1.1. Executive summary*

In 2017, Santander Group conducted its business in a more favourable economic environment than in preceding years. Low interest rates in mature markets were the most adverse factor for the banking business. Against this backdrop, our robust business model enabled us to deliver double-digit growth in the Group’s underlying profit and that of most of the countries where we operate. Our RoTE was among the best in the sector, and we combined balance sheet growth with better capital ratios and a higher dividend per share.

Our strategic priorities were to:

1. Press forward with our commercial transformation, both in traditional banks and through our independent units operating under the start-up model. The three pillars of our transformation programme are to:

 

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Improve customer loyalty through innovative, simple and tailored solutions. Among other actions, we continued to secure the 1|2|3 strategy in various countries, adapted our global strategy for the SME segment to the local characteristics of each market, achieved strong growth in the cards market, particularly in Spain and Brazil, and created the Wealth Management division in order to enhance the service we provide to our private banking and asset management customers. On the back of this transformation process, we now have 17.3 million loyal customers (a 13% year-on-year increase).

 

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Promote the digital transformation of channels, products and services. Initiatives such as Digilosofia in Spain, the fully digital Openbank, Superdigital in Brazil, the Cash Nexus payment platform, Santander Pay, the new global machine learning platform and other initiatives are driving the digital transformation and significantly improving the customer experience as well as opening new sources of revenue. This strategy enabled us in 2017 to increase the number of both digital customers (by more than 4 million to over 25 million) and digital transactions (around 40% of the total).

 

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Continue to improve customer satisfaction and experience with simpler and more efficient processes, underpinned by a multichannel offering. At year-end, seven of our units were among the top three local banks in their respective countries for customer satisfaction. We were named Global Bank of the Year and Bank of the Year, Latin America, by The Banker magazine as well as Best Bank in the World for SMEs and Best Bank in Latin America by Euromoney.

2. Strengthen our position in the markets where we operate. The most notable transaction was our acquisition of Banco Popular, which enabled us to strengthen our leading position in Spain and to become the largest private sector bank in Portugal in terms of domestic business. We also reinforced our position in retail banking in Argentina, increased stake in the United States and closed an agreement to acquire Deutsche Bank’s commercial and retail banking business in Poland.

3. Exit non-core businesses. Our main actions were the sale of TotalBank in the United States and 51% of Banco Popular’s real estate business.

As regards business performance, activity and results grew, profitability was higher and the balance sheet stronger.

Growth. Fluctuations in exchange rates and changes in our perimeter had a significant impact on balances in 2017.

Excluding the forex impact, lending rose by 12%, spurred by the integration of Banco Popular (disregarding this factor, by 2%). On a like-for-like basis, seven units improved. Of particular note were Argentina (+44%, driven by consumer credit and SMEs), Brazil (+7%, due to the strong performance of individual customers and SMEs), Portugal (+8%, partly as a result of a corporate transaction), SCF (+6% due to auto finance) and Poland (+5% from SMEs and corporates).

Customer funds rose 17% (excluding the forex impact), benefiting from the integration of Banco Popular. Excluding Popular, funds increased 8%, due mainly to demand deposits and investment funds, and they rose in eight of the core countries (including double-digit growth in Latin America).

Santander’s business model and geographic diversification between mature and developing countries enable it to generate stable, recurring profits.

Although exchange rates did affect the balance sheet, their impact on the income statement was virtually zero.

Underlying profit before tax was €13,550 million, 20% more than in 2016. The Group’s strength is reflected in its main line items:

 

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A record year for gross income (€48,392 million, a 10% increase), with double-digit growth in net interest income and fee income - together, these two items accounted for 95% of total revenues.

 

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Stable costs in real terms and on a like-for-like basis, despite higher costs related to regulatory matters and investments in the transformation process. Santander Group is one of the world’s most efficient banks, with a cost-to-income ratio of 47%.

 

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Continuous improvement in credit quality, as reflected in a 4% fall in provisions and an improvement in the cost of credit to 1.07%.

A higher tax charge in the lower part of the income statement, as well as some positive and negative non-recurring results in net capital gains and provisions, which totalled €897 million net of tax (€417 million in 2016).

The Group’s attributable profit was €6,619 million (+7%). Excluding Banco Popular, which recorded a loss of €37 million as a result of integration costs, attributable profit stood at €6,656 million.

Profitability. Raising profitability and creating shareholder value were among our main priorities.

Our capacity to generate stable, recurring profits over the last few years has enabled us to accumulate capital, finance business growth and boost total shareholder return in cash.

In 2017, the underlying RoTE was 11.8% and the underlying RoRWA 1.48%, both up on 2016. We increased attributable profit per share by 1% (8% in underlying profit terms) and raised the cash dividend per share by 11%.

The market viewed our strategy and its impact on business and results favourably. Total shareholder return (TSR) was 17%, outperforming the DJ Stoxx Banks and DJ Stoxx 50.

Strength. Santander has a medium-low risk profile and high-quality assets. Our proactive risk management gives us credit quality ratios that are among the best in the sector. We have an NPL ratio of 4.08% (+15 bp as a result of the acquisition of Banco Popular) and a coverage ratio of 65%. Excluding Popular, the NPL ratio was 3.38%, 55 bp lower than in 2016, our fourth consecutive improvement.

In addition, our cost of credit improved further, to 1.07%, 11 bp lower than in 2016.

Almost all the countries where the Group operates improved their credit quality ratios. The NPL ratio was lower in eight countries and the cost of credit, in seven.

We generated capital continuously each quarter (+29 bp), reaching a fully loaded CET1 of 10.84%, higher than our target and putting us well on track to attain our objective of 11% in 2018.

We comfortably met the minimum regulatory requirements, ending the year with a phased-in CET1 of 12.26%, well above the minimum requirement.

 

∎	REGULATORY CAPITAL

 

 

1.	Global Systemically Important Banks buffer

2.	Conservation capital buffer

3.	Anti-cyclical capital buffer Calculated using September 2017 data for requirement as at 1 January 2018.

 

∎	2017 CET1 FULLY LOADED EVOLUTION

 

 

∎	FLOW STATEMENT. CAPITAL REQUIREMENT FOR CREDIT RISK (CR8)*

Millions of Euros
		RWA				Capital
Starting figure (31/12/2016)			500,216				40,017
Asset size			4,677				374
Asset quality			—				—
Model updates			-7,407				-593
Methodology and policy			—				—
Acquisitions and disposals			49,562				3,966
Foreign exchange movements			-29,915				-2,393
Other			—				—
Ending figure (31/12/2017)			517,133				41,371

 

*	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 (31/12/2016)			4.887				61.084
Application of the ASA approach in Mexico			145				1.810
Sale of the Allfunds company			8				96
Management companies by global method			63				783
Incorporation Popular Spain			376				4.698
Incorporation Popular Portugal			25				314
Exchange rate effect			328				4.102
Change in business			28				346
Ending figure (31/12/2017)			4,897				61,217

