Risk management

Credit risk

In addition to the significant macroeconomic challenges posed by the COVID-19 pandemic that led to a decline in GDP in 2020 in many of the countries where the Group operates, the global economy is currently facing a number of exceptional challenges. Russia's invasion of Ukraine has caused significant disruption, instability and volatility in the world markets, as well as increased inflation (contributing to further increases in energy, oil and other commodity prices and further affecting supply chains), leading to slower economic growth as expected at the beginning of 2022.

In relation to the relief measures for customers affected by the pandemic and with the aim of mitigating the impact of these measures for the Group as much as possible, due to the high concentration in the time of their maturities, continuous monitoring of the their effectiveness has been made in order to verify their compliance and their dynamic adjustment to the evolution of the crisis. With regard to these measures, both in Spain and Peru, the possibility of carrying out extensions in the expiration period and in the grace period has been established. In Spain, they may be requested by companies and self-employed as of June 30, 2022 after the expiration of the Temporary State Aid Framework approved by the European Commission. In Peru, the Decree was approved in May, and this measure may be used until December 31, 2022.

As for the direct impact that the war between Russia and Ukraine could have on the Group, it can be qualified as non-material for BBVA given the low direct exposure to customers from those countries. However, the indirect risk is greater due to the activity of clients in the affected area or sectors. The economic effects are coming mainly through higher commodity prices, but also through financial and confidence channels, as well as a further deterioration of global supply chain issues.

The Group has taken different measures geared towards reducing the impact that the war may have, amongst which, the lowering of limits at first followed by the suspension of operations with Russia; the lowering of internal ratings; and, the inclusion of the country and its debtors in the subjective doubtful loans category.

Calculation of expected losses due to credit risk

The estimate at the end of the six months ended June 30, 2022, includes the effect on the expected losses of the update of the macroeconomic forecasts, which have been affected by the war in Ukraine, the evolution of interest rates, inflation rates or the prices of commodities. The estimate includes the update of such forecast which has been reviewed following the internal approval circuits established for this purpose, to reflect the effects of the new inflationary environment on the results of the collective estimates. This adaptation is expected to be reviewed and, if appropriate, incorporated into the calculation methodology within the periodic review process that is carried out each year. All of this taking to account in addition to the estimated individualized and collective expected losses and the macroeconomic estimates in accordance with the requirements of IFRS 9.

Additionally, the Group can supplement the expected losses either by the consideration of additional risk drivers, the incorporation of sectorial particularities or that may affect a set of operations or borrowers. These adjustments should be of temporary nature, until the reasons for them disappear or they materialize. As of June 30, 2022, there are adjustments to expected losses which amounted to €259 million at Group level, €174 million in Spain, €11 million in Peru and €74 million in Mexico. As of December 31, 2021 there were €311 million at the Group level for the same concept, €226 million in Spain, €18 million in Peru and €68 million in Mexico.

BBVA Group's credit risk indicators

The Group’s main credit risk indicators showed the following development in the first half of 2022:

• Credit risk has increased by 4.8% during the second quarter of 2022 (+3.7% at constant exchange rates). An almost generalized growth, at constant exchange rates, was observed at Group level during the first months of the year, led by Turkey, Mexico and South America.
• Slight reduction in the balance of non-performing loans at Group level between March and June 2022 (-0.7% in current terms and -1.7% at constant rates) in the main geographical areas. Compared to the end of December 2021, the amount of non-performing loans remained practically stable.

NON-PERFORMING LOANS AND PROVISIONS (MILLIONS OF EUROS)

• The NPL ratio stood at 3.7% as of June 30, 2022 (3.9% in March 2022 and 4.1% in December 2021), -21 basis points below the figure recorded in March 2022 and -36 basis points below the one of December 2021.
• Loan-loss provisions increased by 2.6% compared to the figure of the first quarter (+5.4 with respect to December 2021) with growth in almost all geographical areas.
• The NPL coverage ratio amounted to 78%, 253 basis points above the figure of March 2022 (+375 basis points higher than at the end of 2021).
• The cumulative cost of risk as of June 30, 2022 stood at 0.81% in line with the end of the first quarter 2022 and 13 basis points below the close of 2021.

NPL AND NPL COVERAGE RATIOS AND COST OF RISK (PERCENTAGE)

CREDIT RISK⁽¹⁾ (MILLIONS OF EUROS)

NON-PERFORMING LOANS EVOLUTION (MILLIONS OF EUROS)

Structural risks

Liquidity and funding

Liquidity and funding management 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 and funding (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.

The BBVA Group maintains a solid liquidity position in every geographical area in which it operates, with liquidity ratios well above the minimum required:

• The BBVA Group's liquidity coverage ratio (LCR) remained comfortably above 100% throughout the first six months of 2022, and stood at 170% as of June 30, 2022. For the calculation of this ratio, it is assumed that there is no transfer of liquidity among subsidiaries; i.e. no type 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 220%.
• The net stable funding ratio (NSFR), defined as the ratio between the amount of stable funding available and the amount of stable funding required, demands 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. The BBVA Group's NSFR ratio, calculated based on the criteria established in the Regulation (UE) 2019/876 of the European Parliament and of the Council of May 20, 2019, with entry into force in June 2021, stood at 134% as of June 30, 2022.

