MASTERS IN FINANCE EQUITY RESEARCH BANCO DE SABADELL, S.A.

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1 MASTERS IN FINANCE EQUITY RESEARCH BANKING SECTOR 08 JANUARY 2016 STUDENT: NARYARA NARANJO BUJARDÓN Looking back to look ahead? Recommendation: BUY Only future matters. The Spanish banking sector saw in the last years a quick accumulation of foreclosed assets and profits quickly fell with the international financial crisis and the real estate bubble burst. This made banks susceptible to developments in the market due to high exposures to the real estate sector, meanly through loans. ROEs has been falling below opportunities cost of capital driven by deteriorations of the banks financial statements. The acquisition of Banco de Sabadell,.S.A. (SAB) of TSB Banking Group PLC (TSB) on 2015 was financed on a capital neutral basis. SAB s current CET 1 ratio is 11.6% and the deal funded with 0.9 billion cash and 1.5 billion shares implied a capital neutral transaction. Synergies were one of the drivers of the acquisition. We expect SAB to substantially change TSB s cost base potentially leading to higher earnings from TSB, expecting for FY2016e synergies of 245 million. The Discounted cash flow to equity model was performed to value both, SAB prior the acquisition and TSB. The target value for the FY2016e resulted from the Sum of the parts valuation. The target price of 2.3 per share implies an upside of 39% to the current share price of 1.6, and our recommendation is to buy. Company description Banco de Sabadell, SA is Spain s fifth largest banking group and it is structured in five areas, Commercial Banking (largest Group s business lines); Corporate Banking and Global Operations; Markets and Private Banking; BS America; and Bancassurance; as well as Other Businesses. Its shares are currently listed on three stock exchanges located in Madrid, Barcelona, Bilbao and Valencia (the Spanish stock exchanges ) and are traded on the Sistema de Interconexión Español (SIBE), the automated quotation system of the Spanish stock exchange. Price Target FY16: 2.3 Price (as of 8-Jan-16) 1.6 Reuters: SAB.MC, Bloomberg: SAB SM 52-week range ( ) Market Cap ( m) 8,888 Outstanding Shares (m) 5,439 Source: Bloomberg Source: Bloomberg (Values in millions) F 2016F Net Interest Income 2,260 3,833 4,224 Gross Income 4,801 6,417 6,211 Net Income Cost/Income 43% 49% 46% Return on Equity 3% 7% 6% Return on Assets 0.2% 0.5% 0.4% NPLs ratio 12.3% 9.6% 9.8% Risk-Weighted Assets 74, , ,260 CET 1 Ratio 11.7% 11.6% 12.5% Source: Company Data and Analyst s estimates THIS REPORT WAS PREPARED BY STUDENT S NAME, A MASTERS IN FINANCE STUDENT OF THE NOVA SCHOOL OF BUSINESS AND ECONOMICS, EXCLUSIVELY FOR ACADEMIC PURPOSES. THIS REPORT WAS SUPERVISED BY ROSÁRIO ANDRÉ WHO REVIEWED THE VALUATION METHODOLOGY AND THE FINANCIAL MODEL. (SEE DISCLOSURES AND DISCLAIMERS AT END OF DOCUMENT) See more information at Page 1/32

2 Table of Contents Executive summary 3 Company overview 4 History Business Strategy Shareholders structure The Sector 6 European Banking Sector 6 Spanish Banking Sector 9 Funding Structure 10 Cost of Funds 12 Profitability 13 Regulatory Capital 15 Basel II 15 Basel III 15 Stress tests 17 Valuation 19 Sabadell s Valuation 19 Sensitivity Analysis 24 TSB s Valuation 26 Sum of the Parts Valuation 28 Multiples Valuation 29 PAGE 2/32

3 Executive summary Based on nominal GDP statistics Spanish economy is in the 5 th place among the largest economies in the European Union (EU) and the 4 th largest in the Eurozone. However, any country escaped from the International Financial Crisis of , the economy contracted by 1.4% in 2012 and remained in recession until the 3Q of Situation for banks became challenging with the crisis; high reduction in assets, declines in the mean sources of fund and large increases in equity (driven also due tighten regulatory requirements). But despite of that Spain has started to show improvements in the overall economy, its nominal GDP growth rate has started to reach positive figures since the 1Q of 2014 and unemployment has begun to decline. Moreover, Standard & Poor s upgraded its credit rating for Spanish public debt to BBB+ with a stable outlook. Under this context SAB has been able to increase in terms of scale in recent years inside and outside Spain. With the latest acquisition of the bank TSB in the UK, expectable growing cash flows has been forecasted from 2016 onwards and cost savings. TSB entered to compete in a stable economy where the unemployment rate of the active population has fallen to 5.4% and wages have increased by nearly 3% YoY. Moreover great expectations regarding an increase of the interest rates sooner than in the Eurozone are arising, especially after the latest decision of the U.S Federal Reserve (Fed) to increase the interest rates by 0.25% and assured a gradual pace of increases. SAB s Net interest income remains resilient primarily benefit from the continued reduction in both wholesale and retail funding costs, offsetting the negative impacts of lower Euribor levels and pressure on loan yields, our forecasts resulted in an increase by 3% YoY of NII from FY2016e until FY2019e. Trading revenues remained a key driver during the last years allowing to increase significantly the level of NPL provisioning and improving asset quality with NPL ratio falling to 9.6% (FY2015e). Moreover, we see SAB with a solid capital position with a CET 1 ratio of 11.6% for FY2015e and reaching a 12.5% CET 1 in FY2016e. Our target price for December 2016 of 2.3 per share was obtained through the Sum of the parts valuation, which implies an upside of 39% over the current price of 1.6 per share and our recommendation is to buy. PAGE 3/32

4 Company overview Banco de Sabadell, S.A. was established in 1881 in Sabadell, it is Spain s fifth largest banking group by total assets (Chart 1), and holds an important position in the personal and business banking market. Chart 1 Largest Spanish Banks by Total Assets as of June 30, 2015 ( Bn) Source: Companies data Chart 2 Sabadell s Gross operating income per business units ( Mn) The bank is the parent company of a corporate group and both together compose the Banco Sabadell Group (The Group). The group is organized into 5 business units; Commercial banking, Corporate Banking and Global Businesses, Markets and Private Banking, Asset transformation and Sabadell America. Commercial Banking (largest group s business lines) which the core function is to provide financial products and services to large and medium-sized business, SMEs, retailers and sole proprietors, professional groupings, entrepreneurs and personal customers. This unit achieved 2,210 billion as of in Gross operating income and 498 million in Profit before tax (Chart 2). Corporate Banking and Global Businesses, which operates internationally and inside Spain, offer products and services to large corporate and financial institutions. Source: Company data Chart 3 Sabadell s ROE per business Source: Company data Markets and Private Banking business unit offers products and management services related with savings accounts and investments. The unit s operations embrace SabadellUrquijo Private Banking; Investment, Products and Research; Treasury and Capital Markets; and Securities Trading and Custodian Services. Chart 3 shows that as of this business unit together with its separate area; Investment, Products and Research, were the ones on top providing 58.6% and 116.5% ROE respectively. Asset transformation unit is divided into two areas: Banco Sabadell Asset transformation (manages the Bank s real estate assets) and Solvia (provides services for real estate asset portfolios for the Group and third parties). Sabadell America includes an international full branch, Sabadell United Bank, Sabadell Securities USA, Inc., and other business units, affiliates and representative offices (New York since 2012). All together offer financial services in the corporate banking, private banking and commercial banking fields in the US. PAGE 4/32

5 History Table I Sabadell s increases in scale as of 2014 Source: Company data Chart 7 Shareholders structure by geographic Source: Bloomberg 2014/ Assets ( Mn) 76,776 97, , x Loans and advances ( Mn) 63,165 73, , x Deposits ( Mn) 34,717 49,374 94, x Branches in Spain 1,225 1,428 2, x Employees 10,234 10,777 17, x Chart 4 Sabadell s Plan Triple Triple Source: Company data Chart 5 Sabadell s Shareholders structure Source: Company data Transformation Sales Balance sheet Production model Profitability Leveraging greater scale into profit Internationalization Preparing for the Group's International expansion Entering new markets Sabadell has undertaken an expansion policy since 1996, which in last years, its increase in scale, has been very notable (Table I). The latest acquisition by the Bank was done during 2015 (Appendix 4 - Sabadell s landmark developments). On March 19 th 2015, was approved by Sabadell s Board of Directors the tender offer for 100% of the shares of TSB at 340 pence per share in cash. Sabadell got control of TSB s assets and assumed its liabilities on June 30 th Strategy Sabadell launched in 2014 a new business plan known as Plan Triple to put in practice from 2014 until The key themes of the business strategy are; transformation, profitability and internationalization (Chart 4). The strategy was designed to leverage the strength of the bank s balance sheet, its strong sales platform and to recover the lending activity in the medium and long term. To achieve that, the following targets were settled for the FY2016; 1,000 million Income, 12% ROTE, 40% Cost to income ratio, 100% Loan-to-deposits, 1% Lending growth CAGR Our estimations if Sabadell is on track to achieve the objectives mentioned before will be explained in the Valuation Chapter. Shareholders structure The share capital of Sabadell is 679,905,624, represented by 5,439,244,992 registered shares after its latest capital increase on October 12 th 2015, with a nominal value of each. Sabadell s shares were listed on April 18 th 2001 on the Stock Exchange and a capital increase in 2004 placed the bank in the IBEX-35 stock market. Since 1999 the largest capital increase that Sabadell has done was on April 27 th 2015 when it issued 1.1 billion shares to perform the acquisition of TSB. Sabadell s shareholders structure as of September 30 th 2015 is split in 45% institutional investors and 55% retail investors (Chart 5). During 2014 Sabadell s management sought to engage actively with institutional investors. The proportion of the bank s shareholder base represented by institutional investors increased from 38.5% in December 2013 to 48% in December The largest Shareholder of Sabadell is the Colombian Banker Jaime Gilinski Bacal, who is a real estate developer and philanthropist. He holds a 5.57% shares outstanding and the second largest shareholder is Winthrop Securities LTD, with a 3.65% outstanding and the company is located in Spain. Most of the institutional investors of Sabadell are Investment advisors (Chart 6); among them the first PAGE 5/32

