Banco Santander, S.A. Q2 FY2022 Earnings Call

Good morning, everybody, and welcome to Banco Santander's conference to discuss our financial results for the first half of 2022. Just as a reminder, both the results report and the presentation we will be following today are available to you on our website. I'm joined here today by our CEO, Mr. Jose Antonio Alvarez; and our CFO, Mr. Jose Garcia Cantera. Following their presentations, we will open the floor for any questions you may have in the Q&A session. With this, I will hand over to Mr. Jose Antonio Alvarez. Jose Antonio, the floor is yours.

Thank you, Begoña, and good morning to everyone. Thank you for joining us this morning. So well, I should start by saying that the second quarter, we've been living in a period in which we saw inflation hitting decade-high levels, interest rates starting to rise, and significant concerns regarding lower economic activity in the future. So this sums up the environment of the last quarter. In this environment, we continue to grow our business, our customer base, and we translate this into growth in loans, deposits, and revenues in our P&L NII plus fees, as you can see in the slide. The progress on the digital front has been significant in the quarter. When we talk about profitability, the second quarter profit was €2.4 billion, reaching €4.9 billion for the first half, which is 33% higher than the previous year. If we look at costs in euros, they are 21% higher than the previous year. The costs, in a highly inflationary environment, remained well below inflation, and our efficiency ratio stood at 45.5%, in line to reach our end-of-the-year target of 45%. We improved our profitability ratios: the return on tangible equity stays at 13.7%, and we continue to create significant value for our shareholders. EPS grew 38% compared to the previous year, and tangible net asset value per share plus cash dividend per share grew 9% year-on-year. In regard to the strength and quality of the balance sheet, NPLs continued to trend down, and the cost of which remains well inside our expected range, and our capital is a slight level of 12%, following a strong net organic generation of 18 basis points in the second quarter. As I have just mentioned, our commercial strategy is reflected in widespread growth. As you can see in the slide, we've been growing in individuals, both in mortgages and consumer areas, in mid- to high single digits, less so in the corporate space where we are seeing a relatively flattish loan book in SMEs and corporates, while corporate investment banking is growing at 13%. Overall, loans were up 2% quarter-on-quarter, amounting to €21 billion in the quarter, with increases in all countries, mainly from mortgages and consumers. In summary, I think we have a high-quality, well-diversified portfolio by market. Our CFO, Jose, will explain later on in more detail the portfolio by geography and collateral. On the other hand, deposits grew 1% quarter-on-quarter and 5% year-on-year, with a market shift towards time deposits due to the changing interest rate environment. Turning to the income statement, I would like to give you a brief overview of the main ideas. The performance in euros was better than in other currencies, due to the depreciation of the euro. Although we experienced a negative pressure, this was partially offset by hedging included in the corporate center. This is included in gains on financial transactions. In constant euros, we grew revenue 4% year-on-year at a faster pace than expected, driven by higher volumes, interest rate hikes starting to feed through in some countries, together with another strong quarter in corporate investment banking. Cost management faced inflationary pressures but continued to grow well below inflation. This allowed us to achieve a record pre-provisioned profit of €14 billion in the first half of this year. As for loan loss provisions, the releases recorded in the U.K. and U.S. in the second quarter of 2021 affect the year-on-year comparison. Finally, we had a positive impact from minority interest following buybacks in Mexico and the U.S. and lower tax burden mainly in Brazil due to the recovery from tax contingencies and others. This led to a record first-half profit of €4.9 billion in 2022. The attributable underlying profit recorded the same amount as we didn't have extraordinary charges in this first half of the year. If we look at ideas in Europe, we continue to accelerate our business transformation towards a common operating model. This was reflected in customer growth year-on-year, increasing by nearly 300,000 in the quarter. We saw double-digit growth in net operating income and profit, with return on tangible equity improved to 8.8%. In North America, we are focusing our position in the U.S. while maintaining a disciplined capital allocation. We accelerated growth volumes. Loans rose 7% in most segments in Mexico, as well as in the auto and corporate investment banking sectors in the U.S. We also increased our customer base by 3% year-on-year, achieving a profit of €1.6 billion in the region. In South America, we are leaders in the region with a unique presence strengthened by group assets, delivering profitable growth. Our growth strategy, based on increasing customers by 6 million year-on-year, led to a sharp increase in volumes. Loans grew 12% and deposits 5%. The first-half underlying profit was over €1.9 billion, a 7% year-on-year increase, with a higher return on tangible equity above 20%. In the Digital Consumer Bank, we continue to strengthen our leadership position as reflected in new lending, which rose by 10% in a shrinking market. Profit grew to double digits, with return on tangible equity rising to 12%. Our efficiency ratio is running at 45.5%, heading towards our target of 45% for the year-end. Return on tangible equity is slightly ahead of our target for the year at 13.7%, and we remain on track to meet our 2022 target. In terms of EPS, it was €0.27 in the quarter, a 38% increase year-on-year and a 19% increase compared to the first half of 2021 in underlying earnings per share. We continue to demonstrate sustained earnings per share growth, particularly given that we've amortized almost €550 million in shares through buybacks, approximately slightly above 3.2% of our capital. The tangible net asset value per share was €4.24, including cash and dividends, in line with the previous quarter and 9% higher year-on-year. Regarding capital, the organic capital generation was in line with our expectations, with net organic generation of 18 basis points. If we consider the payout of 40% in cash dividends and cash buybacks, we generate approximately 10 basis points after accounting for the buybacks. This quarter did not show up in the total capital ratio due to the fact that the held-to-collect-and-sale mark-to-market detracted 13 basis points from our capital, offsetting the growth in organic generation. We are meeting our targets here, showing that risk-weighted assets grow below loan growth, which is one of our targets: achieving better profitability in the front book and reducing the weight of risk-weighted assets to produce a return on equity below the cost of equity. We are making good progress on these targets, as demonstrated by our profitability. Finally, before I hand over to Jose, I would like to highlight Santander's strong commitment to ESG. Specifically, I want to refer to new targets we published just a couple of weeks ago, on top of the already existing targets related to power generation and coal. We published specific targets for energy, aviation, and steel to reduce the absolute level of emissions in the region of 30% for the period from 2019 to 2030. You have the figures on our progress in Green Finance, and we've appointed a new head of refinance to measure and classify properly, according to European taxonomy, our loan book to generate business and help our customers transition to a greener economy. We remain very active in the social front, particularly in Latin America, with financially empowered individuals. You have the figures in the presentation. Overall, I'm proud of the group's progress in delivering on our responsible banking commitments to help tackle global challenges, both in terms of climate and social aspects. I will now hand over to Jose to elaborate on the group and business areas.

