Spanish Savings Banks

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1 Europe Banks (Citi) Industry 24 pages Spanish Savings Banks Survival of the Fittest Equity Cajas Recapitalisation Through a stress test of capital and real estate asset quality, we show how the Spanish cajas could need between 24bn to 34bn to restore an 8% equity Tier 1 for each of them. The current size of the Fund for Orderly Bank Restructuring (FROB) ( 99 billion) is sufficient, in our view. Cajas in Context Cajas account for 49% and 52% of the Spanish deposit and lending market, respectively. Five of the 10 largest banking players in the country are cajas. With 1.3tn of assets and 75bn of equity, they represent broadly 50% of the Spanish banking sector. What s next for Cajas? The cajas should undergo significant changes in the next few months: mergers, downsizing and (further ahead) possible listings. The 46 cajas today will halve in number just from the transactions already announced. And more consolidation is likely in the foreseeable future. Accelerating Change Funds from the FROB are available to the cajas till the end of June 2010, which should lead to numerous consolidation and restructuring announcements this month. The Bank of Spain s new provisioning policies will lead to faster recognition of real estate-related losses, again accelerating M&A. The Strongest Cajas Based on our stress test, only institutions that have an equity Tier 1 ratio above 10.5% today won t require capital injections from the FROB: BBK, CajAstur, Kutxa, Unicaja and Vital. la Caixa, the sector leader, has strong profitability (half of 2009 caja sector earnings) and strategic flexibility. CCM & CajaSur: The Fallen Both institutions were seized by the Bank of Spain due to weak capital and asset quality positions. Both were also loss making last year. Ignacio Moreno ignacio.moreno@citi.com Ronit Ghose ronit.ghose@citi.com European Banks Team Henrik Christiansson Andrew Coombs Leigh Goodwin Azzurra Guelfi Kimon Kalamboussis Sentoor Kanagasabapathy Kinner Lakhani Stefan Nedialkov Simon Nellis Paul Nery Banks To Benefit? The consolidation and restructuring of the cajas will open up market share gain opportunities for the Spanish commercial banks. An acceleration of loss recognition, especially for real estate assets, should also benefit the rating of the overall system, including the quoted banks. See Appendix A-1 for Analyst Certification, Important Disclosures and non-us research analyst disclosures. Citi Investment Research & Analysis is a division of Inc. (the "Firm"), which does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

2 Survival of the Fittest Cajas in Context Cajas account for about half the Spanish banking sector The Spanish banking market is fragmented, with the top 10 players holding only a 66% of the loans and 59% of the deposits. The top 10 is split between banks and savings banks. The top 5 banks (Santander, BBVA, Popular, Banesto, Sabadell) have a bigger market share than the top 5 savings banks ( la Caixa, Caja Madrid, Bancaja, CAM, Caixa Catalunya). But the large number of small savings banks makes the cajas bigger than the commercial banks at an aggregate sector level: 49% vs 43% for loans and 52% vs 42% for deposits. Figure 1. Spanish Banking System Ranking by Loans and Deposits, December 2009 (Euros in Billions) Loans Deposits Santander BBVA "La Caixa" Caja Madrid Popular Bancaja Banesto Sabadell CAM Caixa Catalunya Source: Spanish Banking Association, company data and CECA. 2

3 Mortgages and real estate activities account for two-thirds of caja loans The balance sheet exposure of savings banks is biased towards lending to individuals and developers. Exposure to individuals is especially tilted towards mortgages, c40% higher in savings banks vs. banks. Figure 2. Spain Lending by Institution, December 2009 (Euros in Millions) Banks Savings Banks Sector Corporate Loans 482, , ,326 Construction 52,308 67, ,435 Real Estate Services 132, , ,306 Industry (non construction) 88,169 47, ,199 Commerce 45,072 67,639 81,028 Financial Services Brokerage 45,611 26,642 74,305 Other 118,658 47, ,053 Individual Loans 316, , ,708 Mortgages 231, , ,647 Other home related 8,542 28,394 43,255 Consumer finance 27,309 12,262 49,228 Other household financing 34,911 59, ,800 Other 14,200 15,950 31,778 Total 798, ,630 1,837,034 Source: Bank of Spain Cajas dominate the deposit market, especially time & savings deposits Savings banks have been funded mostly with deposits, while banks have relied more on wholesale funds. Banks have much lower market shares in savings and time deposits than the cajas. Figure 3. Spain Deposits by Institution, March 2010 (Euros in Millions) Banks Savings Banks Sector Sight 133, , ,660 Savings 67, , ,365 Time 233, , ,209 Foreign Currency 19,076 2,985 22,161 Total 434, ,767 1,172,234 Loan-to-Deposit Ratio 1.84x 1.35x 1.57x Source: Bank of Spain At an operating level, cajas are less efficient than banks. Cajas have more branches, a higher cost to income (C/I) ratio and lower productivity per branch. Revenues per branch are 94% higher in banks compared to savings banks. Figure 4. Spanish Financial Institutions Key Operating Metrics (December 2009) Cajas Banks Sector Cost to Income 46% 41% 44% Branches 24,202 14,840 44,431 Employees 132, , ,101 Employees per Branch Income per Branch ( m) Loans per Branch ( m) Source: Bank of Spain, Citi Investment Research and Analysis 3

