Banco Santander SA

MAD:SAN

Earnings Call Transcript 2018-Q4

[Sergio Martínez, IR]

Good morning, everyone. Thanks for joining this Grupo Santander Q4 earnings presentation every January. We're delighted to have our Group Executive Chairman with us.

Today, she will address the 2018 group performance as well as after, obviously, our Group CEO addressing in more detail the group and different business areas, our full year numbers. She will also talk about how we are accelerating the, our commercial and digital transformation before concluding remarks, and obviously, plenty of time for your questions.

With no further delays, Ana, please.

[Ana Patricia Botín, Executive Chairman]

Yes, good morning, and thank you, Sergio. And I have to say congratulations, Sergio, our Head of Investor Relations, had twins two days ago so we very much appreciate you being here today. They were boys. Nobody's perfect, I'm sorry. Two boys, but they are doing fine. So again, thank you for being such a disciplined Santander executive. You should have stayed with your wife.

But we are very happy to have you. So good morning, everybody, and thank you for joining us. As we close our 3-year cycle, I'd like to start by saying that 2018 was an excellent year for Santander, and I would like to say that, as you see from our results this year, we actually performed well and all down the P&L, all the way down to a net profit, which is up 18% and up 32% in constant euros. But very importantly, we did well on revenues, on cost and on cost of risk. And we're also confident that the underlying commercial trends continue to be very positive.

In terms of growth, we have done well with a 9% increase in revenues based on a growth, again, in loyal and digital customers. This has led to better profitability and also to improvement in our balance sheet, where we are reaching ahead of our target of being over 11%. We're actually closing with a CET1 of 11.3%, as you can see on the screen.

And just for reference, I will not go through all the numbers, but we are closing a 3-year cycle we launched in October '15 and we have reached or exceeded all our financial targets. And importantly, we have achieved a double-digit EPS earnings per share growth this year in 2018 at 11.2% increase.

So José Antonio will cover in more detail 2018, but given we're closing the cycle, I would like to briefly review what we have achieved in these 3 years. It's very important that one of the key announcements we made back in 2015 was our new strategy. It's a simple strategy and it works.

It's about loyal customers and digital excellence but it all starts with our people and our team, the culture. We are very proud to be at 82% in terms of team engagement with 88% participation rate across the group. And importantly, this puts us very close, already close to best-in-class. This has led to an increase in customers and has led, in turn, to an increase in fee income and improved profitability, 11.7%, but 12.1% on an underlying basis.

The loyalty strategy is leading to higher customer engagement, which leads to higher returns. Loyal customer in terms of revenues are over 3 times more profitable. This is regarding the retail franchises but very importantly, the churn rate decreases significantly, as you can see, at minus 66% versus the active customers.

And the growth, which is one of the signs or differentiation of Santander, we're growing our revenues again in constant euros, which reflects the commercial effort. We have grown over these 3 years at 24% our top line. And importantly, in 2 key counties for Santander, which represents [25%] of the group's tangible equity, that's Brazil and Mexico, we were at 13% ROE, return on tangible equity, sorry 13% and 14% in 2015. Today, in both of those countries, we're at 20%.

As you can see also, a lot of growth in customers is coming from these 2 countries that are very important, not just today but also for the future. So growth is important, but we also set ourselves a goal of being more profitable in terms of per-share metrics, return on tangible equity, I mentioned, but very importantly, on, return on risk-weighted assets has improved, leading to not just earnings per share growth but a very significant increase in cash dividend per share, up 31%.

In this case, we are referring to 4 years since we did the capital increase of 2015, which is when we changed our policy. We have been very focused on profitability and better capital allocation, as I mentioned, across subsidiaries.

Most of our subsidiaries have significantly increased their profitability. I mentioned Brazil and Mexico, but back in 2015, 60% of the tangible book value of Santander was below the cost of equity. Two of our main countries, Brazil and Spain, were below. Today, we are only at about 10% and that's Santander Bank in the U.S., which, with a normalized capital level, because we have much higher capital than required at the moment, we would be already around 7%. Actually, a bit more than 7% also in the subsidiaries. So a very significant shift in terms of not just capital management and allocation but also capital returns.

