Risk management

Credit risk

Throughout the year, the persistent inflation, the Central Bank rates increases and the uncertainty surrounding economic growth have been the main factors that have impacted the markets, affecting to a greater or lesser extent depending on the region to the credit demand reduction and causing a strain on the payment capacity of families and companies.

Uncertainty continues to be high, and the geopolitical turbulence at the time of drafting of this report could contribute to a rebound in energy prices, and therefore, increase the biases towards more negative scenarios, with higher interest rates, persisting inflation and a greater than expected economic slowdown.

By region, the evolution during the year has been uneven. In Spain, although economy continued slowing down during the year 2023, the level of household debt is far from its all-time highs, favored by the dynamism of the labor market. In Mexico, the improvements in the growth outlook due to the dynamism of private consumption and the effect of the relocation of industrial production (nearshoring) is positively impacting the labor market. The uncertainty in Turkey continues, although growth remains solid. Despite changes in economic policy, system quality indicators remain at low levels. Finally, in general, growth has been less dynamic in South America, in a context of high inflation and interest rates, negative effects related to the slowdown in China, as well as adverse climatic factors and social conflicts, affecting the economic situation of families and companies.

Calculation of expected losses due to credit risk

For the estimation of expected losses, the models include individual and collective estimates, taking into account the macroeconomic forecasts in accordance with IFRS 9. Thus, the estimate at the end of the year includes the effect on expected losses of updating macroeconomic forecasts, which take into account the current global environment.

Additionally, the Group may complement 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, following a formal internal process established for the purpose.

Thus, in Spain, the severity of certain specific operations considered unlikely to pay was reviewed upwards because of different reasons to non-performing loans, with a remaining adjustment as of December 31, 2023 of €227 million, with a €161 million decrease compared with the end of the year 2022 mainly as a result of the annual model review process. In addition, due to the earthquakes that affected an area in the south of Turkey, during the month of February 2023 the classification of the credit exposure recorded in the five most affected cities was reviewed, which led to its reclassification to Stage 2. As of December 31, 2023 the amounts recorded in Stage 2 amounted to €273 million on-balance sheet and €406 million off-balance sheet exposure, with allowances for losses of approximately €25 million at contract level.

On the other hand, as of December 31, 2023, the complementary adjustments pending allocation to specific operations or customers are not significant, after the utilization and/or release of most of the adjustments during 2023. As of December 31, 2022, the complementary adjustments pending allocation to specific operations or customers totaled €302m, of which €163m corresponded to Spain, €92m to Mexico, €25m to Peru, €6m to Rest of Business of the Group, €11m to Colombia and €5m to Chile.

BBVA Group's credit risk indicators

The evolution of the Group’s main credit risk indicators is summarized below:

• Credit risk increased in the fourth quarter of the year by 0.9% (+2.9% in constant terms), with generalized growth at constant exchange rates in all geographic areas except in Spain, which had a flat evolution.
• Non-performing loans presented an increase of 3.0% at the Group level between September and December 2023 (+4.5% in constant terms), with general increases in all geographical areas except in Turkey, due to the effect of exchange rates, focused on retail portfolios, and in some singular clients in Rest of Business and in Mexico. Compared to the end of the previous year, the balance of non-performing loans increased by 5.8% (+7,7% at constant exchange rates), focused on retail portfolio in South America, Mexico, Spain and, to a lesser extent, Rest of Business, affected by singular customers inflows.

NON-PERFORMING LOANS AND PROVISIONS (MILLIONS OF EUROS)

• The NPL ratio rose to 3.4% as of December 31, 2023, which represents an increase of 7 basis points compared to the previous quarter, despite the stable evolution in the last twelve months.
• The NPL coverage ratio ended the quarter at 77%, 221 basis points below the previous quarter and 449 basis points lower than in the end of 2022, as a result of the non-performing loan increase throughout the year with coverage ratios that remain practically stable compared to those of the previous quarter (+0.1%) and of December 2022 (0.0%).
• The cumulative cost of risk as of December 31, 2023 stood at 1.15%, which is above the previous quarter, mainly due to the higher requirements in Spain, affected by the impact of the annual review exercise of models parameters for the losses estimation, and, to a lesser extent, in Colombia and Peru, which continue to be affected by the macroeconomic environment worsening.