4 Savings Banks Financials ROE drops from 18% to 4% in two years The profitability of the sector peaked in 2007 with an ROE of 18%. In 2009, it fell to 4%. This sharp decrease was driven by a fall of non-net interest income revenues and a pick-up in loan losses. During the decade between 1997 and 2007, savings banks loans increased at an average growth rate of c20%; deposits have been also growing but at slightly lower levels. Figure 5. Savings Bank Sector Key Financials (Euros in Millions) % 2008 % 2009 % P&L Data Interest Income 31,994 48,589 52% 59,977 23% 45,661-24% Interest Expenses 18,477 32,313 75% 42,711 32% 26,521-38% Net Interest Income 13,517 16,276 20% 17,266 6% 19,140 11% Non NII Revenue 9,657 13,926 44% 10,654-23% 10,296-3% Total Revenues 23,174 30,203 30% 27,920-8% 29,436 5% Personal Expenses 7,460 8,203 10% 8,922 9% 8,710-2% Other Expenses 4,319 4,706 9% 4,934 5% 4,821-2% Gross Operating Income 11,395 17,293 52% 14,064-19% 15,905 13% Provisions % 630 4% % Loan Losses 3,007 4,965 65% 7,768 56% 10,301 33% Other Financial Assets Losses % % 2, % Other Income 1, % 1,500 77% % Profit Before Taxes 8,714 12,481 43% 6,728-46% 3,206-52% Taxes 1,594 1,488-7% % % Net Income 7,121 10,993 54% 6,437-41% 3,075-52% Ratios ROE 12.2% 18.2% 9.7% 4.3% ROA 0.71% 1.01% 0.53% 0.24% NIM 1.34% 1.49% 1.42% 1.49% LLP 42bps 64bps 90bps 116bps LDR 1.42x 1.45x 1.37x 1.32x Equity / Total Assets 5.8% 5.3% 5.6% 5.5% Balance Sheet Data Total Assets 1,007 1,171 16% 1,262 8% 1,310 4% Customer Loans % 888 7% 882-1% Customer Deposits % % 668 3% Total Equity % 70 13% 73 3% Other Data Employees 124, ,933 6% 134,786 2% 132,340-2% Branches 23,418 24,591 5% 24,985 2% 24,202-3% Source: Bank of Spain There are 46 cajas in Spain. la Caixa based in Barcelona is the largest one, with 271 billion assets, followed by Caja Madrid ( 192 billion) and Bancaja ( 111 billion, based in the Valencian Community). There is at least one caja per each of the 17 Autonomous Communities of Spain. In most cases, the size of the savings bank is linked to the wealth of the Communities. Andalusia, Cataluña, Madrid and Valencian Community are the largest Autonomous Communities in terms of % of Spanish GDP, are home to 6 of the 10 largest savings banks. 4

5 Figure 6. Spanish Savings Banks Key Financial Data, December 2009 (Euros in Millions) Name # Total Assets Loans Deposits LDR S. Equity S. Equity / T. Assets NII Total Revenues LLP PBT Net Income "La Caixa" 1 271, , , x 18, % 3,932 7,187 1,840 1,868 1,833 Caja Madrid 2 191, ,740 89, x 10, % 2,532 3,871 1, Bancaja 3 111,459 81,011 50, x 3, % 1,324 2, CAM 4 75,532 52,896 41, x 3, % 1,606 2, Caixa Catalunya 5 63,650 44,381 27, x 2, % 832 1, Caixa Galicia 6 46,340 35,335 28, x 2, % 677 1, Ibercaja 7 44,691 33,356 28, x 2, % Unicaja 8 34,185 23,955 23, x 2, % 756 1, Caixanova 9 31,738 20,545 20, x 1, % 457 1, BBK 10 29,806 21,178 19, x 3, % Cajasol 11 28,244 21,721 19, x 1, % CCM 12 26,035 17,097 16, x % Caja España 13 25,254 14,675 17, x 1, % Caixa Penedes 14 23,042 15,710 15, x 1, % Caja Murcia 15 22,140 15,303 16, x 1, % CECA 16 22, , x % Caja Duero 17 21,390 13,742 14, x 1, % Kutxa 18 21,095 15,719 16, x 2, % CajaNavarra 19 19,451 12,792 13, x 1, % CajaSur 20 18,960 12,976 13, x % CajAstur 21 15,829 10,591 11, x 1, % SaNostra 22 14,114 10,015 10, x % General de Canarias 23 13,910 9,694 10, x % Caixa Granada 24 13,759 10,309 10, x % Caixa Sabadell 25 13,318 9,020 10, x % Caixa Terrassa 26 12,890 8,248 8, x % Caja Municipal de Burgos 27 12,579 8,155 8, x % CAI 28 11,938 8,138 8, x % Caixa Tarragona 29 10,829 6,402 6, x % Caja Cantabria 30 10,343 8,265 7, x % Caja Insular de Canarias 31 9,305 6,505 6, x % Vital 32 9,252 6,556 6, x % Caixa Laietana 33 9,191 6,924 7, x % Caixa Girona 34 7,815 5,593 5, x % Caja Extremadura 35 7,590 5,695 6, x % Caja Avila 36 7,115 4,754 4, x % Caixa Manresa 37 6,545 4,464 4, x % Caja Segovia 38 6,172 3,999 4, x % Católica de Burgos 39 5,208 3,415 4, x % Caja Badajoz 40 4,248 2,828 3, x % Caja La Rioja 41 3,873 2,756 2, x % Caixa Manlleu 42 2,643 2,235 2, x % Caja Guadalajara 43 1,755 1,214 1, x % Caja Jaen x % Caixa Ontinyent x % Colonya x % Top 10 subtotal 901, , , x 50, % 13,253 22,004 6,293 3,923 3,689 Top 10 share 67% 68% 61% 68% 65% 67% 62% 102% 97% Top 20 subtotal 1,090, , , x 60, % 16,022 26,616 8,170 3,520 3,558 Top 20 share 81% 81% 76% 81% 79% 81% 81% 92% 94% Total 1,341, , , x 74, % 20,275 32,755 10,084 3,839 3,794 Source: CECA, Citi Investment Research and Analysis 5

