1.1. Executive Summary

In 2016, our strategy and business model continued to generate value for our customers and shareholders. Our geographic diversification, with critical mass in our markets, leadership in efficiency, give us a clear competitive advantage that has enabled us to counteract a difficult economic scenario, especially for banks, episodes of elevated volatility and a greater tax burden in some countries.

In this context, we have ended the year with sound financial results, having generated sustainable and predictable returns and fulfilled our financial and commercial commitments.

Profit and dividends are increasing, we have grown in volume excluding the impact of exchange rates, the balance sheet has maintained a balanced structure, with liquidity ratios that are far above required levels, and we have significantly improved our capital position and credit quality. We have achieved this while managing to advance in our process of commercial transformation, renewing the relationship with our customers and enhancing their experience with the bank.

The most important highlights of Grupo Santander in 2016 are:

Strength of results.

Santander’s business model has shown its strength in recent years, enabling us to achieve very predictable results and make us a leader in efficiency and profitability.

Ordinary before-tax profit amounted to EUR 11,288 million in the year, with a 3% increase on 2015. In constant euros, the increase is 12%, with increases in nine of the 10 principal markets.

The main lines of the statement reflect the strategy followed during the year:

 

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Healthy performance of revenue, backed by a margin in interest and in fees, which, as a whole, account for 94% of revenue.

 

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Strict cost control for the third consecutive year, with a decrease in 2016 of 2% in real terms and with no perimeter change.

 

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A further year-on-year reduction of provisions and better cost of lending owing to stronger corporate risk culture.

The lower part of the statement shows the heavier tax burden, with the introduction of new taxes in some units, and the recognition of some non-recurring gains and losses, which, in total, amount to a net tax charge of EUR 417 million in 2016. In 2015, non-recurring results amounted to EUR 600 million.

In sum, Grupo Santander earned an attributable profit of EUR 6,204 million, which is 4% more than in 2015, or 15% more if the impact of exchange rates is stripped out.

 

 

 

*	In operational areas, excluding Spanish Property Business unit and Corporate Centre.

Process of commercial transformation.

In 2016, we continued to make progress in the transformation of our commercial model, focussing more on digitalization and client loyalty and satisfaction.

All units have made advances towards increasing the numbers of connected customers by developing new products and services both for individuals and for companies, offering innovative solutions and global proposals. Examples include: Mundo 1|2|3, Santander Select, Santander Private Banking, Santander pymes, Santander Trade Network, Global Treasury Solutions, Santander Flame and new digital applications in every country.

In order to improve base customer loyalty, we must ensure operational excellence. For us, this means a better customer experience and efficiency. Capitalising on new technologies is vital to achieving this. We are continuing to work at different levels of digital transformation.

 

Our customers are demanding greater availability and closer contact through digital channels, but without overlooking the personal service and treatment that Santander has always featured. So considerable work has also gone into improving branch offices with the SMARTRED project, as well as contact centres. Of no less significance are the major advances being made by our commercial intelligence tool, Santander NEO CRM, which integrates information from every channel – i.e., branch offices, contact centres, digital media, etc. – and adds new transactional capacities, thus enabling us to know our customers better and offer them value propositions based on their experience and needs, and help us make savings in costs.

As a result of this process of transformation, we now have 15.2 million connected customers (+10% in the year) and 20.9 million digital customers (+26% in the year).

These increases reflect the improvement in our revenue base, mainly in fees, where we have doubled the previous year’s growth.

In customer satisfaction, we have also achieved major results this year. We now have eight units, three more than in 2015, that stand among the three best local banks in terms of customer experience.

Growth of activity.

This higher degree of customer linkage and our commercial strategy is reflected in an overall increase in volumes, especially in emerging markets, as we maintain a medium-low risk profile and a well-diversified portfolio.

Lending is increasing most in Latin America, SCF and Poland, and more moderately in the United Kingdom. Notable is Brazil, which ends the year at break-even (+0.4%), after improving the trend in the second half of the year. For their part, Spain and Portugal are still undergoing a deleveraging process, and the US has been partially affected by the sale of portfolios of lower quality.

In customer funds, every principal unit is growing, above all in demand deposits and investment funds, as part of our strategy to improve the cost of credit.

Stronger solvency.

In capital, we again showed our capacity to combine generation of sustainable capital with the payment of dividends. Our fully loaded CET1 capital ratio stood at 10.55% at year end, thus exceeding our target, and consistently advancing toward our target of 11% for 2018.

The fully loaded capital ratio and the leverage ratio also improved during the year. In addition, in regulatory terms, we ended the year with a CET1 phase in of 12.53%, which is far above the minimum level required by the European Central Bank.

 

Better credit quality level.

Santander maintains a medium-low risk profile and high level of quality in its assets. All credit quality indicators improved in the year. Grupo Santander’s NPL rate decreased by 43 basis points to 3.93% coverage increased one percentage point to 74% and the cost of credit decreased by 7 basis points, to 1.18%.

This strong performance is found in nearly every geography and is directly related to the consolidation of our risk culture – called risk pro – throughout Grupo Santander.

Creating value for our shareholders.

Again this has been one of our key priorities this year. We have increased the earnings per share by 1%, the cash dividend per share by 8% and we continue to offer some of the best return rates in the sector, as measured by RoTE

We have also increased our fully loaded capital by more than EUR 3,000 million, and the tangible book value per share has risen to EUR 4.22 per share, thus showing growth for the fourth consecutive year.

This was reflected in a rise in the share price during the year of 8.8% and of 14.2% in total shareholder return, with both performing far better than the DJ Stoxx Banks and DJ Stoxx 50 indices.

 

 

Flow statement. Capital requirements for credit risk (CR8)*

     Millions of Euros

 

		RWA				Capital
Starting figure (31/12/2015)			491,677				39,334
Business risk changes			-4,130				-330
Changes in parameters that affect exposure			5,505				440
Perimeter changes			5,730				458
Exchange rate			1,434				115
End figure (31/12/2016)			500,216				40,017

 

*	Including capital requirements of equities, securitisations and counterparty risk (excluding CVA and CCP).

Flow statement. Capital requirement for operational risk

     Millions of Euros

 

		Capital				RWAs
Starting figure (31/12/2015)			5,270				65,875
Application of ASA approach in Brzil			-627				-7,832
Acquisition of business PSA Germany and PSA Austria			12				144
Acquisition of busines PSA Netherlands and PSA Benelux			8				96
Acquisition of busines PSA Italy			4				52
Acquisition of busines PSA Poland			1				12
Exchange rate effect			13				163
Change in business			206				2,574
End figure (31/12/2016)			4,887				61,084

 

Rorac and value creation

     Millions of Euros

 

		31 Dec. 2016								31 Dec. 2015
Main segments		Rorac				Value creation				Rorac				Value creation
Continental Europe			17.3	%			1,426				13.9	%			883
UK			20.2	%			825				22.5	%			1,065
Latin America			33.1	%			2879				33.8	%			2,746
US			9.2	%			-13				13.4	%			308
TOTAL BUSINESS UNITS			20.7	%			5,117				20.2	%			5,001

 

1.2.1. Background information on Grupo Santander

Banco Santander, S.A. is a private-law company, subject to the rules and regulations applicable to banks operating in Spain. In addition to its own activities, Banco Santander is the parent of a group of subsidiaries engaged in a variety of activities, which together make up Grupo Santander. The CRR, CDR IV and its transposition of Bank of Spain 2/2016 Circular, 2 February, of Supervision and Solvency applicable at consolidated level to the whole Group.

