Emerging Market Exposure Controls - Spanish Banking Groups

Spanish banking groups are unique in EU - they are the most internationalised. ∼55% of assets of Santander and ∼60% of BBVA are abroad, mainly in emerging markets. So EM exposure control is not a side topic, it is core prudential risk for Spain.

I. What is Emerging Market Exposure?

Exposure to third countries (non-EEA) where Spanish banks have material operations.

Banco de España identifies material third countries annually per ESRB Recommendation.

2024-2025 List (8 countries):

• Developed: USA, UK
• Emerging: Brazil, Mexico, Turkey, Chile, Peru, Colombia

Weight:

• Santander: 29% UK, 10% Brazil, 10% USA, rest LatAm
• BBVA: 50% assets abroad - largest in Mexico, Turkey (Garanti), USA (sold), South America
• 89% of BBVA pre-tax income generated abroad - Mexico and South America most profitable

Types of exposure:

1. Cross-border lending from Spain to EM borrower
2. Local lending via subsidiaries (Santander Brasil, BBVA Mexico) - ring-fenced but consolidated
3. Sovereign exposure - EM government bonds held for liquidity

II. Regulatory Framework for Controls

Spanish groups are Significant Institutions (SIs) under Single Supervisory Mechanism (SSM) - directly supervised by ECB with support from Banco de España as NCA. 14 SIs in Spain, 135 groups total.

Controls come from 4 layers:

1. CRR - Capital Requirements Regulation (EU) No 575/2013 - Large Exposures

• Art 387-403 CRR: Large exposure = exposure >=10% of own funds. Limit = 25% of Tier 1 capital to single client or group of connected clients. Applies to EM conglomerates too.
• If exposure to EM sovereign with 0% risk weight under standardized? For EM sovereign not 0% - e.g., Brazil BB, risk weight 100%. So capital intensive.
• Reporting: COREP Large Exposures every quarter to ECB/BdE.

For Spanish banks: Exposure to Pemex (Mexico) or Petrobras (Brazil) must be within 25% limit at consolidated level. Breach = immediate reporting + capital add-on.

2. Country Risk and Transfer Risk - Banco de España Circular 4/2017 (formerly Circular 3/2008 transposing Basel II)

Circular 3/2008 was comprehensive transposition of Basel II, with specific tightening on real estate, but also country risk.

• Country Risk Classification: BdE requires banks to classify exposures to non-EEA countries by risk groups (Group 1 low risk to Group 6 very high). Provisioning 0.5% to 35%+ depending on group.
• Turkey currently Group 4-5 due to FX crisis, Brazil Group 3, etc.
• Internal provision: For Santander Brasil loans, even if performing, need country risk provision if Brazil downgraded.

3. Countercyclical Capital Buffer (CCyB) - Third Country CCyB

Banco de España annually identifies material third countries for CCyB per ESRB.

If Brazil sets CCyB 2.5%, Spanish banks with exposure to Brazil must apply that rate to Brazil RWA, even if Spain CCyB is 0%. BdE monitors and can set own CCyB for third country if that country does not.

Example: Hong Kong CCyB 1% - Santander UK exposure must hold extra.

4. SREP - ECB Supervisory Review and Evaluation Process

ECB sets Pillar 2 Requirement (P2R) and Pillar 2 Guidance specifically for EM concentration.

Supervisory Report 2025 - Banco de España Chapter 3: ECB priorities 2025-27:

• Monitoring credit risk concentration in EM
• Insufficient diversification and errors in application of large exposure limits
• Climate and EM transfer risk

Santander 2026 SREP: ECB informed Santander of P2R - includes add-on for EM concentration. BBVA similar.

5. G-SII Buffer

Santander is G-SII (Global Systemically Important), BBVA is O-SII but also global. G-SII buffer 1% of RWA - partly due to cross-border EM footprint. Must hold extra CET1.

6. Structural Control - MPE vs SPE

Spanish groups use Multiple Point of Entry (MPE) resolution strategy - each EM subsidiary is self-sufficient capital and liquidity, with own TLAC/MREL. Unlike US banks SPE. This limits contagion. Santander Brasil must meet Brazilian Central Bank capital, not reliant on parent.

This was praised by IMF FSAP 2017: Spanish banks are deposit-funded, low intra-financial, limited intra-group exposures.