6 Number of cajas to halve based on announced transactions The restructuring process currently taking place will change the structure of the sector dramatically. Taking into account the mergers already announced, the number of cajas will be reduced from 46 to 23. Below we show the consolidated key financials for the mergers already announced. Most of the transactions are not closed yet and might change in the near future. Figure 7. Spanish Savings Banks Consolidated Key Financial Data After Announced Mergers, December 2009 (Euros in Millions) Names Involved in the Merger # Total Assets Loans Deposits LDR S. Equity NII Revenues LLP PBT Net Income "la Caixa", Girona 1 279, , , x 18,761 4,067 7,383 1,885 1,891 1,850 Caja Madrid, Laietana, Avila, Insular de 2 227, , , x 12,076 3,148 4,715 1, Canarias, Segovia and Rioja CAM, CajAstur, CCM, Caja Cantabria and 3 135,329 94,544 83, x 5,844 2,592 3,788 1, Extremadura Bancaja 4 111,459 81,011 50, x 3,662 1,324 2, Caixa Catalunya, Manresa and Tarragona 5 81,024 55,247 38, x 3,652 1,152 1, Caixa Galicia and Caixanova 6 78,077 55,881 48, x 3,596 1,134 2, Murcia, Penedés, Sa Nostra and Granada 7 73,055 51,337 51, x 3,846 1,181 1, Caja Duero and Caja España 8 46,643 28,417 32, x 2, , Navarra, Canarias and Municipal Burgos 9 45,939 30,642 31, x 3, , Ibercaja 10 44,691 33,356 28, x 2, Unicaja and Caja Jaén 11 35,167 24,609 24, x 2, , Cajasol and Caja Guadalajara 12 29,999 22,935 21, x 1, BBK 13 29,806 21,178 19, x 3, Caixa Manlleu, Sabadell and Terrasa 14 28,851 19,503 21, x 1, CECA 15 22, , x Kutxa 16 21,095 15,719 16, x 2, Cajasur 17 18,960 12,976 13, x CAI 18 11,938 8,138 8, x Vital 19 9,252 6,556 6, x Circulo de Burgos 20 5,208 3,415 4, x Badajoz 21 4,248 2,828 3, x Caixa Ontinyent x Colonya x Top 10 subtotal 1,123, , , x 59,673 16,680 27,088 8,395 3,539 3,499 Top 10 share 84% 84% 81% 80% 82% 83% 83% 92% 92% Top 20 subtotal 1,335, , , x 74,196 20,146 32,581 10,039 3,819 3,779 Top 20 share 100% 100% 99% 99% 99% 99% 100% 99% 100% Total 1,341, , , x 74,613 20,275 32,755 10,084 3,839 3,794 Source: CECA, Citi Investment Research and Analysis and Press Releases 6

7 Stress Test Under our stress test, the Spanish cajas would need 29 billion of capital In this section, we stress the capital needs of the 45 savings banks in Spain (all cajas excluding CECA 1 ). Under our test, the Spanish cajas would need 29 billion of capital to restore an 8% equity Tier 1 for each of them; if we broaden our test, the amount would be in the range of 24bn and 34bn, which would consume 25% to 35% of the funds in the restructuring fund. Figure 8. Stress Test Capital Injection Sensitivity (Euros in Billions) NPLs 20% 30% 40% 50% 60% 30% % Haircut to Collateral 50% % % Source: Citi Investment Research and Analysis In the base case of our stress test, we have stressed each savings bank on an individual basis. The main assumptions are below: 1. We have considered that the recapitalisation takes place within 12 months. IMF takes into account the pre-provision profit of the period for their exercise. In our view, that period is too long. 2. The real estate exposure of each savings bank is the average of the sector. According to BoS, the exposure of the Spanish banks and savings banks to the sector varies from 6% to 50% (see Figure 9). 3. The NPL ratio of the construction and developer sector reaches 40%. This figure represents 6% more than the average of the previous crisis in our database. This number also represents a slightly higher number than the Japanese and Korean crisis (1997). 4. The loan to value of the exposures to the real estate and construction sectors is 80%. 5. We apply a collateral haircut of 50%. This haircut represents the highest of the discounts proposed by BoS in their last consultation, which applies to land for development purposes. In our view, the valuations of Spanish savings bank collateral are considerably inflated % fall in the revenues in 2010, similar to our estimates for Spanish local banks. 7. Increase in provisions on foreclosed and acquired assets of 15%. We estimate this will take overall provisioning on this asset to 30%. 8. Costs stable yoy. 9. We increase the resulting equity Tier 1 up to 8%. 1 The Spanish Savings Banks Association (CECA) is the National Association of 45 Spanish savings banks. CECA is also a credit institution in itself, which provides services to Savings Banks and other entities that request them. From this standpoint, the Confederation is a company providing financial, technological and consumer services. 7

8 Figure 9. NPL Ratio of Construction and Development (y-axis) and % of Construction and Development Loans Over Total Loans (x-axis), (December 2009) Source: Bank of Spain. Note: The institutions considered account for 94% of the credit to construction and property development at the reporting date. Main Conclusions Spanish savings banks need 29 billion to restore equity Tier 1 ratios to a minimum of 8.0%. The only institutions that won t require capital injections from the FROB are those that currently have capital rations above 10.5%. These institutions are: BBK, Unicaja, Kutxa, Vital and CajAstur. The savings banks system core capital falls by 278 bps under our base case. The largest falls in equity Tier 1 (in bps) under our stress test are Cajasur and CCM, both seized by BoS. The two smallest are la Caixa and CajAstur. According to our estimates and as of today, savings banks need c 9 billion to reach an equity Tier 1 ratio of 8%. Currently there are 20 savings banks that exceed this capital threshold. 65% of the capital needs are concentrated in six institutions (including CajaSur and CCM). For this exercise, we haven t taken into account the future regulatory changes under Basel III. These changes could impact some cajas significantly due to the high amount of minorities (ie. CAM) and insurance activities (ie. Ibercaja and la Caixa ) in their shareholders equity. Even in the worst case scenario, the capital needs of savings banks can be fully covered with the current size of the FROB. 8