 

∎	CAPITAL REQUIREMENTS FOR MARKET RISK STANDARDISED APPROACH

Million of Euros
		Capital				RWAs
Starting figure (31/12/2016)			949				11,863
Change in calculation basis of MMPP.			-13				-163
Banco Popular integration			116				1,448
Changes in business			-276				-3,446
Ending figure (31/12/2017)			776				9,702

∎	RoRAC AND VALUE CREATION

Millions of Euros
		31 Dec. 2017								31 Dec. 2016
Main segments		RoRAC				Value creation				RoRAC				Value creation
Continental Europe			19.7	%			2,110				17.3	%			1,426
UK			19.3	%			764				20.2	%			825
Latin America			41.8	%			4,049				33.1	%			2,879
US			8.9	%			22				9.2	%			-13
Total business unit			23.9	%			6,946				20.7	%			5,117

 

1.2. Overview of Pillar 3 at Santander Group

 

1.2.1. Background information on Santander Group

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 Santander Group. The CRR and CRD IV and their transposition in Spain through Bank of Spain Circular 2/2016, on supervision and solvency, apply on a consolidated level across the entire Santander Group.

At the end of 2017, Santander Group was the largest bank in the euro area and the fourteenth largest in the world in terms of stock market capitalisation: EUR 88,410 million.

Its business model is focused on commercial banking products and services with the aim of meeting the needs of its 133 million customers, including private individuals, SMEs and businesses. The Group operates through a global network of 13,697 branch offices, the most extensive in international banking, as well as digital channels, in order to provide top-quality service and the utmost flexibility. Santander Group has EUR 1,444 billion in assets and manages customers funds worth EUR 986 billion across all its customer segments. It has over 4 million shareholders and over 200,000 employees. Commercial and retail banking accounts for 89% of the Group’s income.

At present, Santander Group’s vision is to be the best retail and commercial bank by earning the trust and loyalty of employees, customers, shareholders and society at large, all under the Simple, Personal and Fair corporate culture. Looking ahead, it aims to become the best open digital platform for financial services.

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

In application of Part I (General Provisions) of the CRR, certain Santander Group companies are consolidated using a different method to that used for 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 the 2017 Pillar 3 Appendix document, available on the Santander Group website. As of the reporting date, both types of investment are exempt from deduction pursuant to article 48 of the CRR.

 

Santander Group does not make use of the exemption contemplated in article 49 of the CRR, therefore the disclosure of table INS1 (Non-deducted participations in insurance undertakings) does not apply.

As of 31 December 2017, 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 Santander Group subsidiaries.

On 7 June 2017, Banco Santander announced the acquisition of 100% of the share capital of Banco Popular Español, S.A. As a result, Banco Popular becomes part of Santander Group. Therefore, every amount contained in this report from june 2017 onwards, both in tables and graphs, is shown at a consolidated level taking into account the aforementioned acquisition.

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

For all those aspects whose disclosure is required under Part Eight of the CRR and which are not applicable to Santander Group, see Appendix I – CRR Mapping –, where they are reported as “N/A” (not applicable).

 

1.2.2. Structure of the 2017 Pillar 3 Disclosures Report

Santander’s Pillar 3 Disclosures Report is divided into eight chapters and three appendices. The first chapter describes the background to Pillar 3 at Santander Group, material events affecting the Group that occurred in 2017 and the regulatory environment.

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

Chapters 3 to 7 describe the risk function at Santander Group and provide detailed information on credit risk, securitisation, market and ALM risk, operational risk, liquidity risk, compliance and conduct risk, capital risks and a description of the Internal Control function.

 

Chapter 8 contains information on remuneration policy.

The appendices contain a CRR Mapping that shows the primary location in the report of the disclosed information according to Part Eight of the CRR and a list of the tables contained in the report, as well as a glossary for a better understanding of the report.

The Santander website contains 7 appendices in editable format with the information required under prevailing legislation in relation to various different aspects, including eligible capital, the issue of preferred and subordinated debt and the different consolidation methods for Santander Group’s subsidiaries.

Throughout the report, cross references to other public documents can be found, enlarging the content of this report via QR codes and hyperlinks:

 

 

1.2.3. Governance: approval and publication

Pursuant to the official disclosure policy Santander Group publishes its annual Pillar 3 Disclosures following board approval. Prior to the board of directors’ approval on 13 February 2018, the report was reviewed by the risk, regulation and compliance committee at a meeting held on 29 January and also by the capital committee at a meeting held on 8 February 2018.

In addition, a set of quarterly information has been published since March 2015 in compliance with the “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 proprietary or confidential.

During April, the Joint Supervisory Team (JST) conducted a review of last year´s annual Pillar 3 Disclosure Report, in order to verify its compliance with the disclosure requirements provided by the CRR, without reporting any significant objection in their analysis. Appendix I contains a list showing the location of the information disclosed in accordance with the relevant articles of Part Eight of the Regulation.

In line with corporate governance recommendations on the rotation of the external auditor, the annual general meeting held on 18 March 2016 appointed PricewaterhouseCoopers Auditores S.L. (PwC) as external auditor of the Bank and of its Consolidated Group for 2016, 2017 and 2018.

 

Senior management certification

The board of directors of Santander Group certify that the publication of the Pillar 3 disclosures report is compliant with the guidelines of Part Eight of Regulation (EU) 575/2013 and consistent with the “Pillar 3 Disclosures Policy” adopted by the board of directors.

The Pillar 3 disclosures report relies on a range of processes relating to the internal control framework, duties and responsibilities having been defined for review and certification of the information set out in the report at several levels of the organisation. In addition, the external auditors carry out an ex ante review, and the work plans for recurring reviews by internal audit also cover this report.

The Pillar 3 Disclosures Report is available in the “Shareholders and Investors” section of the Santander Group website (www.santander. com), under “Financial and Economic Information”.

 

Disclosures of Santander Group subsidiaries

In addition to the information contained in this report, Santander Group subsidiaries that are considered to have significant importance for their local market, pursuant to article 13 of the CRR (Application of disclosure requirements on a consolidated basis), publish information on their websites in relation to: own funds, capital requirements, capital buffers, credit risk adjustments, remuneration policy and the application of credit risk mitigation techniques.

 

1.2.4. Transparency enhancements

In recent years, Santander Group has taken note of the recommendation issued by different international bodies with the aim of improving the transparency of the information published each year in the Pillar 3 Disclosures Report.

In December 2016, the European Banking Association (EBA) published its final guidelines on disclosure requirements under Part Eight of the Capital Requirements Regulation. These guidelines apply from this year onward and provide guidance to financial institutions on how to comply with applicable regulations.