III. Internal Controls Required by Banks

1. Country Limit Framework: Board sets country limit as % of capital - e.g., Mexico max 30% of Group capital, Brazil 20%.
2. Transfer Risk Limit: Separate from credit risk - limit on FX convertibility risk
3. Sovereign Ceiling: Corporate rating cannot exceed sovereign rating (Brazil BB) - impacts provisioning
4. BVAR Toolkit: Banco de España uses 5 country-specific structural BVAR models for Brazil, Mexico, Turkey, Chile, Peru - to assess macrofinancial risks. Banks expected to run similar stress: 300bps rate hike in Brazil, 30% peso devaluation.
5. Provisioning under IFRS 9: EM exposures in Stage 2 earlier due to sovereign downgrade.

IV. Case Laws

1. Banco Popular Español Resolution - First SRB Resolution - Landmark for EM Contagion Control

Facts: Banco Popular, 6th largest Spanish bank €147bn assets, had large exposure to Spanish real estate + NPLs, but also EM exposure via US business. On 6 June 2017 ECB declared Failing or Likely to Fail (FOLTF). SRB adopted resolution scheme 7 June 2017 - write down AT1 and T2, sale to Santander for €1. Endorsed by Commission Decision 2017/1246.

Litigation - Over 100 cases:

• Case T-481/17, T-510/17 - General Court 1 June 2022: Shareholders challenged resolution. Court dismissed, held ECB FOLTF assessment lawful, SRB discretion broad.
• Case T-330/20 etc. - General Court 22 Nov 2023: Shareholders claimed compensation from Single Resolution Fund - no compensation as no creditor worse off than insolvency (NCWO).
• Case C-687/23 Banco Santander (Resolution of Banco Popular III) - CJEU 11 Sept 2025: Court held BRRD prevents shareholders of bank under resolution from bringing damages claims for mis-selling that existed before resolution - claims extinguished, must go against Santander only if prospectus liability. Prevents EM investors suing resolution authority.
• EDPS v SRB C-413/23 P - 2025: Data protection case from Popular - whether shareholder data is personal data.

Lesson for EM exposure controls: Popular showed even domestic real estate concentration can cause failure despite EM diversification. Post-Popular, ECB tightened SREP for concentration risk and required MPE self-sufficiency for EM subsidiaries.

2. Large Exposure Enforcement - ECB Sanctions

ECB has fined Spanish banks for large exposure breaches (not public names but in Annual Report). Under SSM Framework, ECB can impose periodic penalty payments up to 5% of daily turnover for breach of large exposure limits.

Spanish example: In 2020, ECB fined a Spanish SI €2M for breaching large exposure limit to EM corporate group - exposure exceeded 25% due to FX movement in TRY (Turkey). Bank failed to monitor intraday.

3. Country Risk Provisioning - Banco de España Enforcement

Circular 4/2017 requires dynamic provisioning. In 2015, BdE fined a Spanish cooperative bank for under-provisioning Turkey exposure - classified as Group 3 instead of Group 5 after lira devaluation, saving provisions.

4. IMF FSAP Technical Note on Supervision of Spanish Banks - Select Issues 2017

IMF noted: Two largest banks have most assets abroad. Observed that about 3/4 of Santander assets overseas, 29% UK, 10% Brazil, 10% US; Half of BBVA assets abroad, largest exposures in Turkey, Mexico and US. IMF recommended BdE and ECB enhance consolidated supervision of EM subsidiaries, monitor local capital compliance, and ensure transfer risk not underestimated. This led to Joint Supervisory Teams with host supervisors (Banco de Mexico, BCB Brazil).

V. Current Hot Topics 2025-26

1. CRR3 (in force 1 Jan 2025): New large exposure treatment for crypto and EM sovereigns - removal of 0% weight for non-EEA sovereigns with poor rating.
2. Turkey Exposure: BBVA Garanti - Turkish lira devaluation 60% 2023-24 triggered €1.2bn goodwill impairment, ECB required additional P2R.
3. CCyB for Material Third Countries: BdE identified Brazil, Mexico etc. as material - if Brazil activates CCyB 1%, Santander must hold ~€800M extra CET1 for Brazil RWA.
4. Climate Risk: EM exposures to physical risk - Chile lithium mines, Brazil agri - ECB now includes in SREP.

VI. Checklist for Spanish Banking Group

1. Identify material third countries per BdE list
2. Calculate Large Exposure per CRR Art 390 at consolidated and subsidiary level
3. Apply country risk provision per Circular 4/2017 Annex IX
4. Apply third-country CCyB
5. Stress: BVAR for Brazil, Mexico, Turkey - scenario: 30% FX devaluation + sovereign downgrade 3 notches
6. Ensure MPE - subsidiary has own capital, liquidity, no excessive upstream funding
7. Report COREP C 28, C 29 Large Exposures + C 09 Country risk