Santander Consumer, which is our other business in the U.S., is at around 13%, 14%. But again, normalized for the capital that's required would be around 20%. And you can see most of the countries have significantly improved the return on risk-weighted assets.

So growth, profitability, but we're also focused on strength. Strength is, of course, about capital even though the holistic management of the balance sheet is really what's important. We have generated over €25 billion in capital over these 3 years. We have made some acquisitions, excluding Popular. We have paid, as I've mentioned, much higher cash dividend per share. We have also issued a lot of AT1s, which have required us close to €13 billion in payments to shareholders and bondholders, which means that after dividends, we have generated €10.2 billion.

We increase capital by €7.5 billion, January '15. Of course, we did Popular but that's basically a wash. The capital we increased was to finance the acquisition, which means we have accumulated, in the period, close to €18 billion in capital, around 300 basis points.

So how have we delivered this plan? We focus very much on digital transformation, but we have also put a lot of focus on our culture. Santander aims to be, and we want to show in that everything we do, every day to our customers, people, communities and shareholders that we are a responsible bank.

How are we thinking about our digital transformation? As we think about our core banks, we want to deliver all the products and services of a bank, not just lending but all types of services, end to end through digital channels.

In some banks, we're doing that already in the group. In others, that's still work in process. Second, even though we are probably one of the most efficient banks, in terms of our peers, the most efficient, we believe we can do better. So we want to do more things in terms of efficiency at the same time that we deliver a better service and building on those foundations which we have established.

One of the goals we set for ourselves is to be in most of our country's top 3 in customer satisfaction. We have achieved that in 7 out of 10. And we are now moving to a more demanding metric, as we'll explain in Investor Day in April, which is Net Promoter Score, NPS.

How we think about the reengineering of our core banks? We call them supertankers. The important change here from before is that more and more we are leveraging the group's scale and we're working along 5 axes. One is transforming the front. What do we mean by this? As an example, today, in the group, we have more than 60, 6-0, mobile banking apps.

We launched the project 6 months ago to start working on this asset group. And after these few months of work, we now can say that 70% of all the costs and all the features are common across countries. So it's 70% common from Brazil to Poland to the U.S. to the UK We are going to start building the front end in a way that is leveraging the scale of the group.

The second thing is, of course, digitizing the back-end processes. This is very important. We are sharing best practices. We are using more and more robots. In back-office process, we are seeing that, that could save around 10% of the cost and this is going to be very increasingly important for the future.

Third very important, is our IT architecture and systems. We will be able to integrate Popular in 18 months. We have integrated Portugal already, and we'll be finishing Spain towards the end of this year. Again, our core banking is an advantage in terms of integrating these banks, and we are modernizing this back end, building APIs, so we can then have more flexibility for our customers but also to connect to the wider ecosystem.

Fourth, very important, how we can scale up new capabilities. We are using more and more, as I said, robots, but we're also working in a way that allows us to integrate whatever is new in innovation.

And finally, we are becoming more and more an agile organization. We have already 35% of our projects being executed in agile and this is going to help us again in terms of time-to-market but also leveraging people in different markets to work for the group.

So you investors rightly and shareholders and ourselves as management, we always ask ourselves, so how do we measure progress? I think this is a great way of seeing it. So in these 3 years, we have doubled digital customers, we have doubled the number of digital transactions, we have much more engaged customers and what's important, 68% of the engagement from customers comes from the mobile; and finally, we have doubled digital sales.

So today, 32% of all our sales across the group are made through digital channels, which again is one of the reasons that we have been able to keep our cost-to-income, actually, we improved it to 47%.

So all of that relates to what we call our core banks, our supertankers. We also have parallel initiatives, which we call the speedboats. And there's 2 things about the speedboats that are important: one is that they compete in the open market with everybody else out there, FinTechs, banks, nonbanks. But the very important difference is that they are also helping to service our supertanker customers. So we do connect between these autonomous ventures and our main banks so we can bring the best of innovation but also the best of speed and the best of going after new revenue provision.