Meanwhile, in March 2017 the Basel Committee released the second phase of its “Revised Pillar 3 Disclosure Requirement”, which we believe will be transposed by the EBA during 2018.

The following graph shows the expected legislative timeframe for the upcoming years:

 

Santander Group has now incorporated all of this year’s applicable enhancements. Appendix I provides a list showing the location of the information required under the different articles of Part Eight of the CRR, while the Santander Group website includes a file containing all of the tables shown in this document in editable format to facilitate their treatment.

 

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 capital ratio based on the nature of their business activities, Santander Group units included in the prudential scope of consolidation are consolidated using the full consolidation method, with the exception of jointly controlled entities, which uses proportionate consolidation. All companies that cannot be consolidated based on their business 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, such as financial reporting, regulatory capital reporting or management information. The exposure data included in the quantitative disclosures in this document are used for calculating regulatory capital.

Appendix IV found on the Santander Group website contains table LI3, which provides information on the consolidation method used for each Group company based on the various scopes of accounting and prudential consolidation.

 

1.2.6. Disclosure criteria used in this report

This report has been prepared in accordance with the applicable European Capital Requirements Regulation (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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Criteria used when 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 following table shows the relationship between the various categories of the financial statements and the risk categories in accordance with prudential requirements.

 

Shown below are the main differences between the accounting values appearing on the financial statements and the exposures for prudential purposes.:

 

The reconciliation of public and non-public balance sheets is shown in Appendix V.

 

1.2.7. Substantial amendments due to a change in perimeter 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 Santander Group last year:

a) Acquisition of Banco Popular Español, S.A.

On 7 June 2017 (the acquisition date), the Group, as part of its strategy for growth in the markets where it operates, acquired 100% of the share capital of Banco Popular Español, S.A. (Banco Popular) under the framework of the resolution system adopted by the Single Resolution Board (“SRB”) and executed by the Spanish Fund for Orderly Bank Restructuring (“FROB”), in accordance with EU Regulation 806/2014 of the European Parliament and of the Council, of 15 July, Directive 2014/59/EU of the European Parliament and of the Council, of 15 May 2014, and Law 11/2015, of 18 June, on the recovery and resolution of credit institutions and investment firms.

Within the framework of the execution of this resolution, the following has occurred:

 

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All of Banco Popular’s shares in circulation at the close of 7 June 2017 and the shares resulting from the conversion of the regulatory Additional Tier 1 capital instruments issued by Banco Popular have been converted into unavailable reserves.

 

•

The conversion of all regulatory capital Tier 2 instruments issued by Banco Popular into newly issued Banco Popular shares, all of which have been acquired by Banco Santander for the price of one euro.

The operation was authorised by the European Commission on 8 August 2017. However, regulatory approval is still pending with regard to the indirect acquisition of some of Banco Popular’s subsidiaries located in the United States.

b) Agreement for the sale of Banco Popular’s property business

With regard to Banco Popular’s property business, on 8 August 2017, Banco Santander reported the transaction between Banco Popular and the Blackstone fund relating to the acquisition by the fund of 51%, and therefore control, of the aforementioned property business comprising the portfolio of repossessed properties, doubtful debts from the property sector and other assets related to this activity of Banco Popular and its subsidiaries (including deferred tax assets) registered on certain specific dates (31 March or 30 April 2017).

 

The signing took place once the European Commission had authorised the acquisition of Banco Popular by Banco Santander, without imposing restrictions, having examined the transaction from a competition law perspective.

Completing the transaction will result in the creation of a company to which Banco Popular will transfer the business consisting of the aforementioned assets, 100% of the capital of Aliseda Servicios de Gestión Inmobiliaria, S.L. (“Aliseda”) and other subsidiary companies included in the transaction. The valuation attributed to the assets in Spain (properties, loans and tax assets, without including Aliseda and the other subsidiary companies) is approximately €10 billion but is subject to final determination depending on the volume of assets remaining on the completion date and the integration of Aliseda and all other subsidiary companies. Management of the capital of the joint venture will be assigned to Blackstone on completion.

The transaction is subject to obtaining, no later than 30 March 2018, the necessary regulatory authorisations and other conditions that are normal for this type of transaction. It is expected that these authorisations and conditions will be obtained and fulfilled by that date, resulting in completion during the first quarter of 2018.

As of 31 December 2017, in accordance with IFRS 5, the assets relating to this transaction have been classified under non-current assets and disposable groups of elements classified as held for sale. The earnings generated by these assets during the 2017 financial year have no material impact on the Group’s income statement. Once the relevant regulatory authorisations have been obtained, the transaction will involve the derecognition of these assets from the Group’s balance sheet, with no material impact on the income statement.

c) Acquisition of the shareholding of DDFS LLC in Santander Consumer USA Holdings Inc. (SCUSA)

On 2 July 2015, the Group reported that it had reached an agreement to purchase the 9.65% shareholding that DDFS LLC held in SCUSA.

On 15 November 2017, after having agreed some amendments to the original agreement and having obtained the relevant regulatory authorisations, the Group completed the acquisition of 9.65% of SCUSA’s shares for a total amount of $942 million, which meant a decrease of €492 million in the balance of minority interests and a reduction in reserves amounting to €307 million. Following this transaction, the Group’s shareholding in SCUSA amounts to approximately 68.12%.

d) Agreement regarding Santander Asset Management

 

i)	Acquisition of 50% of Santander Asset Management

On 16 November 2016, following the abandonment, agreed with the Unicredit Group on 27 July 2016, of the merger project involving Santander Asset Management and Pioneer Investments, the Group reported that it had reached an agreement with Warburg Pincus (“WP”) and General Atlantic (“GA”) through which on 22 December 2017 Santander acquired from these companies their 50% shareholding in Santander Asset Management.

Santander Group has paid a total sum of €545 million and has assumed financing of €439 million, the business combination generating goodwill of €1,173 million and €320 million of “intangible assets – contracts and relations with customers” identified in the preliminary assignment of the price, with no other value adjustments to the net assets of the business. Similarly, the market valuation of

the previous shareholding held has had no material impact on the Group’s income statement.

Considering that the main activity of the business is asset management, the bulk of this is recorded off the balance sheet. The main net assets acquired, in addition to the aforementioned intangible assets, are net deposits in credit institutions (€181 million) and net tax assets (€176 million). Given their nature, their fair value does not differ from the book value recorded in the companies’ books.

In compliance with current accounting standards, and in accordance with the provisions of paragraph 45 of IFRS 3 “Business combinations”, the acquiring company has a period of one year from the acquisition date to value the business combination and to adjust the acquired company’s assets and liabilities to fair value. The valuations made by the Group are the best estimate available on the date of drawing up these consolidated annual accounts, so they are provisional in nature and cannot be considered final. However, the Group does not expect any significant changes to occur to this amount up to the end of the period available for considering the valuation as final.