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 promotes the financing of the recurring growth of the banking business at suitable maturities and costs using a wide range of funding sources. BBVA's business model, risk appetite framework and funding strategy are designed to reach a solid funding structure based on stable customer deposits, mainly retail (granular). As a result of this model, deposits have a high degree of assurance in each geographical area, close to 55% in Spain and Mexico. It is important to note that, given the nature of BBVA's business, lending is mainly financed through stable customer funds.

One of the key elements in the BBVA Group's liquidity and funding management is the maintenance of large high-quality liquidity buffers in all geographical areas. In this respect, the Group has maintained during the last 12 months an average volume of high quality liquid assets (HQLA) of €130.77 billion, of which 97% corresponds to maximum quality assets (level 1 in the liquidity coverage ratio, LCR).

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). This strategy limits the spread of a liquidity crisis among the Group's different areas and ensures the adequate transmission of the cost of liquidity and financing to the price formation process.

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

• The LCR requires banks to maintain a volume of high-quality liquid assets sufficient to withstand liquidity stress for 30 days. BBVA Group's consolidated LCR remained comfortably above 100% during 2022 and stood at 149% as of December 31, 2023. It should be noted that, given the MPE nature of BBVA, this ratio limits the numerator of the LCR for subsidiaries other than BBVA S.A. to 100% of its net outflows. Therefore, the resulting ratio is below that of the individual units (the LCR of the main components reaches 178% in BBVA, S.A., 192% in Mexico and 212% in Turkey). Without considering this restriction, the Group's LCR ratio would reach 193%.
• The net stable funding ratio (NSFR) requires banks to maintain a stable funding profile in relation to the composition of their assets and off-balance sheet activities. The BBVA Group's NSFR ratio stood at 131% as of December 31, 2023.

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

LCR AND NSFR RATIOS (PERCETANGE. 31-12-23)

In addition to the above, the most relevant aspects related to the main geographical areas are the following:

• BBVA, S.A. has maintained a strong position with a large high-quality liquidity buffer, having repaid almost the entire TLTRO III program. During 2023, commercial activity has provided liquidity to the balance sheet mainly due to the good evolution of customer deposits in the last quarter of the year, with growth greater than that of lending activity. This performance is partially by the end of year seasonal component. On the other hand, in December 2022 the Bank started the repayment of the TLTRO III program for an amount of €12 billion, plus an additional repayment of €12 billion between February and March 2023 and another one of €11 billion in June 2023, which together represent more than the 90% of the original amount, maintaining at all times the regulatory liquidity metrics well above the established minimums.
• BBVA Mexico shows a solid liquidity situation, which has contributed to an efficient management of the cost of funds in an environment of rising interest rates. During the year, however, commercial activity has drained liquidity due to a sustained loan growth that has been greater than the fund growth. However, the change in the trend of the evolution of deposits stands out, which had kept a negative performance during the year due to transfers to off-balance sheet funds and which in the last quarter of the year show a significant increase mainly thanks to the seasonal inflows at the end of the year,
• In Turkey, during 2023, the lending gap in local currency has been reduced, due to a greater growth in deposits than in loans, while the lending gap in foreign currency has increased due to higher reductions in deposits. Garanti BBVA continues to maintain a stable liquidity position with comfortable ratios. On the other hand, the Central Bank of Turkey has promoted a gradual change of FX protected scheme to standard deposits in Turkish lira, specially in the second half of the year, as an additional step on dedollarization process of the economy.
• In South America, the liquidity situation remains adequate throughout the region. In Argentina, liquidity in the system continues to increase, as well as in BBVA due to a higher growth in deposits than in loans in local currency and no significant variations in foreign currency. In BBVA Colombia, the credit gap declined due to a higher volume of deposits together with a slowdown in lending growth. BBVA Peru maintains solid liquidity levels, showing a reduction in the credit gap throughout the year thanks to a growth in deposits higher than in lending activity, affected by the expiration of loans covered by COVID-19 programs.