The Grupo Santander companies included in the scope of regulatory consolidation for the purposes of calculating the capital ratio under the CRR are the same as those that are included in the scope of consolidation for accounting purposes under Bank of Spain Circular 4/2004.

In application of Part I of the General Provisions of the CRR, certain Grupo Santander companies are consolidated using a different method from that used for the accounting consolidation.

The companies for which a different consolidation method is used, based on the regulations applied, and the equity investments that are deducted from capital are listed in Appendix IV, of 2016 Pillar III Appendix file, distinguishing between financial institutions and insurance companies in which Grupo Santander has a significant ownership interest. As of the reporting date, both types of investment are exempt from deduction pursuant to article 48 of the CRR.

 

Grupo Santander does not make use of the exemption contemplated in article 19 of the CRR, therefore the disclosure of table INS1 (Non-deducted participations in insurance undertakings) does not apply .

At 31 December 2016, under Article 7 and 9 from the CRR, the subsidiaries Santander Leasing S.A. EFC and Santander Factoring y Confirming S.A. EFC are exempt from the minimum capital requirements, the limit on large exposures and the internal corporate governance obligations. No use of the exemptions under the applicable regulations has been made for any other Grupo Santander subsidiaries.

Grupo Santander is one of the banks that have not required state aid in any of the countries in which it operates

1.2.2 Structure of the 2016 Pillar III Disclosures

Santander’s Pillar III Disclosures are divided into eight sections and three appendices. The first chapter describes the background to Pillar III in Grupo Santander, material events affecting the Group that occurred in 2016 and the regulatory environment.

The second chapter provides full information on capital, including qualitative information on the capital function in Grupo Santander and quantitative information on Grupo Santander’s capital base and capital requirements.

Chapters 3 to 7 describe the risk function in Grupo Santander and provide detailed information on credit risk, securitisations, market and ALM risk, operational risk, liquidity risk, compliance and conduct risk, and a description of the Internal Control function.

Chapter 8 contains information on remuneration policy of Material Risk Takers (MRT).

The appendices contain a listing of regulatory changes in 2016, a list of tables and a glossary of terms to facilitate the understanding of the report.

The Santander website contains five appendices in editable format with information required pursuant to prevailing legislation on certain aspects, such as eligible capital, the issue of preference shares and subordinated debt and the various consolidation methods of Grupo Santander’s subsidiaries.

Throughout the report cross references to other public documents are made, amplifying the content via QR codes and hyperlinks:

 

 

1.2.3 Governance: approval and publication

Pursuant to the official disclosure policy approved by the Board and recently updated at its meeting on 12 February 2017 to incorporate the EBA’s recommendations, Grupo Santander publishes its annual Pillar II Disclosures following Board approval. Prior to Board approval on 2 March 2017, the report was reviewed by the Committee of Risk Supervision, Regulations and Compliance at its meeting on 17 February and the Capital Committee at its meeting on 9 February 2017.

In addition, since March 2015, a set of quarterly information has been published, in compliance with the European Banking Authority “Guidelines on materiality, proprietary and confidentiality and on disclosure frequency” pursuant to article 432, sections 1 and 2 and article 433 of Regulation (EU) 575/2013.

No exceptions have been made to the publication of information considered reserved or confidential.

In September, the ECB performed a review over the 2015 report to verify compliance with the reporting requirements laid down in the European Capital Requirements Regulation. The scant observations communicated have been included in this report.

In line with the corporate governance recommendations regarding the rotation of the external auditor, the ordinary general meeting of March 18, 2016 appointed Price Waterhouse Coopers Auditores S.L. (PwC) as external auditor of the Bank and its Consolidated Group for 2016, 2017 and 2018.

The Pillar III Disclosures are available in the “Investor Relations” section of Grupo Santander website (www.santander.com), under “Financial reports”.

 

In addition to the information in this report, some Group subsidiaries publish information on capital and solvency on their websites pursuant to regulatory requirements.

1.2.4 Transparency enhancements

Santander has taken note of the recommendations issued by the EBA and other working groups such as the Financial Stability Board (FSB) through the Enhanced Disclosure Task Force (EDTF) to improve the transparency of the information published each year in its Pillar III report.

In addition, the Basel Committee published, in January 2015, the Revised Pillar 3 Disclosure Requirements. Last year’s Pillar II Disclosures incorporated a large number of the recommendations included in the document.

In December 2016, the EBA published its Final Guidelines on disclosure requirements. These Guidelines provide banks with guidance in attaining compliance with the CRR and with the Basel Committee, and they will apply from 31 December 2017. Grupo Santander made an effort to incorporate virtually all the enhancements this year.

The enhancements introduced are detailed below:

 

1.2.5. Differences between the consolidation method for accounting purposes and the consolidation method for regulatory capital calculation purposes

For the purposes of calculating the solvency ratio in accordance with the nature of their activities, Grupo Santander units included in the prudential scope of consolidation, are consolidated using the global consolidation method, with the exception of jointly controlled entities, which are consolidated using proportionate consolidation. All companies that cannot be consolidated in accordance with their activities are accounted for using the equity method and so are treated as equity exposures.

The basis of the information used for accounting purposes differs from that used for the calculation of regulatory capital requirements. The measures of risk exposure may differ, depending on the purpose for which they are calculated, e.g. generation of accounting information, calculation of regulatory capital or generation of management information. The exposure data included in the quantitative disclosures in this document are used for calculating regulatory capital.

1.2.6. Equity investments and capital instruments not included in the trading book

This section provides definitions of investments in associates and available-for-sale equity instruments, as well as the accounting policies and valuation methods applied to them. In addition, data

 

accounting for any amounts of such capital instruments not included in the trading book are provided.

Investments in associates are those over which Grupo Santander exercises significant influence, but not control or joint control. This capacity is usually observed with 20% or more of the voting power of the investee.

Equity instruments classified as available for sale are capital instruments issued by entities other than subsidiaries, associates and jointly controlled entities, provided that such instruments have not been classified as financial assets/liabilities held for trading or other financial assets at fair value through profit or loss.

Investments in associates are accounted by its cost and are periodically tested for impairment.

Capital instruments classified as available-for-sale assets are measured and recorded at fair value, with changes in fair value being recognised in equity under valuation adjustments, unless there is evidence of impairment, in which case the impairment loss would be recognised in the income statement.

Capital instruments whose fair value cannot be reliably measured are carried at acquisition cost, less any impairment losses.

 

Table 3. Available-for-sale equity instruments.      Consolidated gross valuation adjustments

     Thousands of Euros

 

		31 Dec. 2016
Prior-year balance			954,184
Revaluation gains and losses			840,844
Amounts transferred to income:			-284,058
Of which, from sales			-297,883
Of which, from impairment			13,826
Current-year balance			1,510,970

 

With respect to holdings accounted for using the equity method at year-end 2016, the amounts for associates and jointly controlled entities were EUR 3,457 million and EUR 464 million respectively.

There are also investments in Group entities totalling EUR 2,964 million which are accounted for in the public perimeter using the full consolidation method.

Grupo Santander tests these investments for impairment on a regular basis. No evidence of significant impairment was found during 2016.

1.2.7. Disclosure criteria used in this report

This report has been prepared in accordance with the applicable European Capital Requirements (CRR).

Below are the details of the type of information that best reflects the discrepancies between the regulatory information, shown in this report, and the information shown in the annual report, and the accounting information:

 

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The measures of credit risk exposure used for calculating regulatory capital requirements include (i) not only current exposures, but also potential future risk exposures arising from future commitments (contingent liabilities and commitments) or changes in market risk factors (derivative instruments) and (ii) the mitigating factors of these exposures (netting arrangements and collateral agreements for derivative exposures and collateral, and personal guarantees for on-balance-sheet exposures).