The amount contributed by this business to income and to the net attributed profit of the Group, both from the acquisition date and if the transaction were assumed to be carried out on 1 January 2017, is immaterial.

 

ii)	Sale of the shareholding in Allfunds Bank

As part of the transaction to acquire the 50% of Santander Asset Management not owned by Santander Group, Santander, WP and GA agreed to explore different alternatives for the sale of their shareholding in Allfunds Bank, S.A. (“Allfunds Bank”), including a possible sale or floatation. On 7 March 2017, the Bank announced that, together with its partners in Allfunds Bank, it had reached an agreement for the sale of 100% of Allfunds Bank to funds affiliated with Hellman & Friedman, a leading venture capital fund, and GIC, the sovereign wealth fund from Singapore.

On 21 November 2017, the Group reported that it had completed the sale by the Bank and its partners of 100% of the capital of Allfunds Bank, obtaining the sum of €501 million from the sale of its 25% shareholding in Allfunds Bank, which has led to a net capital tax gain of €297 million.

e) Acquisition of the retail banking and private banking business of Deutsche Bank Polska, S.A.

On 14 December 2017, the Group reported that its subsidiary Bank Zachodni WBK, S.A., together with Banco Santander, S.A., had reached an agreement with Deutsche Bank, A.G. to acquire the retail banking and private banking business of Deutsche Bank Polska, S.A., excluding the portfolio of mortgages in a foreign currency and including the acquisition of shares in DB Securities, S.A. (Poland), for an estimated amount of €305 million, which will be paid in cash and newly-issued Bank Zachodni WBK, S.A. shares.

The transaction, which is subject to obtaining the corresponding regulatory authorisations and its approval by the General Shareholders’ Meetings of Bank Zachodni WBK, S.A. and Deutsche Bank Polska, S.A, will not have a significant impact on the Group’s fully loaded CET1 common equity.

 

1.3. 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 regulation, 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 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 phased-in period that will allow institutions to adapt gradually to the new requirements in the European Union. The phased-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. In March 2016, the ECB published Regulation 2016/445/EU, adjusting certain timelines established in Bank of Spain Circular 2/2014, especially the calendar for (Deferred Tax Assets) DTAs. 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 1 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 regulatory requirements more sensitive to the risks actually incurred by financial institutions when carrying on their business activities. Pillar 2 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 3 deals with disclosure and market discipline.

Capital regulatory framework in force is being reviewed in order to reduce risk in the banking sector, introducing different Basel standards and integrating the loss absorption requirement into the European framework. Thus, 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 (NSFR) for liquidity risk or the SA-CCR for calculation of the EAD by counterparty risk, interest rate risk in the banking book, as well as modifications related to the treatment of central counterparty entities, the MDA, the Pillar 2, the leverage ratio and the Pillar 3, among others. The most significant change is the implementation of the TLAC Term Sheet, established internationally by the Financial Stability Board (FSB) in the capital framework. Therefore, systemically important banks will have to comply with MREL/TLAC requirements under Pillar 1, while non-sistemically important banks need only comply with MREL under Pillar 2 that the resolution authority will decide on a case-by-case basis.

Additionaly, other elements of the resolution framework are examined, whose practical application has occurred this year for the first time due to the resolution of Banco Popular.

The Single Resolution Board published its MREL policy for the year 2017. With regard to the planning cycle of these resolutions, the Single Resolution Board is currently in a period of transition from the informative MREL targets to the establishment of bank-specific features requirements, applicable both in the single point of entry (SPE) and the multiple point of entry (MPE), and intended specially for the categorized as global systematically important banks (G-SIBs).

The 2017 MREL policy for the Single Resolution Board is based upon an approach of gradually achieving the target level over the next years. Shall this not be accomplished, it could be considered that the resolution of the entity is not possible. Additionally, with regard to the subordination requirement of eligible instruments for systematically important banks (G-SIBs), they must meet a minimum level of 13.5% of the RWAs plus the combined buffer requirement.

1.3.1. Regulatory changes in 2017

The Basel III review concluded in 2017 after nearly three years on the table and the first resolution is now on trial in Europe, where negotiations are advancing on the review of the capital and resolution framework.

International framework

On 7 December, the Group of Governors and Heads of Supervision of the Central Banks (GHOS) approved the final framework for Basel III, after reaching agreement on how best to calibrate capital floors, which limit the capital savings generated from the use of internal models. This review seeks to ensure that the frameworks for calculating capital requirements in relation to credit, market and operational risk are more simple, readily comparable and risk-sensitive, while also reducing any variability in risk-weighted assets that is not justified with regard to the different risk profiles. The main aspects now agreed upon are as follows:

 

•

The capital floors threshold, which has been set at 72.5% on an aggregate basis for all risks, subject to a maximum impact cap of 25% on RWAs by institution.

 

•

A review of the standardised approach to calculating capital for credit risk, which now features the non-mechanistic reliance on external ratings for exposures to banks and companies and greater risk sensitivity for certain exposures.

 

•

A review of the advanced approaches to calculating capital for credit risk for low default portfolios; sets limitations on the estimation of parameters through exposure floors; standardises the methodology for estimating risk parameters; and reviews treatment of risk mitigation techniques.

 

•

A new standardised approach to calculating capital for operational risk, which combines size with indicators on past loss events. This new approach will replace internal AMA models and currently existing standardised approaches.

 

•

The final calibration of the leverage ratio, which has been set at 3% for all institutions, while G-SIBs are subject to an additional surcharge of 50% of the G-SIB buffer (which depends on the bucket of systemic importance the bank falls within).

 

•

A review of the credit valuation adjustment (CVA), which eliminates internal models and reviews standardised approaches to bring them in line with the updated framework for market risk.

This final agreement will take effect on 1 January 2022, though there will be a phased-in period through to 2027 for the capital floors. The Basel Committee also announced that implementation of the new market risk framework (FRTB) will be put back to 1 January 2022 (initially envisioned for 2019).

The final framework makes significant improvements on the proposals initially raised by the Basel Committee. Santander holds a positive view of the final completion of this new framework, which will enhance certainty within the banking system on the requirements that entities must meet, while helping to reduce any unjustified variability among RWAs, thus diminishing credibility.

Taking into account the capital floors threshold established by Basel with our current capital consumption and the rest of the aspects contemplated in the new regulation, we consider that they will not have significant impacts on our solvency ratio.

The Basel Committee also released a discussion paper reviewing the treatment of sovereign debt through to March 2018. The main options raised in the paper involve additional disclosure requirements (Pillar 3) and capital surcharges (Pillar 1 and Pillar 2) for sovereign debt exposures except for exposures to central banks denominated in domestic currency (of the central bank) and for exposures to central banks in countries where monetary policy is centred on the exchange rate. However, the communication of the Basel Committee announcing this consultation acknowledges that no consensus has yet been reached on the need to make changes to the current treatment.