6 Chart 6 Shareholders structure by type Source: Bloomberg Chart 8 Debt of general government and private sector debt as a percentage of GDP (EU OECD countries, USA and Japan, end of 2013) Source: OECD statistics, EBA calculations Chart 9 Common equity tier 1 ratio (Until Dec-13: tier 1 excluding hybrid instruments) weighted average Source: EBA KRI and EBA calculations Table II Tier 1 ratio, RoA, loan-todeposit ratio EU banks compared to US banks EU Tier 1 ratio 10.2% 11.0% 11.1% 12.5% 13.1% 13.3% RoA 0.20% 0.30% 0.00% 0.02% 0.15% 0.21% Loans to deposits 117.1% 117.8% 117.7% 115.7% 112.8% 108.4% USA Tier 1 ratio 11.4% 12.4% 12.6% 12.9% 12.7% 12.4% RoA 0.39% 0.66% 0.65% 0.75% 0.88% 0.78% Loans to deposits 79.5% 81.2% 74.9% 72.2% 69.9% 69.1% Source: EBA KRI, SNL Financial and EBA calculations position by revenue is hold by the Norges Bank Investment Management from Norway with a 1.69% shares outstanding. The second and third positions are hold by Vanguard Group Inc and Blackrock Fund Advisors from United States, with 1.68% and 1.47% shares outstanding respectively. The fourth and fifth positions are hold by Dimensional Fund advisors LP 1.2 USA and Fidelity international, Bermuda, both with 0.47% shares outstanding. The geographic distribution of Sabadell s shareholders have changed during the last three years (Chart 7), most of them continued to be unknown from 2013 to 2015 and the primary known location continues to be United States, although its representative percentage has decreased from 2013 to The second known location is Spain, which has notably increased from 2014 to 2015 by 16.31p.p. Moreover, in the composition of the bank s shareholders we can see that most of them are asset management companies. The mean objective of these companies is to offer returns to the customers, but usually they show no intention to hold the shares for longer periods. Given the previous analysis, it can be concluded that Sabadell s shares are dispersed across multiple entities, although regarding the big size of the bank, in our opinion, it is not vulnerable for a takeover. The Sector European Banking Sector The EU banks continue facing important challenges and vulnerabilities in the European banking sector. The levels of private and public debt still remain high for EU countries. Chart 8 shows the aggregated values of public and private debt compared to GDP, which range from 175% and 514%. Moreover, inflation remains low, with expectations that will decrease from 0.6% in 2014 to 0.1% in 2015 (EU) and from 0.4% in 2014 to 0.1% (euro area). It is also expected that the unemployment rate will fall from 10.2% in 2014 to 9.6% in 2015 (EU, %) and from 11.6% to 11.0% (euro area, %). The growth on employment and the low levels of inflation rates may discourage consumers and investors spending and slowdown the pressures on economic growth. Some countries within the euro area, such as Greece, continue facing geopolitical risk, economic and financial uncertainties. The risk arising from emerging markets and the general macroeconomic uncertainty is; increasing worries on further instability, possible effects on sovereign bond markets and major deterioration of assets quality. The pursuit for yield in a context of low PAGE 6/32

7 Chart 10 - Total assets ( Trillion) Source: EBA KRI and EBA Chart 11 - Total loan volumes ( Trillion) Source: EBA KRI and EBA Chart 12 - Funding mix (weighted average) per year end 2014 Source: EBA KRI Table III Comparison of RoE and CET 1 ratio (weighted average, per year end) Year end RoE 0.0% 0.5% 2.7% 3.6% CET1 9.2% 10.8% 11.6% 12.1% Source: EBA KRI Chart 13 CoE for EU countries inflation and low interest rates may lead to potential asset price bubbles and also low interest rates impose challenges for bank s profitability. However, banks capital position has being strengthened since 2011 with the repair process of the European banking system. Chart 9 shows EU banks weighted average common equity tier 1 (CET 1) ratio s increase from 2011 to 2014, growing from 9.2% to 12.1%. The improvements of the capital ratios are more related to increases in common equity than to decreases of RWAs. When comparing EU banks with the 20 largest US banks (Table II 1 ), it is perceivable the improvements of the EU banks capital positions, which levels are above the peers in US, since 2009 until The net capital increases, since the Lehman Brothers crisis, have been more substantial for EU banks. However, in terms of profitability (measured by ROA), EU banks are outperformed by US banks which have better positions to keep moving forward a gradual growth of their capital base by the retention of earnings. On the asset side, the deleveraging trend has plateaued with some signs of growth in total assets (by 5.9% - FY2014 YoY) and loan volumes (by 2.6%), at a slower peace (Chart 10 and 11). But the constant overall deleveraging tendency has stopped in the sector in the past years, even though banks continue reducing their exposures to fields such as investment banking. Everything seems to point out that banks are trying to recover their traditional business and come back to plain vanilla products. Despite there has been a progressive reduction of impairments on financial assets, there are still concerns around assets quality, associated mainly with specific geographies with action needed to move along the resolution of non-performing exposures. Regarding funding markets and deposit bases, in the 2H 2014 and 1Q 2015, have shown positive pictures. There has been no real shortage of market funding, even though certain volatility in issuance volumes. The investors search for yield has positively influenced the increasing demand of subordinated debt instruments (issued by banks), especially after the publication of the quantitative easing (QE) programme by the European Central Bank (ECB). Also, in general terms, deposits bases increased supporting the overall positive of funding. During 2014 bonds and debt certificates share, as well as of client deposits in the overall funding mix, increased. By 2014, c50% of the funding mix was composed by customer deposits and by deposits from credit institutions (Chart 12). Source: Bloomberg, NYU Leonard N. Stern School of Business, EBA calculation 1 The EU banks (55 banks considered in the EBA KRI) and the US banks (market data for the 20 biggest banks according to their total assets) (data no adjusted for the difference in netting rules between US GAAP and IFRS). PAGE 7/32

8 Chart 14 - Trends that will impact European banks Source: EBA RAQ for analysts Chart 15 Spain s nominal GDP (Index Base 2010) and estimates Chart 16 Spain s unemployment rate from March September 2015 Chart 17 Unemployment rate estimates Source: European Central Bank Regardless the improvements in funding conditions, financial markets continue fragile and volatile in general terms. The remaining vulnerabilities are related to funding in foreign currencies, passive cross-border interbank markets, and the liquidity worries of the trading market. The levels of asset burden remain high, as such the Central bank based funding, which means that trust across banks in the single market has not been completely restored yet, and that funding markets have not returned either to pre-crisis conditions. In terms of profitability, the challenges remain for EU banks. It was registered on December 2014, the highest weighted average RoE of 3.6%, since This ratio has been constantly increasing on a year-to-year basis with similar increases in the CET 1 ratio (Table III), although far away from the pre-crisis levels. This modest increase has been driven mostly by the growth of the NII by 15 billion (+5% compared to FY2013) and the sharp decline of impairments of financial instruments ( 24 billion, -20% on a year-to-year basis). The growth of total loans and debt instruments explain the positive increase of net interest income during Furthermore, the greater portion of loans that are funded by deposits in conjunction with the Central banks funding, have reduced cost of funding for banks and interest expenses, plus has a positive impact on net interest margins (NIMs). On the other hand, asset quality continues to be a drag due to the associated litigation costs that impose significant fee on banks profitability. The ROE remains thus subdued and not enough to cover the cost of equity (CoE) for many banks that might lead to disproportionate risk taking or cost cutting in an effort to increase profitability. Chart 13 shows the comparison of the CoE in 2015 with the one in mid-2011 in order to assess its evolution. The outcomes show that the average CoE for the EU in 2015 is 9.5% (excl. Greece), which is lower than the 14.6% in This difference is due to the current interest rates context that reached a peak in There are other concerns linked to the sustainability and viability of some banks business models. Because it is not clear enough which are the strategies that banks are going to follow in order to return to adequate levels of profitability, while they walk away from official funding. Market analysts are considering that in the short term, shadow banking 2 and technological advances are tendencies that can highly impact the EU banking sector and banks business models (Chart 14 3 ). The continuing tightening of banks regulations together with abundant liquidity and investors search for yields are issues that could be boosting a change of traditional banking activities into shadow banking. An increasing role 2 Shadow banking such as mutual funds, hedge funds, finance companies, venture capital corporations and securitisation vehicles. 3 Results obtained through Risk assessment questionnaire (RAQ): You expect that the following trends will impact European banks most in the next 6 12 months (please do not agree with more than two options). PAGE 8/32

