario Ropero from Bestinver Securities.

Mario Ropero, Analyst

I have a few follow-ups. Initially, about fee income in Spain this third quarter—can you confirm whether any one-offs influenced that positively? Regarding the eco-loans, could you clarify how many are currently paying principal? Is the end of the grace periods a significant milestone for you regarding releasing the overlay provisions in Spain?

Onur Genc, CEO

To address the fee structure in Spain, there were no one-offs involved; that is straightforward. The figures in Q3 did show slight declines compared to Q2 due to successful asset management success fees, but this has remained consistent through the year to date. Regarding eco-loans, Rafa?</s>

Rafael Salinas, CFO

Currently, the majority of eco-loans remain in the federal grace period; principal repayments will begin around mid-next year. So far, during 2021, 34% of eco beneficiaries requested extensions, meaning many will transition to 2022 before we're able to assess their repayment capabilities.

Onur Genc, CEO

The total eco program equated to EUR 20 billion for us, with EUR 13 billion allocated to loans. The portion under the extension is EUR 5 billion. We're closely monitoring this portfolio and observing a very high percentage—45% is categorized as Stage 2, though currently, no deterioration signals arise. Our provisions on this portfolio are prudent, but we will reserve any releases until we can evaluate the situation in 2022.

Operator, Operator

Our final question comes from Britta Schmidt from Autonomous Research.

Britta Schmidt, Analyst

I've got three questions, please. Could you detail your outlook for Turkey considering rate moves? What is the status of your CPI linker portfolio, and what inflation rates do you expect? Additionally, how can you assure us that you can keep pace with FX devaluation regarding earnings growth? For my second question, I’d appreciate confirmation about costs—did the variable compensation in Q3 include any catch-up from the first half, or is this a recurring number? Lastly, can you comment on any developments in your real estate business regarding the 20% joint venture put option with servers? Can you confirm any impact?

Onur Genc, CEO

On the last two questions because they are quite straightforward. We can confirm that the put option for the real estate business has been executed, and while there won’t be a material P&L impact, we do expect a capital impact of around 7 bps in the fourth quarter. The sale was completed in October. Regarding the cost increase—did it include a first-half catch-up? The answer is yes. Now, moving on to the first question concerning the outlook for Turkey and interest rates. The current forecasting incorporates an 18% CPI; we expect our research team to call it at 19.5% by the end of the year, indicating a slight upside in terms of CPI accrual revenue. On the structural aspect of achieving earnings growth to outpace FX devaluation, that depends on the FX devaluation magnitude. However, our firm belief is that being the best bank in the country will consistently generate profits; thus, a fundamental return to sustainable growth is expected. Our long-term objective is to focus on tangible book value and uphold growth amidst the economic challenges.

Operator, Operator

Thank you very much. There are no further questions. Thank you, everyone, for participating in the call. Let me remind you that the entire IR team will be available to answer any further questions you may have. Now, Onur, if you would like to close.

Onur Genc, CEO

No need for further closing comments from my end. We are expecting all of you to attend our Investor Day on November 18. We hope for a fruitful discussion around our strategy and future goals. Thank you all for joining this morning.