Banco Santander is among the Spanish banks that will hope to see an increase in non-interest income, such as that from ATM fees, as historically low rates push net interest margins down. Source: Cristina Arias/Cover via Getty Images

After a nervy 2020, Spain's largest banks began 2021 in a more confident manner. Three of the country's four largest lenders by total assets — CaixaBank SA being the exception due to lower-than-expected accounting gains from its merger with Bankia SA — enjoyed an almost clean sweep of beats against analysts' expectations in the first quarter, according to S&P Global Market Intelligence data.

The positive earnings picture was largely due to reduced provisioning following the wave of caution in 2020 prompted by the COVID-19 pandemic. Loan provisions as a percentage of average loans at amortized cost fell by an average of 0.75 percentage point in the first quarter of 2021 year over year across the four lenders — Banco Santander SA, Banco Bilbao Vizcaya Argentaria SA, CaixaBank and Banco de Sabadell SA — Market Intelligence data shows.

With confidence growing that the worst impacts of the COVID-19 pandemic may have passed for the banks, and the worst forecasts averted, analysts are now looking beyond provisions and asset quality to their underlying performance.

"There's likely to be an increasing focus back toward pre-provision profit momentum," Benjie Creelan-Sandford, banking equity analyst at global investment bank Jefferies, said in an interview.

"Provision beats are useful and meaningful in that they contribute to your tangible book value, your capital and your dividend-paying capacity, but from a structural earnings point of view, most people would tend to look through provisions and focus more on pre-provision momentum as the key driver for valuation."

Three of Spain's four largest banks — CaixaBank again the exception — reported pre-provision operating profit declines in the first quarter of 2021. Sabadell suffered the largest year-over-year drop at 18.50%, while Santander recorded a 9.29% fall and BBVA a 7.15% decrease during the same period. CaixaBank enjoyed a 16.97% year-over-year increase in pre-provision operating profits.

The main driver of the first-quarter pre-provision profit squeeze was sizeable falls in net interest income. BBVA reported a 14.24% year-over-year fall in net interest income, with Santander recording a 6.26% drop, Sabadell a 5.82% decrease and CaixaBank a 0.75% dip.

"One of the main takeaways from [the first quarter] is that margin pressure will continue, and it's here to stay," said Gonzalo Lopez, European banking equity research analyst at Redburn. "The environment is very competitive, especially with mortgages."

Net interest margins at the four Spanish banks shrunk by an average of 0.42 percentage point since the first quarter of 2019. CaixaBank has recorded the largest fall of the four at 0.57 percentage point to 1.07%, while Sabadell had the smallest contraction of 0.28 percentage point to 1.48%. Both lenders are predominantly or entirely focused on the Spanish market.

"People are looking and interested in the reflation theme and the rising rate angle but ultimately for the banks in Europe, and for Southern European banks in particular, Euribor remains a key sensitivity and Euribor continues to bump along near historic lows," Creelan-Sandford said. "That's the near-term challenge for these banks."

The one-week Euro interbank offered rate, or Euribor, the reference rate based on averaged interest rates at which eurozone banks offer to lend unsecured funds to other banks in the euro wholesale market, was -0.559% as of May 24. The rate has fallen steadily since the peak of the COVID-19 crisis in March 2020, when it hit -0.379%, and has been negative since March 2015.

Spanish banks' ability to generate non-interest income will be important in the coming quarters, said Creelan-Sandford. "For those banks that have good asset management and insurance businesses, they are continuing to do well in a negative rate environment, and that fee-based income is also a helpful offset against weaker NII," Creelan-Sandford said.

Net non-interest income increased year-over-year in the first quarter at three of the four largest Spanish banks, with Sabadell the only faller. CaixaBank led the pack with a 13.50% year-over-year rise, driven by a 26.25% year-over-year jump in net insurance income and a 7.74% year-over-year rise in net fee and commission income.

Santander recorded a 3.70% year-over-year increase in net non-interest income, while BBVA managed a 1.66% rise during the same period. Sabadell, which is set to announce a new strategy at the end of May, registered an 11.10% year-over-year decline.

Spanish banks' income should receive a further boost due to an improving outlook for Spain and other countries' economies as the COVID-19 pandemic is brought under greater control, said Pablo Manzano, vice president, global financial institutions at credit rating agency DBRS Morningstar.

While concerns remain among analysts about the longer term impact of the COVID-19 pandemic on Spanish banks' asset quality, the outlook for the lenders in the coming quarters appears to be brightening, Manzano added. "The Spanish banks are very optimistic about the economic situation and commercial activity is surprisingly strong."