9 Chart 18 % of Real estate activities/gdp of the shadow banking and of the disintermediation of the traditionally financial activities developed by banks, can possibly impact banks revenues such as fees and commissions, as well as their ability to grow in other areas that could offset the weakening in net interest returns. Spanish Banking Sector Chart 19 Residential property prices index - Spain Chart 20 Spain s number of employees Chart 21 Spain number of branches Banco de España (BDE) is Spain s central bank and the supervisor of its banking sector. It has established numerous measures since 2007 to increase the resilience of the sector such as; increasing provisioning and transparency 4 in relation to the banks exposures to the real estate development and construction segments, it has promoted mergers between saving banks, and set up the SAREB 5. Moreover, information regarding the results of the stress tests conducted by the European Banking Authority (EBA), where 90% of the banking system participated (Sabadell included), must be clearly accessible too. Despite all the measures undertaken, the system continues having doubts about the quality of the assets on banks balance sheets and also about banks' level of solvency. Currently, BDE is managing a complex restructuring and recapitalisation programme, the Memorandum of Understanding (MoU) which was agreed with the European authorities in July 2012, the mean objective is to restore confidence and stabilise the Spanish banking sector and place it on a more secure footing for the future. Before going deeper into the Spanish banking sector we would like to comment first, some points in the macroeconomic context in Spain, that in past years had major impacts in the refer banking system. The economy in Spain was enjoying a prolonged period of expansion between the years 2000 and 2008, growing at a CAGR of 7.1% (Chart 15). Spain s GDP reached its biggest increased in 2008 ( 1,116 trillion), which fall by 3.3% in 2009 and continue declining afterwards as of During 2008 to 2013, there were no indicators of growth in the economy, only in 2014 the GDP has shown some positive results reaching 1,041 trillion and it is expected at the end of 2015 will amount 1,078 trillion. Overall, this is a very positive indication of recovery for the Spanish economy. The unemployment rate is another important macroeconomic variable to take into account (Chart 16), because it impacts directly the performance of; the Non- Performing Loans (NPLs), the volume of loans the banks are willing to offer to its customers and the deposits received from them as well. The refer rate has 4 Information provided by the banks to the markets. 5 Company for the Management of Assets proceeding from Restructuring of the Banking System to which non-performing real assets of banks have been transferred. PAGE 9/32

10 Chart 22 Spain s number of institutions Chart 23 Mean Sources of funding ( '000) Chart 24 Total Deposits ( 000) Chart 25 Total amount of deposits by type ( 000) increased since 2007 in Spain until March 2013 (26.94%), and it has started to decrease from that moment on until September 2015 to 21.18%. According to the ECB estimations (Chart 17) the unemployment rate for FY2015 will decrease to 22.3% and continue declining for the next two years, which will translate in a positive impact in the items mentioned before. Despite the economic indicators mentioned before, the Real estate sector is very relevant for the Spanish economy. Chart 18 shows that in 2008 real estate activities accounted for 8.2% of GDP, where most of the houses were purchased and built through loans obtained from financial institutions. Housing prices grew at an incredible CAGR of 42% from 1995 until 1Q of 2008 (Chart 19), bring as result the housing bubble 6. This housing bubble burst in the beginning of 2008 and house prices started to fall until the 3Q of 2015 at a CAGR of 18%. Basically the real estate activity in Spain was developing very well in the past and Spanish s banks were increasing their exposure to this sector in a constantly basis. The real estate assets were used as collateral, meaning that loans were considered safe and due to long maturities the expectations of high returns were big. The incentive to increase mortgage loans was growing and therefore the sources they were allocating to this type of loan. Consequently, when the real estate crisis begun, the values of these collaterals fell considerably, the real estate market became illiquid and banks became unable to recover the expected returns from selling the collaterals in case of default. During the restructuring process of the Spanish banking system, many employees were fired, offices were closed and the smallest and weakest banks were merged or acquired. This is part of the consolidation process this sector in Spain is facing through, where the smaller institutions are becoming large multiregional banks. Charts 20, 21 and 22 show that from 2007 to 2014 the reduction; in the number of employees in the sector from 277,311 to 208,291 (CAGR of - 4%), in the number of branches from 45,500 to 31,999 (CAGR of -5%) and in the number of institutions from 357 to 272 (CAGR of -4%). Funding Structure The mean reactions in the financial markets driven by the International Financial Crisis were; i) banks isolated themselves from each other (lending market slowed down) and ii) central banks started to apply monetary policies to promote economic growth and access to capital by the banks. 6 Housing bubble: Refers to the economic bubble occurred in the global real estate markets, followed by a land boom (rapid increase in valuations of real property such as housing until they reach unsustainable levels and then decline in a bubble). PAGE 10/32

11 Chart 26 Spanish Loans to gross disposable income Chart 27 - Spanish Book Value of Equity ( '000) Chart 28 Debt securities issued by the Spanish Banks ( Mn) Table IV Long term credit ratings (S&P) Sabadell Popular Santander BBVA 2013 BB BB- BBB BBB BB BB BBB BBB BBB BBB+ A+ AA A A AA AA 2009 A A AA AA 2008 A+ AA- AA AA 2007 A+ AA AA AA- Source: Companies data and Standard & Poor Sources of funding are split in four groups (Chart 23); Total deposits, Equity, Securities (other than shares) and Others 7. Spanish banks have always relied on deposits as their mean source of funding. The strategy has not changed in the last times (Chart 24) especially due to the illiquid characteristics of the interbank lending market and the restrictions imposed by central banks to credit lines. Also, because despite financial institutions bonds have lower yield to maturity, they continue being more expensive with respect to deposits. Since 2000 up to 2008, the total amount of the mean source of funding was increasing at a CAGR of 11%, after 2008 it started to fall at a 3% CAGR up to August 2015 (consequence of the Lehman Brothers bank crash). Chart 25 shows the total amount of deposits by type, where the amount of funding coming from the General government and the Resident sector (includes non-financial institutions and households), both fall at a CAGR of 2% as of 2015 from 2008 in Spain. The deposits from the Resident sector hold the highest percentage of total deposits and it is mostly composed by savings accounts and time deposits from households. Families that were already indebted (Loans to gross disposable income in 2017 was 130% - Chart 26), after the initiation of the International Financial Crisis saw future income will be lower than expected, plus the fact that banks were being more restricted when conceding credits to customers. As a result, credits fall; families withdrawn huge amount of money from their deposits to pay debts and started also to save less. In conclusion, the main source of funds for banks was being in risk. Another important source of funding for banks is the Equity, which is considered the most expensive one. The value of Equity in the Spanish economy has seen an increase in the last years. The outcomes of the stress in 2012 have been one the drivers of this increase due to the major changes in regulations and legislations related to the banking system. When looking at the increasing tendency of the Equity held by banks in Spain from 2007 up to now (Chart 27), we notice how severed the new regulatory capital requirements have been implemented after the crisis in order to create a better safety cushion to support the unexpected losses on their assets. Regarding Spanish banks debt, when studying the behaviour of short-term and long-term debt securities in the past, we see that since the beginning of 2000 until the end of 2007 these items have being growing at 38% and 34% CAGR respectively (Chart 28). Banks, started to look for funds in the market, that were priced at lower rates than the mortgages loans with the purpose of financing their own growth through real estate loans. But after 2008, the interconnectivity 7 Others caption is composed by: Accrual and sundry accounts. PAGE 11/32

12 Chart 29 Deposits' annual interest rates for households and corporations Chart 30 ECB s refinancing rate Chart 31 Euribor 6-month evolution Chart 32 Spanish bank s deposits market share in the Sector and company s data Chart 33 Spanish bank s loans market share in the Sector and companies data between the financial institutions in the system started to face serious problems; the global financial system saw itself highly exposed to systemic risk. The worries from institutions in placing their debt securities on investors increased. Banks started to stop lending each other, also because the changes in the regulatory requirements that obliged banks to issue more equity in order to provide such loans because suddenly all the institutions were consider risky by the rating agencies (Table IV). When in 2012 it was made public the recapitalization need of the Spanish Banking system and the Basel III accords (explained further in this report) started to be known by banks, the banks debt maturities structure suffered changes again. There was then an opportunity for banks to shift their short-term debt for a higher quality funding to comply with the new regulatory requirements. Long-term debt are less risky for investors (because they are more senior) and easier to place in the market. Cost of Funds The banks interest rates paid for all type of depositors and all type of maturities were peacefully increasing over time since 2003 and reaching its peak on October 2008 (Chart 29). However, from October 2008 to October 2015, interest rates with maturity higher than or equal one year paid on households deposits in Spain fell by 4.3.p.p. to 0.44.p.p. and in the Euro area fell by 3.7.p.p. to 0.75.p.p. For Corporations the situation was very similar for interest rates with the same maturity. Interest rates have fallen by 4.6.p.p. to 0.40.p.p. in Spain and the Euro area by 4.3.p.p. to 0.63.p.p. The Euro Area and Spain s interest rates follow a very similar pattern. From September 2008 the ECB s refinancing rate has been decreasing and reaching its historical low in September 2014 of 0.05% as of today (Chart 30). The reasoning behind is to promote economic growth and boost Eurozone inflation rate to reach again the desire 2% by the ECB. Moreover, the Euribor 6-months, which is positive correlated with the ECB s refinancing rate, has being following the same declining trend (Chart 31). This is because the opportunity cost of borrowing from the central bank or money market. Overall it is observed a market decrease in the interest rates used as benchmark, which means that banks cost of funds is decreasing as well. In the stock markets the situation for banks has changed. Banks share prices have become cheaper, while the return demanded by shareholders increased due to lower expected cash flows. The main drivers of a stock price are; the dividends per share paid by a company and growth rate of the dividends. Ever since shareholders responsibility for the good performance of the company PAGE 12/32