Meanwhile, the Basel Committee has continued to work on the following aspects in 2017:

 

•

reviewing the methodology for identifying global systemically important banks. The first list of systemically important financial institutions, based on this new methodology, will be published in November 2019.

 

•

reviewing the integration between the new accounting framework and the prudential framework on provisions following the entry into force of IFRS 9. Further consultations on this debate are expected throughout 2018.

 

 

•

elaboration of a new regulatory framework that establishes a preferred capital treatment for short term securitisations meeting STC (simple, transparent and comparable) requirements.

Turning to crisis management, the Financial Stability Board (FSB) and Basel have continued to address the key issues in 2017. Following successful completion in 2015 of the standard governing the total loss absorbing capacity (TLAC) needed to recapitalise a Global Systemically Important Bank (G-SIB) in the event of resolution, this year the FSB has published its Internal TLAC guidance (loss absorbing capacity for significant entities that form part of a resolution group), and two important consultations aimed at: (i) ensuring financing during resolution and (ii) guaranteeing completion of a bail-in process. Basel

published its final TLAC disclosure proposal and a new consultation is now expected in 2018.

In November 2017, the Financial Stability Board (FSB) updated the list of G-SIBs for 2019. Santander remains within the least systemic group of banks and is subject to the minimum additional capital surcharge for banks of systemic importance (1%).

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 i mplementation of minimum capital requirements within the European Union. These include the following regulatory initiatives: guidelines on uniform disclosure of IFRS 9 transitional agreements; discussion paper on the treatment of structural FX risk; consultation on significant risk transfer, risk retention and homogeneity of securitisations’ underlying exposures; and updates to the guidelines on SREP, stress tests and IRRBB (interest rate risk in the banking book) in order to enhance the Pillar 2 framework.

Meanwhile, the EBA released the following documents as part of its work programme published in February 2016 aimed at reducing unjustified variability in capital consumption by different risk profiles, thus improving the homogeneity and comparability of capital ratios among banks:

 

•

in January 2017, the final guidelines on the application of the definition of default in a bid to harmonise the definition of default across Europe.

 

•

In March 2017, consultation paper on draft RTS on the specification of the nature, severity and duration of an economic downturn in order to estimate LGD (loss given default) and CCF (credit conversion factors).

 

•

in November 2017, the final guidelines on the estimation of risk parameters (PD, LGD and treatment of defaulted assets).

On the subject of liquidity, following the 2016 consultations the EBA released its final proposals in 2017 with the aim of establishing the liquidity coverage ratio (LCR) and asset encumbrance disclosure requirements. The EBA is also expected to develop a set of standards to harmonise NSFR reporting requirements.

Work has also continued across Europe in 2017 to review the capital framework (CRR / CRD IV) and the resolution framework with the aim of the new capital framework entering into force before 1 January 2019 and being implanted in 2020-2021.

On the other hand, in December 2017, a new general regulatory framework for securitisations and a specific regulatory framework for STS (simple, transparent and standardised) securitisations were published. Furthermore, a new capital treatment for securitisations is established (modifying its actual treatment in CRR), along with preferred capital treatment for those securitisations meeting STS requirements. These modifications over the existing regulatory framework must be applied from 1 January 2019.

Meanwhile, the European Commission has yet to determine the equivalence of the jurisdictions of third countries, based on EBA questionnaires. The work had been put on hold in 2016 but was resumed in late 2017, with Argentina being one of the jurisdictions to undergo an assessment. When it comes to the qualification of CCPs, the Commission has extended the phased-in period until 15 June 2018.

 

With respect to supervision, the supervisory activity conducted by the Single Supervisory Mechanism (SSM) in the framework of the Supervisory Review and Evaluation Process (SREP) is notable. In this area, Santander Group’s Joint Supervisory Team from European Central Bank worked tirelessly in 2016, holding over 100 meetings with the Bank, most of which were related to its monitoring and refinement.

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 Single Resolution Mechanism (SRM, the second pillar of the Banking Union after the Single Supervisory Mechanism) has been operational since 1 January 2016. The Single Resolution Board has been working alongside national resolution authorities to develop the policies of the MREL (minimum requirement of eligible liabilities). Banks must meet this requirement following a phased-in period to last no longer than four years. The Single Resolution Board is expected to inform the Bank of its requirement in the first quarter of 2018.

Turning to the Single Resolution Fund managed by the Single Resolution Board, the period of gradual mutualisation will allow for a transition from the national resolution funds in place in several eurozone countries through to 2016, to the Single Resolution Fund, which will be fully implemented by 2024. The funding target of the Single Resolution Fund is 1% of covered deposits in 2024. The first year was calculated at 60% nationally (BRRD perimeter) and 40% across the euro area (SRM perimeter). In 2017, these percentages have been inverted, with 40% of funding in the BRRD perimeter and 60% within the SRM perimeter. Funding under the SRM perimeter will be steadily raised to reach 100% in 2024.

In October 2017, the Commission issued a release calling for the completion of the Banking Union. The measures it proposes include the need to reach an agreement in 2018 on the creation of a backstop for the Single Resolution Fund and Pillar 3 of the Banking Union: the European Deposit Insurance Scheme (EDIS). There are also plans to legislate a framework to create sovereign bond-baked securities (SBBS) in early 2018 and reduce NPL before the end of 2018.

Santander Group voices the concerns and thoughts of its corporate offices and local teams on matters relating to the financial sector where these affect business at the Group. 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 Santander Group’s stance.

The main courses of action taken along these lines are as follows:

 

•

Santander Group 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 inputs to the replies drawn up in connection with ongoing regulatory consultations.

 

•

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

 

•

In particular, Santander Group has worked to consolidate and make known the sturdiness of our organisational model through subsidiaries that are fully independent when it comes to capital and liquidity. It also has the benefits of geographic diversification and recognition of the issuance of capital instruments from third countries and 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.

 

2. Capital

2.1. Capital

Capital management and control at Santander Group is a fully transversal process that seeks to guarantee the Bank’s capital adequacy, while complying with regulatory requirements and maximising profitability. It is determined by the strategic objectives and by risk appetite set by the board of directors. To achieve this, the following policies have been established to shape the approach that the Group applies to capital management:

 

•

Establish adequate capital planning, so as to meet current needs and provide the necessary resources to meet the needs of the business plans, regulatory requirements and the associated risks in the short and medium term, while maintaining the risk profile approved by the board.

 

•

Ensuring that the Group and its companies maintain sufficient capital to cover requirements during stress scenarios due to the increase in risks as the macroeconomic climate deteriorates.

 

•

Optimising capital use through appropriate allocation of capital among the businesses, based on the relative return on regulatory and economic capital and taking the risk appetite, growth and strategic objectives into account.

Santander Group maintains a very comfortable capital adequacy position well clear of the levels required by applicable regulations and by the European Central Bank.

