In particular, lower interest rate levels help reduce losses on credit portfolios, thanks to the favourable effect they have on borrowers’ ability to repay their loans, associated both with lower loan costs and with the higher income and lower unemployment levels linked to the positive macroeconomic impact of lower interest rates. These effects have been especially significant in countries such as Spain where the banking system had a high level of non-performing loans and where short-term and variable rate lending predominates, since this means that changes in market yields are rapidly passed through to the cost of outstanding debt. This effect thus explains part of the decline in the NPL ratio in recent years. In addition, lower interest rates help drive up the prices of financial and real assets. This effect is immediate in the case of debt securities, especially long-term ones, as their prices are more sensitive to yield changes. The prices of equities and real assets, such as housing, are also boosted by lower interest rates, owing to their effect on the discount factor, although these prices are also affected by other factors, such as macroeconomic expectations. All this entails capital gains for banks exposed to these financial and real assets. It also increases the value of loan collateral, which enhances the credit quality of loans and, therefore, reduces losses on the credit portfolio. That said, it is true that these capital gains become exhausted once interest rates cease to decline and remain at low levels.
Responses to the low profitability environment In recent years, Spanish banks have partially cushioned the fall in net interest income by means of various strategies. To address the current low profitability environment, they should persevere in some of these strategies and embark on others. First, as I mentioned earlier, banks have made great efforts to reduce their nonperforming and foreclosed assets. But the non-performing loan ratio still stands at 5.3% for business in Spain and foreclosed assets amount to around € billion, in both cases well above the pre-crisis levels. Banks should therefore persevere with this strategy. To illustrate the room for improvement that still exists in connection with these non-performing assets, if the level of provisioning of average total assets were as low as in 2005 (which, at 0.26%, was the lowest level recorded since 2000), it is estimated that Spanish deposit institutions’ annual consolidated profit would increase by € billion. This would raise average ROA by 10 bp and ROE by 1.3 pp.4  4  In addition, in a hypothetical scenario in which all foreclosed assets were performing assets, earning a return equivalent to average ROA (0.49%), net profit would increase by around € million, a modest but far from negligible figure. 15/29  Second, banks have diversified their revenue generation and in particular there has been an increase in fee income.