 

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The criteria used for classifying defaulted exposures in portfolios subject to advanced approaches for calculation of regulatory capital are more conservative than those used for preparing the disaggregated information provided in the Annual Report.

The reconciliation of public and confidential balance sheets is shown in appendix V.

 

1.2.8. Substantial modifications due to scope changes and corporate transactions

A breakdown is provided below of the main purchases and sales of stakes in other companies, and other major corporate transactions by Grupo Santander last year:

i. Agreement concerning Santander Asset Management

On 16 November 2016, following the discontinuation agreed with the Unicredit Group on 27 July 2016 with regard to the merger project between Santander Asset Management and Pioneer Investments, Grupo Santander announced it had reached an agreement with Warburg Pincus (“WP”) and General Atlantic (“GA”) whereby Santander will purchase the 50% stake held by the companies in Santander Asset Management, thus making it a wholly-owned Grupo Santander company once more.

As part of this operation, Santander, WP and GA agreed to explore a number of alternatives for the sale of stakes in Allfunds Bank, S.A. (“Allfunds Bank”) and these included a possible sale or a stock market listing.

Grupo Santander believes that in 2018 the operation will assist its earnings per share (>1%) and generate a return on invested capital (RoIC) in excess of 20% (and 25% in 2019). Grupo Santander also believes that at year-end 2017 the adverse effect of the operation on its capital (core equity tier 1) will be approximately 11 basis points. All estimates are net of the effect of the foreseeable sale of Grupo Santander’s indirect 25.25% stake in Allfunds Bank.

The operation is subject to the regulatory permits being secured.

ii. Agreement with Banque PSA Finance

Grupo Santander, through its subsidiary Santander Consumer Finance, S.A. and Banque PSA Finance, the vehicle finance unit of the PSA Peugeot Citroën Group, signed an agreement in 2014 for joint operation of the vehicle finance and insurance business in twelve European countries. Under the contract, Grupo Santander will finance this business in certain circumstances and under certain conditions.

Regulatory permits were obtained in January 2015 to commence operations in France and the United Kingdom, and so on 2 and 3 February 2015 Grupo Santander bought up 50% of Société Financière de Banque – SOFIB (now PSA Banque France) and PSA Finance UK Limited for EUR 462 million and EUR 148 million respectively.

PSA Insurance Europe Limited and PSA Life Insurance Europe Limited were incorporated on 1 May (both insurance companies registered in Malta) and Grupo Santander contributed 50% of the capital in the amount of EUR 23 million. 100% of PSA Gestão - Comércio E Aluguer de Veiculos, S.A. (a company registered in Portugal) was acquired on 3 August, as was the lending portfolio of the Portuguese subsidiary of Banque PSA Finance, for EUR 10 million and EUR 25 million respectively. PSA Financial Services Spain, E.F.C., S.A. (a company registered in Spain) was incorporated on 1 October, and Grupo Santander contributed EUR 181 million or 50% of the capital (the company in turn holds 100% of the capital of PSA Finance Suisse, S.A. , a company registered in Switzerland).

 

Permits were obtained from the regulatory authorities to commence operations in the other countries covered by the framework agreement (Italy, the Netherlands, Austria, Belgium, Germany, Brazil and Poland). Grupo Santander disbursed EUR 464 million in 2016 to acquire a 50% stake in each of the structures created in each region, with the exception of PSA Finance Arrendamento Mercantil S.A., where all the shares were bought up.

The new businesses acquired contributed EUR 79 million to Group results in 2016. Had the business combination taken place on 1 January 2016, the results contributed to Grupo Santander in 2016 would have been approximately EUR 118 million.

iii. Metrovacesa agreement

On 21 June 2016 Grupo Santander announced an agreement with Merlin Properties, SOCIMI, S.A., along with the other shareholders of Metrovacesa, S.A., for the integration in the MERLIN group, following the total spin-off of Metrovacesa, S.A, of Metrovacesa S.A.’s property rental business in Merlin Properties, SOCIMI, S.A. and Metrovacesa, S.A.’s residential rental business in the current Merlin subsidiary, Testa Residencial, SOCIMI, S.A. (formerly Testa Residencial, S.L.). The other assets of Metrovacesa, S.A. not integrated in the Merlin group as a result of the merger, consisting of a residual group of land assets for development and subsequent lease, were to be transferred to a newly created company wholly owned by the current shareholders of Metrovacesa, S.A.

The General Shareholders’ Meetings of Merlin Properties, SOCIMI, S.A and Metrovacesa S.A. were held on 15 September 2016, and both meetings approved the operation.

Subsequently, on 20 October 2016 a deed was drawn up for the total spin-off of Metrovacesa, S.A. in favour of the two companies, and was entered in the Business Register on 26 October 2016.

As a result of the merger, Grupo Santander has a 21.95% stake in Merlin Properties, SOCIMI, S.A., a direct 46.21% stake in Testa Residencial, SOCIMI, S.A. and a 70.27% stake in Metrovacesa Promoción y Arrendamiento, S.A.

The main impacts of the spin-off on the consolidated Group balance sheet were as follows; a decrease of approximately EUR 3,800 million in investment property (see Note 16), a decrease of EUR 621 million in minority interests (see Note 28) and an increase in investments in joint ventures and associates through stakes in the business received by associate companies Merlin Properties and Testa Residencial, in the respective amounts of EUR 1,168 million and EUR 307 million (see Note 13.a).

Moreover, plans have been made for Banco Santander, S.A., along with other companies, to contribute assets to Testa Residencial, SOCIMI, S.A. during the first quarter of 2017, with no major changes to Santander’s stake in the company.

1.3. Regulatory framework

1.3.1 Regulatory framework

In December 2010, with the aim of enhancing the quality, consistency and transparency of the capital base and improving risk coverage, the Basel Committee on Banking Supervision (BCBS) published a new global regulatory framework for the international capital standards (Basel III), reinforcing the requirements established in the previous frameworks (known as Basel I, Basel II and Basel 2.5). On 26 June 2013 the Basel III legal framework was incorporated in the European legal order via Directive 2013/36 (CRD IV), which repeals Directives 2006/48 and 2006/49, and Regulation 575/2013 on prudential requirements for credit institutions and investment firms (CRR).

CRD IV was introduced into Spanish law through Law 10/2014 on the ordering, supervision and solvency of credit institutions, and its subsequent regulatory implementation via Royal Decree 84/2015 and Circular 2/2016 of the Bank of Spain, which completes its adaptation to Spanish law. This Circular largely repeals largely Circular 3/2008, on the calculation and monitoring of minimum capital (though, in the aspects covered by Circular 5/2008, on minimum capital and other mandatory reporting of information for mutual guarantee societies, the latter will remain in effect); and a section of Circular 2/2014, on the exercise of various regulatory options contained in the CRR. The CRR is directly applicable in Member States from 1 January 2014, and repeals all subordinate acts that entail additional capital requirements.

The CRR provides for a phase-in period that will allow institutions to adapt gradually to the new requirements in the European Union. The phase-in arrangements have been introduced into Spanish law through Bank of Spain Circular 2/2014 affecting both the new deductions from capital and the instruments and elements of capital that cease to be eligible as capital under the new regulation. The capital conservation buffers provided for in CRD IV will also be phased in gradually, starting in 2016 and reaching full implementation in 2019.