 

∎	TABLE 4. MAIN CAPITAL FIGURES AND CAPITAL ADEQUACY RATIOS

Millions of Euros

 

		Fully loaded								Phased-in
Concept		Dec-17				Dec-16				Dec-17				Dec-16
Common Equity (CET1)			65,563				62,068				74,173				73,709
Tier 1			73,293				67,834				77,283				73,709
Total capital			87,588				81,584				90,706				86,337
Risk weighted assets			605,064				588,088				605,064				588,088
Ratio CET1			10.84	%			10.55	%			12.26	%			12.53	%
Ratio Tier 1			12.11	%			11.53	%			12.77	%			12.53	%
TOTAL CAPITAL RATIO			14.48	%			13.87	%			14.99	%			14.68	%

∎	CAPITAL AND SOLVENCY RATIOS

 

Santander Group’s main solvency ratios at 31 December 2017 are as shown in table 4. Phased-in ratios are calculated applying the transitory schedules for implementation of Basel III, whereas fully loaded ratios are calculated without applying any schedules, hence with the final regulation.

In fully-loaded terms CET1 in December stood at 10.84%, increasing by 29 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 14.48%, up by 61 basis points during the year.

 

∎	2017 CET1 FULLY LOADED EVOLUTION

    %

 

The increase of 29 basis points in the year is mainly due to profit generation and risk assets management, which contribute to the ordinary generation in the year, that reaches 53 b.p. However, 19 b.p. from perimeter must be substracted (SAM operation/Allfunds and acquisition of participation in SC USA) and other 5 b.p. from various causes, among which the valuation of available for sale portfolios is found. The acquisition of Banco Popular did not entail any effects regarding the solvency ratio, since it was offset by the capital increase fulfilled in July 2017.

From a qualitative point of view, Santander Group has solid ratios suited to its business model, the structure of its balance sheet and its risk profile. Santander Group exceeds the 2018 minimum regulatory capital requirements for the total ratio by 284 basis points, taking into account the surpluses and shortfalls of AT1 y T2.

 

 

•

Autonomy. The Group’s corporate structure is based on a legally independent subsidiary model, each responsible for its own capital and liquidity. This provides advantages when raising funds and limits the risk of contagion, thus reducing systemic risk. Under this structure, subsidiaries are subject to two tiers of supervision and internal control: local and global. Each unit must raise and manage its own financial resources accordingly in order to maintain the required levels of capital at all times. Local units must have the necessary capital to carry on their activity autonomously and meet local regulatory requirements and the expectations of their local market.

•

Solvency. The Group and its subsidiaries must ensure at all times that the structure and level of their capital is suitable in view of the risks to which they are exposed. Capital must be allocated accordingly so as to ensure the effective management of the risks assumed within the subsidiaries and it must be assigned proportionately among all those risks.

•

Efficiency. The Group and its subsidiaries must roll out mechanisms to actively seek and promote an efficient use of capita and to ensure that the value created by an investment exceeds at least the cost of the capital invested. Capital is a scarce commodity that must be used as efficiently as possible, given the high cost of generating capital, whether organically or through the markets. Subsidiaries must have ongoing monitoring mechanisms in place to optimise their capital consumption.

 

 

2.1.1. Capital function

The core principles provide the basic guidelines for the Group entities in managing, monitoring and controlling capital.

2.1.1.1. Organisation

The organisational structure has been defined with a view to achieving compliance with the principles of capital management while ensuring that the relationship between each subsidiary and the corporation in this function facilitates the subsidiary’s financial autonomy, subject to strict monitoring coordinated at Group level.

Santander Group’s risk management and control model is based on three lines of defence. The first line comprises the business functions or activities that assume or generate exposure to risk. Risks undertaken or generated within the first line of defence must be compatible with the risk appetite and the limit in place. To carry out its function, the first line of defence must have the resources to identify, measure, address and report the risks assumed. The second line of defence comprises the function of controlling and supervising risk, along with 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 the other functions they control and supervise when carrying out their tasks. They likewise 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 capital function operates properly when it comes to both decision-making and supervision and control, Santander Group has developed a structure of responsive and efficient governance bodies so as to ensure the involvement of all the areas concerned and the necessary involvement of senior management. Because of the Group’s hallmark subsidiary-based structure, the governance structure of the capital function must be adapted to preserve the subsidiaries’ capital autonomy, while allowing centralised monitoring and coordinated management at Group level. There are also various committees that have responsibilities at regional 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 centre.

 

2.1.2. Capital management and adequacy

The goal of capital management and adequacy at Santander Group is to guarantee the entity’s capital adequacy and maximise its profitability, while ensuring compliance with internal capital goals and regulatory requirements. Capital management 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 uniform definitions of capital management criteria, policies, functions, metrics and processes.

 

Regulatory capital

 

•

Capital requirements: The minimum amount of capital the supervisory authority requires the entity to hold to safeguard its solvency, based on the amount of risk assumed, in terms of credit, market and operational risk.

 

•

Eligible capital: The capital the regulator considers eligible to meet capital requirements. The main components of eligible capital are accounting capital and reserves.

Economic capital

 

•

Internal capital requirements: The minimum amount of capital that the Group needs with a specified level of probability to absorb unexpected losses deriving from its current exposure to all risks taken on by the entity (including risks additional to those contemplated under the regulatory capital requirements).

 

•

Available capital: The amount of capital the Group itself considers eligible, on management criteria, to meet capital needs.

Cost of capital

The minimum return required by investors (shareholders) as compensation for the opportunity cost incurred and the risk assumed in investing their capital in the entity. This cost of capital represents a “cut-off rate” or “minimum return” to be achieved and allows comparisons to be made between the different business units and their efficiency to be assessed.

Leverage ratio

Regulatory measure that monitors the financial solidity and strength of the Entity by linking size and capital. This ratio is calculated dividing the Tier 1 by the leverage exposure, which takes into account the balance sheet exposure and adjustments due to derivatives, secured financing transactions (SFTs) and off-balance sheet items.

Return on risk-adjusted capital (RoRAC)

The return (understood as net profit after tax) on internally required economic capital, Therefore, the higher the economic capital, the lower the RoRAC. For this reason, the Bank must demand a higher return from transactions or business units that consume more capital.

RoRAC takes the investment risk into account and so provides a risk-adjusted measure of return.

The use of RoRAC allows the Bank to better manage its activities, assess the real risk-adjusted return of businesses and be more efficient in decision-making relating to investments.

Return on Risk Weighted Asset (RoRWA)

Defined as the return (understood as net profit after tax) on a business’ risk-weighted assets.

The use of RoRWA allows the Bank to set up strategies to allocate regulatory capital and ensure the maximum return is obtained.

Value creation

Any profit generated above and beyond the cost of economic capital.