The breakdown of these ratios in the main geographical areas in which the Group operates is shown below:

LCR AND NSFR RATIOS (PERCETANGE. 30-06-22)

One of the key elements in BBVA's Group liquidity and funding management is the maintenance of large high quality liquidity buffers in all the geographical areas where the Group operates. In this respect, the Group has maintained for the last 12 months an average volume of high quality liquid assets (HQLA) accounting to €133.7 billion, among which, 94% correspond to maximum quality assets (LCR Tier 1).

It should be noted that the war in Ukraine has not had a significant impact on the liquidity and financing situation of the BBVA Group units during the first half of 2022. The most relevant aspects related to the main geographical areas are the following:

• BBVA, S.A. has maintained a sound position with a large high-quality liquidity buffer. During the first half of 2022, commercial activity has provided liquidity amounting to approximately €4 billion due to the growth in customer deposits above lending activity. On the other hand, collateral generation activities have continued with the issuance of mortgage and regional bonds to be retain for an amount of €2 billion, highlighting the creation of a new mortgage securitization fund held as collateral for an amount of €12.4 billion, which groups the assets previously held in seven funds, generating an additional collateral of approximately €3 billion.
• In BBVA Mexico, commercial activity has drained liquidity for the amount of approximately 57 billion Mexican pesos between January and June 2022, derived from a growth in lending activity that exceeded the growth of customer funds. Despite the aforementioned liquidity drain, BBVA Mexico continues to present a comfortable liquidity position, which contributed to a cost-efficient funding management in an environment of rising rates.
• In Turkey, in the first half of 2022, both local and foreign currency lending gaps have increased. The lending gap in local currency increased due to a higher growth in loans than in deposits and the lending gap in foreign currency due to greater reductions in deposits, as a result of the mechanism to encourage local currency deposits, partially offset by a reduction in loans. Garanti BBVA continues to maintain a stable liquidity position with comfortable ratios. The Central Bank of Turkey has continued to implement measures to reduce the dollarization of the economy.
• In South America, the liquidity situation remains adequate throughout the region. In Argentina, liquidity in the system and in BBVA continues to increase due to the higher growth in deposits than in loans in local currency. In BBVA Colombia, lending activity and funds grow at similar levels. For its part, BBVA Peru maintains solid levels of liquidity, in a quarter in which liquidity has slightly decreased in the local currency balance and has increased in the foreign currency balance.

The main wholesale financing transactions carried out by the companies of the BBVA Group are listed below:

• In January 2022, BBVA, S.A. issued a €1 billion senior non-preferred bond, with a maturity of 7 years and the option for early redemption in the sixth year, with a coupon of 0.875%. In May of the same year, BBVA, S.A. carried out a preferred senior debt issue for a term of three and a half years and separated into two tranches, one with a fixed coupon of 1.75% for an amount of €1,250m and another with a variable coupon set at three-month Euribor plus 64 basis points of spread (3-month Euribor coupon plus 100 basis points) for an amount of €500m. On the other hand, two private issues have been closed, one in May for €100m at a fixed 1% and another in July for €400m at the 3-month floating rate Euribor plus 70 basis points, both with a 2-year term, and in June 2022 a securitization of loans for the financing of vehicles was completed for an amount of €1,200m. In addition, in May 2022, the Group carried out the early redemption of the preference shares contingently convertible into ordinary shares of BBVA (CoCos) issued in May 2017 by BBVA.
• On June 21, BBVA Mexico issued a sustainable bond for 10 billion Mexican pesos (€470m, approximately), thus becoming the first private bank to carry out an issue of this type in Mexico, taking TIIE (Balanced Interbank Interest Rate used in Mexico) as the funding benchmark.
• On June 7, Garanti BBVA renewed 100% of a syndicated loan indexed to environmental, social and corporate governance (ESG) criteria that consists of two separate tranches of USD 283.5m and €290.5m, both with a maturity of one year. Garanti BBVA also made sustainable funding of USD 75m in the first semester.
• On June 28, BBVA Colombia closed a 5-year financing with the International Finance Corporation (IFC) for USD 200m, the aim of which is to promote the financing and construction of energy-sustainable buildings and reduce CO₂ emissions, among others.

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.

During the first half of the year, the foreign exchange markets have not been immune to the volatility observed in other financial assets. In a context of great uncertainty, the US dollar has benefited, appreciating 9.0% against a euro more affected by the consequences of the war in Ukraine. The currencies of Latin America have presented, in general, a good performance in the first half of 2022. The Mexican peso accumulates an appreciation of 10.4% against the euro, the Peruvian sol by 14.8%, the Colombian peso by 5.2% and the Chilean peso by 0.1%. For its part, the Argentine peso accumulated a depreciation of 10.4%. With regard to the Turkish lira, the environment of high inflation continues to penalize it and it lost 12.1% against the euro in the first half of the year.