9 The Future of the Sector: Restructuring Caja restructuring a key theme for the Spanish economy The restructuring of the financial sector, mainly savings banks, is one of the three key economic themes for Spain. The other two themes are reform of the labor market and fiscal consolidation. The savings bank sector is currently under market scrutiny due to its asset quality, capital/funding issues and the macro outlook. All those items have been highlighted by international authorities looking for a faster and cleaner restructuring process. A restructuring fund (FROB) with 99 billion firepower was created a year ago to recapitalise the institutions. The last day to apply for funds from the FROB will be the 30 th June, according to BoS. FROB In June 2009 the Spanish Government approved the creation of the FROB ( Fondo de Reestructuración Ordenada Bancaria or Fund for Orderly Bank Restructuring). FROB is the vehicle from where the BoS will recapitalise all the troubled institutions. If a bank/savings bank wants to benefit from the FROB, all the following cumulative conditions have to be met: Legal conditions to access the FROB 1. According to Bank of Spain, the Beneficiary does not present any weakness that can affect its viability in the light of the evolution of financial markets. 2. Core capital of at least 6%. 3. The capital injection by the FROB does not exceed 2% of the RWA (threshold can be exceeded if the additional amount of the capital is linked to the costs of the integration between banks). The FROB has an established original funding of 9 billion, of which 6.75 billion is contributed by the State Budget and the rest ( 2.25 billion) has been contributed by the Deposit Guarantee Funds. In addition, the FROB may resort to external funding to finance its activities; being able to reach a maximum size of 99 billion with the approval of the Ministry of Economy ( 27 billion already approved). So far only 3 billion of debt has been issued. The remuneration of the FROB Securities is equal to the minimum of 7.75% and the Spanish Government Bond Yield bps. Special conditions will apply to Beneficiaries that meet conditions 1 and 2 above but need a recapitalisation in excess of 2% RWA if they are to be considered non-fundamentally sound. 9

10 Operational conditions for all FROB participants In order to benefit from the FROB, all the Beneficiaries must agree: 1. To refrain from non-organic growth. 2. Not to use the fact that they benefit from the Scheme for advertising or marketing purposes or carry out aggressive commercial strategies. 3. To accommodate the remuneration of senior management to the applicable Union rules and to the criteria laid down in the Commission Recommendation of 30 April 2009, on the remuneration policies in the financial services sector. 4. To cap dividend payment to 30% of annual profits or, in the case of savings banks, to limit distribution to "obra bénefico-social" up to 30% of annual profits, unless a higher percentage is necessary to honour existing commitments. Operational conditions for nonfundamentally sound beneficiaries In cases where the FROB subscribes for the FROB Securities in Beneficiaries that are non-fundamentally sound (recap >2% RWA and first two legal conditions met) above, the following additional commitments are required: 1. A reduction of 20% of the installed capacity. 2. After three years from the subscription of the FROB Securities, the aggregate total assets of the Beneficiary may not exceed 95% of the sum of the total assets of the credit institutions involved in the merger. 3. Not to remunerate any outstanding hybrid instruments unless this obligation stems from legal obligation. Operational conditions for fundamentally sound but FROB recap above 2% RWAs In cases where the FROB has subscribed for the FROB Securities in excess of 2% RWA of a Beneficiary that is nevertheless considered to be fundamentally sound, the following additional commitments will be required: 1. To divest at least 10% of the installed capacity. 2. To refrain from increasing the number of branches in Spain. 3. Not to pay dividends or, in the case of savings banks, not to distribute any amount to the "obra benefico-social" for new projects. 4. To maintain the staff productivity ratio between the revamped branch network and the central services during the next five years. 10

11 Execution Strategy Slow execution strategy in tackling cajas issues Instead of undertaking a fast and aggressive process for restructuring the cajas, the BoS is perceived to have taken a slower approach, which had made the market fear a worst-case scenario. One of the key reasons for the slow process has been the politicised nature of the cajas. Recent reports from the Bank of Spain and IMF estimate that the maximum amount of capital needed by the Spanish financial system is well below the 99 billion of the FROB. The IMF estimated that 17 billion is needed to recapitalise the cajas; they also highlighted the need to speed up the process. According to BoS, the exposure to the troubled construction and property development sector amounts to 166 billion for the Spanish banks and cajas. Out of this, 42.8 billion are doubtful loans, 59 billion substandard loans, 60 billion foreclosed assets, and 4 billion loans write-offs. Net exposure to troubled construction and developers c 120 billion, ex collateral The net exposure (exposure minus provisions) would be 123 billion. The provisioning level for each category is shown below: Figure 10. Spanish Banking Sector Coverage of Construction and Developers Exposure Specific Coverage ( Bn) % of Coverage Doubtful assets Substandard loans Foreclosures Write-offs Source: Bank of Spain The 123 billion exposure (net of provisions) would be almost fully covered by the 99 billion restructuring fund. If we consider that most of this exposure has some collateral, then the size of the fund seems more than enough. According to our stress test, the size of the restructuring fund is also sufficient. The current provisioning levels, the current capital levels, and the collateral values are the buffers that should enable Spanish savings banks to survive this crisis. The main risk of the current execution strategy is the possibility of having a financial system with zombie institutions unable to give loans, reducing the chances of a healthy economic recovery. Provisioning changes just announced by the Bank of Spain The consultation process opened by Bank of Spain last week shows the willingness to accelerate the pace of the restructuring process. The three proposed changes are: 1. Shortening and simplification of the NPL provisioning calendar. 2. Haircuts to provisioning according to collateral. 3. Increasing the provisioning requirements of foreclosed assets. 11

12 The first two proposals combined mean that in absolute figures the amount to be provisioned will be reduced but the timeframe will also be reduced. Most of the Spanish listed banks have used until now a short-term calendar BBVA and Santander already at new real estate asset coverage levels The change in the provisioning policy of real estate assets was expected. The big Spanish banks have provisioned their foreclosed and acquired assets up to 30%. Since the beginning of the crisis, Spanish listed banks have been more cautious with their provisioning policies than savings banks. We have already included the new provisioning rules for real estate assets held by banks in our forecast. The bank that shows the weakest coverage level is Sabadell. This problem will be solved with the 265 million of capital gains from the sale & leaseback of branches agreement signed in April. Figure 11. Spanish Banks Foreclosed and Acquired Real Estate Assets, 1Q10 (Euros in Millions) BBVA SAN POP BTO BKT SAB Foreclosed 1,149 2,400 1,106 1, Acquired 2,450 4,200 2,333 1, ,112 Coverage of Real Estate Assets 30% 31% 20% 26% 22% 15% Source: Company Data The Bank of Spain has calculated the impact of the proposed new provision rules: (1) for 2010, an extra 2% in specific provisions, equaling a 10% cut to profits before taxes and (2) if we include the change in treatment of repossessed assets in 2011, this would increase specific provisions by almost 7% instead of 2%. New BoS rules will hardly change big cap Spanish bank earnings If we include the BoS estimate of the 2010 impact of the new rules (eg 2% higher specific provisions), our group forecasts would hardly change for the big Spanish banks. Figure 12. Spanish Banks Expected Impact of Provisioning Change (Euros in Millions) BBVA SAN POP BTO BKT SAB Actual Specific Provisions 2010E -1, , Specific Provisions After BoS Expected Increase Increase of 2% 2010E -1, ,547-1, ,018 Group Net Income 2010E Before 4,849 9, After 4,834 9, % -0.3% -0.1% -3.0% -2.3% -1.8% -3.8% Source: Citi Investment Research and Analysis 12

