Risk management

Credit risk

The calculation of the cumulative expected credit losses at the end of September includes:

• To respond to the circumstances that the global COVID-19 pandemic has created in the macroeconomic environment, which has been characterized by a high degree of uncertainty regarding its intensity, duration and speed of recovery, an 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 portfolios, 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.
• Among the diverse economic support measures implemented in the different geographical areas where the Group operates, the most relevant are the granting of relief measures in terms of temporary payment deferrals for customers affected by the pandemic, as well as the granting of loans, especially to companies and SMEs, with 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.

In relation to the payment deferrals for customers affected by the pandemic, and with the goal of mitigating to the most the impact of these measures in the Group, due to the high concentration of its maturities over time, an anticipation plan has been worked out, based on basic lines of action which have allowed for anticipating managerial action with customers, considering their level of affection as well as local regulation. Those lines stand on the following pillars:

• Diagnose: portfolio segmentation.
• Strategy: value offering and action protocols by segment.
• Operationality: equipment and channel sizing.

BBVA Group's main risk indicators evolved during the first nine months of 2020 as described below, as a result, among other reasons, of the situation generated by the pandemic:

• Credit risk decreased by 5.3% in the quarter (down 2.8% at constant exchange rates). The evolution in the quarter is mainly due to the drop in activity in Spain and the United States, due to the lower provision of credit lines associated with governmental support programs to mitigate the impacts of COVID-19. Rest of Eurasia also registered a deleveraging of investment, due to amortizations and lower availability of credit by wholesale customers between July and September.
• The balance of non-performing loans was lower than at the close of June 2020 and December of the previous year (down 0.9% in the quarter, down 2.9 compared to December).
• The NPL ratio remained stable compared to December 2019, at 3.8%, with a slight upward tick in the quarter due to the decrease in credit risk mentioned above.
• Loan-loss provisions fell by 1.0% in the quarter. Compared to December 2019, they were 8.1% higher due to the provisions made in the first half of the year as a result of the negative effects of COVID-19.
• The NPL coverage ratio closed at 85%, in line with the previous quarter and showed an improvement of 873 basis points compared to the end of 2019.
• The cumulative cost of risk at September 30, 2020 stood at 1.69%, compared to a cumulative 2.04% at the end of June following 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 (MILLIONS OF 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 nine months of 2020, liquidity conditions have 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. These drawdowns were largely returned throughout the second and third quarters. Given this initial uncertainty, the different central banks provided a joint response through specific measures and programs to facilitate the funding of the real economy and the provision of liquidity in the financial markets, increasing liquidity buffers in almost all geographical areas.

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

• The BBVA Group's liquidity coverage ratio (LCR) remained significantly above 100% and stood at 159% as of September 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 196%.
• 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, stood at 127% as of September 30, 2020.

These ratios in the main geographical areas in which the Group operates are shown below:

LCR AND NSFR RATIOS (PERCETANGE. 30-09-20)

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

• In the Eurozone, BBVA’s liquidity situation remains comfortable with a high quality ample liquidity buffer that has been strengthened during the first nine months of the year as a result of the management measures implemented and the actions of the European Central Bank (ECB) which have led to an increase of liquidity in the system. In the wake of the COVID-19 crisis, there was initially a higher demand for lending through increased drawdowns of credit facilities by the Corporate & Investment Banking wholesale business, which was also accompanied by growth in customer deposits. Subsequently, in the second and third quarters 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 ECB in order to face the crisis, which have included different actions, such as: the expansion of asset purchase programs, in particular 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 U.S. 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 (Pandemic emergency longer-term refinancing operations, PELTRO). In March and June, BBVA took part in the TLTRO III liquidity windows (with an amount drawn at the end of September of €35,000m) 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 during the first nine months of 2020. 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 U.S. government's stimulus program for SMEs and self-employed workers (Paycheck Protection Program). Repayments made in the second and third quarters have now brought the credit facility usage percentage back to pre-pandemic levels. In addition, deposits have grown very significantly during the first nine months of the year, reflecting the high level of liquidity in the system as a result of the stimulus programs established by the government and the Fed.
• At BBVA Mexico, the liquidity position has remained strong during the first nine months of 2020. Following the COVID-19 crisis, the lending gap increased in the first quarter of the year due to increased drawdowns of credit facilities. However, in the second quarter, the success of the commercial actions and the normalization of lending growth led to a reduction in the lending gap compared to December 2019 levels. During the third quarter of the year, the reduction in the lending gap has been exacerbated, driven by a reduction in loans and a growth in deposits, albeit more moderate than in the second quarter due to the progressive ending of the commercial policies, creating a comfortable position in liquidity ratios. Regarding the measures taken by Banxico over the year, in addition to reducing the monetary policy rate, it announced a reduction in the Monetary Regulation Deposit and the start of auctions of U.S. dollars with credit institutions (swap line with the Fed) in which BBVA Mexico participated in April, in the amount of USD 1,250m, partially renewing that position from June to September for USD 700m.
• In Garanti BBVA, the liquidity situation remained comfortable during the first nine months of 2020, with a contraction of loans and a growth of deposits in foreign currency, as well as higher growth of loans than deposits in local currency. 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 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. In the third quarter, the regulator reduced the asset ratio limit from 100% to 90%, reducing pressure on the lending gap. In the face of contractionary policies, CBRT increased the reserve requirement rates, as well as the cost of lending and the base rate. In addition, some taxes on deposits in the local currency were reduced to encourage a swap to Turkish lira deposits. Garanti BBVA meets the requirements of the asset ratio and continues to have a good liquidity buffer.
• In South America, an adequate liquidity situation prevails throughout the region, helped by 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, U.S. dollar deposit outflows in the banking system continued at a very gradual pace, although BBVA Argentina continues to maintain a strong liquidity position with comfortable liquidity ratios. In Colombia, excess liquidity has been adjusted by reducing wholesale deposits, while BBVA Peru continues to increase the level of deposits. Both countries have 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 COVID-19 crisis 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 level of volatility are still evident, 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 nine months of 2020 are:

