Risk management

Credit risk

The calculation of the expected credit losses at the end of June includes:

• To respond to the circumstances created by the global COVID-19 pandemic in the macroeconomic environment, which has been characterized by a high degree of uncertainty regarding its intensity, duration and speed of recovery, the update of the forward looking information in the IFRS 9 models has been performed to incorporate the best information available at the date of publication of this report. The estimation of the expected credit losses has been calculated for all the geographical areas where the Group operates, with the best information available for each one, taking into account both the macroeconomic scenarios as well as the effects on specific sectors and customers. The scenarios used consider the various economic measures that have been announced by governments as well as the monetary, supervisory and macro-prudential authorities all over the world. Nevertheless, the degree of the impact of this pandemic on the business, the financial situation and the results of the Group, which could be material, will depend on future and uncertain events, including the intensity and the persistence over the time of the consequences derived from the pandemic in the various geographical areas where the Group operates.
• Amongst the diverse economic support measures implemented in the different geographical areas where the Group operates, stand out the granting of relief measures in terms of temporary payment deferments for customers affected by the pandemic, as well as the granting of loans, especially to companies and SMEs, which count on public guarantees. These measures are supported by the rules issued by the authorities of the geographical areas where the Group operates as well by certain industry agreements and should help to ease the temporary liquidity needs of the customers. The classification of the customers’ credit quality and the calculation of the expected credit loss, once the credit quality of those customers will have been reviewed under the new circumstances, will depend on the effectiveness of these relief measures. In any case, the incorporation of public guarantees is considered to be a mitigating factor in the estimation of the expected credit losses.

BBVA Group's main risk indicators evolved as follows in the first semester of 2020, as a result, among other reasons, of the situation generated by the pandemic:

• Credit risk increased by 0.9% in the quarter (up 1.8% at constant exchange rates) due to the increase in the activity in those countries which count with governmental support programs to mitigate the impacts of COVID-19, particularly Spain (ICO lines) and the United States (Paycheck Protection Program). Compared to December, the credit risk increased by 1.1% (up 4.9% at constant exchange rates).
• The balance of non-performing loans grew by 2.4% in the second quarter of 2020 (up 3.4% at constant exchange rates) mainly in Turkey, but without reaching yet the levels at the end of 2019.
• The NPL ratio increased slightly to 3.7% as of June 30, 2020 (3.6% as of March 31, 2020), showing a reduction of 12 basis points compared to December 2019.
• Loan-loss provisions showed a strong increase of 9.2% compared to December (up 1.8% in the quarter) due to the higher provisions for the adjustment in the macro scenario due to the negative effects of COVID-19 and for specific clients in the commercial portfolio of certain business areas, mainly carried out during the first quarter.
• The NPL coverage ratio closed at 85% (slightly below March 31, 2020, down 50 basis points), and showed an improvement of 882 basis points compared to the end of 2019.
• The cumulative cost of risk stood at 2.04% as of June 30, 2020 after the strong growth registered in March related to the significant increase in the loan loss allowances in the first quarter.

NON-PERFORMING LOANS AND PROVISIONS (MILLIONS OF EUROS)

Credit risk ⁽¹⁾ (Millions of euros)

Non-performing loans evolution (Millones de euros)

Structural risks

Liquidity and funding

Management of liquidity and funding at BBVA aims to finance the recurring growth of the banking business at suitable maturities and costs, using a wide range of instruments that provide access to a large number of alternative sources of financing. In this context, it is important to notice that, given the nature of BBVA's business, the funding of lending activity is fundamentally carried out through the use of stable customer funds.

Due to its subsidiary-based management model, BBVA is one of the few major European banks that follows the Multiple Point of Entry (MPE) resolution strategy: the parent company sets the liquidity policies, but the subsidiaries are self-sufficient and responsible for managing their own liquidity (taking deposits or accessing the market with their own rating), without fund transfers or financing occurring between either the parent company and the subsidiaries or between the different subsidiaries. This strategy limits the spread of a liquidity crisis among the Group's different areas, and ensures that the cost of liquidity and financing is correctly reflected in the price formation process.