I just want to provide a brief overview of the main highlights for the quarter, and I will go into more detail about the P&L of the group and the progress of the country and business areas. In the quarter, we earned €2.4 billion after recording regulatory charges of nearly €500 million, €400 million for the resolution fund and €88 million contribution to the new institutional protection scheme in Poland. In the first half, total income exceeded €25 billion. Both NII and fee income grew at 7% in constant euros and accounted for 97% of total income. Trading gains and other income decreased 40% compared to last year, mostly affected by FX hedging, which attracted €300 million and also from lower lease income from ALCO portfolio sales in '21 and higher regulatory contributions. In the quarterly performance, we saw similar trends, with revenue up 4%, excluding regulatory charges. Let me take a moment to go through the main drivers of NII in more detail. Group NII was supported by broad-based growth in loans and deposits, coupled with margin management and interest rate hikes in the U.K. and Poland. As a result, net interest income and margin increased from 2.38% last year to 2.49% in the first half of this year. You have all the information on the slide, but I would like to highlight the following by country: we had very strong NII in the U.K. and Poland, as I mentioned since these are the two countries where we see the impact of higher rates in Europe. We also had robust activity in both countries. Spain and Poland decreased NII by 6% and 8%, respectively, despite the rise in volumes due to continued pressure on yields and lower ALCO portfolios. In the U.S., NII was affected by the Bluestem portfolio disposal and consumer loan pricing competition. Mexico's NII was up 9% due to strong loan growth in individuals and corporates. Finally, in Brazil, NII rose 2%, backed by volume growth and credit mix, but was primarily offset by negative sensitivity to initial rate hikes. We expect this negative impact from liability repricing to level out in the fourth quarter of this year and turn positive into next year. Regarding fees, we had very positive performance in all regions, supported by greater activity in high value-added products and services, as you can see on the right-hand side of the slide. All countries increased income, with the exception of the U.K., which was affected by the transfer of the corporate investment banking business to the London branch. Excluding this impact, it would have been flat, and in the U.S., it was affected by the disposal of Bluestem and lower overdraft fees. In terms of costs, we kept our target of growing costs below inflation while improving efficiency. In Europe, costs were down 7% in real terms, with widespread falls across countries, and efficiency improved by 4 percentage points. In summary, we continue to make structural changes to our operating model to drive new productivity improvements in the future. Turning to risk, the group maintained positive credit quality ratios. The NPL ratio was 3.05%, which is 21 basis points better than in the previous quarter, and most markets improved. In Spain, it fell 64 basis points due to portfolio sales. Total loan loss reserves stood at €24 billion, and the loan loss coverage at 71%, up 2 percentage points in the quarter. The distribution of the loan portfolio by stages remained stable, and even Stage 3 assets were lower in the quarter. Our cost of credit stood at 83 basis points. For the first six months of the year, the cost of risk was 91 basis points, in line with our target for the year. I would like to dive a bit deeper into loan loss provisions and cost of risk performance. By country in Europe, all countries remain below 1% or were negative, with Spain's cost of risk improving due to lower loan loss provisions and better portfolio quality. The U.K. and Portugal saw slightly positive costs considering only six months, while Poland improved provisions; however, the cost of risk was affected by the contribution to the Swiss franc mortgage portfolio. The U.S. cost of risk remained below 1% after the 2021 releases. Loan loss provisions are up year-on-year but still well below pre-pandemic levels. In Mexico, the cost of risk improved significantly, thanks to better-than-expected performance of the loan portfolio. In Brazil, cost of risk increased, primarily in our secured individuals, which represent around 20% of the portfolio. Secured individuals and SMEs and corporates, representing 80% of the total portfolio, remained stable. The coverage ratio over 90 days is well above pre-pandemic levels. We are better positioned than in the previous crisis as we increased the individual secured portfolio and have less volatility than the market, and 'cheque especial' decreased its weight compared to prior crises. In the digital consumer sector, the cost of risk improved and continues to show outstanding low levels, considering the nature of the business. Finally, I would like to show you a brief overview of our loan portfolio. It is mostly concentrated in mature markets, around 80%. In developing markets, Brazil accounts for just 9% of the group total. 