The main wholesale financing transactions carried out by the BBVA Group during 2023 are listed below:

Additionally, in June 2023, BBVA, S.A. completed a securitization of a portfolio of car loans for an amount of €804m.

In January 2024, BBVA, S.A. has carried out a public senior bond issue for €1,250m with a maturity of 10 years and a coupon of 3,875%. Moreover, BBVA, S.A. has announced its irrevocable decision to amortize an issue of Tier 2 subordinated bonds issued in February 2019, for an amount of €750m, on February 22, 2024. On the other hand, BBVA Mexico has issued Tier 2 bonds for USD 900m with a maturity of 15 years and early repayment option in 10 years with a coupon of 8,125%.

In Turkey, Garanti BBVA renewed in June a syndicated loan associated to environmental, social and corporate governance (ESG) criteria, consisting of two separate tranches of USD199m and €218.5m, both maturing in one year. In December, Garanti BBVA announced the renovation of the 100% of the maturity of a syndicated loan of USD 259.5m and €142.5m with a maturity of 367 days, also linked to ESG criteria. The total loan cost was SOFR + 3.50% for the tranche in USD and Euribor + 3.25% for the tranche in euros.

BBVA Colombia announced the launch of the first blue bond in Colombia, together with the International Finance Corporation (IFC), for an amount of USD 50m in its first tranche. Later, in October, the second tranche of the operation was disbursed for an amount of USD 67m.

Foreign exchange

Foreign exchange risk management aims to reduce both the sensitivity of the capital ratios and the net attributable profit variability to currency fluctuations.

The performance of the Group's main currencies during 2023 has been very uneven. Due to its relevance for the Group, it should be noted the strength of the Mexican peso, which has appreciated 11.4% against the euro. The other currency which stands out was the Colombian peso (+21.5%). On the other hand, the depreciation of both the Turkish lira (-38.9%), mainly concentrated in June after the elections, and the Argentinian peso (-78.9%) intensified in the last quarter of the year after the measures enacted by the new government , stands out. In both cases, the currencies have been pressured by the negative dynamism of inflation. The rest of currencies evolved moderately during the year: the Peruvian sol (+-1.1%), the U.S. dollar (+-3.5%) and the Chilean peso (-6.2%).

EXCHANGE RATES (EXPRESSED IN CURRENCY/EURO)

In relation to the hedging of the capital ratios, BBVA covers, in aggregate, 70% of its subsidiaries' capital excess. The sensitivity of the Group's CET1 fully-loaded ratio to 10% depreciations in major currencies is estimated at: +17 basis points for the U.S. dollar, -9 basis points for the Mexican peso and -4 basis points for the Turkish lira¹⁰. With regard to the hedging of results, BBVA hedges between 40% and 50% of the aggregate net attributable profit it expects to generate in the next 12 months. For each currency, the final amount hedged depends on its expected future evolution, the costs and the relevance of the incomes related to the Group's results as a whole.

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), with the aim of analyzing 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. The assumptions regarding the behavior of accounts with no explicit maturity and prepayment estimates are specially relevant. 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 have a positive sensitivity toward interest rate increases in the net interest income.