During the first half of 2020, liquidity conditions remained comfortable across all countries in which the BBVA Group operates. Since the beginning of March, the global crisis caused by COVID-19 has had a significant impact on financial markets. The effects of this crisis on the Group's balance sheets have fundamentally been felt initially through increased drawdown of credit facilities by wholesale customers in the face of worsening funding conditions in the markets, with no significant effect in the retail world. In view of this situation, there was a joint response by various central banks, through specific measures and programs to facilitate the funding of the real economy and the provision of liquidity in the financial markets. It should be noted that during the second quarter, significant net repayments were observed from wholesale customers who had drawn down credit facilities during the first quarter of the year.

BBVA Group maintains a solid liquidity position in every geographical area with regulatory ratios maintained comfortably above the minimum required:

• The BBVA Group's liquidity coverage ratio (LCR) remained significantly above 100% and stood at 159% as of June 30, 2020. For the calculation of this ratio, it is assumed that there is no transfer of liquidity among subsidiaries; i.e. no kind of excess liquidity levels in foreign subsidiaries are considered in the calculation of the consolidated ratio. When considering these excess liquidity levels, the BBVA Group's LCR would stand at 191% (32 percentage points above 159%). In addition, it comfortably exceeded 100% in all subsidiaries (Eurozone 198%, Mexico 169%, the United States 144% and Turkey 142%).
• The Net Stable Funding Ratio (NSFR), defined as the ratio between the amount of stable funding available and the amount of stable funding required, is one of the Basel Committee's essential reforms, and requires banks to maintain a stable funding profile in relation to the composition of their assets and off-balance sheet activities. This ratio should be at least 100% at all times. At the BBVA Group, the NSFR, calculated according to the Basel requirements, remained above 100% throughout 2019 and stood at 124% as of June 30, 2020. It comfortably exceeded 100% in all subsidiaries (Eurozone 118%, Mexico 132%, the United States 120% and Turkey 144%).

The most relevant aspects related to the main geographical areas are the following:

• In the Eurozone, the liquidity situation remains comfortable with a high quality ample liquidity buffer that has been increasing during the first half of the year. In the wake of the COVID-19 crisis, there was initially a higher demand for lending through increased drawdown of credit facilities by the Corporate & Investment Banking wholesale business, which was also accompanied by growth in customer deposits. Subsequently, in the second quarter of the year there were partial repayments of the aforementioned drawdowns, while deposits have continued to grow. In addition, it is important to mention the measures implemented by the European Central Bank (ECB) in order to face the crisis, such as: the expansion of asset purchase programs, especially through the Pandemic Emergency Purchase Programme (PEPP) for €750,000m in a first tranche announced in March and extended with a second tranche for a further €600,000m until June 2021, or until the ECB considers the crisis to be over; the coordinated action by Central Banks for the provision of US dollars; a package of temporary collateral easing measures affecting eligibility for use in funding operations and the easing and improvement of the conditions for the TLTRO III program and the creation of the new program of long-term, non-targeted emergency refinancing operations (PELTRO). In March and June, BBVA took part in the TLTRO III liquidity windows (with an amount drawn at the end of June of €35 billion) due to its favorable cost and maturity conditions, and repaid the corresponding part of the TLTRO II program.
• BBVA USA also maintains an adequate liquidity buffer consisting of high-quality assets, which has been strengthened in this first half of the year. As in the Eurozone, there was an increase in loans toward the end of the first quarter of 2020, mainly due to a rise in the drawing down of credit facilities by wholesale customers and the US government's stimulus program for SMEs and self-employed workers (Paycheck Protection Program). In the second quarter there were repayments of a significant amount. However, during the first half, deposits have grown faster than lending, mainly because of government-established stimulus programs.
• At BBVA Mexico, the liquidity position has remained strong during the first half of 2020. Following the COVID-19 crisis, the lending gap increased in the first quarter of the year due to increased drawdown of credit facilities. However, the success of the commercial actions taken during the second quarter increased deposits. This, coupled with a normalization of lending growth, led to a reduction in the lending gap compared to December 2019 levels, creating a comfortable position in liquidity ratios. Regarding the measures taken by Banxico, in addition to reducing the monetary policy rate, it announced a reduction in the Monetary Regulation Deposit and the start of auctions of US dollars with credit institutions (swap line with the Fed) in which BBVA Mexico participated in April, for the amount of USD 1,250m, partially renewing that position in June for USD 700m.
• In Garanti BBVA, the liquidity situation remained comfortable in the first half of 2020, with a similar contraction in foreign currency loans and deposits, while in the local currency there was similar growth in deposits and loans. As a result of the COVID-19 crisis, an increase in collateral requirements was seen due to the credit risk in Turkey (Credit Default Swaps) to cover derivative valuations and wholesale funding. Moreover, Turkey's regulator has established the so-called asset ratio to encourage banks, first and foremost, to increase lending and avoid the accumulation of deposits, which has caused an increase in the lending gap. This has been covered by the bank's excess liquidity. Garanti BBVA meets the asset ratio requirements and continues to show a solid liquidity buffer.
• In South America, an adequate liquidity situation prevails throughout the region due to the support of various central banks and governments which, in order to mitigate the impact of the COVID-19 crisis, have acted by implementing measures to stimulate economic activity and provide greater liquidity in financial systems. In Argentina, US dollar deposit outflows in the banking system continued at a very gradual pace during the first half of the year, although BBVA Argentina continues to maintain a strong liquidity position with comfortable liquidity ratios. In Colombia, the increase in customer bank deposits has been maintained (improving the lending gap), in line with the situation for BBVA Peru, with both demonstrating a comfortable liquidity position.