The Basel regulatory framework is based on three pillars. Pillar I determines the minimum capital requirement and allows for the use of internal ratings and models to calculate risk-weighted exposures. The aim is to make the regulatory requirements more sensitive to the risks actually incurred by financial institutions in carrying on their business activities. Pillar II establishes a system of supervisory review, aimed at improving banks’ internal risk management and capital adequacy assessment in line with their risk profile. Lastly, Pillar III deals with disclosure and market discipline.

On 23 November 2016, the European Commission released a draft of the new CRR and CRD IV incorporating different Basel standards, such as the Fundamental Review of the Trading Book for Market Risk, the Net Stable Funding Ratio for liquidity risk or the SA-CCR for calculation of the EAD by counterparty risk, and introduces modifications related to the treatment of central counterparties, from the MDA, Pillar II and the leverage ratio, among others. The most significant change is the implementation of the TLAC Term Sheet issued by the Financial Stability Board (FSB) in the capital framework, so that systemically important banks will have to comply with TLAC requirements in a Pillar I, while non-systemically important banks need only comply with MREL in a Pillar II that the resolution authority will decide on a case-by-case basis.

 

1.3.1.1 Regulatory changes in 2016

Progress continued in review of the prudential framework and in the development of crisis management frameworks in 2016.

The Basel Committee continued to review the frameworks for the calculation of the capital requirements for credit, market and operational risk, in terms of capital consumption, in a bid to improve their simplicity, comparability and sensitivity to risk While seeking to reduce the variability of risk-weighted assets not justified by the different risk profiles, the Basel Committee is adjusting its initial proposals, with the aim that such reviews should not entail a widespread capital increase within the entire system:

 

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Credit risk: A revised proposal concerning the standardised approach was tabled in December 2015. This proposal simplifies the previous version, and reintroduces the use of external ratings, in a non-mechanistic manner, for exposures to banks and corporates. The revised proposal also includes alternative approaches for jurisdictions that do not allow the use of external ratings for regulatory purposes. Furthermore, in March 2016, a review of internal models was released for consultation purposes, with the aim of eliminating the use of internal models for certain portfolios classified as low default; to set limitations in the estimation of parameters through exposure level floors; to standardise the methodology for estimating risk parameters; and to review treatment of risk mitigation techniques

 

•

Market risk: The Basel Committee released in January 2016 the final calibration and fundamental review of capital in the trading book, which includes the standard model, the advanced model, and the separation between the banking book and the trading book.

 

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Operational risk: In March 2016, the first proposed standardised approach was released for consultation purposes. It involved replacing business lines in the current standardised calculation methodology with a size basis as the main driver. This second proposal sets out a new approach that combines size with indicators of losses from past events. The new methodology is expected to not only replace current standardised approaches but also AMA internal models.

This review of the capital framework is expected to be completed in early 2017. The outcome is expected to be a hybrid approach, in which the utilisation of internal models will be permitted, albeit with limitations, and capital floors will be applied based on standardised methodologies of credit, market and operational risk. Accordingly, the calibration of these floors is expected to be between 60% and 90%.

The Basel Committee also worked in the following areas in 2016:

 

•

In April 2016, the Committee released its final proposal on the review of the regulatory treatment of the interest rate in the investment book, which means that this risk is maintained within Pillar II, but with certain additional requirements, such as a quantitative disclosure based on the Pillar I approach proposed for this risk.

 

•

In September 2016, the Committee released the Regulatory Consistency Assessment Program (RCAP) for Argentina, with the aim of evaluating the degree of local implementation of Basel standards relating to the capital and liquidity framework. This report determined that local implementation of Basel III in Argentina is compliant with Basel standards, Argentina jurisdiction.

 

•

In October 2016, the Basel Committee released a consultation and discussion paper on the regulatory treatment of provisions that allow for applying a transitional period for calculating the capital impact of the implementation of IFRS 9 and they propose several long-term alternatives in provisions for review of the interaction between the accounting framework and the prudential framework. Further consultations on this debate are expected throughout 2017.

Another aspect on which the Basel Committee is engaged is a review of the treatment of sovereign debt within the prudential framework, which could lead to withdrawal of the application of zero risk for certain sovereign debt exposure or even the imposition of concentration limits on such exposures and the introduction of additional disclosure requirements. A consultation concerning this debate is expected during the first quarter of 2017.

With respect to the leverage ratio, final calibration has been scheduled for 2017 and will depend on the final calibration of capital measures for credit, operational and market risk. But it is expected to be 3% for all banks except for G-SIBs, which must comply with an additional buffer.

In addition, the publication of the final proposal of the review of the risk framework of the credit valuation adjustment (CVA) is pending. The latter aims at ensuring that all drivers of CVA and coverages are included in the Basel capital framework, aligning the capital standard with measurement of the fair value of the CVA employed for accounting purposes, and guaranteeing consistency with the basic review of the trading book (published for review in October 2015).

Additionally, with respect to the crisis management framework, in 2016, the Financial Stability Board has continued to make progress in developing crisis management frameworks to put an end to the notion of “too big to fail” in the banking sector. After finalising the standard to demand the minimum loss absorbing-capacity in order to recapitalise a bank (Total Loss Absorbing Capacity or TLAC), which will be required of G-SIBs (global systemically important banks), in 2016 it continued to make progress in TLAC holding and disclosure rules.

Hence, in November 2016, the Financial Stability Board (FSB) has updated the list of G-SIbs for 2018. Santander remains in Grupo Santander of the least systemic banks, with the minimum additional capital buffer requirement (1%) and a confirmed phase-in buffer of 0.75% for 2018.

 

European regulation

The European Banking Authority (EBA) continued to issue standards and guidelines implementing aspects of European capital requirements (CRR/CRD IV) and helping to guarantee harmonious implementation of minimum capital requirements within the European Union. Regulatory initiatives include the following: guidelines on assessment of the risk of information and communications technology (ICT) within the framework of the process of review and evaluation of the SREP, guidelines on customers connected under the regime of large exposures, guidelines on management of credit risk and expected losses and final guidelines on ILAAP and ICAAP reporting.

Also, in a bid to reduce the variability of capital consumptions not justified by the various risk profiles, thereby enhancing the level playing field and the comparability among banks, in February 2016, the EBA released the final working plan announced in the discussion paper on the future of IRB models. This working plan was launched in 2016 and is expected to continue in 2017. It is focused mainly on releasing a series of regulatory proposals on internal models of credit risk, in a bid to improve sturdiness, comparability and transparency, restore confidence in the models and to ensure consistency by regulators. As part of this working plan, the EBA has released the following:

 

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In July 2016, the final proposal with requirements for appraisal of the use of internal models of credit risk by competent authorities.

 

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In September 2016, final guidelines for the application of the definition of default, with the aim of improving consistency and harmonising the definition of default within the EU prudential framework.

 

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In November 2016, a consultation proposal for the methodology of estimating risk parameters (PD, LGD and treatment of defaulted assets).

 

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In December 2016, the final disclosure requirements to improve comparability and consistency of information between European institutions.

Also, in November 2016, the European Commission published a regulatory proposal that reopens the Capital Requirement Regulation (CRR and CRD IV) to include aspects such as:

 

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New finalised Basel regulatory developments, such as the fundamental review of the trading book (FRTB), the standardised approach for counterparty credit risk (SA-CCR), new disclosure requirements, the HSFR liquidity ratio, the leverage ratio, TLAC and the treatment of the interest rate in the banking book (IRRBB).

 

•

Modifications to the framework of limits on large exposures and in treatment of risk by CVA.

And also include, among others, the following additional aspects that were identified in consultations (published in 2015) on the impact of CRD IV on financing of the economy and the call for evidence that was aimed at assessing the impact of the regulation and identifying obstacles keeping the financial system from performing its function:

 

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Application of the principle of proportionality in reporting and disclosure requirements.