The first quarters of 2023 were characterized by a persistent high level of inflation, which, together with the strong growth indicators, served as reason for both the ECB and the Fed to consolidate their hawkish messages of high interest rates for a longer time. This positioning from monetary authorities contributed the sovereign curves to certain rises. However, in the last quarter of the year, decreasing inflation data and expectations converging towards central bank objectives, together with the weakening of some macroeconomic indicators, suggest that the rate hike cycle has come to an end in Europe and in the United States and have led the market to discount rate drops by mid-2024. This has triggered a fall in sovereign bond profitability and has caused a positive performance in most debt portfolios of the Group. Other peripheral rate curve spreads remain supported. In Mexico, the rate hike cycle is considered to be over, while in most countries of South America, interest rate cuts have started taking place. On the contrary, the Central Bank of Turkey has continued the tightening of its monetary policy launched in June with significant rate hikes.

By area, the main features are:

• Spain has a balance sheet characterized by a lending portfolio with high proportion of variable-rate loans (mortgages and corporate lending) and liabilities composed mainly by customer demand deposits. The ALCO portfolio acts as a management lever and hedge for the balance sheet, mitigating its sensitivity to interest rate fluctuations. In an environment of high rates, currently close to their market-predicted terminal rates, the interest rate risk profile of the balance sheet has been reduced during the year.
  
  On the other hand, the ECB left rates unchanged in the last quarter of the year, bringing the benchmark interest rate to 4.5%, the marginal deposit facility rate at 4.0% and the marginal loan facility rate at 4.75% as of December 31, 2023. The market expects there to be a first rate drop in the first half of 2024 and, in this environment, the Euribor 6 and 12 month reference rates fell in the fourth quarter of 2023, starting to reflect these expectations, while shorter term benchmark rates remained broadly stable. All in all, the customer spread benefited in 2023 from asset repricing and the containment in the cost of deposits, yet at a slower pace during the last quarter of the year.
• Mexico continues to show a balance between fixed and variable interest rates balances, which results in a limited sensitivity to interest rates fluctuations. In terms of assets that are most sensitive to interest rate changes, the commercial portfolio stood out, while consumer loans and mortgages are mostly at a fixed rate. With regard to customer funds, the high proportion of non-interest bearing deposits, which are insensitive to interest rate movements, should be highlighted. The ALCO portfolio is invested primarily in fixed-rate sovereign bonds with limited maturities. The monetary policy rate stood at 11.25%, 75 basis points above the end-of-year level of 2022, but has remained stable since March 2023. Regarding customer spread, there has been an improvement during 2023, favored by both the containment of the cost of deposits and the positive evolution of the loan yield.
• In Turkey, the sensitivity of deposits is offset by the ALCO portfolio and loans (fixed rate and relatively short-term). The sensitivity of the net interest income remains very limited thanks to the different efforts carried out by the Bank. The CBRT has recently increased monetary policy rates, taking interest rates from 8.5% to 42.5% by the end of 2023. In terms of customer spread, it has worsened due to the evolution of the deposit costs linked to regulatory requirements, despite the high profitability of loans.
• 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, the balance sheets with several currencies, interest rate risk is managed for each of the currencies, showing a very low level of exposure. Regarding benchmark rates, the cut cycle has begun in the region. In Peru it stood at 6.75% as of December 2023, 75 basis points below its 2022 closing level, with an additional cut of 25 basis points in January 2024. The customer spread in Peru had a positive performance in the year due to the positive evolution of loan performance and the containment of deposit costs. In Colombia, after not changing the monetary policy since April 2023, in December 2023 the central bank cut rates by 25 basis points, leaving the official rate at 13.00%. Thus, customer spread in Colombia continued the improvement trend initiated in the second quarter of the year. In Argentina, after the primary elections in August, a significant rate hike of 2,100 basis points was implemented reaching 118%, and kept increasing further up to 133%, but was reduced to 100% after the last central bank meeting in December 2023.

INTEREST RATES (PERCENTAGE)

¹⁰ This sensitivity does not include the cost of capital hedges, which are currently estimated at 3 basis points per quarter for Mexican peso and 3 basis points per quarter for Turkish lira.