65% of the portfolio is secured, mostly by real estate collateral. By segment, mortgages with loan-to-values below 80% account for 90% of the total. The consumer lending portfolio is very well collateralized and has a very short-term duration. SMEs and corporates are secured with 50% real guarantees. Lastly, 65% of our corporate portfolio, particularly the large corporate portfolio, is rated investment grade, with 42% rated above A-. A very high-quality portfolio. Let me now make some brief comments about the evolution of our main units in 2022. In Spain, year-on-year results were driven by lower costs of 4% and reduced cost of risk in an environment of weak revenue performance. Looking forward, we expect trends to continue in the second half. NII should absorb the impact of TLTRO cancellations. We expect 2023 to reflect asset repricing, delivering margin expansion. Fee income should remain robust in the second half. Costs should maintain their downward trend, aiming to achieve our cost-to-income target. The cost of risk in Spain is expected to remain around 55 to 60 basis points for the year. In the U.K., we maintained very positive dynamics in new lending and strong NII. Looking ahead, we expect these trends to continue, with NII growing well but probably at lower rates than in the past and flat costs, with cost of risk normalization close to around 10 basis points. In the United States, the results of 2022 compare to high financials in 2021. Nevertheless, in the first half, profit remained very high, above €1 billion. Our outlook for 2022 is lower revenue impacted by lease businesses, costs slightly up, due in part to the incorporation of Amherst Pierpont, while cost of risk is better than initially anticipated, staying well below normalized levels. Santander Mexico had another excellent quarter. For the year as a whole, we expect higher NII and fees, with costs rising as we invest in digitalization amid higher inflation, and a cost of risk below 2.5%, supporting credit quality that is better than average. In Brazil, the first half faced a negative impact due to the initial sensitivity of our balance sheet to higher rates and inflation pressures affecting costs, and cost of risk deteriorated in unsecured loans to individuals. We expect to finish 2022 with efficiency around 30% and a cost of risk below 4% to 4.5%, resulting in a return on equity around 20%. All in all, in a difficult year, we expect strong results and profitability, and we are optimistic for 2023, anticipating improved revenue. In the Digital Consumer Bank, new business activity increased 10% year-on-year. We gained market share, particularly in the used car segment. Looking towards the second half, the environment will continue to be challenging, but we expect to meet our goals and surpass our previous record in new business exceeding €49 billion in 2019. We expect some normalization from the current low cost of risk rate but should remain well below previous normalized levels. This is because, in this case, cost of risk is more closely linked to unemployment than interest rates, and we anticipate a strong labor market in Europe in the coming years. CIB delivered another very strong quarter. In the upcoming quarters, we expect to continue gaining market share, increasing revenue through excellent dynamics in structured finance and project finance, transaction volumes in markets where we are protecting the value of our trading books. Wealth Management and insurance, despite market volatility, saw profits grow 15%. In Private Banking, we had new net money inflows of €6 billion, while in asset management, profits rose 8%. In Insurance, gross written premiums increased by 17%. Looking ahead, we expect to maintain double-digit growth in profit contribution across these three businesses. In PagoNxt, total revenue in the first half surged 87% year-on-year, backed by our four main business segments, especially merchants and trade. Activity is evolving very well, and we believe we will meet our target of over 50% revenue growth for the whole year. Finally, in cards, we managed 96 million cards throughout the group, with revenue growing 28% year-on-year to around €2 billion, with double-digit growth in America and Europe. We expect to continue to grow turnover and revenue at high double digits in the coming months. Let me now turn it back to Jose Antonio for his closing remarks.