13 Table V DuPont analysis of the Sector 9M ROE 4% 18% Profit Margin 13% 35% Total Asset Turnover 2% 3% Equity Multiplier 1371% 1643% Source: Companies data and Analyst s Chart 34 Net Income evolution of the 4 Spanish bank as of 9M 2015 ( Mn) Source: Companies data Table VI Spanish banks financial analysis ( Mn) 9M 2015 Popular Santander BBVA Sabadell Operating Income 3,103 34,378 17,534 4,258 Net interest income 1,760 24,302 12,011 2,240 Net Fees & Com ,584 3, Trading income 687 1,702 1,558 1,152 Other income Net Income 302 5,106 1, Provisions for NPLs - 1,820-7,797-3,859-1,955 Assets 160,028 1,320, , ,141 Equity 12,695 98,687 53,601 12,366 REO - Dupont 2% 5% 3% 5% 2007 Operating Income 3,452 27,095 17,271 2,162 Net interest income 2,288 15,296 9,628 1,317 Net Fees & Com ,040 4, Trading income 66 2,998 1, Other income , Net Income 1,341 9,059 6, Provisions for NPLs ,549-2, Assets 107, , ,726 76,776 Equity 6,644 58,080 27,943 4,605 ROE - Dupont 20% 16% 23% 17% Source: Companies data and analyst s calculations became tighter, the negative results would be supported by them. This means that in order to issue additional capital to comply with the new capital requirements, banks have to retain earnings and do not distribute them among its shareholders. This increases the uncertainties around the expected dividends that are going to be paid in financial institutions and lower the expectation for the future cash flows. Profitability With the objective to analyse the Profitability of the sector we selected three banks that, together with Sabadell, are very influent in the Spanish Banking sector: Banco Santander S.A. (Santander), Banco Bilbao Vizcaya Argentaria (BBVA) and Banco Popular Español (Popular) all belonging to the Ibex-35 Index. The accumulated market shares for Deposits and Loans as of the 3Q of 2015 for these institutions in the Spanish market were 91% and 98% respectively (Chart 32 and 33). The market share in loans held by these institutions has been constant since 2007 up to Notable increased is perceived after 2013 in Santander and BBVA s case, which in 2014 and 2015 its deposits and loans have increased considerably. One way to measure the profitability of the sector is by applying a DuPont analysis, being especially useful when comparing two different periods to check for differences in underlying drivers. To do that, we compared 9M 2015 results with FY2007 results, even if 2007 was a peak year for banks and not an average year. Looking at Table V, we can see that ROE decreased from 18% in 2007 to 4% in 9M2015, with negative impacts from all components. By far the most important driver was the very significant reduction in the Profit Margin, from 35% to 13%. This can be traced mainly to 2 questions: i) the very big increase in provisions in Spain and ii) the negative impact of low interest rates on NII. The former was the most important one and was caused by the impact of the Financial Crisis (but also the end of the Spanish real estate bubble) on banks credit quality, which forced a major provisioning effort to reflect the marked deterioration on their credit books (Table VI). The later has been more important recently, as the very low interest rate environment in Europe has been limiting banks ability to earn money through their NIMs, damaging significantly their profitability. On top of that, the economic slowdown in Spain also affected other P&L lines like commissions, further reducing banks revenues and therefore their bottom line. PAGE 13/32

14 Chart 35 CNY/USD evolution from 31 Jan Jan 2016 Source: Reuters Chart 36 CNY/EUR evolution from 31 Jan Jan 2016 Source: Reuters Chart 37 How Brazil bolstered Santander earnings during Spain s crisis Source: Company data Chart 38 TRK/EUR evolution from 31 Jan Jan 2016 Source: Reuters The equity multiplier reduction also had a negative effect, as due to regulatory reasons banks were forced to carry major capital increases to reduce their previous (too) high leverage ratios. Since banks were required to have more equity to perform the same (or less) business, it was naturally a drag on ROE (more Equity to less Return). Moreover, emerging currencies have been working against BBVA and Santander which are placed within the six European banks 8 that bet on growth on emerging markets and now are facing a deteriorating profit outlook as chaos roils economies from Asia to South America. These both Spain s largest lenders; have been relying on income from Latin America (LatAm) due to limits of growth at home in a low interest rates environment. Roughly 20% of the loan book value of Santander and BBVA is in LatAm and now are suffering a shift in sentiment. On August 2015, China s yuan devaluation (Chart 35 and 36), rose concerns that the global economy is going for a slowdown, although the Fed rose interest rates on Dec 16 th 2015 showing improvements in the US economy. Moreover currencies from Malaysia to Turkey to Brazil fell on August 2015 as well, while an index of commodities fell to its lowest since Santander, settled a strategy to transform its structure from a provincial lender into the second biggest bank in Europe by market value, it has spent, under former Chairman Emilio Botin, more than $70 billion (c 64 billion) on acquisitions which include Banco Real in Brazil. Santander generates about a fifth of profit from commodities-rich Brazil (Chart 37) that relies on the demand for metals of China and is living the worst recession since It does not seem that the political situation in Brazil is getting any better and overall the economic situation is pretty bad shape. In conclusion the bank will start cutting types of lending in Brazil that are most prone to losses. On the other hand BBVA derived two-thirds of its operating income from Mexico, South America and Turkey in the first half of Mexico s GDP is expected to expand 2.5% in 2015 although some economists are paring their growth forecasts for Mexico. In Turkey, where BBVA owns c40% of Turkiye Garanti Bankasi AS (Turkey s largest bank), a political impasse intensified security risks and accelerating inflation pushed the lira to a record low against the euro (Chart 38). Both banks tried to balance growth offered by emerging countries, especially in Santander s case that enjoys stability from mature economies such as the UK and Germany. The seek to add emerging-markets revenue helped Santander 8 The six European Banks are: BBVA, Erste Bank, HSBC, Santander, Standard Chartered, and UniCredit. PAGE 14/32

15 and BBVA to resist Spain s five-year economic crash, however everything affecting the ability to repair their balance sheets through retained earnings, will come back to haunt them. Chart 39 Income s share over Total Revenues (9M 2015) Source: Companies data and analyst s calculations Chart 40 Income s weight over Total Revenues (2007) Source: Companies data and analyst s calculations Table VII Basel I classification system Risk Categories Bank's Assets Cash, Central bank and government debt 0% and any OECD government debt 0%, 10%, Public sector debt 20% or 50% Development bank debt, OECD bank debt, OECD securities firm debt, Non- 20% OECD bank debt (under one year maturity) and Non-OECD public sector debt, Cash in collection 50% Residential mortgages Private sector debt, Non-OECD bank debt (maturity over a year), Real estate, Plant 100% and equipment, Capital instruments issued at other banks Source: Bank for International Settlements - BIS Table VIII Regulatory requirements comparison Basel II Basel III Capital Requirements: Minimum Common Equity Tier 1 (CET1) 2% 4.5% Additional Tier 1 (AT1) 2% 1.5% Additional Capital Buffers: Capital Conservation Buffer 2.5% Discretionary Counter-Cyclical Buffer 2.5% Tier 2 Capital 4% 2% Source: Bank for International Settlements - BIS On the other hand, no big changes are perceived in the Asset Turnover which decreased by only 1p.p. and this is because total assets in Santander, BBVA and Sabadell have considerable increased as of 9M 2015 driven by the acquisitions made inside and outside Spain. On Charts 39 and 40 we can see the Total revenues breakdown for the four banks as of 9M 2015 and for FY2007, respectively. NII is still the major source of revenue as of 2015, mostly because they are Retail oriented banks and also we can see how the Trading income has become a valuable source of revenues for Sabadell and Popular which is not common in retail banks. Although the increase in the item impacts positively the operating income must not be consider recurrent for the sector as a whole, because this kind of source of revenues is not sustainable over time because of its high volatile level. Regulatory Capital Basel II Basel II was written with the objective of revising certain issues on Basel I (1988 Basel Accord) that were not able to control the new complications in the financial instruments and activities. Basel I was primarily focused on credit risk by creating a bank asset classification system (Table VII), but this kind of control were staying behind with the markets globalization, deregulation and technology s development. Basel II, published in June 4, was organized in three pillars: The first pillar Minimum capital requirement, The second pillar Supervisory review and The third pillar The market discipline. Pillar I manages the maintenance of regulatory capital that is calculated based on the three main components of risk a bank faces: credit risk, operational risk and market risk. Pillar II aims to give regulators better tools than the ones available in Pillar I, because it deals also with so called residual risks 9. Pillar III focuses on the disclosure of the information that would allow market s participants to measure the capital adequacy of an institution. 9 Residual risk: systemic risk, pension risk, concentration risk, strategic risk, reputational risk, liquidity risk and legal risk. PAGE 15/32

