OREANDA-NEWS. Spanish mid-sized banks are likely to remain independent at least over the next 12 months because their earnings and capital ratios are still sufficiently healthy to stave off consolidation, says Fitch Ratings. However, over the medium term, and possibly starting towards end-2016, we believe consolidation could gain momentum driven by challenges to produce adequate returns in a low interest rate and competitive domestic environment and to cope with higher capital pressures.

Fitch-rated medium-sized Spanish banks that originated from mergers or acquisitions of former savings banks (Kutxabank, Unicaja, Ibercaja, Abanca, BMN and Liberbank) had total assets ranging from EUR43bn to EUR67bn at end-1H15. These banks are generally only active in three to four different regions and hardly have a national presence (national market shares range from just below 1% to 3%). However, they have strong links to and good market positions in loans and deposits in their home provinces and regions (typically well above 15% market share). Standalone Viability Ratings of the Spanish mid-sized banks are mainly in the 'bb' range but Unicaja and Kutxabank are more highly rated in the 'bbb' range.

We expect mid-sized banks to focus on strengthening their standalone viability in 2016 through balance sheet de-risking (i.e. sales of problem assets), further cost rationalisation plans and/or debt or equity issuances to enhance their capital structures in the context of higher regulatory capital requirements.

A decline in the cost of retail funds and loan impairment charges on the back of falling non-performing loans largely supported earnings in 1H15. However, profitability could weaken in 2016 due to persistently low interest rates, lower income contribution from carry trade operations and the cost of guaranteed deferred tax assets. Kutxabank and Ibercaja benefit from a more diversified revenue profile thanks to their relatively large non-banking financial businesses, primarily related to insurance, pension and investment management services.

Margins are also likely to come under pressure if Spanish courts rule that banks must remove interest rate 'floor' clauses from existing mortgage loans, potentially requiring extra provisions if retroactivity rights are granted. Abanca is the only bank exempt from the latter risk as it has no floors.

Capital ratios have improved largely due to deleveraging, sales of non-core assets and equity investments, plus earnings retention. The six mid-sized peers all reported core equity Tier 1 capital ratios above 10% at end-June 2015, with notably sound ratios reported by Kutxabank and Abanca. However, capital remains vulnerable to unreserved problem assets (ranging between 60% and 135% of banks' phased-in common equity tier 1 at end-1H15), particularly at BMN and Liberbank.

We do not expect any of the banks to struggle to meet capital requirements in the near term but, as the market becomes more demanding, forcing banks to operate with more robust capital ratios, we expect banks to raise additional capital. Some may struggle, acting as a potential catalyst for consolidation.

Asset quality indicators, while improving, are still weak, with problem assets ratios in excess of 10%. Loan loss reserve coverage ratios are reasonable in our view but working out the foreclosed assets will take time and could drain profitability and capital.

We believe stronger capitalised banks, banks with more diversified earnings and/or lower legacy problem assets tying up capital are more likely to withstand short-term pressures and be less vulnerable to takeovers and/or embark on any merger process.