 

•

Introduction of supporting factors for financing of infrastructure projects and improvement of the current SME supporting factor.

 

•

Holding Companies for non-EU GSIBs or assets of at least EUR 30bn.

 

•

Establishment of limits to large exposure risks to European exposures.

 

•

Clarification of MDA, Pillar 2R and Pillar 2G.

In addition, the Commission has still to determine the equivalence of the jurisdictions of third countries (such as, for example, Argentina) based on EBA questionnaires. On CCPs, the Commission extended the transitional period to 15 June 2017 and ruled favourably on the rating of the CCPs of Brazil. Lastly, the EBA published in August 2016 a report on the calibration of the leverage ratio, ahead of the end of its mandate in October 2016. The report introduces a 3% level for all banks and, in line with the Basel Committee, recommends an additional add-on for G-SIBs.

In liquidity, the EBA published in 2016 two consultations aimed at specifying disclosure of the Liquidity Coverage Ratio (LCR) and encumbrance. Meanwhile, the European Commission conducted a consultation on defining and developing the NSFR that served as preparation for the Commission proposal for modifying the CRR that includes a proposal for implementation of the NSFR in Europe.

With respect to supervision, the supervisory activity conducted by the Single Supervisory Mechanism in the framework of the Supervisory Review and Evaluation Process (SREP) is notable. In this area, Banco Santander’s joint supervisory team worked tirelessly in 2016, holding over 100 meetings with the Bank.

Along with the intense agenda of supervision within the framework of the Supervisory Review and Evaluation Process (SREP), the SSM has made great strides towards the harmonisation of supervisory policies across countries, and in the transparency of their expectations.

 

Europe also continues to make progress in the implementation of the crisis management framework. The SRB or Single Resolution Board, the second pillar of Banking Union after the Single Supervisory Mechanism, has been operational since 1 January 2016, and it will undergo gradual mutualisation until the year 2022. This period of gradual mutualisation will allow for a transition from the national resolution funds in place in several eurozone countries until 2016, to the Single Resolution Fund, which will be fully implemented by 2023. In 2016, the first year in the life of the single resolution fund, 60% of the fund’s funding target (1% of covered deposits by 2023) was calculated on the basis of a national perimeter (BRRD perimeter) and 40% on the basis of a eurozone perimeter (SRM perimeter). In 2017, these percentages have been inverted, with 40% of funding in the BRRD perimeter and 60% within the SRM perimeter:

 

Grupo Santander communicates and maintains corporate and local positions on any issues submitted for debate in the financial sector that could affect its business. The corporate and local public policy function, in coordination with the business units and support divisions concerned in each case, identifies the regulatory alerts and establishes Grupo Santander’s position.

The main courses of action taken as a result were as follows:

 

•

Grupo Santander has been a keen participant in the main banking associations worldwide and in Europe, and in the main markets in which we operate. Among other assistance, it contributes to the replies drawn up in connection with ongoing regulatory consultations.

 

•

Grupo Santander has maintained proactive, constructive dialogue with policy-makers through the existing channels (hearings to send individual replies to official consultations on issues considered relevant to Grupo Santander).

 

•

In particular, Grupo Santander has worked towards acknowledgement of the sturdiness of our organisational model with independent subsidiaries in terms of capital and liquidity, the benefits of geographic diversification and recognition of the equivalence of the jurisdictions of third countries where the Bank operates. In addition, one of the Bank’s main objectives is for subsidiaries to adopt advanced return- and capital-based management systems via internal models, given the improvements in comprehensive risk management and adequacy in the calculation of capital these provide.

 

		Note: For further details regarding the new 2016 regulatory requirements, see Appendix I

 

 

2.1. Capital

Capital management and adequacy in Grupo Santander is performed in an integrated way, seeking to guarantee the Bank’s solvency, fulfilment of regulatory requirements and profit maximization. It is determined by the strategic objectives and by risk appetite set by the Board of Directors. In order to achieve this, the following policies have been established to shape the approach that Grupo Santander applies regarding to capital management:

 

•

Establish adequate capital planning that covers current needs and provides the necessary resources to meet the business plan requirements, regulatory requirements and the associated risks in the short and medium term, while maintaining the risk profile approved by the board.

 

•

Ensure that, under stress scenarios, Grupo Santander and its companies maintain enough capital to cover the needs arising from the risk increase due to deterioration of macroeconomic conditions.

 

•

Optimise capital use through appropriate allocation of capital among the businesses, based on the relative return on regulatory and economic capital, considering risk appetite, its growth and strategic objectives.

Grupo Santander has a comfortable solvency position which exceeds the levels required by regulations and by the European Central Bank (hereinafter, ECB).

Table 4. Main capital and solvency ratio figures

     Millions of Euros

 

		Fully loaded								Phase in
EUR million		Dec-16				Dec-15				Dec-16				Dec-15
Common Equity (CET1)			62,068				58,705				73,709				73,478
Tier 1			67,834				64,209				73,709				73,478
Total capital			81,584				76,209				86,337				84,350
Risk wighted assets			588,088				583,917				588,088				585,633
CET1 Ratio			10.55	%			10.05	%			12.53	%			12.55	%
Tier 1 Ratio			11.53	%			11.00	%			12.53	%			12.55	%
TOTAL CAPITAL RATIO			13.87	%			13.05	%			14.68	%			14.40	%

Note: On February 3, 2016, the European Central Bank authorised the use of the Standard Alternative Method for the calculation of capital requirements at consolidated level for operational risk at Banco Santander (Brazil) S.A. The impact of the aforementioned authorization on the risk-weighted assets of Grupo Santander (-7,836 million euros) and consequently its capital ratios was not taken into account in the data published on 27 January 2016 and which are presented in this report for December 15.

 

Grupo Santander’s main solvency ratios at 31 December 2016 are as shown in table 4. Phase-in ratios are calculated applying the transitory schedules for implementation of Basel III, whereas fully loaded are calculated without applying any schedules, hence with the final regulation.

In fully-loaded terms CET1 in December stood at 10.55%, increasing by 50 basis points during the year and reaching the goal at year-end which was announced at the beginning of the year.

The fully-loaded capital ratio was 13.87%, up by 82 basis points during the year.

 

The increase of 50 basis points in 2016 is, mainly due to profit generation and management of risk assets together with some positive non-recurring impacts (regulatory, valuation of portfolios available for sale and others) and negative ones (increased perimeter).

From the point of view of quality, Grupo Santander has solid ratios suited to its business model, the structure of its balance sheet and its risk profile. Grupo Santander exceeds by 328 basis points the 2017 minimum regulatory capital requirements of total ratio taking into account the surplus and shortfall of AT1 y T2 (see section 2.1.5.).

 

 

•

Capital autonomy. The Group’s corporate structure is based on a model of legally independent subsidiaries, each with responsibility for its own capital and liquidity. This helps advantage in raising funds and limits the risk of contagion, thus reducing systemic risk, and subjects subsidiaries to two tiers of supervision and internal control: local and global. The local units have the necessary capital to carry on their activity autonomously and to meet regulatory requirements.

 

•

Centralised monitoring, The capital management model must ensure a holistic view, through a corporate environment of global coordination and review (every business, every geographic region). The first level of monitoring, by the local units themselves, is supplemented by the monitoring activity of the corporate units.

 

•

Appropriate capital distribution, The allocation of capital resources must be consistent with the effective location of risk assumed within the Group and proportional to the risk taken, in order to strike an optimal balance between solvency and profitability. Both the subsidiaries and the parent entity must be adequately capitalised, and capital must be allocated using balanced criteria.