16 Chart 41 Book Value of Equity (Index Jan/2005) Table IX Spanish domestic financial institutions in-scope Market share Financial group (% of Spanish assets) Santander (incl. Banesto) 19% BBVA (incl. UNNIM) 15% Caixabank (incl. Banca Cívica) 12% BFA-Bankia 12% Banc Sabadell (incl. CAM) 6% Popular (incl. Pastor) 6% Libercaja (Ibercaja - Caja 3 - Liberbank) 4% Unicaja - CEISS 3% Kutxabank 3% Catalunyabanc 3% NCG Banco 3% BMN 2% Bankinter 2% Banco de Valencia 1% Source: Oliver Wyman-Asset quality review and bottom up stress test. September 28, 2012 Table X Overview of estimated capital needs at entity level under adverse scenario ( Bn) Financial group Projected Loss Loss Absorption Capital excess (pre-tax) Source: Oliver Wyman-Asset quality review and bottom up stress test. September 28, 2012 Capital excess (post-tax) Santander BBVA-UNNIM La Caixa Kutxabank - Cajasur Sabadell-CAM Bankinter Unicaja - CEISS BMN Libercaja Banco Valencia Popular - Pastor NCG Catalunya Banc BFA-Bankia System Table XI Overview of estimated capital needs at entity level under base scenario ( Bn) Financial group Expected Loss Loss Absorption Capital excess (pre-tax) Capital excess (post-tax) Santander BBVA-UNNIM La Caixa Sabadell-CAM Kutxabank - Cajasur Unicaja - CEISS Popular - Pastor Bankinter Libercaja BMN Banco Valencia NCG Catalunya Banc BFA-Bankia System Source: Oliver Wyman-Asset quality review and bottom up stress test. September 28, 2012 Basel III Basel III appeared from 2012 to fix the vulnerabilities of the exposed financial system after the international financial crisis. It would focus primarily on the risk of a run on the bank by requiring different levels of reserves according to the type of bank deposits and other borrowings. Therefore, Basel III does not displace the guidelines of Basel I and II; but it will work alongside them. The Key principles are related to Capital requirements, Leverage ratio and Liquidity requirements. Regarding Capital requirements (Table VIII), banks must hold from 2010 a minimum Common Equity Tier 1 (CET 1) ratio of 4.5% (up from 2% in Basel II) of Risk weighted assets (RWAs) and must be kept at all times by the banks. Moreover the minimum Tier 1 capital increases from 4% in Basel II to 6% over RWAs, applicable in This 6% is composed of 4.5% of CET 1, plus an extra 1.5% of Additional Tier 1 (AT 1). Furthermore, Basel III has introduced two additional capital buffers: a mandatory capital conservation buffer and a discretionary counter-cyclical buffer. The capital conservation buffer is equal to 2.5% of RWAs and taking into account the 4.5% CET 1 capital ratio also required, banks must hold in total 7% CET 1 capital, from 2019 onwards. The discretionary counter-cyclical buffer would allow regulators to demand up to an additional 2.5% of capital on periods of high credit growth. Basel III introduced as well a minimum leverage ratio and it is expected banks to keep in excess a leverage ratio of 3%. Among the Liquidity requirements it was introduced two required liquidity ratios; i) the Liquidity Coverage Ratio which obliges a bank to hold sufficient high quality liquid assets to cover its total net cash outflows over 30 days and ii) the Net Stable Funding Ratio to require the available amount of stable funding to exceed the required amount of stable funding over a one-year period of extended stress. The Tier 2 capital ratio, considered as a supplementary capital was reduced from 4% to 2% under Basel III. All the changes introduced by this latest Accord should be fulfilling by all the banks in 2019, forcing them to start issuing more shares. The amount of Equity registered in the 1 st of January 2005 was 148 billion, as expected with the changes in the minimum capital requirements, a large increased of equity in the financial and credit institutions occurred as up today. However, by looking at Chart 41 we noticed that from the middle of 2014 until June 2015 the amount of equity has decreased at a CAGR of 11% which means that even though the amount of equity continues being high with respect to 10 PAGE 16/32

17 years ago, the cleanse of balance sheet from risky assets in this institutions is being effective in general terms, which translate in less capital to be hold and another way to increase the capital ratios and comply with them. Stress tests The test scenarios and methodology for the 91 European credit institutions were developed between the Committee of European Banking Supervisor (CEBS) and the ECB. It was defined by the CEBS a Tier 1 capital ratio of 6% to be hold in the adverse scenario (+50% than the legally minimum required). The outcomes in Chart 42 Capital needs under the base scenario (Core Tier 1=9%) and under the adverse scenario (Core Tier 1=6%) - Bn 2010 revealed the capital needs in a highly stressed and unlikely scenario; however no private bank needed more capital to reach the settled Tier 1 ratio in both scenarios. After two years in a row disclosing positive results, Spain s savings banks collapsed and required to ask for a bailout. It was required then in 2012 a topdown stress test exercise that it was concluded on the 21 st of June and after Oliver Wyman was commissioned to perform a bottom-up stress test analysis of the most significant financial groups in Spain (Table IX shows the 14 banks under Source: Oliver Wyman-Asset quality review and bottom up stress test. September 28, 2012 analysis, considering the on-going consolidation processes), covering c90% of the Spanish banking assets. Table XII Macroeconomic scenarios provided by the Steering Committee Base case Adverse case GDP: Real GDP 0.7% -1.7% -0.3% 0.3% -4.1% -2.1% -0.3% Nominal GDP 2.1% -0.7% 0.7% 1.2% -4.1% -2.8% -0.2% Unemployment 21.6% 23.8% 23.5% 23.4% 25.0% 26.8% 27.2% rate Price evolution: Harmonised CPI 3.1% 1.8% 1.6% 1.4% 1.1% 0.0% 0.3% GDP deflator 1.4% 1.0% 1.0% 0.9% 0.0% -0.7% 0.1% Real estate prices: Housing Prices -5.6% -5.6% -2.8% -1.5% -19.9% -4.5% -2.0% Land prices -6.7% -25.0% -12.5% 5.0% -50.0% -16.0% -6.0% Interest rates: Euribor, 3 months 1.5% 0.9% 0.8% 0.8% 1.9% 1.8% 1.8% Euribor, 12 months 2.1% 1.6% 1.5% 1.5% 2.6% 2.5% 2.5% Spanish debt, 10 years 5.6% 6.4% 6.7% 6.7% 7.4% 7.7% 7.7% Ex. Rate/USD 1.4% 1.3% 1.3% 1.3% 1.3% 1.3% 1.3% Credit to other resident sectors: Households -1.7% -3.8% -3.1% -2.7% -6.8% -6.8% -4.0% Non-Financial Firms -4.1% -5.3% -4.3% -2.7% -6.4% -5.3% -4.0% Madrid Stock Exchange -9.7% -1.3% -0.4% 0.0% -51.3% -5.0% 0.0% Index Source: Oliver Wyman-Asset quality review and bottom up stress test. September 28, 2012 This bottom-up exercise aimed to estimate the capital needs of the system and individual banks in the base and adverse scenarios 10. The difference between the top-down stress test exercise and the bottom-up stress test, were that the former analysed historical performance, the entities conditions at the beginning of the stress period and assets mix at an aggregate level. While in the second one supervisors had the chance to analyse bank s portfolio more accurately, by evaluating the individual risk profiles of the different banks and resulting in an individual valuation of capital needs. The bottom-up analysis estimated first the expected credit losses and each entity s loss absorption capacity, embedding the results from the concurrent portfolio and asset quality review. The process included three key components: Projected loss forecast, Loss absorption capacity forecast and Potential capital impact and resulting solvency position in the two scenarios. When the estimations of the bottom-up test were finished on June 2012, the results showed that the Spanish banking system had projected losses of 270 billion and a loss absorption capacity of 252 billion (Table X) under the adverse scenario. The total estimated capital needs (pre-tax) of the sector under the same scenario were c 60 billion ( 59.3 bn), expected to be reduced to around 57.3 billion with the mergers in progress considered within 10 Base or baseline scenario reflected the consensus expectation of professional forecast in February 2009 on the depth and duration of the recession, and the adverse scenario was designed to reflect a recession that is longer and more severe than the consensus expectation. PAGE 17/32