13 Cajas Consolidation The current picture of the savings banks sector won t look the same in 12 months. The current 46 savings banks will be reduced significantly given the wave of mergers about to happen in the sector in the next 3 weeks. So far only 523 million have been deployed by the FROB to recover Cajasur capital ratios. Requested and approved transactions include: Figure 13. Restructuring Process Update, As of June 2010 Process Approved by Banco de España and FROB Cajas Catalunya, Tarragona and Manresa Cajas Duero and España Cajas of Manlleu, Sabadell and Terrasa Approved by Banco de España but no funds from the FROB Cajas Navarra, Burgos and CajaCanarias (Banca Cívica) Unicaja and Caja Jaén Process under development Caixanova and CaixaGalicia CajaSol and Caja Guadalajara Cajas Asturias, CCM, CAM, Cantabria and Extremadura la Caixa and Caixa Girona Caja Murcia, Caja Granada, Caixa Penedes y Sa Nostra Caja Madrid, Insular de Canarias, Caixa Laietana, Caja Segovia and Caja Rioja Cajas under receivership CCM Cajasur Money received from FROB 12% of total assets of the savings banks sector 1,250 m of preference shares to be repaid in five years 525 m of preference shares to be repaid in five years 380 m of preference shares to be repaid in five years 7% of total assets of the savings banks sector 61% of total assets of the savings banks sector Estimated 1,162 m Estimated zero Estimated 1,600 m Estimated zero Estimated 875 m Estimated 3,000 m 1,6% of total assets of the savings banks sector Deposit Guarantee Fund of the savings banks FROB Source: Bank of Spain, Citi Investment Research and Analysis The consolidation within the sector is taking place with two different structures: traditional mergers and light mergers (SIP). A traditional merger (ie Catalonian savings Banks) is a complete integration of the institutions, which will benefit from a higher level of integration maximising the level of synergies in front office and back office. Light mergers are considered those created around the SIPs (Sistema Institucional de Protección). SIPs are defined as A contractual or statutory liability arrangement which protects those institutions and in particular ensures their liquidity and solvency to avoid bankruptcy in case it becomes necessary. This means that in the base case, the SIP keeps the brand, legal entity and economic independence of each savings bank. The synergies come from back office and product factories. The current law requires SIPs to comply with different requirements, the most significant being: 1. Centralised internal control and risk policies. 2. At least 40% of the own funds of each of the members of the SIP have to be committed to a common solvency and liquidity agreement. 3. Institutions mutualise at least 40% of their results. 4. There is a minimum term of 10 years, with severe penalties to deter members from leaving the SIP. 5. 0% risk weighting for exposures of each member of the SIP with other members. 13

14 The lack of a commercial view and the political willingness should drive most of the transactions to light mergers, which are less desirable given the lack of operating synergies, which will increase the cost to tax payers. Access to capital markets One of the main weaknesses of savings banks is their lack of access to the equity capital markets. Currently there is only one security, cuotas participativas, that allows this. The problem is that it doesn t have voting rights, reducing the interest of the institutional investor base. So far only one institution has issued this security, CAM, which is traded but with low volumes and very low free float. Some of the current proposals to change the law include the possibility of issuing equity instruments with voting rights, which would imply the privatisation of the sector. The political noise around all the consolidation process and the lack of focus on profit maximisation, among other factors, will not benefit savings banks in the future when accessing the capital markets. We think only the names that have been consistent in terms of strategy and disclosure, strongly correlated with a professional management, will be able to IPO when the time comes. CajaSur & CCM: The Fallen Both Caja de Ahorros y Monte de Piedad de Córdoba (CajaSur) and Caja de Ahorros de Castilla-La Mancha (CCM) were seized by the Bank of Spain due to their weak financial situation. Their close relationship with the real estate sector, both in the lending and on the investment side, made them the first institutions to be seized in the crisis. Too much real estate exposure CCM was a successful savings bank very committed to, not only involved with, the real estate sector. With a former member of the Spanish congress as Chairman, CCM got mandated in several projects by the regional government, in some cases with unrealistic business plans. The high concentration of developers in the loan book triggered alarms. The deposit outflow did the rest. Bank of Spain finished the work, seizing the savings bank on 29 th March BoS started sending the first warnings to CajaSur almost 18 months ago. The savings bank was too exposed to the real estate sector. Its main exposures, big developers from its home town, filed for bankruptcy, leaving the savings bank in a very weak situation. BoS requested a solution from CajaSur involving a merger with a competitor. Different solutions with savings banks from different regions were blocked because of political reasons. A merger with Unicaja, also from Andalucia, was blocked because of CajaSur s unwillingness to stand for all the synergies of a merger. Bank of Spain got tired after more than 6 months of negotiations, seizing the savings bank. On 29 th May 2010, BoS took control of CajaSur. 14