After two months of great stability at the start of 2020, the wholesale funding markets in which the Group operates were affected by the events of COVID-19 and secondary market prices suffered a material correction as a result of the increased volatility. This led to a significant increase in the issue premiums and levels of access to the primary market. While certain degrees of volatility are still notable, this situation has been stabilizing and prices in the secondary market have been correcting themselves.

The main transactions carried out by the companies that form part of the BBVA Group in the first quarter of 2020 were:

• During the first quarter of 2020, BBVA, S.A. carried out two issuances of senior non-preferred debt totaling €1,400m and a Tier 2 issuance totaling €1,000m (see the "Solvency" chapter of this report for more information). In the second quarter of 2020, it issued preferred senior debt totaling €1,000m as a COVID-19 social bond, the first of its kind from a private financial institution in Europe (see the "Solvency" chapter of this report for more information). In July 2020 two issuances have been made: the first, is the first green convertible bond (CoCo) ever issued by a financial institution worldwide for the amount of €1,000m, with a coupon of 6% and an option for early amortization in five and a half years; and the second, a subordinated debt issuance of Tier 2 in Pounds sterling, for the amount of 300m, to a term of eleven years and option of amortization to the sixth, with a coupon of 3.104% (for more information on both operations see the "Solvency" chapter of this report).
• In the United States, BBVA USA did not issue wholesale debt in the first half, in line with the funding plan.
• In Mexico, a local senior issuance was successfully carried out in February for MXN 15,000m (€578 m) in three tranches. Two tranches in Mexican pesos over 3 and 5 years (one for MXN 7,123m at the Interbank Equilibrium Interest Rate (TIIE) 28 + 5 basis points and another for MXN 6,000m at TIIE 28 + 15 basis points, respectively), and another tranche in US dollars over 3 years (USD 100m at 3-month Libor + 49 basis points). The purpose of this issuance was to bring forward the refinancing of maturities in the year, taking advantage of the good market conditions, as well as to strengthen the liquidity situation by offsetting the seasonal outflows of deposits in the early months of the year.
• In Turkey, Garanti BBVA carried out a Tier 2 issuance for TRY 750 m in the first quarter (see the "Solvency" chapter of this report for more information). In the second quarter, Garanti BBVA renewed a syndicated loan by issuing the first green syndicated loan indexed to sustainability criteria, and in whose renovation the EBRD -European Bank for Reconstruction and Development- and the IFC -International Finance Corporation- have participated.
• In South America, there have been no issuances during the first two quarters of 2020.

Foreign exchange

Foreign exchange risk management of BBVA's long-term investments, principally stemming from its overseas franchises, aims to preserve the Group's capital adequacy ratio and ensure the stability of its income statement.