18 Chart 43 - Loans and Receivables by type ( Mn) Source: Company data Chart 44 - Sabadell's market shares over the Total Loans of Credit Int. in Spain to Customers and analyst s estimations Chart 45 - Sabadell's market shares over the Total Loans of Credit Int. in Spain to Credit Institutions ( '000) and analyst s estimations the scope of the exercise. The estimated capital needs applied to 7 out of the 14 entities (Capital excess post-tax) under the adverse scenario (38% of the exposure under consideration). The three largest institutions (SAN, BBVA, and Caixabank 43% of the considered exposure) had an estimated capital excess of 37 billion in the adverse scenario. Sabadell was not one of the banks under capital needs, actually in both scenarios, adverse and base, it was counting with an excess capital post-tax of 0.9 billion and 3.3 billion respectively. The base and adverse scenarios settled a CET 1 of 9% and 6% respectively and the estimated wide pre-tax capital needs were 24 billion (base scenario) and c 57 billion (adverse scenario) (Chart 42). The big question arising is, why the previous tests did not detect the actual shortfalls the banks were having? The answer relies on the methodology that was implemented to perform this test, which focused special attention on the credit portfolio of the 14 groups, due to the increasing concerns in the markets over the solvency and quality of the Spanish banking system. It differs mostly from the previous stress tests performed in the greater effort applied this time in the Spanish exercise. For example, 14 macroeconomic factors were considered (Table XII), being the most significant factors of the Spanish economy, such as land and housing prices, financial data of the Madrid stock exchange, etc. Moreover, the time horizon was extended for a period of three years (from 2012 to 2014), when in most of the other tests conducted the period analysed comprised two. This means that the economic recession would last for a longer period of time, which translate in higher potential losses of the analysed banks, and their potential capital needs. It was also included much more adverse assumptions or greater deteriorations of all factors: a fall in GDP of 6.5% in the adverse scenario over the three years while in 2010 and 2011 was considered a fall of 2.6% and 2.2% respectively, a maximum of 5.6% increase in the unemployment rate by the end of the time horizon (variable not considered in 2010 and 2011 stress tests), and house and land prices and the extension of credit all fall over the three years, and more markedly so in the adverse scenario. Last but not least, the capital ratios used in this stress test were much higher than the ones used in the latest similar tests, such as in the European Banking Authority (EBA) exercise where it was settled a 5% in the adverse scenario and 8% in the base scenario. PAGE 18/32

19 Chart 46 - Available-for-sale (AFS) Financial Assets evolution ( Mn) Valuation The SOTP method was used to perform the valuation of Sabadell to add up TSB divisions value to Sabadell s value. It was necessary to value first; Sabadell as a group (excl TSB) and TSB using for both the FTE method. Sabadell s valuation Source: Company data and analyst s estimations Chart 47 - Tangible and Intangible assets' evolution ( Mn) Source: Company data and analyst s estimations Chart 48 - Non-current assets held for sale evolution ( Mn) Source: Company data and analyst s estimations Chart 49 - Sabadell's market shares over the Total Deposits of Credit Int. in Spain from Customers ( '000) and analyst s estimations Starting with the Commercial Activity of the bank, the Cash and balance with Central Banks was projected under the assumption that Sabadell will aim to keep 3% reserves over the deposits from customers. This percentage is higher than the minimum required reserves enforced by the ECB (1%) and no changes in the near future are expected. One of the most important captions inside the BS of Sabadell is the Loans and receivables (L&R) portfolio which is segmented into Customers, Credit institutions and Debt securities (Chart 43). In general terms this item has experienced for all the banks in Spain a slowed down after 2008, driven mostly by the decline in loans to customers, but in Sabadell s case this item actually has being increasing from 2008 as of 2014 at a CAGR of 10%. The projection for the Total amount of L&R were based on the market shares Sabadell holds over the Total loans and advances to Customers and to Credit Institutions over the same items in Spain. Sabadell has kept an average of 5.1% market share in the Loans and advances to customers from (increasing YoY), in 2014 the market share was 8% (Chart 44). It was projected that Sabadell would aim to keep a market share of c8% for the FY2015 and continue strengthen its position over the next years by keeping a constant market share of 8%. The reasoning behind is the restabilization of the Spanish economy, therefore families will become less indebted and able to request for more loans. Besides, because more acquisitions are expected to be done by the bank in the future and the purchase of mortgage loans is also within the business strategy of the bank 11. On the other hand the Loans and advances to Credit institutions has kept an average of market share of 1.7% from , in 2014 the market share was c3% (Chart 45). For the FY2015e and FY2016e was forecasted that Sabadell would have a market share of 2.2% in this item, and will gradually growing at 0.1.p.p. YoY. Based on the improvements in the Spanish economy, credit institutions must tend to start trusting each other and start increasing their lending activity again. Whilst Debt securities segment is a residual item and given the 11 Sabadell is in bid for a 13 billion portfolio of former Northern Rock mortgages from the tax payer. PAGE 19/32

20 historical behaviour, it only appeared in 2012, it was projected to disappear as time goes by. Chart 50 - Revenues breakdown as a percentage of total revenues Source: Company data and analyst s estimations Chart 51 Euribor 12-month s evolution from 1999 to 2015 Source: Reuters Chart 52 Euribor 12-month s estimations from 2015 to 2019 Source: Reuters and analyst s estimations Chart 53 NII evolution ( Mn) Source: Company data and analyst s estimations The Available-for-Sale (AFS) Financial Assets portfolio, which is the second largest portfolio of Sabadell, has shown signs of growth over the past years (Chart 46). The portfolio includes mostly debt securities and other equity instruments that do not fit into the FVTPL, HTM or L&R portfolios and are held to sell when appropriate. The debt securities included in the AFS financial assets, in 2014 amounted 20,393 million, comprising government securities of which 10,167 million were Spanish government securities, while 8,080 million were securities issued by foreign governments 12. This shows that Sabadell has a higher exposure to the Spanish Government, which makes it more vulnerable to the Spanish economy. Regarding the fact that there has been a decreased to the exposure of Credit Institutions, it seems that Sabadell is seeking for a more conservative policy in order to avoid unnecessary risk exposure to the financial sector (the government bonds yields were high and the probability of default much lower than for credit institutions, especially nowadays). This portfolio is hard to forecast in terms of evolution, because it is mostly an investment policy choice, but an increase in the item is not expected due to the fact that it impacts negatively the RWAs. Moreover during the last years the selling of the Spanish Government bonds has been generating big trading profits to the bank due to the decline in the bonds yields. So, it was projected for the portfolio to downsize slowly. One of the key themes included in Sabadell s Triple Plan is the Internationalization. Therefore, Tangible and Intangible assets captions were forecasted to increase over the years (Chart 47). Although the Triple Plan will finish in 2016 and an acquisition was already done during 2015, it is expected, due to the improvement of the Spanish economy, that Sabadell s tangible assets will continue growing due to expansion in terms of branches and employees. On the other hand, intangible assets, which include goodwill, it is expected to increase for this matter as well and due to the needs of the banks to provide electronic access to its users as well as the computer software required for operations. Certain amount of assets have been grouped in the caption Other Assets (Appendix 1 Consolidated Balance Sheet), among them is the Non-current assets held for sale which is composed by all the foreclosed assets of the bank. The biggest item including in this caption is the repossessed assets, which as of 2014, amounted 3,110 million. As Chart 48 shows, non-current assets held for 12 Foreign Government Securities: Italian, US, Portuguese and Mexican governments. PAGE 20/32

21 Chart 54 NIM evolution (NII/ATAs) Source: Company data and analyst s estimations Chart 55 Customer spread and Margin evolution (%) Source: Company data Chart 56 Customer loan yield and cost of customer funds (%) Source: Company data Chart 57 Customer loan yield and cost of customer funds estimations (%) Source: Company data and analyst s estimations sale suffered a sharp increase from 2011 as of today, which was associated with the deterioration in the quality of the banks credit portfolios in the sector. There are still strong pressures that would imply a growth of the amount of collateralized loans going into default. However, betting on the improvements of the Spanish economy and on the real estate market starts being more liquid, we believe this item will decrease over the years. On Sabadell s Liabilities side, all the items except Liabilities under insurance contracts and Provisions were forecasted. The Financial Liabilities at amortized cost (FLAC) that is mostly composed by deposits from; Central banks, Credit Institutions and Customers it is mostly influenced by economic growth and the national savings rate. In the current environment and near future, it is expected an increase of income for the next years (meaning that saving rates should be higher), however, householders are still highly indebted and an increase in Deposits from customers might see perceivable in two or more years. So, the Total deposits in Spain, which have being decreasing as of today, were projected to continue falling until 2016 and start increasing at a small peace afterwards, based on the recovery of trust from customers that Financial Institutions in Spain are facing now. It was applied the same reasoning of the L&R portfolio by taking into account the market share Sabadell holds in the Total Deposits of Credit Institutions in Spain, that on average has been c5% from (Chart 49) and 7.6% in For FY2015e it was projected Sabadell will have the same market share of 2014 and it will aim to keep a constant 7% market share from 2016 onwards over Spain s Total Deposits. The wide variety of business activities a financial institution has are grouped in the three common types of income they generate for a bank. The NII for Sabadell generates the highest percentage of revenues (53% of total revenues as of 2015 Chart 50) and in order to forecast the evolution of this item, the yields and costs of the average balance values of the different assets and liabilities that generates interest income and interest expenses results were forecasted. To do so, the Euribor 12-month was used as a benchmark because is the rate used for calculating monthly instalment payments on over 90% of mortgages in Spain. The projection of the Euribor 12-month s evolution was based on the latest decision of the ECB on his last meeting on December 9 th, In the meeting the ECB announced that interest rate on the main refinancing operations (MRO), which provide the bulk of liquidity to the banking system, will remain in its lowest level of 0.05%. It kept the marginal lending facility at the same level as well (0.30%) and decreased the rate on deposit facility to -0.30%. We can see how much the Euribor 12-month has declined (Chart 51) when we take a look at figures from PAGE 21/32