A great example is One Pay FX, which has already been launched in several markets where we, for example, in Spain, since the launch, we're up 55% on FX transactions. It's the first blockchain-based retail payment, foreign exchange payment for individuals. And we hope soon to launch it also in the open market so we can actually attract new customers to the bank.

Openbank is the first fully digital bank. In terms of the asset side, which we launched recently, the numbers, the growth is exponential. Mortgages was just recently launched, and again, it's end-to-end digital and those numbers are up 390%. And if you look at the asset side, which is really a lot of the new products, it's growing at 90% in the last year.

So I mentioned how important the team's engagement is, and we define that Santander wants to be different. So if you ask any of us, why is Santander different from other banks, we want everybody to have a common answer and we want this to be reflected also, of course, in how our customers, society and shareholders see us, which is that we are doing things in a way that is simple and personal and fair.

And we are already top 3 in 7 of our 10 geographies, I mentioned that. In terms of team engagement, we are doing better. And very importantly, if we want to deliver for customers in a simple way, for example, and this is difficult because we have lots of new regulation coming up all the time and so this is probably the hardest thing for us to achieve, and as an example of what we're doing here of the progress and let me use Spain again as an example, today, 68% of our response to a mortgage application is automatic. This was 47% in 2016 and this, what it means is that this is a risk approval that is totally automated. So this is very, very important.

Another example is on the mobile app. Consumer lending can be approved in only 3 clicks. And these are the kind of things we're doing so that we would really become an organization that can respond in a faster way to all our stakeholders.

In terms of our communities, we continue to be very focused on inclusive and sustainable growth, which created a new committee of the board to basically oversee our, all our responsibility, culture, sustainability efforts.

We've supported 5.6 million people over the last 3 years and granted 136,000 scholarships. We are working with universities, the Santander X platform is now in about 100 universities. It aims to be the entrepreneurship platform and leading in the world. And we are also doing a lot of financial inclusion with initiatives like Prospera and Tuiio in Mexico. There's still 200 million unbanked people in Latin America. But very importantly, there is $620 billion unmet SME financing needs and Santander is very well placed to be able to address this.

So to end on this section before I give, we go to José Antonio and 2018 numbers, so we have achieved a lot in these 3 years. One of the very important and most ambitious targets we set was to achieve double-digit earnings per share growth. We've achieved that, 11.2%. And we have also delivered in terms of tangible NAV plus cash dividend per share, 21%.

Actually, it's the plan period. Here, we've gone back to 2015. Everything else relates to the plan period. But these numbers relate to the beginning of 2015 when we launched the capital increase when we started our, in the bank.

So we will get a bit more detail on 2018 numbers now from José Antonio.

[José Antonio Álvarez, CEO]

Thank you, Ana, and good morning to everyone. As Ana said, I am going to look today at group numbers, the group performance in 2018 as well as the big, the major units. I'll make some brief comments on the smaller units in order to have time to the, to go through the, to your questions.

So starting with the, that Ana mentioned. This is some, well, this is like some update of all the business model we have. A more committed team is able to offer better customer solutions to the customers that translate into higher revenues. And finally, this translate into higher return on tangible equity, and this is the center of our model.

You can show, you can see this in our P&L in 2018, where we, as I need to sum up the futures of the P&L, I would say, it's predictable. This shows the profitability and it shows an efficient bank with a business model that create a bank that is, generate high profits in a recurring way.

In the fourth quarter, we were again above the mark of €2 billion in the quarter and growing compared with the previous quarters. And even taking into account the contribution to deposit guarantee fund that, in the quarter.

If you compare it with the same quarter in 2017, the growth was also double rate. Profit for the whole year is €7,910,000,000 (sic) [€7,810,000,000] with a charge, extraordinary charge of €254 million.

In the quarter, we have a positive bad will coming from the carve-out of Deutsche Bank in Poland of €45 million that is record, that was recorded in the quarter. The underlying profit was about €8 billion.

Well, as you can see in the P&L, the FX impact was very large in the year. If you go through the P&L lines, you have exactly what I said before. Predictable means that we are generating recurrent NII, recurrent fee income coming from the most, the part of the business that is 100% related to the customers.