•

Capital strengthening. Independently of the need to operate with a level of adequate capital (available capital) to meet legal requirements, the right mix of capital must also be ensured, encouraging the choice of the eligible elements with the maximum possible quality (based on its loss-absorbing capacity, its likelihood of remaining on the entity’s balance sheet in the longer term, and its ranking in the priority of payments), so as to guarantee the capital stability over time and support the Group’s sustained growth strategy.

 

•

Capital conservation. Capital is a scarce resource which must be used as efficiently as possible, given the high cost of generating capital organically or by resorting to the markets. All units must therefore have ongoing monitoring mechanisms to optimise capital usage.

 

•

Prudent capital management. The fundamental aim of capital management is to preserve the entity’s solvency without losing focus on the return on invested capital. This requires setting capital targets that are consistent with the entity’s risk profile, both locally and globally, so as to limit the levels and types of risk the entity is willing to assume in the course of its business and ensure that capital levels consistent with those risks are maintained.

•

Maximisation of value creation. Investment decisions are aimed at optimising value creation from invested capital. In order to align business management with capital management, a set of metrics relating the cost of capital to the return on capital investment are monitored, allowing the profitability of transactions, customer portfolios and businesses to be compared on a consistent basis.

 

2.1.1. Capital function

The core principles provide the basic guidelines for Grupo Santander entities in capital management, monitoring and control.

2.1.1.1. Organisation

The organisational structure has been defined with to ensure compliance with the principles of capital management, and to guarantee that the existing relationship between each subsidiary and the corporation in this function is such as to facilitate the subsidiary’s financial autonomy, subject to strict monitoring, coordinated at Group level.

Santander’s risk management and control model is based on three lines of defence. The first line is composed of the business functions or activities that assume or generate exposure to risk. Risks undertaken or generated within the first line of defence must be in accordance with appetite and the limited defined. To carry out its function, the first line of defence must have the resources to identify, measure, manage and report the risks assumed. The second line of defence comprises the function of controlling and supervising risk, and the compliance function. The second line is charged with effective control of risks, and ensures that they are managed in accordance with the risk appetite defined.

Internal audit is the third line of defence and the last layer of control, and regularly assesses policies, methods and procedures to ensure they are suitable and also checks they are operational. The risk control function, the compliance function and the Internal Audit function are sufficiently separate and independent from each other and also regarding other functions that they control and supervise in order to carry out their tasks, and have access to the Board of Directors and/or to its Committees at the highest level.

2.1.1.2. Capital governance

To ensure the proper exercise of the capital function, both in terms of decision making and in terms of supervision and control, Grupo Santander has developed a structure of responsive and efficient governance bodies, which ensure the participation of all the areas concerned and guarantee the necessary involvement of senior management. Because of Grupo Santander’s characteristic subsidiaries structure, the governance structure of the capital function has to be adapted to preserve the subsidiaries’ capital autonomy, while allowing centralised monitoring and coordinated management at Group level. There are also committees that have responsibilities both at local level and also for coordination at Group level. The local committees must report to the corporate committees as and when required on any relevant aspects of their activity that may affect capital, so as to ensure proper coordination between the subsidiaries and the corporate level.

 

2.1.2. Capital management and adequacy

The goal of capital management and adequacy at Grupo Santander is to guarantee the entity’s solvency and maximise its profitability, while ensuring compliance with internal capital goals and regulatory requirements. Capital management and control is a fundamental strategic tool for decision making at both local and corporate level, and serves to create a common framework of action by establishing definitions and homogenisation of capital management criteria, policies, functions, metrics and processes.

 

Grupo Santander’s capital function is performed at two levels:

 

•

Regulatory capital: Regulatory capital management is based on the analysis of the capital base, the solvency ratios as defined by applicable regulation and the scenarios used in capital planning. The aim of the capital structure is to be as efficient as possible, both in terms of cost and in terms of compliance with the requirements of regulators. Active capital management includes strategies for capital allocation and for efficient usage of business units, securitisations, asset sales and issues of capital instruments (preferred stock, subordinated debt) and hybrid capital instruments.

 

•

Economic capital: Economic capital management aims to optimise value creation in the Group and its business units. For this purpose, economic capital, RORAC and value creation per business unit are calculated, analysed and reported to the capital management committee. Within the framework of the internal capital adequacy assessment process (Basel Pillar II), Grupo Santander uses an economic capital measurement model to ensure that sufficient capital is available to support all the risks of its activity under several economic scenarios, and with the capital adequacy levels set by the Group.

 

2.1.3. Capital management priorities in 2016

Details of the most significant actions taken in 2016 are set out below:

Issues of financial instruments with the legal status of capital

In April Banco Santander S.A. issued EUR 1,500 million in subordinated debt eligible as Tier 2 capital with a fixed annual return of 3.25%, to boost its overall capital ratio.

In June and August Banco Santander S.A. issued the total equivalent of EUR 84 million in two private issues of subordinated debt in yens eligible as Tier 2 capital with fixed annual returns of 1.94% and 2.195% respectively, to boost its overall capital ratio.

In September Banco Santander S.A. issued the equivalent of EUR 125 million in a private issue of subordinated debt in dollars eligible as Tier 2 capital with a fixed annual return of 4.65%, to boost its overall capital ratio.

Also, in October, November and December Banco Santander S.A. issued the equivalent of EUR 493 million in three issues of subordinated debt in dollars with fixed annual returns of 4.75%, 5.25% and 5.25% respectively; and in December it issued EUR 110 million in two issues of subordinated debt with fixed annual returns of 4.35% and 4.46%, all of which were intended to boost the total capital ratio, although their Tier 2 eligibility is still pending ECB approval.

Finally, in December Bank Zachodni WBK S.A. issued EUR 120 million of subordinated debt to boost the overall capital ratio, and this is pending KNF approval to be eligible as Tier 2 capital. ]

Dividend policy

In 2016 cash pay-outs were maintained for most quarterly remuneration, and it was announced that remuneration charged against 2016 would be EUR 0.21—three cash dividends, and a scrip dividend (Santander Dividendo Elección) of EUR 0.045 per share. It was also announced that cash pay-outs this year and in the years following would account for 30%-40% of profits, and shareholder remuneration would be in line with rising profits.

Targets were met in 2016, with an effective dividend of 40% of profits and an increase of the per-share cash dividend of 8%.

In December 2016 the European Central Bank issued a recommendation for dividend allocation policies, applicable to all Eurozone credit institutions as of 2016. The recommendation urges banks to establish conservative dividend policies with prudent assumptions.

Finally, in some areas restrictions on the distribution of dividends were established on the basis of the new more stringent regulation concerning solvency although, notwithstanding the objections voiced by the Boston Federal Reserve concerning the Comprehensive Capital Analysis Review (CCAR) of the sub-holding of our subsidiary in the United States and the new dividend policy published by the National Competent Authority of our subsidiary in Poland (KNF) for Banks with significant participation in foreign currency mortgages, there is no record of any other practical or legal impediment, to the transfer of funds from the subsidiaries to the parent through dividends, loans or advances, repatriation of capital or other instruments, by Grupo Santander subsidiaries.

2.1.4. Capital goals

Grupo Santander is working with the objective of achieving a fully loaded CET 1 ratio of above 11% in 2018.

 

The continuous improvement in capital ratios reflects the profitable growth strategy followed by the Group, where we aim to increase lending and profits above the increase in risk assets. It is also due to a number of actions taken by the Group, including the effort to improve and deepen a culture of more active capital management throughout the organization.