15 Las Cajas: The Basics The Cajas de Ahorro ( savings banks ) are legal entities created under a structure between foundation and mutual company. These institutions have full capabilities to offer banking services at the same level as banks. The key differences with banks are three: savings banks don t have shareholders, a General Assembly controls the institution, and a significant part of their profits are invested in social welfare programmes. Savings banks don t have shareholders As a non-profit foundational financial institution, savings banks don t have a legal owner. Many things have changed since the first savings bank was founded in 1834 and the non-profit part of the legal name has been completely diluted. The Government approved a security for the savings banks to have access to the equity markets (cuotas participativas). So far only Caja de Ahorros del Mediterraneo has been listed this way due to the non-voting status for the bearer of the cuotas. The General Assembly is the highest governing body of the savings bank and is equivalent to the AGM of a private bank. The General Assembly decides the key political issues of the institution, including the appointment of the top executives. The composition of the general assembly includes all the stakeholders of the savings banks including: deposit holders, local government, regional government, employees and founding entities. The number and percentage of stakeholders varies among institutions. More than 1.1 billion was invested in social welfare programmes by savings banks in 2009, which represents 27% of sector profits. The human side of savings banks for some, an additional marketing tool for others, it represents the public face of savings banks at the high street level. New cajas law under review A new law to regulate savings banks is currently under review by the Congress. The new regulatory framework will need to face several issues to regulate the sector. Identity problems, governance issues, lack of capital access and political interference are the areas of focus that should be tackled in the new law. Who owns the cajas? It is not very clear if cajas are mutual companies or foundations; it is not even clear if they are public or private institutions. This is a significant problem and is a source of confusion on the identity side. Savings banks don t have access to the equity capital markets. The only instrument currently available, the cuotas participativas, hasn t caught the attention of institutional investors. Foundation The initial foundational purpose of the cajas was to support local banking activities. These activities were supposed to be enhanced by a better knowledge of the regional industrial sector and good connections with the local authorities, which very often were clients and assembly members of the local savings bank. Government authorities have been present in savings banks since the very beginning, using them in some cases as political instruments in order to drive lending and the social welfare funds in a specific direction. 15

16 Lots of industrial stakes The savings banks focus on lending was also to a large extent supporting local companies, where sometimes they even ended up as a shareholder. A significant part of the capital gains in the equity portfolios of the cajas come from this type of stakes (ie. Caixanova/Caixa with Unión Fenosa, CajAstur with HC, BBK/Kutxa with Iberdrola). In the privatisation wave of the late 90 s, some savings banks played an important role. They substituted the government as key shareholders of the largest public companies of the country (Telefonica, Endesa, Repsol, Enagas, etc). la Caixa became a very active player in this process, creating a holding company that later was listed with significant capital gains. Strategic sectors (ie. sugar) also gathered support from the regional savings banks to maintain the local ownership and the employment in the region. Different cajas took different approaches to the strategic sectors. As an example, while CajaMadrid supported Iberia to keep its operating headquarters in Madrid, la Caixa didn t support the bail-out of a local airline given the lack of visibility of the business plan. Given the excess of liquidity in their balance sheets, some savings banks started acquiring stakes of Spanish listed companies. Energy and real estate were the preferred sectors. Most of the stakes were above 5% to save the withholding tax of dividends. Stakes below 5% of total capital were most of the time syndicated among cajas to gain board representation. Savings Banks and Developers: The Love Story A real estate boom The 1990 s global economic improvement together with the raised investment outlook and declining real interest rates drove the country into a decade of continuous growth. This growth was driven by the real estate sector, fuelled by very relaxed construction laws and beneficial fiscal frameworks for home ownership. The impressive economic outlook also caught the attention of immigrants. Population grew from 40 million (Dec 96) to 47 million in 13 years, which represents 1.3% CAGR, only 0.2% of which is related to organic growth. A significant amount of European citizens also joined the migration flows, retiring in the Spanish coastal areas in the same period. As of December 2009, 12% of the total population were immigrants. With an improving economic situation and increasing housing demand, the real estate sector started developing a new wave of residential properties to satisfy the foreign and local demand. These properties were financed by the local financial sector, which saw a potential goldmine in this trend. Lenders entering into new markets took riskier positions than well-established local competitors. If the lender managed its contracts with the developers well, they could reach agreements with them in order to be the preferred lender. Some players even started to take riskier positions, creating JVs with developers to have control of the final step of the process. 16

17 Wholesale Markets: The Affair There was demand for real estate, with local and international investors willing to invest money. There was production capacity, supported by a strong incoming flow of immigrants from LatAm and North Africa. But there was some liquidity shortage given the massive loan growth during the period. The problem was solved with the wholesale markets and the growing interest from institutional debt investors. Wholesale markets offered the possibility of issuing different types of products to gather funds, including covered bonds and securitisations. Figure 14. Outstanding Multi Issuer Covered Bonds Largest Caja Issuers Issuers m CAM 7,579 Unicaja 6,545 CCM 5,585 Cajasol 5,190 Ibercaja 4,800 Caixa Galicia 4,415 Cixa Penedes 4,255 Caja Murcia 4,155 Caja Madrid 4,085 Subtotal 46,610 Total 104,646 Source: Fitch With securitizations, savings banks could unload their loan book to issue debt with the loans as collateral, taking it out of the balance sheet. In the case of covered bonds, they could keep the asset on balance sheet and issue the bonds at very tight spreads. Even the smaller players had the chance to issue both thanks to the invention of multi-issuer products such as covered bonds (see Figure 14). These products were sold as low-risk high-diversification products, all with the blessing of rating agencies. Usage of the wholesale market was high within Spanish institutions. UK and Spanish issuers topped the ABS rankings by issuer and by country during the peak period (see Figure 16). In terms of covered bond issuance, Spain was the second largest issuer after Germany (see Figure 15). Figure 15. Covered Bond Issuance Largest Issuers by Country Before Dec 07 Country of Issuance Bn Germany 1,700 Spain 155 Belgium 121 Italy 110 France 64 Sweden 35 United Kingdom 3 Austria 0 Switzerland 0 Source: Dealogic Figure 16. Largest ABS Issuers in Europe, (Euros in Billions) Santander RBS LBG Northern Rock CS Barclays DB UBS BBVA UCI Paragon SNS Reaal Bancaja Rabobank RFC RealKredit B&B CAM BOI ABN AMRO Caja Madrid Bankinter CCCF BNP Paribas Caixa Catalunya UCI Spain Source: Dealogic, Citi Investment Research and Analysis 17