Thank you, Jose. Let me try to guide you through what we see regarding the group evolving in the coming quarters. On the revenue side, we have an environment where NII should increase in the coming quarters, mainly benefiting from interest rate hikes. Normally, the interest rate hike takes a while to show up in the P&L; it starts slowly and accelerates later on. With expected activity levels, we anticipate a significant acceleration of revenues, particularly in 2023. You will see some of this already, clearly in Poland and the U.K., where rates start going up faster. Next year, we will see strong acceleration mainly due to higher rates in the Eurozone, Mexico, and other countries. On fee income, as Jose mentioned, we are generating business across different sectors that are evolving positively. We are gaining shares in CIB, which is performing very well, and also doing well in private banking and insurance. We believe we can grow in wealth management and insurance well into double digits. Therefore, I remain fairly optimistic about the commercial activity leading to fee income growth. Regarding costs, it seems like we face clearly higher inflation than we initially forecasted; nevertheless, we continue to think we will be able to improve productivity and manage costs below inflation as we have been doing quarter after quarter. Naturally, some inflation could impact our cost base, particularly in high inflation countries. However, we believe productivity gains will allow us to keep cost growth well below inflation. In terms of asset quality, we are aware of the discussions surrounding potential GDP deterioration and recession. Already in the first half of the year, we've accounted for around €600 million worth of provisions regarding potential deterioration. Given our loan portfolio structure, high household savings rates, lower unemployment rates, and resilient real estate prices, we feel our portfolio remains protected. For this year, we feel comfortable with our target, which is below 1%, as we are running at 91 basis points and are confident we will meet our target. Regarding capital, we remain committed to staying at or above 12% in every quarter, maintaining disciplined capital allocation, reflecting this in higher profitability. The capital generation of the group, aside from the mark-to-market of held-to-collect-and-sale assets, has been solid this quarter, and I believe it will continue to generate capital steadily moving forward. This will translate into shareholder returns as we have committed to a 40% payout this year, with hopes to increase it closer to 50% in the future, as communicated during our shareholder meeting. To reiterate, we are comfortable achieving our targets for efficiency, return on tangible equity, and core equity Tier 1 this year, and for the future, we believe revenue growth will outpace any possible increase in costs or cost of risk. Thus, I remain optimistic about our ability to generate future profits. That's it. We are now available for any questions you may have.