We would do the NII for, quarter-on-quarter, the same is happening with the fee income. For the quarter, at this, the fourth quarter has some seasonal effects coming from insurance premiums in Brazil. And other income was affected with the contribution to the deposit guarantee fund and also following the volatility in the markets. All in all, the 3 lines of the revenues were, have been performing very well.

You go to the cost. We have like two models. We are growing, let's say, double digit in emerging markets. You see all the emerging market growing revenues double digit. We are also investing in those markets. You see this in the numbers because [are growing], in real terms, a little and at the same time in markets, in which the revenues are more difficult to achieve, we are trying to reduce the cost, and we are doing that with integrations in Spain that you see, consumer finance, and also in Portugal where we are reducing costs in real terms.

So at the end, we achieved our target of 47% of cost/income ratio. This was established before Popular and this is with Popular. Excluding Popular, the 47% is 46.5%, something like that. So we were well inside our target. We get this evolution in costs at the same time improving customer satisfaction.

That is what we, at the time, we established a target, call it, operating efficiency in the sense that we are able to match cost in a way that doesn't deteriorate or improves the customer satisfaction.

Credit quality, very little to say on this. The numbers speak by themselves. All the numbers, all the trends in the right direction. We improved the cost of credit ratio [100%] in almost every geography and the lower, and the NPL is lower. The coverage is higher.

On capital, we've been guiding you for a average capital generation of 10 basis points quarter-on-quarter organic. And we got this year the, a higher number, 64 basis points. But within that, the 10 basis points is the number that you should have in mind. Our leverage ratio is very good and more on that than the stated capital number.

While we show extraordinary resiliency in the stress test, not the first time. In every stress test, the bank shows extraordinary numbers due to the fact that we have a very high diversification that produce a higher resiliency, higher solvency compared with our peers.

Finally, our funding plan in the past 2 years, we have been very focused in the number of hybrid staff. We are already compliant with the TLAC, with all TLAC instruments. Going forward, our issuance is going to be more focused in preferred, senior preferred and covered bonds to just to, for funding purposes, once we cover all the requirements, capital requirements about hybrids and TLAC requirements.

Going back the units, the split of the profits by geographies. The Americas and Europe is basically 50-50 with the weights of the countries. You have in the screen very small changes year-on-year. The underlying attributable profit in constant euros grew in 7 out of the 10 markets. Double-digit growth in the majority of emerging markets and Spain and Portugal. And the weight tends to go more into Brazil and Spain due to the performance they had in the P&L.

Starting with Brazil. I will say another good quarter. You see the numbers, good growth in the activity both in loans and deposits. The spreads basically on call. Credit quality is improving. The cost average is falling. And we are gaining very significant share in the country.

This is showing the numbers. They speak by themselves. The efficiency ratio is very low. The return on equity, on tangible equity is in the region of 20%. And we are in a position, as I've been telling you in the previous quarter, that our franchise has improved significantly in the past 3 years, and we are collecting the results of this improvement in our franchise.

So going to Spain. The main task in Spain at this point of time is integration, and I mentioned this. We are exactly in the middle of integration. We start to integrate branches of Popular in, back in November last year. We plan to finish at a, June, July, integration of the branches. And the Finnish integration are more in the October/November. You'll see the numbers, we are showing a, the NII growing in the quarter due to the reduction of the cost of funding.

You see a little bit sustained yield on loans that you see in the numbers. The cost of credit is relatively stable in the region of 30, 30-something basis points. And the activity, you see the loan book shrinking. This is mainly due, this is due, 100% due to the, our policy in CIB and institutional lending, where we are aiming a lighter capital model. And we are being more active in capital markets and less active in having the loans, storing the loans in the balance sheet.

Going to UK Competition remained tough, particularly in the mortgage market. So the mortgage market is fairly competitive at this point in the UK, grew the mortgage book by 2%. This year, also we were working the whole year in creating the ring-fence structure. Ring-fence structure means that we did a carve-out of the bank in UK of around €50 billion in assets to the London branch, Santander London branch. This was complete and we've been continuing to doing significant investments in our multichannel and digital proposal that you see is reflected in the cost of the, that grew significantly more than, or slightly below, above the inflation.