EXCHANGE RATES (EXPRESSED IN CURRENCY/EURO)

BBVA maintains 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 surplus. The sensitivity of the Group's CET1 fully-loaded ratio to 10% depreciations in major currencies is estimated at: +18 basis points for the US dollar, -3 basis points for the Mexican peso and -3 basis points for the Turkish lira. The coverage levels of the expected results for 2022 is close to 100% in the case of Mexico, Peru and Colombia. In the case of Turkey, the transition to hyperinflation accounting generates a relevant reduction in the expected profits in 2022, even if it is neutral at the level of wealth accumulation.

Interest rate

Interest rate risk management seeks to limit the impact that BBVA may suffer, both in terms of net interest income (short-term) and economic value (long-term), from adverse movements in the interest rate curves in the various currencies in which the Group operates. BBVA carries out this work through an internal procedure, pursuant to the guidelines established by the European Banking Authority (EBA), in order to analyze the potential impact that could derive from 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 observed behavior.

At the aggregate level, BBVA continues to maintain a moderate risk profile, in accordance with the established objective, showing positive sensitivity toward interest rate increases in the net interest income.

At the market level, during the first half of 2022, the United States sovereign curve has continued to flatten, in an environment of higher inflation levels, with the Fed raising interest rates by 150 basis points in the year. Regarding the Eurozone, the ECB has kept official rates unchanged during the semester and, as announced, has ended its asset purchase programs Pandemic Emergency Purchase Program (PEPP) and Asset Purchase Program (APP). Subsequently, at its July meeting it decided to raise official rates by 50 basis points and approved the Transmission Protection Instrument (TPI) with the aim of ensuring the appropriate transmission of monetary policy in the Eurozone as a whole Germany’s sovereign curve has experienced strong rises in the first half of the year, also increasing its slope, while the curves of peripheral countries have behaved similarly, with additional slight upturns. With regard to the emerging world, flattening moves have occurred similar to those of the United States, continuing with the rate hikes cycle, even accelerating the pace in many countries. Turkey, for its part, has kept the monetary policy rate unchanged at 14%. Regarding the behavior of sovereign curves, there is divergence between the real rate curve (lower yields) and the nominal curve (higher yields).

By area, the main features are:

• Spain has a balance sheet characterized by a high proportion of variable-rate loans (basically mortgages and corporate lending) and liabilities composed mainly of customer demand deposits. The ALCO portfolio acts as a management lever and hedging for the bank's balance sheet, mitigating its sensitivity to interest rate fluctuations. The balance sheet interest rate risk profile remained stable during the year, showing a positive net interest income sensitivity to 100 basis points increases by the interest rates slightly around 15 to 20%.

  On the other hand, as mentioned, the ECB held the marginal deposit facility rate unchanged at -0.50% during the first half of 2022. However, European benchmark interest rates (Euribor) began to pick up the ECB’s expectations of rate hikes in the second half of the year, especially the 12-month Euribor which closed June at 1.04%, representing an increase of 154 basis points in the semester. In this sense, customer spread will benefit from interest rate hikes in the coming quarters.

• Mexico continues to show a balance between fixed and variable interest rates balances. In terms of assets that are most sensitive to interest rate fluctuations, the commercial portfolio stands out, while consumer loans and mortgages are mostly at a fixed rate. With regard to the customer funds, the high proportion of non-interest bearing deposits should be highlighted, which are insensitive to interest rate movements. The ALCO portfolio is invested primarily in fixed-rate sovereign bonds with limited maturities. Net interest income sensitivity continues to be limited, registering a positive impact against 100 basis points increases in the Mexican peso, which is around 2.6%%. The monetary policy rate stands at 7.75%, 225 basis points above the end-of-year level of 2021, accelerating the rate of hikes at the last meeting in June in line with the rise made by the Fed. Regarding the client spread, an improvement can be appreciated so far in 2022, a trend which should continue due to the higher interest rates environment.
• In Turkey, the sensitivity of loans, which are mostly fixed-rate but with relatively short maturities, and the ALCO portfolio balance the sensitivity of deposits on the liability side. The interest rate risk is thus limited, both in Turkish lira and in foreign currencies. With regard to benchmark rates, the Central Bank of the Republic of Turkey has kept them unchanged during the first half of 2022. In addition, there has been a sharp upturn in inflation, which has generated positive impacts on Garanti BBVA's net interest income and on the valuation of the bond portfolio linked to it. The customer spread has continued to improve during the first half of 2022.
• In South America, the interest rate risk profile remains low as most countries in the area have a fixed/variable composition and maturities that are very similar for assets and liabilities, with limited net interest income sensitivity. 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 benchmark rates of the central banks of Peru and Colombia continued to rise during the first half of the year, with increases of 300 and 450 basis points, respectively (Peru's Central Bank continued its 50 basis point hike cycle at the July meeting). Customer spreads have changed little during the half of the year in both geographical areas, with slight increases in Peru and slight falls in Colombia, although they are expected to improve during 2022, favored by an environment of higher interest rates.

INTEREST RATES (PERCENTAGE)