The Bank will create value when the risk-adjusted return, measured by RoRAC, is higher than its cost of capital. Otherwise value will be destroyed. It measures the risk-adjusted return in absolute terms (monetary units), supplementing the RoRAC result.

Expected loss

Average NPL losses expected by the entity over the course of an economic cycle. From the point of view of expected loss, defaults are considered a “cost” that could be eliminated or reduced through appropriate selection of borrowers.

 

The Group’s capital function is preformed at two levels:

 

•

Regulatory capital: regulatory capital management is based on an analysis of the capital base, the capital adequacy ratios as defined by applicable regulations and the scenarios used in capital planning. The aim is for the capital structure to be as efficient as possible, in terms of both cost and compliance with regulatory requirements. Active capital management includes strategies for capital allocation and for efficient usage of business units, securitisation, asset sales and placements of capital instruments (preference shares, subordinated debt) and hybrid capital instruments.

 

•

Economic capital: economic capital management is there to ensure that sufficient capital is available and assigned accordingly to cover all the risks to which the Group is exposed as a result of its business activity and according to its risk appetite. It also aims to optimise value creation at the Group and across all its business units. By effectively measuring the capital needed for a given business activity, together with the return on that business, the Group is able to optimise value creation by selecting those business activities that offer the best return on capital. This capital assignment process is carried out under different economic scenarios and with the level of capital adequacy decided by Santander Group in each case. The scenarios include those that are expected to occur and those that are far less likely though still plausible.

 

2.1.3. Capital management priorities in 2017

Details of the most significant actions undertaken in 2017 are set out below.

Issues of financial instruments with the legal status of capital

Banco Santander S.A. effected two issues of contingent convertible bonds (CoCos) during the year for 750 million euros and 1,000 million euros in a bid to strengthen its AT1 capital.

Banco Santander S.A. carried out two issuances of subordinated debt in the first half of the year for a combined total of 1,150 million euros. Both placements are intended to enhance the total capital ratio by qualifying as Tier 2 capital.

Further, in December Banco Santander S.A. completed a placement of contingently redeemable perpetual bonds (Loyalty Bonds) offered to certain Santander Group customers affected by the resolution of Banco Popular and totalling 981 million euros. This placement had no impact on the Group’s capital ratios.

Following the acquisition of Banco Popular, Banco Santander announced a capital increase in July for a nominal sum of 729,116,372.50 euros. The rights issue was to be carried out by issuing and circulating 1,458,232,745 new common shares, all of the same series as those

 

*	Dividends charged to the 2017 results are subject to approval of the Shareholders Meeting.

currently in circulation and all conferring a pre-emptive subscription right on their holders. The new shares were issued at a face value of 0.50 euros plus a share premium of 4.35 euros per share, thus bringing the total price of the new shares to 4.85 euros per share and the total cash value of the capital increase (including both nominal and share premium) to 7,072,428,813.25 euros.

Dividend policy*

Most of the Group’s quarterly remuneration for shareholders in 2017 was paid out in cash and it was announced that remuneration charged to 2017 earnings would be 0.22 euros distributed in four dividends: three cash dividends and one scrip dividend (Santander Dividendo Elección), the latter amounting to 0.04 euros 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.

The targets were met in 2017, resulting in an effective dividend payment of 40% of profits and a 9% increase in the per-share cash dividend.

In December 2015, the European Central Bank issued a recommendation on dividend allocation policies applicable to all Eurozone credit entities as of 2016. The recommendation calls for conservative dividend policies and prudent assumptions and has been fully observed by Banco Santander S.A.

Last but not least, a number of restrictions on the payment of dividends have been imposed in certain regions as a result of new and stricter regulations on capital adequacy. That said, the Group currently has no knowledge of any practical or legal impediment to the transfer of funds from the subsidiaries to the parent of Santander Group in the form of dividends, loans or advances, repatriation of capital or other instruments beyond the dividend policy issued by the competent national authority of our Polish subsidiary (KNF), which applies to banks that hold a significant interest in mortgages denominated in foreign currency. Meanwhile, our subsidiary in the United States has passed the Comprehensive Capital Analysis Review (CCAR) process and a number of existing restrictions on dividend payments have now disappeared.

2.1.4. Capital targets

Santander Group continues to work towards a fully loaded CET 1 ratio of over 11% in 2018.

 

∎	FULLY LOADED CET1 CAPITAL EVOLUTION

    %

 

Note 1: Pro-forma including Jan’ 15 capital increase

 

The continuous improvements seen in the capital ratios is a product of the profitable growth strategy pursued by Santander Group and a culture of active capital management across all levels of the organisation Highlights:

 

•

The reinforcement of teams dedicated to capital management and greater coordination with the Corporate Centre and local teams.

 

•

All countries and business units have drawn up individual capital plans focused on achieving a business that maximises the return on capital.

 

•

Greater weighting of capital as part of incentive schemes. Certain aspects relating to capital and returns on capital are now taken into account when setting the variable remuneration payable to members of the senior management.

 

•

The relevant metrics include the fully-loaded CET 1, capital contribution, or the return on risk-weighted assets (RoRWA).

 

•

The qualitative aspects in question include the proper management of regulatory changes affecting capital, effective management of capital relating to business decisions, moving the capital plan towards the defined objective and effective capital allocation.

In tandem, the Group is continuing to develop a programme to ensure the continuous improvement of infrastructure, processes and methodologies supporting all aspects relating to capital. The aim here is to ensure more active management of capital, enable the Group to respond rapidly to the already numerous and still growing number of regulatory requirements and carry out all associated activities more efficiently.

2.1.5. Capital buffers and eligible capital requirements

Santander Group must comply, at all times, with the combined capital buffers requirement, defined as the total CET 1 capital necessary to meet the following obligations:

 

•

Capital conservation buffer (CCoB): mandatory for all entities and to be phased in from 1 January 2016. The buffer for banks in 2018 will therefore be 1.875%.

 

•

Systemic buffers: a four-year phase-in period is provided for these buffers, applicable from 1 January 2016.

 

•

Systemically Important Financial Institutions (SIFIs): for entities designated as systemically important, using a common methodology. Here, there are two different surcharges, with the largest buffer rate of the two being applicable:

 

1)

G-SIB buffer (Global Systemically Important Banks): common methodology whereby banks are classified into buckets based on their systemic global risk.

 

2)

D-SIB buffer (Domestic Systemically Important Banks).

 

•

Systemic risk buffer (SRB): intended for entities with systemic importance that must possess additional loss-absorbing capacity. This buffer is discretionary and applies to all or some exposures of an entity (domestic and/or foreign risks, risks specific to certain business sectors, etc.), as determined by the 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-SIB or D-SIB).

 

•

Countercyclical capital buffer (CCyB): the CCyB will be applied when the authorities deem that lending is growing excessively in an specific jurisdiction and it will be applied in order to constrain this excessive growth. 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 relevant exposures are located. For applying this buffer, a four-year phase-in period applicable from 1 January 2016 has been established too.