Those are basically regulatory and risk related projects and investments in technology and digital. Provisions remain fairly low. This quarter, we have some extra provisions but is a still very low number.

For consumer finance, I will say another good year, consistent trends. The capacity of generating recurring profit is very well demonstrated over the years. We grow, we continue to capture some market share gains, particularly in auto lending all across the geographies. As you know, this unit is highly diversified across all Europe and we are showing a consistent profitability of this business.

In the other smaller units in Mexico, our business model, we are investing a lot in Mexico. As you see, the costs are growing significantly, improving the franchise. Having said that, we've been able to show a bottom line number that grows 14%. That, and the return on tangible equity is in the region of 20%. So good execution in Mexico in a bank that is the franchise that is improving.

In Chile, the economic environment was a little bit more constructive than the previous year. The economy grew faster, and we translate this into higher profitability in a bank that, as you know, is the leader of market and is a consistent leader on the market.

In U.S., good year. Profit grew significantly. So we are progressing very well in our regulatory milestones. We improved the net interest margin in SBNA. Also, SCUSA has a very good year with a return on tangible equity, as Ana said, in the north of 20%.

In the last quarter, there was a reclassification that affects the P&L of the SCUSA and the group. €200 million went to net interest income that we net in the provisional lines with another €200 million more provisions in the quarter.

So in Portugal, we finished integration in October of Banco Popular, very well executed. So in 2 years, they execute Banif and now Popular. We are gaining share with around 20% share in Portugal. So we are the leading bank in the country. In Portugal, the leading bank in profitability.

In Poland, 2 events this year. We changed the brand, now the bank is called, is not called anymore BZ WBK, it's called Santander Polska. And we did the carve-out of Deutsche Bank by November. So this increased the cost, one-off cost, in Poland this year. Having said that, the recurring items of the P&L are going very well.

In Argentina, difficult year. Depreciation forced us to change the accounting. The accounting is now inflationary accounting and the one-off impact going forward is significant, as you see in the numbers.

In the Corporate Centre, very little to say. Higher NII, negative NII due to the issuance regarding senior unsecured and hybrid instruments. The gains and losses in financial transactions is the result of, the change is the result of the hedges. And all the other numbers, well, in provisions we have small items, several small items that fall into the Corporate Centre related with the group activities. But overall, nothing too specifically. Nothing important here in this quarter.

So I'll hand it back to Ana that continues to elaborate in the, our transformation and the takeaways.

[Ana Patricia Botín, Executive Chairman]

Thank you very much, José Antonio. I will be brief. Just to recapitulate, we are staying on course, as you'll hear in April in our Investor Day, which we'll tell you now the date. We are going to continue on the same strategy. We have a clear purpose, and we have a clear, as a bank, to become the best open financial services platform, earning the lasting loyalty of our people, customers, shareholders and communities, and of course, doing things in a way that is simple and personal and fair.

I've repeated many times over the last few months that our goal now is to accelerate execution and this is what we're going to focus on. We're going to continue building on our strengths. The first one is scale. Scale allows us today with technology to be competitive in ways that was not possible a few years ago.

I want to just remind everyone that we are already leaders in 6 out of our 10 markets. In the other 3, we are top 3. In the case of Brazil, of the private banks, in Mexico and in the UK on the retail side on basically on mortgages, and we are top 5 in our Santander Consumer Business in the U.S.

Importantly, and we had examples, again, more detail coming, but we have generated and will be generating this year, it's a 2-year program, €200 million in savings by centralizing global negotiations with T&O providers. This would not be able to do for one country alone. We are estimating again 25% to 30% savings in 3, just 3 group transversal processes, again building them together.

And we have already, and this goes back to 2015, over the last 3 years, we've increased the collaboration between our countries by giving service, product service from our corporate investment bank to the mid-corps and increased revenues by €1.4 billion. So this is happening more and more. And when I say accelerate execution, I mean mostly this cross, across the group collaboration.

The other very important feature is that we are working together on things that are not just process and not just technology. I was, this morning, in our Santander work café here in Madrid. This is an innovation that happened in Chile. We now have it in 4 countries. Customers love it. When a customer, a noncustomer comes into Santander work café, within 30 days, they become a customer.