Thank you, José Antonio. We'll now open the floor for any questions.

We already have our first question from Ignacio Ulargui from BNP Paribas Exane. The next question is coming from Alvaro Serrano from Morgan Stanley.

Hopefully, you can hear me. I have two questions, one regarding Brazil and another for clarification on your previous comments about capital. Regarding Brazil, I heard Jose mention that you maintain a cost of risk between 4% and 4.5%. However, when looking at Q2 alone, the cost of risk seems to be 525 basis points. To meet your guidance for the full year in the second half, it appears you'd need to get below 400 basis points. I want to ensure I've interpreted the guidance correctly and would appreciate some insight into what is happening, as the increase seems steeper than expected, although you indicated the peak would occur in Q2. Also, on the capital issue, the 50% you referenced, Jose Antonio, can we expect that to happen in 2023? Alternatively, is there anything we should consider that might hinder you from reaching that 50%, like remaining capital challenges? I believe you mentioned there are no more challenges for 2023, but I'm uncertain if any issues may arise in the second half. Knowing Banamex is no longer a factor, I don’t see any reason you shouldn't be able to raise it to 50%.

Thank you, Alvaro, for your questions. Regarding Brazil, Jose has already provided some insights, but I'll go into more detail. As Jose mentioned, we're experiencing an increase in the costs associated with building our consumer mass market portfolio. You're correct that these costs were higher in the second quarter compared to the first. Despite this, we remain confident in the guidance we've given you. In fact, we have seen improved results in June compared to the previous three or four months, and we feel optimistic about staying within our projected range. As you know, we reduced lending last year, and Jose highlighted that our exposure to overdrafts, which is contributing to the increased cost of risk, has diminished. We're comfortable with our expectations for the year, especially considering that Brazil is one of the few countries where the IMF has raised GDP growth forecasts. We do have elections coming up in October, but overall, our outlook remains positive. We believe that the measures we've implemented and the trends we've observed will allow us to maintain a cost of risk in the 4% to 4.5% range for the entire year. There are no signs of deterioration beyond what we've previously noted. The corporate portfolio is performing well, including SMEs, while the individual consumer segment, particularly the auto portfolio, has shown improvements. However, the unsecured consumer space continues to drive up costs. Regarding your second question, we have previously communicated that we anticipate no challenges affecting our future capital. As stated in the AGM, the Board intends to target a capital level of 50%. When this will be achieved is determined by the Board, and I cannot predict their decision timeline, but it is clear that our goal is to return to those levels and continue engaging in buybacks, as well as paying cash dividends, as we've been doing over the past year.

If I may give you a bit of color about the regulatory charges in the second half, in the first half, we had 5 basis points in the first quarter. The second quarter accounted for 3 basis points, which has two components: plus 7 basis points from the nonperforming loan backstop difference and minus 4 basis points from models. So from a pure regulatory perspective, we have around 9 to 10 basis points already accounted for, and we would expect another 10 to 15 basis points in the second half. So very much in line with the guidance we provided at the beginning of the year for a total of 20 to 25 basis points total regulatory charges for the year as a whole.

The next question is coming from Ignacio Ulargui.

You hear me now?

Very well, indeed.

Okay, perfect. Sorry for the problem before. Just have one follow-up question on Mexico. Just following the sort of like the outcome of Banamex, what is the strategy that you plan to follow there? And what are the priorities for the bank, in terms of organic growth, in which segments you think that you can gain market share? And the other question is on cost of risk at a group level? I mean, you have given a bit of comfort about Brazil. I mean, is there any other market where you think there could be some deterioration in the cost of risk but still below 100 basis points guidance for 2022?

Thank you for your question, Ignacio. Regarding Mexico, our strategy is centered around organic growth. Currently, we hold a market share of about 13% to 14%, which gives us sufficient scale to compete effectively. Specifically, we plan to concentrate on increasing our customer base in the individual market, as our corporate market share is performing better than that of individuals. This focus should lead to a bigger deposit base and improved market share in the consumer sector. We have made progress in auto finance, where we have gained a 14% market share in just three years. We also launched a new credit card last September, which is selling 100,000 units a month, indicating strong growth potential. Our balance sheet reflects this accelerating growth. In the mortgage sector, we hold an 18% to 19% market share, which is significantly above our average. This mirrors our experience in Brazil when Bradesco acquired HSBC, where we increased our market share during a tough period, and we aim for similar results in the coming years. As for the cost of risk, while I won’t focus heavily on Brazil since Alvaro has already addressed that, other markets are also seeing a rise in cost of risk. The U.S. market is returning to normal after an unusually low cost of risk in 2021. The cost of risk in the auto market is still affected by the limited availability of new cars and high used car prices, stabilizing in the context of low unemployment. We anticipate a gradual normalization in the U.S., but no alarming signs in other markets. In Spain, we expect the cost of risk to decline this year and next, and we have no concerns in consumer finance. Our portfolio in Mexico remains strong, and we are also performing well in Chile, with no signs of deterioration; in fact, non-performing loans are decreasing, currently around 3%, down from about 2.80% last year. I previously mentioned provisions of €600 million in the first half, largely due to macroeconomic conditions as we adjust to those changes.

The next question is coming from Pamela Zuluaga from Credit Suisse.

The first one is around capital. Most of the organic capital that you keep generating has been offset by fair valuation adjustments from your bond portfolios. Are you thinking about maybe changing your risk allocation strategy, shifting your accounting towards held to maturity for bonds in order to somehow shield capital better? How should we think about this risk moving forward? Because thinking about the pending regulatory impact that you were guiding for, could we, therefore, expect some further risk to capital if market dynamics continue impacting valuations? And my second question is on Poland. Do you have any estimates on the potential impact from mortgage moratoria in Poland, because we already have confirmation that four of those months are going to happen this year and four next year? And should we continue to expect further provisioning in Poland related to the FX-denominated mortgages?