 

To achieve this, a number of instruments have been activated or strengthened during the year, including:

 

•

Increases in teams dedicated to management of capital, while improvements continue to be made in coordination of the corporate center and local teams.

 

•

Greater weight of capital in 2016 incentives.

 

•

The launch of a global training programme.

 

•

All local units and business units have developed individual capital plans with the priority of having a business that consumes less capital per unit of return in the future.

2.1.5. Capital buffers and eligible capital requirements

At all times the Group must meet the combined capital buffer requisite, understood as the total ordinary Tier 1 capital necessary to meet the obligation to maintain the following:

 

•

Capital conservation buffer (CCoB): obligatory for all entities, phased-in beginning on 1 January 2016. So that the surcharge for entities in 2017 will be 1.25%.

 

•

Systemic buffers: a four-year phase-in period is established for systemic buffers. This includes two types:

 

•

Systemically Important Institutions: for entities designated as systemically important, using a common methodology. There are two different sub-categories, with the largest buffer rate of the two being applicable:

 

1.

G-SIB buffer (Global Systemically Important Institutions): Common methodology, classifying the different entities into buckets based on their systemic risk.

 

2.

D-SIB buffer (Other Systemically Important Institutions).

 

•

Systemic risk buffer (SRB): for entities with systemic importance that must hold additional loss-absorbing capacity. This buffer is discretionary in nature and applicable to either all exposures of an entity or to part of its exposures (domestic and/or foreign, specific business sector, etc.), as determined by the relevant authorities.

If the SRB covers all types of exposures, the greatest of the three systemic buffer rates will be applied. If the SRB only applies to a certain type of exposure, the SRB buffer will be added to the greater of the other two systemic buffers (G-SII and O-SII).

 

•

Countercyclical buffer (CCyB): The CCyB will be applied when the authorities deem that lending growth is giving rise to an unacceptable accumulation of systemic risks. This buffer is specifically calculated for each bank or group, and consists of the weighted average of percentages of countercyclical buffers applied in regions in which the bank’s credit exposures are located.

The table below summarizes the required regulatory rates based on the different capital buffers to be applied, along with the phase-in timeline and Grupo Santander’s situation in 2017:

Applicable to		Buffers (% RWAs)		2016		2017		2018		2019
All entities		Conservation (CCoB)		0.625%		1.25%		1.875%		2.5%
Designated		G-SIB entities (1% - 3%) (1)		25% of buffer		50% of buffer		75% of buffer		100% of buffer
entities		D-SIB entities (2)		25% of buffer		50% of buffer		75% of buffer		100% of buffer
At discretion		Systemic risk (SRB) (3)		0%-5%		0%-5%		0%-5%		0%-5%
of competent national authority		Countercyclical (CCyB) (4)		0%- 0.625%		0%-1.25%		0% - 1.875%		0% - 2.5%
		Consolidated		CCoB + CCyB + Max (5)
		combined buffer		(G-SIB, D-SIB, SRB)

 

(1)	Global Systemically Important Institutions. FSB has published for 2017, and has demanded a total buffer of 1% for Santander (this means that 0.50% is required in 2017).

(2)	Other Systemically Important Institutions. The Bank of Spain requires a 1% buffer for Santander (this means that 0.5% is required in 2017.

(3)	To Grupo Santander the requirement by this concept is of 0%.

(4)	Bank of Spain, first quarter of 2017: exposures located in Spain: 0%.

(5)	The maximum of the 3 buffers applies if the SRB buffer covers domestic and non-domestic exposures. Otherwise, the higher of G-SIB and D-SIB plus the SRB buffer applies.

Capital requirements

The decision on capital, which is the result of the Supervisory Review and Evaluation Process (SREP) of the European Central Bank’s (ECB) Single Supervisory Mechanism, for the first time consists of a Pillar 2 Requirement (Pillar 2R) and Pillar 2 Guidance (Pillar 2G). Pillar 2R is binding, and failure to comply may have direct legal consequences for banks. Pillar 2G is not directly binding, and failure to comply with it is not significant in terms of the Maximum Distributable Amount (MDA). In addition, the latter does not automatically produce action by the ECB. However, the ECB does expect compliance with the Pillar 2G at all times. If a bank is not compliant with Pillar 2G, the ECB will give careful consideration to the reasons and circumstances therefore and may devise additional supervisory measures for control. In deciding whether to require an additional buffer under Pillar 2G, the ECB will make use of the bank’s stress test results, among other data.

At the end of 2016 the ECB sent each bank the minimum prudential capital requirements for the following year. In 2017, Grupo Santander must maintain a minimum consolidated capital ratio of 7.75% of phase-in CET1 (Pillar I requires 4.5%, Pillar II 1.5%, 1.25% is the capital conservation buffer requirement and 0.50% the G-SIB requirement). Grupo Santander must also maintain a minimum capital ratio of 9.25% for phase-in T1, and a minimum total ratio of 11.25% for phase-in. At 31 December 2016, Banco Santander had a CET1 regulatory capital ratio of 12.53% and a total ratio of 14.68%.

 

 

1.	Global Systemically Important Banks,

2.	Conservation Capital Buffer

2.1.5.1 Global systemically important financial institutions

Grupo Santander is one of the 30 institutions designated as global systemically important institution.

The situation of global systemically important financial institutions may jeopardize the financial stability. Bankruptcy of a systemically important institution, or even its mere expectation, could generate adverse effects of an unpredictable scale on the financial system and even the real economy

This requires special prudential treatment, which has led to the introduction of specific capital buffer requirements for both global (G-SIB) and domestic (D-SIB) systemically important financial institutions.

This designation requires Grupo Santander to meet additional requirements mainly relating to the following:

 

•

Its capital buffer (we are in the group of banks with the smallest capital buffer, 1%)

 

•

TLAC (Total Loss-Absorbing Capacity) requirements

 

•

The requirement to publish relevant information with more frequency than other banks

 

•

Greater regulatory requirements for the internal control bodies

 

•

Special supervision

 

•

The requirement to submit special reports to the supervisors

The designation as an entity that is globally systemically important is made by the Basel Committee, together with the Financial Stability Board, using a metric that will be modified in 2017. This metric is currently based on five “indicators” (size, interjurisdictional activity, interconnection with other financial entities, substitutability and complexity).

 

For the evaluation of these risks banks with a leveraged position in excess of 200bn Euros (76 banks as of December 2014) are required to publish information before 30 April of the following years (see the Investor Relations section of the corporate website for more details regarding quantitative indicators for Grupo Santander).

On the basis of this information a global indicator is developed. The score obtained by each bank will determine the size of the additional loss absorbency requirement, demanded in accordance with the buckets defined by regulators.

In November 2016, the Financial Stability Board (FSB) released the list of global systematically important financial institutions, based on December 2015 data, which will become applicable in 2018. Compliance with these requirements provides Grupo Santander with greater solidity than its domestic competitors. At present, Grupo Santander has an additional capital buffer of 1%.