18 And The Straw House was Blown Down Warnings signs at the peak Cajas go abroad In August 2007, money markets gave us the first big warning of the situation. Like in any other cycle, we saw the excesses of the end of an era. Here are some of the examples for Spain: 1. Savings Banks buying significant equity stakes in big real estate companies (ie Sacyr). 2. Ferrovial and Banco Sabadell selling their real estate activities in Spain. 3. Consolidation of big real estate developers financed with syndicated debt. Savings banks are part of the syndicate. 4. A group of developers announces the intention to create a developers bank. 5. Extending maturities in the average tenure of loans, up to 40 years in some cases. 6. Noise of corruption surrounding the real estate sector. 7. Speculation of the Government stopping any big bankruptcies before the elections (March 2008). 8. Announcement of real estate projects without any financial sense (ie. Airports and casinos in remote, uneconomic areas). 9. A small specialist developer, Astroc, increases its share price from 6.4 to 72 within 12 months. A few months later the share price was close to zero. 10. Acquisition of international real estate with no experience of that market (ie. Metrovacesa and HSBC headquarters in London). 11. International banking players enter the country, opening branches in the costal areas to join the lending boom. One additional factor was announced that raised warnings from Bank of Spain: Some savings banks announced their intention to grow beyond their home market. Bank of Spain obliged banks to get the scrutiny of the market either directly or through a listed vehicle before going abroad. In most cases, the international strategy followed the path of big brothers Santander and BBVA. Some companies started both processes, with only la Caixa and CAM being successful in both of them. la Caixa listed its industrial portfolio and later consolidated its international expansion that now includes stakes in Banco BPI (Portugal), Erste Bank (Austria), Bank of East Asia (HK) and Inbursa (Mexico). CAM issued cuotas participativas and bought a 21% stake in Banco Guayaquil (Ecuador) in June 2007 and in April 2009 bought a small lender in Mexico. On the other hand, Caja Madrid and Caja Navarra started their international expansion but failed on the listing side. Caja Madrid announced the acquisition of City National Bank of Florida (USA) and the acquisition of a stake in Su Casita (Mexico). Caja Navarra also announced the listing of their industrial portfolio and the acquisition of a stake in HBW Express in Hungary. Both listing aspirations were dismissed due to the market conditions and unattractive equity stories. After all these signs, there was only one way, and it was down. A landmark event was the fall of Martinsa Fadesa, a c 11bn asset developer, which became the largest bankruptcy in Spanish history. Martinsa started from scratch 10 years before the bankruptcy and in that period became the leader of the sector. How the story continues is something that the market already knows. 18

19 Appendix: Spanish Banking & Sovereign With a GDP of 1,050 billion and a population of 47 million, Spain is home of one of the most competitive banking sectors in Europe. The banking industry pie is distributed among banks, savings banks, and mutual companies. Depending on the banking product, banks or savings banks lead the way. Figure 17. Spanish Banking Sector Loans Split, February 2010 (%) Figure 18. Spain Banking Sector Deposits Split, February 2010 (%) Coop 5% Other 3% Coop Other 6% 0% Banks 43% Cajas 49% Banks 42% Cajas 52% Source: Bank of Spain Source: Bank of Spain The Spanish private sector is currently highly leveraged in comparison to other European countries. The situation was different 10 years ago and the change comes mainly from the then blossoming real estate sector, both from the corporate and from individual side. Figure 19. Spain Loans to GDP Selected Countries, Dec 09 Figure 20. Deposits to GDP Selected Countries, Dec % 300% 250% 225% 210% 250% 252% 200% 184% 175% 172% 168% 200% 150% 150% 150% 127% 126% 100% 110% 109% 101% 95% 100% 98% 93% 93% 90% 78% 50% 50% 0% Ireland Belgium Sweden Spain Netherlands Portugal UK Germany Italy France 0% Belgium Spain Germany Italy Ireland Netherlands UK Portugal Sweden Source: National sources and Citi Investment Research and Analysis Source: National sources and Citi Investment Research and Analysis Spain faces a challenging fiscal situation. According to the EU Commission, the fiscal deficit is expected to reach 9.8% and 8.8% of GDP in 2010 and 2011, respectively. The current stock of Government debt is much lower than that of its peers, but the outlook looks weaker. 19

20 Without any additional fiscal adjustment, the current stock of debt is expected to increase significantly. The political organisation of the country, with regional Governments having been key in the restructuring process, makes the needed changes difficult to execute. Figure 21. Gross National Debt as % GDP Selected Countries (2010E) Figure 22. Fiscal Deficit as % GDP Selected Countries, (2010E) Italy Belgium Portugal France UK Germany Ireland Netherlands Spain Sweden 0.0 UK Ireland Spain Portugal France Netherlands Italy Belgium Germany Sweden Source: EU Commission Source: EU Commission A short-term funding challenge: the Spanish Government has yet to issue a large chunk of the 76.8 billion net issuance for Additionally, it faces large redemptions in July ( 25 billion). In terms of costs. the last 6M auction the Kingdom of Spain increased the cost of its debt from 0.76% to 1.32%. Bank lending has been growing at very healthy rates in the last 13 years. In this time, total lending grew to 1.8tn from 0.3tn (February 1997), with real estate lending increasing its share from 5% to 18% of total lending in the same period. Figure 23. YoY Loan Growth by Institution, Jan 93-Feb 10 Figure 24. YoY Deposit Growth by Institution, Mar 93-Feb 10 40% 40% 30% 35% 20% 30% 25% 10% 20% 0% 15% -10% 10% -20% 5% 0% -30% -5% -40% -10% Jan-93 Aug-93 Apr-94 Dec-94 Aug-95 Apr-96 Dec-96 Aug-97 Apr-98 Dec-98 Jul-99 Mar-00 Nov-00 Jul-01 Mar-02 Nov-02 Jul-03 Mar-04 Oct-04 Jun-05 Feb-06 Oct-06 Jun-07 Feb-08 Oct-08 Jun-09 Feb-10 Mar-93 Nov-93 Aug-94 May-95 Feb-96 Nov-96 Aug-97 Apr-98 Jan-99 Oct-99 Jul-00 Apr-01 Jan-02 Sep-02 Jun-03 Mar-04 Dec-04 Sep-05 Jun-06 Feb-07 Nov-07 Aug-08 May-09 Feb-10 Banks Cajas Other Banks Cajas Other Source: Bank of Spain Source: Bank of Spain 20