• 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. 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. In the third quarter, it carried out three public issues: the first is the first green convertible bond (CoCo) ever issued by a financial institution worldwide in the amount of €1,000m, with a coupon of 6% and an option for early amortization in five and a half years; the second is a subordinated Tier 2 debt issuance 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%; and the third is a preferred debt issue filed with the U.S. Securities and Exchange Commission (SEC), in two tranches over three and five years, in a total amount of USD 2,000m. For more information about these transactions, see the "Solvency" chapter of this report.
• In Mexico, a local senior issuance was successfully carried out in February for MXN 15,000m (€587m) 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 U.S. 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 September, it carried out an international issuance of unsecured 5-year senior debt in an amount of USD 500m at a rate of 1.875%, which represents the lowest ever for a financial institution in Mexico and the lowest of any of Latin America's private financial institutions. This issue is the second under BBVA Mexico's Global Issuer Program, which has a value of up to USD 10,000m.
• In Turkey, Garanti BBVA carried out a Tier 2 issuance for TRY 750m in the first quarter. In the second quarter, Garanti BBVA renewed a syndicated loan by issuing the first green syndicated loan for a bank indexed to sustainability criteria, and in whose renovation the EBRD -European Bank for Reconstruction and Development- and the IFC -International Finance Corporation- participated. In the third quarter, Garanti did not issue wholesale funding.
• In South America, there have been no material issuances from January to September 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.

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 depreciation of 10% against the euro of the main emerging-market currencies stood at -4 basis points for the Mexican peso and -3.6 basis points for the Turkish lira. In the case of the U.S. dollar, the sensitivity to a depreciation of 10% against the euro is approximately +9 basis points, as a result of RWAs denominated in U.S. dollars outside the United States. At the end of September, the coverage level for expected earnings for 2020 was at levels close to 50% in the case of Turkey, and close to 90% for Mexico. Coverage levels for expected earnings in the case of Colombia and Peru are around 50%.

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. Assumptions regarding the behavior of accounts with no explicit maturity and prepayment estimates are of particular relevance. 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 accordance with the established target, showing a net interest income position which would be favored by an increase in interest rates. The effective management of structural balance sheet risk has allowed it to mitigate the negative impact of the downward trend in interest rates and the volatility experienced as a result of the effects of COVID-19, and is reflected in the soundness and recurrence of net interest 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 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 the light of the COVID-19 crisis. However, since May, Euribor has fallen by between -30 and -35 basis points, reaching record lows, 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 nine months of the year (falling by between -160 and -170 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 stability between the balance sheet items benchmarked at fixed and variable interest rates. In terms of assets that are 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. In this regard, the monetary policy rate at the end of September stood at 4.25%, which has meant a reduction of -300 basis points during the first nine months of 2020 (-75 basis points in the third quarter).
• In Turkey, the interest-rate risk (broken down into Turkish lira and U.S. dollars) is 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 increased due to the measures taken in relation to the asset ratio, but has remained low in this quarter with the accumulation of short-term customer deposits.
• 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.