Banco Bilbao Vizcaya Argentaria SA's potential acquisition of Spanish peer Banco de Sabadell SA would refocus its strategy on Spain from emerging markets such as Mexico and Turkey, strengthening its position in small and medium-sized business lending and consolidating its position in its domestic market.

The mooted deal comes hot on the heels of CaixaBank SA's plans to buy Bankia SA. The Spanish banking sector went through a massive transformation following the financial crisis, with the number of savings banks falling to 11 from 45 between 2010 and 2015, and fresh merger activity heralds a long-awaited second wave of mergers in the country. In general, Spanish banks, as with their rivals in Europe, have suffered from weak profits as years of low interest rates take their toll, with the coronavirus pandemic compounding their difficulties.

READ MORE: Sign up for our weekly coronavirus newsletter here, and read our latest coverage on the crisis here.

The combined BBVA-Sabadell entity would have €963.11 billion in assets, according to S&P Global Market Intelligence data, and dramatically change the nature of Spain's banking sector, creating a big three of Spanish lenders. Banco Santander SA would remain in top place, with the merged CaixaBank and Bankia taking third place.

Santander, like BBVA, generates much of its income outside Spain in Latin America, though it acquired failed lender Banco Popular Español SA for €1 in 2017, boosting its position in Spain. BBVA owns Mexico's largest bank by assets Grupo Financiero BBVA Bancomer SA de CV and is also present in Turkey.

Capital boost

BBVA had been previously linked to Sabadell, but capital constraints on both lenders had made a deal unlikely, according to analysts.

However, BBVA's sale of BBVA USA Bancshares Inc. and BBVA USA to PNC Financial Services Group Inc. for $11.60 billion provides it with enough capital to buy Sabadell, said Javier Santacruz, an economist who specializes in the Spanish banking sector at the Instituto de Estudios Bursátiles, a Madrid business school.

BBVA's common equity Tier 1 ratio — a key measure of financial strength — stood at 11.52% at the end of the third quarter, according to S&P Global Market Intelligence data, while Sabadell's was at 12.01%. BBVA is expecting to boost its capital by 294 basis points through the U.S. sale to 14.46%.

The potential deal represents a capital hit of 130 basis points for BBVA, leaving it with a pro forma ratio of 13.2%, analysts at Jefferies said in a note. The "overall valuation impact is broadly neutral," they said.

SME lending

BBVA would be able to make the most of Sabadell's strong position in SME lending, Santacruz said, and build up its already strong corporate lending.

Excluding Sabadell's U.K. unit, TSB Banking Group PLC, 26% of Sabadell's gross loans are to SMEs. Corporate and investment bank lending accounted for 24.4% of BBVA's lending in the first nine months of the year, while 15% of loans are to very small businesses.

A deal would bolster BBVA's position in Catalonia, Spain's economic powerhouse, as Sabadell has strong roots in the region, Santacruz said. In addition, BBVA will be able to take advantage of Sabadell's asset management distribution deal with Amundi SA after its decision to sell the unit to the French asset manager. Those assets, combined with BBVA's asset management business, will help it to take a leading position in Spain in a generally high-fee-generating business, he said.

BBVA has built itself into a leading digital bank and will bring that expertise to Sabadell, he said.

Albert Banal-Estanol, an associate professor in the department of economics and business at Universitat Pompeu Fabra in Barcelona, said the merger would reduce the number of branches in what is one of Europe's most overbanked markets.

As of 2019, the country had 49.7 banks per 100,000 adults, as opposed to 38.8 banks per 100,000 adults in Italy and 34.3 in France, according to World Bank data. Germany, by comparison, has around 11 banks per 100,000 adults.

BBVA has 2,520 branches in Spain, while Sabadell has 1,807.

It would also create less competition in the Spanish market for BBVA, he said, as it would reduce the number of players vying for market share.

Challenges

Sabadell has been struggling with its U.K. TSB unit, suffering losses following a bungled IT migration and undergoing a restructuring program. BBVA may want to take a "wait and see" approach in deciding whether it wants to remain in the U.K., a mature market offering low profitability, Santacruz said.

The TSB tribulations and its difficulties "in keeping pace with other banks" make it "a candidate to be taken over," Banal-Estanol said.

Sabadell's return on average equity — a key measure of profitability — stood at 1.85% at the end of the third quarter, compared to 11.86% for BBVA, according to S&P Global Market Intelligence data.

The prolonged nature of the pandemic also casts a shadow on the merger because the economic costs of the crisis are not yet known, Santacruz said. There is a risk of rising nonperforming loans in the coming months particularly among SMEs in Spain, which could potentially hit Sabadell, while BBVA's operations in both Mexico and Turkey could take asset quality hits, he said. The merged bank would need to increase revenues in digital products and asset management to offset the impact, he said.

BBVA's NPLs as a percentage of loans held at amortized cost stood at 4.22% at the end of the third quarter, down from 4.31% in the year-ago period. At Sabadell, the figure stood at 4.02%, versus 4.33% during the prior-year period.