Regarding organic capital, your question is about if we can convert to held-to-maturity. As for our portfolios, they are relatively short-duration. The portfolio is around €50 billion. I think that the duration is short, and we haven’t made any immediate plans to change this reclassification. We are aware that if we do, we could regain 25 basis points, but with the short duration, we find that as long as rates remain stable, it's feeding through the P&L month after month and will reduce the impact moving forward. Of course, fluctuations in rates will affect P&L, but we don’t feel rushed to make any change considering the portfolio size and duration. Jose, do you want to add anything?

Yes, just to elaborate further, of the €75 billion ALCO portfolio, €53 billion is held to collect on sale, while only €20 billion or €22 billion is held to collect. Most of our portfolio is marked-to-market and 75% has a duration of less than two years. For example, in Poland, it's one year and in Mexico, it’s 1.7 years. This means that any potential further deterioration with this duration will pose significantly less risk going forward than it has thus far.

Regarding the second question about Poland, if I understood you correctly, you are asking two questions: one about mortgage moratoria and the second about FX Swiss franc provisions for mortgages. Regarding the moratoria, what has been published recently is that we assume a 50% take-up across the entire portfolio, which will account for an impact of PLN 1.3 billion. In euros, that measures approximately €200 million. Most likely, this will be charged to the third quarter in our P&L in Poland, coming in slightly below €300 million. For FX, we now stand at about 32% coverage. Should we need to top that up? We will see. The market coverage is around 35%. We are in position to reach between 36% and 37%. However, it would only represent 3% of a €1.9 billion portfolio, or around €50 million to €60 million. I hope that clarifies your questions.

The next question is coming from Sofie Peterzens from JPMorgan.

My first one would be on the proposed Spanish banking tax. Do you have any additional comments on what the potential impact on you will be, and will it only be on your Spanish operations or also on your international operations? My second question would be a follow-up on the auto portfolio. Could you remind us how much ALCO bonds you have in Spain, and over time where you need to build up that ALCO portfolio level to? How much can you potentially increase the ALCO by? And a final question on Mexico: could you clarify why you walked away from the Banamex transaction?

Regarding the Spanish banking tax, unfortunately, I do not have any information at this moment. I've heard that there are rumors indicating that a presentation will occur in parliament today. We will learn more when it's presented more formally. I expect this will impact Spanish operations, but I am unsure at this point. ALCO in Spain, we don't have any ALCO bonds; that is zero. The potential size of a normalized ALCO portfolio would amount to a very large amount; you can do the math from the relative duration of the balance sheet, which is around five years. I think creating a reasonable ALCO portfolio for Spain would mean adjusting the balance sheet duration to something between minus two and plus two years. We attempt to reconstruct this portfolio gradually depending on the market view and the ideal balance of our balance sheet's duration. The decision about Banamex is simply that we are interested in the asset, yet the price we offered did not align with the return on investment we sought. We openly submitted a non-binding offer and were informed we would not continue in the process. That's all there is to it. We were disciplined in our approach. Nevertheless, we expect that, based on the current situation, we have a strong opportunity to grow organically and gain several percentage points of market share through our existing franchise.

The next question is coming from Benjie Creelan-Sandford from Jefferies.

I had three questions on the revenue outlook, please. First of all, just on the Digital Consumer Bank. I guess looking in the quarter, volumes are going up, but margins are going down. So just wondering if you could discuss a little bit about what you're seeing regarding consumer loan demand across the European business. How are clients reacting to cost of living pressures versus what are still very good employment trends? In terms of margins in the Consumer business, is there a lag effect regarding asset price repricing that is weighing on margins? Or are you seeing increasing pricing competition in that segment? The second question was just a clarification on Brazil and the NII outlook in the second half of the year. So I understand that you expect the rate repricing to level out in Q4. Should we assume that NII will be down sequentially in Q3 again? And perhaps if you could just provide a bit more guidance regarding the rebound as the lag effect and the rate repricing runs off into 2023. I know you gave us guidance on the rate sensitivity on a year one basis. Can you give any indication of what that rate sensitivity looks like on a year two basis in Brazil?