In the first half of 2020, foreign exchange markets have also been affected by the shock of the global spread of COVID-19 and its effects on the economy. The Mexican peso, which was heavily affected in the second half of February and in March, has closed the first half with a depreciation of 18.2% against the euro. Other currencies in the geographical areas in which BBVA Group operates have also suffered double-digit depreciations: In particular, the Argentine peso (down 14.6%), the Turkish lira (down 12.9%) and the Colombian peso (down 12.5%). To a lesser extent, the Chilean peso (down 8.0%) and the Peruvian sol (down 5.7%) also showed a decline in value against the euro. For its part, the US dollar (up 0.3% in the first half of the year) has moved within a range against the euro, appreciating to 1.07 at times of greater global fear, with the euro recovering with positive news about the economic rescue plan in Europe. BBVA has maintained its policy of actively hedging its main investments in emerging markets, covering on average between 30% and 50% of annual earnings and around 70% of the CET1 capital ratio excess. Based on this policy, the sensitivity of the CET1 ratio to a 10% depreciation of the main emerging-market currencies against the euro stood at -3 basis points for the Mexican peso and -3 basis points for the Turkish lira. In the case of the US dollar, the sensitivity to a depreciation of 10% against the euro is approximately +9 basis points, as a result of RWAs denominated in US dollars outside the United States. At the close of June, the coverage level for expected earnings for 2020 stood near 50% in the case of Turkey, Colombia and Peru and around 90% for Mexico.

Interest rate

The aim of managing interest-rate risk is to limit the sensitivity of the balance sheets to interest rate fluctuations. BBVA carries out this work through an internal procedure following the guidelines established by the European Banking Authority (EBA), which measures the sensitivity of net interest income and economic value to determine the potential impact of a range of scenarios on the Group's different balance sheets.

The model is based on assumptions intended to realistically mimic the behavior of the balance sheet. Of particular relevance are assumptions regarding the behavior of accounts with no explicit maturity and prepayment estimates. These assumptions are reviewed and adapted at least once a year to take into account any changes in behavior.

At the aggregate level, BBVA continues to maintain a moderate risk profile, in line with the established target, showing a net interest income position which would be favored by an increase in interest rates, through effective management of structural balance sheet risk, taking into account the volatility in rates generated by COVID-19 in the second part of the quarter, this having virtually no effect due to the sound recurrence of the income.

By area, the main features are:

• Spain and the United States have balance sheets characterized by a high proportion of variable-rate loans in the loan portfolio (basically mortgages in Spain and corporate lending in both countries) and liability composed mainly of customer deposits. The ALCO portfolios act as hedging for the bank's balance sheet, mitigating its sensitivity to interest rate fluctuations. The profile of both balance sheets has remained stable during the first half of 2020.
  
  In addition, following a slightly downward trend at the start of the year for European benchmark interest rates (Euribor), there was a rebound of around 20–30 basis points (depending on the maturity) in mid-March. This was a result of an adjustment in expectations after the ECB held the marginal deposit facility rate at -0.50% when the market had discounted a fall, and an increase in the required credit spread in light of the COVID-19 crisis. Since May, Euribor has fallen by around -20 basis points, mainly due to the easing of credit spreads and the ECB's monetary stimulus measures. In the United States, base rates (Libor) have maintained a downward trend during the first half of the year (falling by between -150 and -160 basis points, depending on the maturity), in line with the Fed's rate cuts in the first quarter of the year.
• Mexico continues to show a stability between the balance sheet items benchmarked at fixed and variable interest rates. In terms of the assets most sensitive to interest rate fluctuations, the corporate portfolio stands out, while consumer loans and mortgages are mostly at a fixed rate. The ALCO portfolio is used to neutralize the longer duration of customer deposits. The sensitivity of net interest income continues to be limited and stable in 2020, considering the new interest rate scenario that emerged in March, with a downward trend in benchmark rates throughout 2020 compared to expectations at the beginning of the year. The monetary policy rate at the end of June stands at 5%, which has entailed a reduction of -225 basis points in the first half of the year (-150 basis points in the second quarter, downward movement also seen in the bond yield curve).
• In Turkey, the interest-rate risk (broken down into Turkish lira and US dollars) is very limited. In terms of assets, the sensitivity of lending, which is mostly fixed-rate but with relatively short maturities, and the ALCO portfolio, including inflation-linked bonds, are balanced by the sensitivity of deposits on the liability side, which are repriced in the short term. The sensitivity of net interest income on the currency balance sheets, although slightly higher than in the first quarter due to measures taken with regard to the asset ratio, continues to be low in this second quarter.
• In South America, the risk profile for interest rates remains low as most countries in the area have a fixed/variable composition and maturities that are very similar for assets and liabilities, with a low and virtually constant net interest income sensitivity throughout 2020. In addition, in balance sheets with several currencies, interest-rate risk is managed for each of the currencies, showing a very low level of risk. The measures promoted by central banks have helped benchmark interest rates to follow a path below that expected at the beginning of the year.