21 Notes 21

22 Appendix A-1 Analyst Certification The research analyst(s) primarily responsible for the preparation and content of all or any identified portion of this research report hereby certifies that, with respect to each issuer or security or any identified portion of the report with respect to an issuer or security that the research analyst covers in this research report, all of the views expressed in this research report accurately reflect their personal views about those issuer(s) or securities. The research analyst(s) also certify that no part of their compensation was, is, or will be, directly or indirectly, related to the specific recommendation(s) or view(s) expressed by that research analyst in this research report. IMPORTANT DISCLOSURES Rohini Malkani has in the past worked with the India government or its divisions in her personal capacity. Analysts' compensation is determined based upon activities and services intended to benefit the investor clients of Inc. and its affiliates ("the Firm"). Like all Firm employees, analysts receive compensation that is impacted by overall firm profitability which includes investment banking revenues. For important disclosures (including copies of historical disclosures) regarding the companies that are the subject of this Citi Investment Research & Analysis product ("the Product"), please contact Citi Investment Research & Analysis, 388 Greenwich Street, 28th Floor, New York, NY, 10013, Attention: Legal/Compliance. In addition, the same important disclosures, with the exception of the Valuation and Risk assessments and historical disclosures, are contained on the Firm's disclosure website at Valuation and Risk assessments can be found in the text of the most recent research note/report regarding the subject company. Historical disclosures (for up to the past three years) will be provided upon request. Citi Investment Research & Analysis Ratings Distribution Data current as of 31 Mar 2010 Buy Hold Sell Citi Investment Research & Analysis Global Fundamental Coverage 51% 36% 14% % of companies in each rating category that are investment banking clients 48% 46% 39% Guide to Citi Investment Research & Analysis (CIRA) Fundamental Research Investment Ratings: CIRA's stock recommendations include a risk rating and an investment rating. Risk ratings, which take into account both price volatility and fundamental criteria, are: Low (L), Medium (M), High (H), and Speculative (S). Investment ratings are a function of CIRA's expectation of total return (forecast price appreciation and dividend yield within the next 12 months) and risk rating. For securities in developed markets (US, UK, Europe, Japan, and Australia/New Zealand), investment ratings are:buy (1) (expected total return of 10% or more for Low-Risk stocks, 15% or more for Medium-Risk stocks, 20% or more for High-Risk stocks, and 35% or more for Speculative stocks); Hold (2) (0%-10% for Low-Risk stocks, 0%-15% for Medium-Risk stocks, 0%-20% for High-Risk stocks, and 0%-35% for Speculative stocks); and Sell (3) (negative total return). For securities in emerging markets (Asia Pacific, Emerging Europe/Middle East/Africa, and Latin America), investment ratings are:buy (1) (expected total return of 15% or more for Low-Risk stocks, 20% or more for Medium-Risk stocks, 30% or more for High-Risk stocks, and 40% or more for Speculative stocks); Hold (2) (5%-15% for Low- Risk stocks, 10%-20% for Medium-Risk stocks, 15%-30% for High-Risk stocks, and 20%-40% for Speculative stocks); and Sell (3) (5% or less for Low-Risk stocks, 10% or less for Medium-Risk stocks, 15% or less for High-Risk stocks, and 20% or less for Speculative stocks). Investment ratings are determined by the ranges described above at the time of initiation of coverage, a change in investment and/or risk rating, or a change in target price (subject to limited management discretion). At other times, the expected total returns may fall outside of these ranges because of market price movements and/or other short-term volatility or trading patterns. Such interim deviations from specified ranges will be permitted but will become subject to review by Research Management. Your decision to buy or sell a security should be based upon your personal investment objectives and should be made only after evaluating the stock's expected performance and risk. Guide to Citi Investment Research & Analysis (CIRA) Corporate Bond Research Credit Opinions and Investment Ratings: CIRA's corporate bond research issuer publications include a fundamental credit opinion of Improving, Stable or Deteriorating and a complementary risk rating of Low (L), Medium (M), High (H) or Speculative (S) regarding the credit risk of the company featured in the report. The fundamental credit opinion reflects the CIRA analyst's opinion of the direction of credit fundamentals of the issuer without respect to securities market vagaries. The fundamental credit opinion is not geared to, but should be viewed in the context of debt ratings issued by major public debt ratings companies such as Moody's Investors Service, Standard and Poor's, and Fitch Ratings. CBR risk ratings are approximately equivalent to the following matrix: Low Risk Triple A to Low Double A; Low to Medium Risk High Single A through High Triple B; Medium to High Risk Mid Triple B through High Double B; High to Speculative Risk Mid Double B and Below. The risk rating element illustrates the analyst's opinion of the relative likelihood of loss of principal when a fixed income security issued by a company is held to maturity, based upon both fundamental and market risk factors. Certain reports published by CIRA will also include investment ratings on specific issues of companies under coverage which have been assigned fundamental credit opinions and risk ratings. Investment ratings are a function of CIRA's expectations for total return, relative return (to publicly available Citigroup bond indices performance), and risk rating. These investment ratings are: Buy/Overweight the bond is expected to outperform the relevant Citigroup bond market sector index (Broad Investment Grade, High Yield Market or Emerging Market), performances of which are updated monthly and can be viewed at using the "Indexes" tab; Hold/Neutral Weight the bond is expected to perform in line with the relevant Citigroup bond market sector index; or Sell/Underweight the bond is expected to underperform the relevant sector of the Citigroup indexes. NON-US RESEARCH ANALYST DISCLOSURES Non-US research analysts who have prepared this report (i.e., all research analysts listed below other than those identified as employed by Inc.) are not registered/qualified as research analysts with FINRA. Such research analysts may not be associated persons of the member organization and therefore may not be subject to the NYSE Rule 472 and NASD Rule 2711 restrictions on communications with a subject company, public appearances and trading securities held by a research analyst account. The legal entities employing the authors of this report are listed below: Ltd Ignacio Moreno,Ronit Ghose,Henrik Christiansson,Andrew Coombs,Leigh Goodwin,Azzurra Guelfi,Kimon Kalamboussis,Sentoor Kanagasabapathy,Kinner Lakhani,Stefan Nedialkov,Simon Nellis,Paul Nery OTHER DISCLOSURES 22