Let me elaborate on the Digital Consumer Bank and consumer loan demand in Europe. The demand for consumer loans is quite good. However, the challenge with our portfolio is that it consists of €120 billion, with €85 billion related to auto loans. The rest is primarily direct lending and point of sale financing. We are observing positive trends in both sectors, but lead times in the auto industry are extending significantly. Typically, we have stock finance for car dealers that runs around €13 billion to €15 billion, but currently, it's about half of that, around €6 billion to €7 billion. This suggests a limitation in the auto industry’s ability to meet demand. Similarly, in the U.S. market, we are seeing robust activity levels and prices in the used car segment, which is also true for Europe. This year, we anticipate reaching around €50 billion in originations, and while volume is expected to grow by 10%, we are capturing a larger share of the market. Nevertheless, the overall market is contracting considerably, as car sales are dropping sharply. Despite this, we are gaining market share, which accounts for the 10% increase in originations. Moving on to Brazil and the outlook for net interest income, the loan book is increasing as we expected. However, market-related activities have declined and entered negative territory as interest rates rose from 2% to 12%. Usually, it takes about two quarters post-tightening for changes to materialize. We believe we are approaching the peak, and we will have a clearer picture by August or September. We anticipate an additional increase of a couple of basis points, likely between 75 and 100 basis points, and then we should see positive effects on net interest income two quarters later. We expect customer growth to persist, which will lead to a positive impact on the profit and loss statement. Jose indicated that expectations for 2023 align with this outlook.

The next question is coming from Ignacio Cerezo from UBS.

I have two questions on the U.S., regarding asset quality. So if you can kind of let us know your view about what we need to monitor to gauge when and how quickly asset quality can start deteriorating. If it's unemployment, like you were mentioning, the European consumer finance operation, or are you also concerned around collateral prices going down and reversing the increase we have seen in the last couple of years? The second question around this is, I mean, obviously, the units have been blended into one, and we do not have the disclosure between SCUSA and the rest of the bank. There have been significant changes in the mix of SCUSA in recent years as well, so it's difficult for us actually to have a realistic view through the cycle of the cost of risk for the unit. Could you share your view on where the cost of risk in the U.S. might land in a normal environment?

Regarding asset quality, when we consider the potential eroding factors, unemployment rates are one of the crucial drivers in the U.S. Let me guide you through what's occurring in SCUSA. We are generating in the loan book with a FICO that is 35 points higher than what we generated a year ago. This highlights our ability to adjust towards the arising FICO trends. Moreover, the pricing model is intricately aligned to the FICOs we are generating. This explains a lot about yield trends. Now concerning our leasing business, traditionally, we would allow customers to take the cars on a leasing model, where they would return the vehicle in 3 or 4 years when the vehicle changes ownership in auctions. During 2021, this turned profitable, but in 2022, we are seeing a shift since customers are reluctant to return the vehicles; they prefer to sell them due to prevailing high prices. This has altered dynamics in our P&L, resulting in decreased income from other sources. Previously this generated around €200 million in the last period; now those profits are significantly reduced. Generally, this could be a market maturity issue, but we expect that traditional credit quality ratios will normalize over time. This is not necessarily bad news as we are generating loans at higher FICOs, meaning cost of risk will fall when unemployment deteriorates. I think unemployment remains a significant factor, not as much interest rates, since we are lending at very high yields. An extra 100 basis point hike, for instance, will not have as severe an impact as it would for loans taken in much lower segments.

The next question is coming from Carlos Peixoto from CaixaBank.

I have a couple of questions from my side as well. One is really just a follow-up. I believe I missed the exact guidance that you provided for NII in Brazil for the full year. The second question is on the outlook for cost of risk in Spain. I believe that in the past, you have mentioned something in the area of 50 basis points. Right now, cost of risk is still trending a bit above those levels. I was wondering how you see it for the second half of the year and possibly in 2022.

In Brazil, our expectations are for mid-single-digit growth in NII for the entire year. Regarding cost of risk in Spain, we haven't altered our expectations; we set the guidance as 50 to 60 basis points for the whole year. That's what you can expect for Spain this year. Of course, this means, as you know, the cost of risk largely depends on macroeconomic conditions. As I previously said, €600 million in the first half was due to shifts in our macroeconomic outlook. In the second half, since macro conditions remain uncertain, we will have to see how that impacts our numbers by the end of the year. But if the macro environment remains steady as it is today, I would expect us to stay within that range.

The next question is coming from Andrea Filtri from Mediobanca.