22 December 2012 (0.964%) and December 2014 (0.435%), the reason why the Chart 58 - Loan spreads evolution by segment (%) - Back book Euribor is falling to new lows each month is due to action taken by the ECB in the bid to stimulate the euro zone market. While it looks like the economy in the euro zone is improving, it doesn t mean that the situation is likely to change any time soon regarding interest rates and the Euribor rates are still expected to decrease for the foreseeable future, especially due the latest ECB s actions. Therefore our estimations by the end of 2016 is the Euribor rate will continue reaching lower levels (0.146% FY2016 Chart 52) and from 2017 onwards will start increasing at Source: Company data Chart 59 - Loan spreads evolution by segment (%) - Front book a low peace, based on that the European economy will start showing more notable improvements that will allow the ECB to take on decisions of increasing the key interest rates of the euro area. The overall evolution of Sabadell s NII has seen an increasing tendency since 2008 up to 2014 (Chart 53), the low costs funding context play an important role on this trend and this was reflected in the forecasts made, so it is expected by the end of 2015F a NII of million. On the other hand Net Interest Margins (NIMs) as a percentage of Average total assets (ATAs) has been sharply Source: Company data Table XIII - Maturities of term deposits: volume and average interest rate cost ( Mn) Maturities Rate Amount 4Q % 10,550 1Q % 6,549 2Q % 8,359 3Q % 6,767 4Q % 1,138 1Q % 495 >2Q % 1,414 Source: Company data Table XIV - Wholesale funding maturities ( Mn) Maturities Rate Amount % % 4, % 3, % 1, % % 1, % 2, % 1,144 > % 761 Source: Company data declining from 2008 until 2014 driven mostly by the constant increases in Total assets at a CAGR of 13% (NII CAGR: 8%). However, since the 1Q of 2014 until 3Q of 2015 Sabadell has been able to increase NIMs in this low interest rate environment and it is expected 1.6% NIM for FY2015e, 20bps higher than 2014 (Chart 54). This is all driven by the steady improvements in customer spreads on the back of lower cost of funding for both wholesale and retail (Chart 56), steady improvements that we believe will continue for the next four years under the assumptions that interest rates will be probably start increasing from 2017 onwards (Chart 57). Moreover on Charts 58 and 59 we can see how loan spreads from the Back and Front books are beginning to stabilise in the different segments. This is meanly due to the fact that companies and SMEs in Spain are been currently priced at similar levels that other countries in Europe. As we can see on the back book the total average of loan spreads of the Sabadell has decreased only by 2bps from 2Q to 3Q of It is also expected that liability repricing will continue in coming years. Tables XIII and XIV shows the different maturities of term deposits and the wholesale funding maturities, both in terms of volume and in terms of price. We assumed that markets will maintain its current stable conditions, so if Sabadell manages to renovate those deposits at 0.3% cost (current one) and also the wholesale funding to 0.62% (current one), NII will be benefit from deposit and wholesale funding re pricing of about 330 million and 220 million, respectively. The NII has been and will continue to be under pressure for some given years driven the on-going very low interest rate environment in developed countries, Sabadell could generate more income from PAGE 22/32

23 Chart 60 - Net Fees and commissions income evolution per quarter ( '000) Source: Company data and analyst s estimations Chart 61 - Net Gains/Losses on financial assets and liabilities evolution ( Mn) Source: Company data and analyst s estimations Chart 62 - Provisions for NPLs and other impairments ( Mn) and the Provisioned percentage over the Loan portfolio Source: Company data and analyst s estimations Chart 63 - Income tax evolution ( Mn) Source: Company data and analyst s estimations the loans to SMEs since it is a segment that has been growing in the economy, but due to competition and the Euribor playing against loans interest rates, NII is being affecting. Although, we expect Sabadell s NII to continue increasing from FY2015e until FY2019e at a CAGR of 4% (Chart 53). Net Fees and Commission income (F&C), the second largest source of revenue of Sabadell has been growing in a seasonally weak 3Q 2015 (Chart 60). The big increases are related to; i) the asset management business activity, which are currently accounting for the largest share of F&C in Spain and they are gaining importance, in part due to the unattractiveness of deposit s remuneration, and ii) all the collection and payment fees related to credit cards. Similar results of the mentioned items are expected for the 4Q of 2015, growing the total amount by 17% with respect to Overall, this item was forecasted to continue its growing trend at a constant 7% growth rate YoY, especially due to the need of the bank to continue exploring other sources of revenues different than NII. Trading income has seen a bulk in the last two years amounting 1.5 and 1.8 billion in 2013 and 2014 respectively (Chart 61), likely to remain a key driver in In the last eight quarter trading revenues have accounted for an average 36% of Sabadell s total revenues, which is unusually high for a pure retail bank. Sabadell has been benefiting from the sale of Spanish government bonds that were bought in 2011 and has seen a decline in its yield from the middle of 2012 as of today. The gains have been allocated to provisions to reinforce coverage ratios. The bank still has unrealized trading gains in its securities portfolio in the balance sheet in 2015, so we expect trading income to amount 1.2 billion by the end of 2015e. For FY2016e onwards we forecast, based on the size of the trading portfolio and the expected return on it, more normalized trading income of 513 million for FY2016e and continue declining. The Provisions for non-performing-loans (NPLs) and impairments were done over the Loan portfolio. From 2007 up to 2014 Sabadell has been provisioning on average 1.3% of the loan portfolio and for the next years we expect the bank to provision 2% over the loan portfolio (Chart 62). We expect this caption to decrease by the end of 2015 with respect to 2014 by 6%, regarding the fact that Sabadell has already provisioned their problematic assets for an amount of 1.7 billion in the first half of In relation to Income Taxes, it was assumed that Sabadell will pay a Corporate Income tax rate of 26% from the 4Q 2015 onwards (Chart 63). The Law 27/2014 that came into force on January 1 st 2015 and stated in its article 130 that the aforementioned deferred tax assets might be exchanged for public debt securities after a period of 18 years from the last date of the tax period in which PAGE 23/32

24 the assets were recognised 13. These means that Sabadell will be able to benefit from tax credits for the period being analysed and according to the available amount of Tax Assets Sabadell has on its Balance Sheet, the expected income taxes will be deducted from it. After deducting income taxes and the share of profit attributed to non-controlling interests, the estimated profit attributed to the bank is 432 million for FY2015e, representing 16% increase YoY with respect to FY2014 ( 372 million). Table XV Sabadell s Cost of equity Levered Beta 1.3 GTDEM10Y Govt 0.586% Market risk premium 5% CoE 7% Chart 64 Sabadell s betas regression Source: Company data and analyst s estimations Chart 65 Spain Nominal GDP growth rate (Change over same quarter of the previous year) Source: OECD The calculated discount rate to perform the FTE valuation for Sabadell was obtained through the Capital Asset Pricing Model (CAPM) model (Table XV). As a Risk free rate was used the 10 year German Government Bond (GTDEM10Y Govt) as of January 1 st, It was not used any Spanish Government bond due to the diversified composition of investors that Sabadell has. Concerning the beta for the bank (Chart 64), we regressed the Euro Stoxx 50 Index (SX5E) against Sabadell s stock using monthly data from 2011 until 2015 to measure the risk that compares the returns of the stock to the market. It was used a confidence interval of 95% to assess the probability that our calculated betas will fall between the upper and lower bound estimated. An average of the last two quarters of 2015 (where our betas get closer to the confidence interval) was computed, resulting in a beta 1.3. The calculation of the Market risk premium (MRP) was computed over the last year by using the Index mentioned before and assuming that the realized return of last year is the expected excess return for future years, the outcome was 5%. The resulted CoE was 7%. Sensitivity Analysis The defined growth rate to perform the valuation for the long time horizon was 2.1%. It was calculated an average of the changes over the same quarter of the previous year since 1Q 2014 to 2Q 2015, which is the period where the Nominal GDP in Spain has started to show positive growth rates (Chart 65). Perhaps this growth rate can be seen as conservative, regarding the fact that in the second quarter of 2015 the percentage change over the year before was 3.1%, however, the reasoning behind is the current characteristics of the banking sector, which is going through several changes not only due to the international financial crisis and the real estate bubble, but also due to its regulatory response. The higher capital requirements after the implementation of Basel III accords might slow down the growth of the sector. So, worries about how banks will be actually able to develop their business strategies and the returns they will be able to achieve will always be present under this environment. 13 The Law 27/2014 of 27 November on Corporate Income Tax (The CIT law or LIS ) came into force on 1 January 2015 and repeals the Revised Text of the Income Tax Law (TRLIS). PAGE 24/32

25 It was assessed the sensitivity of the estimated target value ( 1.8 per share 14 ) resulting from the valuation of Sabadell excluding TSB, to the changes of the growth rate and CoE under adverse and stable scenarios. To do so different inputs were used to analyse whether our expectations might go wrong and what would be a fair range for uncertain variables such as the beta and the MRP. For the nominal growth rates was used a range from -4.1% and 3.4%. The refer series include the positive changes in the nominal GDP growth rate of the latest six quarters in Spain and negative rates used in the Oliver Wyman Stress test in 2012, where the economy was test under a severe economic recession (adverse scenario) with nominal GDP declines of 4.1% and 2.8% (Table XII). To assess the changes to the CoE, different betas and benchmark MRPs were used. With the beta varying from 1.1 to 1.4 and the MRP varying from 3% and 6%, it was obtained a series of CoE from 4% to 9%. It was also test the price by using the average CoE for the sector in Spain in 2011 and 2015, 18% and 11% respectively (Chart 13). The results on table XVI, show that in high risk scenarios in the economy in Spain (-4.1% growth rate and 18% CoE), Sabadell s share price can fall until almost cero. On the upside, if the CoE is reduced to 4% and the long run growth rate increases until 3.4%, it is perceivable a drastic and unreasonable jump in the price per share for the bank. However, by keeping the same growth rate and a CoE of 5%, Sabadell is likely to return to its share prices on Table XVI: Cost of equity Growth rate -4.1% -2.8% -1.9% -0.7% 0.7% 1.2% 1.7% 2.1% 2.7% 3.1% 3.4% 4% % % % % % These data suggests that the estimated share value is very sensitive to variations of the baseline assumptions of 2.1% long-run growth rate and 7% discount rate. Adverse variation in valuation parameters could reduce Sabadell s share value estimates to 0.4 per share and favourable variations could increase it to 4.6 per share. Considering that the forecasts and valuation assumptions done are realistic, the baseline estimated for Sabadell at the end of 2016 is 1.8 per share, meaning that by that time the current market price of 1.6 per share of Sabadell is under- 14 The resulted Sabadell s target value of 1.8 per share was obtained through its FTE valuation. We only refer to this value in the sensitivity analysis exercise, but the definite target value is 2.3 per share through the SOTP valuation. PAGE 25/32