The table below summarises the required regulatory rates based on the different capital buffers to be applied, along with the phased-in timeline and Banco Santander’s situation in 2018:

 

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%-3,5%) (1)		25% del buffer		50% del buffer		75% del buffer		100% del buffer
entities		D-SIB entities (2)		25% del buffer		50% del buffer		75% del buffer		100% del 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)	According to the list of Global Sistemically Important Banks (G-SIBs) published by the FSB for 2018, it is demanded a total buffer of 1% for Santander (this means that 0.75% is required in 2018)

(2)	Domestic Systemically Important Banks. The Bank of Spain requires a 1% buffer for Santander (this means that 0.75% is required in 2018).

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

(4)	Applicable countercyclical buffer:

a)

Bank of Spain, first quarter of 2018: exposures located in Spain: 0%

b)

Exposures located in Norway, Sweden: 2%

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

The geographic distribution of relevant lending exposures for calculating the countercyclical capital buffer is shown in Appendix X available on the Santander Group website.

 

Capital requirements

The decision on capital resulting from the Supervisory Review and Evaluation Process (SREP) under the European Central Bank’s (ECB) Single Supervisory Mechanism comprises 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 has no bearing on the Maximum Distributable Amount (MDA) threshold. Moreover, Pillar 2G does not automatically trigger action by the ECB. However, the ECB does

 

expect compliance with 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 and may define additional supervisory control measures.

At the end of 2017, the ECB sent each bank the minimum prudential capital requirements for the following year. In 2018, Santander Group must report a phased-in Common Equity Tier 1 (CET1) ratio of at least 8.655% on a consolidated level. This requirement includes the Pillar 1 requirement (4.5%); the Pillar 2 requirement (1.5%); the capital conservation buffer (1.875%); the requirement due to its status as a global systemically important bank (0.75%) and the countercyclical capital buffer requirement (0.03% of CET1). Santander Group must also maintain a minimum capital ratio of 10.155% for phased-in T1, and a minimum total ratio of 12.155% for phased-in.

As of 31 December 2017, Banco Santander had a CET1 regulatory capital ratio of 12,26% and a total ratio of 14,99%

 

∎	REGULATORY CAPITAL

 

 

1.	Global Systemically Important Banks buffer.

2.	Capital conservation buffer.

3.	Counter-cyclical capital buffer calculated using September 2017 data for requirement as of 1 January 2018.

2.1.5.1. Global Systemically Important Institutions

Santander Group is one of the 30 institutions designated as global sistemically important institutions (G-SIIs).

The health of a global systemically important institution poses a risk to financial stability. The insolvency of a systemically important institution, or even just the expectation that it might become insolvent, is difficult to predict but could certainly undermine the financial system and even the real economy.

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

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

 

•

Its capital buffer (Santander Group is included in the group of banks with the smallest capital buffer of 1%)

 

•

TLAC (Total Loss-Absorbing Capacity) requirements

 

•

The requirement to publish relevant information more often than other banks

 

•

Stricter regulatory requirements for the internal control bodies

 

•

Special supervision

 

•

Requirement to submit special reports to the supervisors

The Basel Committee and the Financial Stability Board decide what banks qualify as global systemically important institutions, using a method based on five indicators: size, cross-jurisdiction activity, interconnectedness with other financial institutions, substitutability of financial services/infrastructure and complexity (with each category given an equal weighting of 20%). This methodology is currently under review by the Basel Committee on Banking Supervision. The first list of global systemically important institutions based on this new methodology will be published in November 2019.

 

The information needed to evaluate the indicators is requested yearly from banks whose leverage exposure exceeds 200,000 million Euros, or from any other banks at the supervisor’s discretion (in December 2016 a total of 76 banks were considered). All these institutions are then required to publish the information before 30 April of the following year.

The information is used to draw up a global indicator. The score obtained by each bank will determine the size of the capital buffer required of it, which is based on a set of buckets defined by the regulators (CET1 surcharge ranging from 1% to 3.5%).

In November 2017, the Financial Stability Board (FSB) published the list of global systemically important institutions based on December 2016 data. This list applies to 2019. Compliance with these requirements gives Santander Group greater solidity than its domestic peers. Santander Group is currently subject to a systemic buffer surcharge of 1%, which will become fully effective in 2019 (0.75% in 2018).

 

∎	TABLE 6. GLOBAL SYSTEMICALLY IMPORTANT INSTITUTIONS

 

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

 

2.1.5.2. Domestic Systemically Important Institutions

When identifying Domestic Systemically Important Institutions (D-SIIs), Banco de España, according to the methodology established on Rule 14 of Circular 2/2016, applies a mix of guidelines based on size, importance, complexity (cross-jurisdiction activity) and degree of interconnectedness between the institutions concerned and the financial system. Banco de España conducts a yearly review of this classification and the following institutions are included on its list for 2018:

 

∎	SYSTEMIC BUFFER

    Domestic Systemically Important Institutions

 

Santander Group appears on the lists of both global and domestic systemically important institutions. Banco de España, based on Rule 23 of Circular 2/2016, insists that the highest of the two buffers be applied. Since both buffers are the same for Banco Santander, the surcharge applicable in 2019 will be 1% (0.75% in 2018).

2.2. Pillar 1 regulatory capital

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

 

•

Pillar 1 sets the minimum capital requirements for credit risk, market risk and operational risk, allowing internal ratings and models to be used. The aim is to make regulatory requirements more sensitive to the risks actually incurred by financial institutions when carrying on their business activities.

 

•

Pillar 2 establishes a system of supervisory review, aimed at improving banks’ internal risk management and capital adequacy assessment in line with their risk profile.

 

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Pillar 3 is intended to enhance market discipline by developing a set of disclosure requirements that will allow market agents to appraise key information relating to the application of Basel II, capital, risk exposures, risk assessment processes and, by extension, the Bank’s capital adequacy.

2.2.1. Eligible capital

Total eligible capital, after retained earnings, amounts to EUR 116,265, up EUR 10,287 million in the year, a 9.7% increase.

As a consequence of the acquisition of Banco Popular Español, S.A. and to strengthen and optimise the Bank’s capital structure to provide adequate cover for that acquisition, on 3 July 2017 the Group communicated the resolution of the executive committee of Banco Santander, S.A. to increase the Bank’s capital by EUR 7,072 million by issuing 1,458 million shares. In addition, on 1 November 2017, the Bank effected a rights issue of EUR 48 million under the Santander Scrip Dividend scheme, issuing 95,580,136 shares (0.6% of the share capital).

Valuation adjustments decreased by EUR 6,737 million, mainly due to the net impact of exchange rate fluctuations, offset by the decrease in risk-weighted assets due to exchange rate risk.

 

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