Two questions. One on rate sensitivity. This is the flavor of the moment, but the visibility you're giving is still quite low compared to other names. Can you please provide your 12-month rate sensitivity for each main area, assuming 0 deposits beta? I think you plugged in the forward curve that we can all see just to add some transparency there. The second question is on Brazil; again, on rate sensitivity. You elaborated quite a lot on this, but I wanted to understand in Brazilian real terms what you would expect to be the tailwind when liability repricing stops and asset repricing is completed. Can you clarify how much this could lead to cost of risk improvements?

Sure. Let me provide you with the details on the rate sensitivity and how it impacts our business. High-level, I should say that considering the forward rates I mentioned, the process is accelerating. If I take the full year of 2023 with our overall business in Europe, we should expect north of €2 billion. This is a centralized figure. You asked about the Spanish ALCO, and I mentioned we could reasonably consider an ALCO portfolio between €20 billion and €40 billion; this sounds reasonable to me. ALCO does not necessarily mean a single sovereign; instead, it refers to a portfolio of fixed-rate assets that we do not generate in commercial terms. The bulk of our portfolio consists of floating rate loans; therefore, existing ALCO portfolios are limited. Looking at the Brazilian context for rate sensitivity, Jose has provided some specifics around this. You should expect a positive sensitivity of around €140 million to €150 million when the last interest rate increases take place. If the final rate hike occurs in August or September, and we begin to recognize the associated positive impacts on P&L in Brazil approximately at the end of this year or early next year, these results should start flowing through as we expect significant improvements.

The next question is coming from Carlos Cobo Catena from Societe Generale.

A couple of questions for me. One regarding M&A appetite now that you've ruled out Mexico. There have been some media reports about you exploring some agreements or expanding the agreements with carmakers in Europe. Could that be an area where you could pursue some bolt-on deals? And how material, if you could quantify, that might be in terms of capital consumption, if it's possible to give that view. Also, I understand there has been some top-up to the macro provision overlay. Can you elaborate on which countries you've been allocating those provisions, as I see that in previous discussions, your Spanish competitors haven’t topped up much on that COVID overlay? It would be interesting to understand where you differ.

Thank you, Carlos. Regarding M&A appetite, I want to highlight that we are not actively looking in the M&A space. However, we remain committed to establishing agreements with OEMs. Last year, we signed three significant deals. The main agreement was with Stellantis to restructure our previous deal, leading to a portfolio growth of around €5 billion, alongside another important collaboration with Mitsubishi in the U.S. and a major agreement with Honda in Mexico to serve as the provider for Honda. We have ongoing discussions with OEMs for specific countries, and we see this as business as usual for our Digital Consumer Finance division. The provisions overlay: I mentioned the roughly €100 million allocation in Spain, €260 million in the U.K., and €130 million in the U.S. That's composed of the €600 million allocated due to macroeconomic shifts during the first half results.

The last question is coming from Britta Schmidt from Autonomous Research.

I've got two questions, please. One is on the rate outlook for Brazil. The consensus expects that there will be rate cuts in 2023. Can you help us understand the dynamics of your NII outlook as a result? Would we see even wider spreads, say, in the second half of 2023, depending, of course, on the timing? My second question will be on Poland. Do you have any update on the WIBOR issues? Are you expecting this to still lead to a legal case and drag on? What's the latest from your perspective?

In Brazil's retail market, we expect rates to pick sooner rather than later, possibly in August or September. Once rates begin to fall, predicting how they will progress is more complex. However, as Jose clarified, we should expect NII to experience a tailwind effect over one or two quarters thereafter. Our forecasts indicate that when liabilities repricing ceases and asset repricing occurs, the commercial dynamics will prevail in Q4 or the first quarter of 2023. It's still quite uncertain, especially in Brazil. Regarding Poland, you inquired about the WIBOR situation. The proposal to alter WIBOR is still in the air, while we have observed a suggestion for a modification. The execution will be complicated and may present challenges. We currently lack concrete details beyond this information, and we do not expect any rapid progress in this area.

Well, if I could add regarding WIBOR, we do know there is a proposal to change it; however, detailed actionable plans currently remain elusive. It would face challenges, as changing the index contradicts established regulatory framework recommendations in Europe, making it a tough process. We have no new updates at this time.

The proposal is indeed challenging to execute. As Jose mentioned, European regulations hinder these changes. That's the current status on the matter. We do not anticipate news in the near future.

Thank you, José Antonio. There are no further questions.

Thank you, everyone. Take care, and have a good holiday to those taking holidays in the coming weeks. Thank you. Goodbye.

Thank you, everybody. Goodbye.