26 priced by about 13%. Given these estimates, it is reveal that Sabadell s share value has limited downside potential but substantial upside potential. Chart 66 Inflation rate evolution and estimations for the long run Source: Inflation.eu, European Commission, British Chambers of Commerce and Statista websites Chart 67 Loans and advances to customers evolution ( Mn) TSB s valuation TSB is segmented into two business units; The Franchise and The Mortgage Enhancement 15. The valuation of the Group was performed in pounds and the outcomes were converted into euros in order to do the SOTP valuation. The exchange interest rate used to convert the Free Cash Flows (FCF) to equity holders were: GBPEUR for FY2015e and GBPEUR for FY2016e onwards. The exchange rate for the long run was estimated using the Purchasing Power Parity (PPP) and the inflation rates for Spain and The UK for the long run which is 1.2% and 2.1% respectively (Chart 66) The projection of TSB s Loans and advances to Customer item was based on Source: Company data and Analyst s estimates Chart 68 Financial Liabilities breakdown (% over Total amount) Source: Analyst s estimates Chart 69 Customer deposits evolution ( Mn) Source: Company data and Analyst s estimates the positive results obtained through the new Franchise s intermediary channel 16 for the first since the moment it was launched (January 2015). The Franchise lending balances grew by million in the first half. The success enabled TSB to deliver positive quarterly lending growth, the total amount of this item increased to 21,660 million in the 2Q 2015 ( 21,386 million 1Q 2015). In the 1Q and 2Q of 2015 TSB was named mortgage lender of the quarter by Mortgage Strategy Magazine. Other attractive products were also launched during the 1H of 2015; the Fix and Flex 17 that allow customers to fix their interest rate for 10 years with flexibility to switch to a new product after 5 years and the Breathing Space, which allows customers to make lower payments in the first year of their mortgage. On top of this, TSB exceeded their target of winning more than 6% of all customers opening or switching bank accounts in the UK. Overall we expect the caption Loans and advances to customers to continue increasing over the years (Chart 67), since through the implementation of these business strategies, TSB has become one of the fastest growing mortgage providers in the UK. TSB increased its Funding and Liquidity position by attracting new customers and retaining existing deposit balances in the first half of This led to an increase in deposit balances of 1.3%, or 313 million to 24,937 million during the first semester. The caption Financial Liabilities it is mostly composed by Customer deposits (98% of total financial liabilities in 2014 Chart 68) which is made up mostly of customer bank accounts and saving balances. The Franchise Loan to deposit ratio as of June 2015 was 76.6% (December 31 st, %). We expect customers deposits to increase by 6% in FY2015e with respect to 2014, 15 Franchise segment comprises the retail banking business which offers a broad range of retail financial services that include current accounts, savings products, personal loans, credit cards and mortgages. The Mortgage Enhancement segment comprises a separate portfolio of mortgage assets which was assigned to TSB by Lloyds Banking Group with effect from February 28 th, TSB launched a range of products through this channel to include house purchase, remortgaging and buy-to-let mortgages. 17 Fix and Flex product won the Innovation in Personal Finance award at the Moneyfacts PAGE 26/32

27 Chart 70 Total revenues breakdown (% over Total amount) Source: Company data Chart 71 NII forecast ( Mn) Source: Company data and Analyst s Chart 72 Operating expenses evolution ( Mn) Source: Company data and Analyst s estimates Chart 73 Impairment losses on loans and advances to customers ( Mn) Source: Company data and Analyst s estimates especially after July 2015, when Moody s published for TSB Bank plc an investment grade long-term debt rating of Baa2 with positive outlook and for TSB Group plc (Baa3), which represents in our view a good independent assessment and recognition of TSB s strategic progress. Based on the latest performance of this item and the overall good conditions of the UK s economy it is believed TSB will be able to continue increasing its mean sources of fund (Chart 69). As expected from a retail bank, NII generates the highest percentage of income over total revenues and in TSB s case NII represented 84% of the Total Income as of 2014 (Chart 70). The reasoning applied to forecast this item was based on the scenario that in the mid of 2016 or during 2017, The Bank of England will take on the decision of raising interest rates especially after the Fed finally raised interest rates for the first time in almost a decade. In 2014, there was an increase by 66.1% to million in NII in TSB s balance sheet, meanly due to; the customer transfers in 2013 and the NII earned on the Mortgage Enhancement portfolio since it was transferred to the Group on February The NIM of the Franchise increased by 6bps in the 1H of 2015, mostly due to lower deposit funding costs. We expect the NII arising from the two business segment of TSB to benefit from the higher expectations around the increase in interest rates in the UK and increase over time at a CAGR of 8% from 2015 to 2019 (Chart 71). Operating expenses has remained stable in the 1H of 2015 because the Group spent a huge amount in marketing during the last quarter of 2014 together with the ongoing focus on managing costs in the current low interest rate environment. We expect Sabadell to substantially change TSB s cost base which before the acquisition was dependent on a service agreement with Lloyds. As a result, with a potentially lower cost IT system more suited to TSB, we would expect TSB to generate higher earnings under Sabadell mandate. The item was forecasted to continue decrease significantly YoY (Chart 72). TSB s Impairment losses on loans and advances to customers was projected as a percentage of Loans and advances to customers. The caption decreased in the 1H of 2015 by 15% with respect to 2H The absolute value of impaired loans decreased by 12.3% and the Asset quality have been decreasing from 2013 until the 1H of 2015 reaching 0.37% (0.61% and 0.44% ) driven by the constant favourable macroeconomic conditions in UK (particularly due to lower unemployment). Based on the behaviour of this item is highly influenced by general conditions of the economy, we expect it to decrease over time (Chart 73). PAGE 27/32

28 The resulting estimated attributable profit for the company for FY2015e was 173 million ( 245 million) and the synergies TSB will generate to Sabadell from 2015 onwards are expected to grow at CAGR of 40% (Chart 74). Chart 74 Net Income attributable to the company ( Mn) Source: Company data and Analyst s estimates Table XVII TSB s Cost of Equity Levered Beta 1 GTGBP10Y 1.8% Market risk premium 5% CoE 7% Chart 75 UK nominal GDP growth rate (Change over same quarter previous year) Source: OECD The resulting CoE for TSB by using the CAPM model was 7% (Table XVII). As a risk free rate it was used the United Kingdom 10 year Government Bond of 1.8% as of January 4 th, 2016 and a benchmark of 5% as a MRP. The continuation growth rate for TSB is more ambitious than the long run growth rate of Sabadell, regarding the stronger performance of the UK s economy. The former resulted from the computation of an average of the last quarter s nominal GDP growth rate (Chart 75). The latest available data for the beta of TSB on Bloomberg against the FTSE 100 Index is significantly lower than 1 (adjusted beta of 0.333) meaning that the volatility of TSB is significantly lower than the market volatility, therefore it was assumed a beta equal to 1. Sum of the parts valuation On Appendixes are presented the consolidated figures of the financial statements (Appendixes 1 and 3) and the resulted capital structure of Sabadell including the acquisition of TSB (Appendix 2). The SOTP valuation was performed from the resulted FCF to equity holders obtained from each financial institution and the estimated Target Price for Sabadell including the acquisition is 2.3 per share price. The expected capital gains are 39% over the current share price of 1.6 per share, the total shareholders expected return is 36% and our recommendation is to buy. On FY2016e Sabadell is estimated a cash out of 4% that will have to be cover with a capital increase amounting 266 million, the amount is feasible to raise due the fact that expected income for 2016e amounts 726 million. Table XVIII: Description (Values in Mn) 2015F 2016F 2017F 2018F 2019F Banco Sabadell Group, S.A FTE (excl TSB) 1, TSB Banking Group plc FTE Sabadell (excl TSB) - Market capitalization 8,710 9,906 10,355 10,704 10,927 TSB - Market capitalization 2,484 2,463 2,428 2,426 2,489 Sabadell's Total Market capitalization 11,193 12,369 12,783 13,129 13,416 Sabadell's shares outsatnding (Mn) 5,439 5,439 5,439 5,439 5,439 Expected share price Expected Capital Gain 39% Shareholders' Cash in/out (per share) Expected "Cash" Gain -4% Total Shareholders' Expected Return 36% Regarding the objectives settled in the Triple Plan, although Sabadell won t be able to achieve all of them by FY2016e according to our estimations, some PAGE 28/32