 

Table 6. Global systemically important financial institutions

 

Capital buffer		Entity
5 (-3.50%)		(Empty)
4 (-2.50%)		Citigroup
		JP Morgan Chase
		Bank of America
3 (-2.00%)		BNP Paribas
		Deutsche Bank
		HSBC
		Barclays
		Credit Suisse
		Goldman Sachs
2 (-1.50%)		Industrial and Commercial
		Bank of China Limited
		Mitsubishi UFJ FG
		Wells Fargo
		Agricultural Bank of China
		Bank of China
		Bank of New York Mellon
		China Constructuon Bank
		Groupe BPCE
		Group Crédit Agricole
		ING Bank
		Mizuho FG
		Morgan Stanley
1 (-1.00%)		Nordea
		Royal Bank of Scotland
		Santander
		Société Générale
		Société Générale
		Standard Chartered
		State Street
		Sumitomo Mitsui FG
		UBS
		Unicredit Group

2.5.1.2. Domestic systemically important entities

In order to identify other systemically important entities, the Bank of Spain applies a mix of guidelines based on size, importance, complexity and the degree of interconnection between entities. Bank of Spain reviews the classification annually, considering in 2016 the following entities:

Grupo Santander is on the lists of both global and domestic systemically important financial institutions. Bank of Spain, based on the Norm 23 from Circular 2/2016, requires the application of the highest of both corresponding buffers.

2.2. Pillar I regulatory capital

The current regulatory framework for capital calculation is based on three pillars:

 

•

Pillar I sets the minimum capital requirement for credit, market and operational risk, allowing the possibility of using internal ratings and internal models (IRB approach) for calculating credit-risk-weighted average exposures, internal models for market risk and internal models for operational risk. The aim is to make the regulatory requirements more sensitive to the risks actually incurred by financial institutions in carrying out their business activities.

 

•

Pillar II establishes a system of supervisory review, aimed at improving banks’ internal risk management and capital adequacy self-assessment in line with their risk profile.

 

•

Lastly, Pillar III defines the elements related to market discipline and disclosure.

2.2.1. Eligible capital

Total eligible capital, after retained earnings, amounts to EUR 105,978, up EUR 3,575 million in the year (3.4%).

In January 2015, Banco Santander carried out a capital increase of EUR 7,500 million, through the issue of 1,213 million new shares. In addition, during 2016 the bank launched an ordinary share issue to meet the demand of shareholders opting to receive an amount equal to dividends in shares under the Santander Dividendo Elección programme. Hence, under the scrip dividend carried out in the year, a total of 147,848,122 shares have been issued, with a combined take-up of 89.1%.

Valuation adjustments decreased by EUR 678 million, mainly due to the net impact of exchange rate fluctuations, valuations of the available-for-sale portfolio and changes in actuarial losses.

A reconciliation of accounting capital, which is the subject of the preceding paragraphs, to regulatory capital is shown below:

 

The following table provides a breakdown of the Group’s eligible capital and a comparison with the previous year:

 

Common equity tier 1 (CET1) capital comprises the elements of Tier 1 capital (applying prudential filters) and CET1 deductions after applying the threshold exemptions specified in the CRR. The CRR provides for a phase-in period that will give institutions time to adapt to the new requirements in the European Union. This phase-in applies to Grupo Santander under EU Regulation 2016/445 of the European Central Bank on the exercise of options and discretions published on 14 March 2016.

Without considering the phase-in schedule, CET1 is made up of:

 

•

Subscribed share capital, which stood at EUR 7,291 million in December 2016

 

•

Other tier 1 capital items: (i) paid-up share premium; (ii) effective and disclosed reserves generated against profits and those amounts that are not taken to the income statement but are recorded under “Other reserves” (any item); (iii) other retained earnings, which includes certain valuation adjustments, primarily for exchange differences and for hedges of net investments in foreign operations.

 

•

The paid-up portion of any minority interest arising from the issue of ordinary shares by consolidated companies, subject to the limits specified in the CRR.

 

•

Attributable profit net of dividends, which stood at EUR 3,735 million in December 2016.

 

•

The prudential filters exclude any gain or loss on cash flow hedges. They also exclude gains or losses on liabilities and liabilities from derivatives valued at fair value resulting from changes in the institution’s own credit standing.

 

•

The deductions from CET1 items: treasury shares; losses for the current financial year; goodwill and other intangible assets recognized in the balance sheet; deferred tax assets that rely on future profitability (with the limitations specified in the CRR); the expected loss on equity exposures and defined-benefit pension fund assets on the balance sheet.

Tier 1 capital comprises CET1 capital plus Additional Tier 1 (AT1) capital, including preferred securities issued by the Group less the deductions from AT1, consisting essentially of direct, indirect or synthetic holdings of own AT1 instruments and AT1 instruments of other financial sector entities.

Tier 2 capital comprises Tier 1 capital plus Tier 2 capital (T2 and include the following items, among others:

 

•

Capital instruments and subordinated loans where the conditions laid down in the CRR are met.

 

•

The carrying amount of the general provision for portfolios subject to the Standardised approach, up to a maximum of 1.25% of the credit risk-weighted assets used as the basis for calculating the general provision.

 

•

Any excess of the sum of impairment loss allowances and risk provisions for IRB exposures over the expected losses on those exposures, up to a maximum of 0.6% of credit-risk-weighted assets calculated under the IRB approach.

•

Deductions from Tier 2 capital, which consist essentially of direct, indirect or synthetic holdings of own Tier 2 instruments and Tier 2 instruments of other financial sector entities.

Table 9. Flow statement. Regulatory capital

     Thousands of Euros

 

		31 Dec. 2016
Core Tier 1 capital
Starting figure (31/12/2015)			73,478,132
Shares issued during the year and share premium account			-14,785
Treasury shares and own shares financed			204,030
Reserves			-439,183
Attributable profit net of dividends			3,735,436
Changes in other retained earnings			-1,488,797
Minority interests			193,224
Decrease/(increase) in goodwill and other intangibles			1,962
Other deductions			-1,961,160
End figure (31/12/2016)			73,708,859
		31 Dec. 2016
Additional Tier 1 capital
Starting figure (31/12/2015)			—
Eligible instruments AT1			-101,093
T1 excesses - subsidiaries			254,205
Residual value of intangibles			-153,113
Deductions			—
End figure (31/12/2016)			—
		31 Dec. 2016
Capital Tier II
Starting figure (31/12/2015)			10,871,630
Eligible instruments T2			2,102,275
Gen, funds and surplus loan loss prov, IRB			-373,455
T2 excesses - subsidiaries			27,591
Deductions			—
End figure (31/12/2016)			12,628,041
Deductions from total capital			—
FINAL FIGURE FOR TOTAL CAPITAL (31/12/2016)			86,336,900

 

Total eligible capital rose EUR 1,987 million from 2015 to 2016, to EUR 86,337 million.

Regulatory capital changes include the estimated cash dividend for 2016 (EUR 2,469 million), which brings attributable profit net of dividends to EUR 3,735 million.

Minority interests rose, primarily due to earnings generated during the period and to incorporation of PSA. Movement in “Other retained earnings” mainly reflects valuation adjustments due to the above-mentioned fluctuations.

Other deductions are impacted mainly by the application of the phase-in period of Basel III, changes in deductions for deferred tax assets and the greater impact of prudential filters of prudent value adjustments.

During 2016, eligible Tier 2 capital instruments increased, primarily due to new preference share issues by Santander Issuances for EUR 2,302 million.

2.2.2. Capital requirements

This section gives details of capital requirements by risk type and portfolio (see Table 11) and by geography (see Table 12). Table 10 shows that capital requirements barely changed from 2015 to 2016, maintaining a Pillar I risk distribution similar to that of the prior year: credit risk 85%, market risk 4% and operational risk 11%.

Capital requirements for credit risk increased 1.7% compared to 2015 up to 40,074 MM €. On the other hand, capital requirements for market and operational risk fell 5% and 7,3%, respectively.

 

		Note: Further details on the causes behind these variations are provided in sections 2.2.2.1, 2.2.2.3 and 2.2.2.4

 

 

 

 

 

 

 

 

A general overview of total RWA by type of risk is provided below. Moreover, in the next sections additional disclosures are presented.