Spanish banks expect a slower-than-expected increase in deposit costs to fuel further growth in lending income for at least another quarter.

Spain's six largest lenders — CaixaBank SA, Banco Santander SA, Banco Bilbao Vizcaya Argentaria SA, Banco de Sabadell SA, Bankinter SA and Unicaja Banco SA — saw aggregate domestic net interest income rise by 12.5% quarter-on-quarter to more than €7 billion in the three months to the end of June, company filings data shows. Net interest income (NII) is the difference between interest revenues and interest expenses.

The country's banks are enjoying a surge in NII as higher interest rates feed through to their loan books. A slower pass-through of higher interest rate to depositors compared to many other European countries means Spanish banks are exceeding NII forecasts made earlier in the year.

"The cost of funding in Spain is still probably lagging behind what was the initial expectation at the beginning of the year," BBVA CFO Rafael Salinas said during a second-quarter earnings call in July. "As of today, we are not facing much pressure on deposit remuneration."

The lower-than-expected deposit beta, the portion of short-term central bank rates passed on to depositors, was the main reason BBVA upgraded its NII guidance for 2023 to growth of between 40% and 45%, Salinas said.

Low deposit betas helped all six banks increase NII in the three months to the end of June. Santander enjoyed the largest rise, of more than 60%, to €1.7 billion, the data shows. Bankinter had the smallest increase at 4.6% to €546 million.

"We're still seeing rational competition [for deposits] with low betas for individuals in a system which remains highly liquid," Santander CEO Héctor Grisi said during a second-quarter earnings call in July. "As of today, we don't expect much higher remuneration in the foreseeable future."

Spanish banks' NII could further benefit from a relatively low portion of term deposits — accounts that can only be accessed after a certain time has elapsed and are remunerated at a higher rate — on their books compared to previous interest rate cycles.

"This idea is driven by the fact that, on the one hand, banks have a very solid liquidity position [compared to] previous cycles," Sabadell CFO Leopoldo Alvear said during a second-quarter earnings call. "And it's also driven by the fact that we are offering alternative products to our clients."

The NII tailwinds are encouraging Sabadell to forecast its lending income to increase "well through 2024," said Alvear.

Spanish and other eurozone banks will encounter an NII headwind before the end of 2023 as the remuneration of minimum reserves held at the European Central Bank ends. The ECB announced July 27 that it would no longer pay banks its deposit facility rate, currently at 3.75%, for the reserve balances they are required to hold with their national central bank.

"This is going to have a negative impact," CaixaBank CFO Javier Pano said during a second-quarter earnings call in July. "We are estimating [to lose] approximately between €140 million and €145 million per year, assuming current rates."