One of the key assets or one of the key advantages we have is that we have 100,000 people talking to customers every day from branches, from contact centers, and we are very much going to continue investing in our brand's network in different ways. We today have 13,000 branches across the group.

The second strength upon which we're going to build, José Antonio mentioned that, is our diversification. We do have a predictability in our results that's higher. We do have the opportunity to deliver across the cycle and one of the reasons is this diversification, which means that we continue to be the best performer under stress, and this is very important and gives us an advantage in terms of capital.

Predictability, you've seen this before, but I want to mention that we've looked back 20 years, but we've also looked back at what has happened the last 3, 4, 5 years, and we continue to be in the same place, as you can see here with quarterly earnings per share volatility that is way lower than our peers. And of course, as you can see there, with earnings that are growing, not the most, but still growing 4 times over the 20-plus years.

So accelerate execution is the goal. We will continue to invest in our digital transformation, which delivers a more capital-light model and increased profitability. I mentioned before how this has allowed us, also, there's many other things. Of course, we've changed people. We've changed governance. We are working more together. But what's important is that we are now delivering above the cost of equity in most, close to 90% of our tangible equity, which was not the case 3 years ago.

So how are we going to, and what is it you're going to hear more about in April? I refer to that before because we've been doing some of that already for the past 3 years, but we're going to continue in investing in our core banks, digitizing the core. We're going to continue to leverage group capabilities.

Another example where we are also working together, and this is for the future, is digitizing our contact centers but doing it together as a group. The numbers here are pretty significant. We believe we can achieve another €200 million in savings, but importantly, also generate around €100 million more revenues by working on this together.

As we think on the parallel ventures, which I mentioned I'm not just competing in the open market but also servicing, in some cases, our core banks, Openbank is, of course, one of the key projects where we'll be aiming to go to new countries. We can open a full bank with full services for individuals for around €20 million and there's many more things we can actually do with Openbank.

I mentioned also One Pay and we will be announcing what we'll be doing with all these new ventures also in April.

So even though we cannot give you more detail today, we do want to share with you what our medium-term targets are. In terms of profitability and in terms of our capital, the aim is to be between 13% to 15% return on tangible equity. As a reminder, for this 3-year plan, we aim to be above 11.5%. We've delivered 11.7% and actually above 12% on an underlying basis.

In terms of capital, our aim was to be above 11%. We're 11.3%. And we aim to be between 11% to 12% CET1. This will give us flexibility in terms of hedging and other areas and also, of course, certain regulatory changes that we continue to foresee in the next few years.

We have set a date, which is April 3, in London, where we will give you all the updates that I was referring to.

So just to sum up, we're very proud of what our teams have done. Really, these 3 years have been very hard work. We have managed to deliver for shareholders, and we've done it in a responsible way because we have continued to invest so we can deliver to you for many years to come.

We have a clear strategy. The strategy is not going to change. We're going to accelerate execution. By this, we mean working together across the group in ways that leverage our scale and the talent and the innovation that we have across Santander.

We'll continue to focus on the loyalty strategy and digital excellence, and what we're seeing is very strong underlying commercial and business strengths. And really, it's about better together. We think and we are confident we can do this by making us more competitive but really working in an agile way across the group so we can continue to be a winner in the next decade.

So again, London, we'll give you more details. And we're now, obviously, ready to answer questions on 2018 or the past 3 years. Thank you.

[Sergio Martínez, IR]

Indeed. Thanks, Ana. Thanks, José Antonio. So we have now time for, to answer your questions. So please, operator, we can kick off with the Q&A now.

[Operator]

[Operator Instructions] The first question comes from José Abad from Goldman Sachs.

[José Abad, Goldman Sachs]

Well, I'm aware, obviously, that you will give us actually all the granularity about your new plans, RoTE targets and capital targets in early April. But I will try because, I mean, this is, obviously, the RoTE target is 13% to 15%. This is 200 basis points difference. This implies a high degree of uncertainty over the coming years, and obviously, we will discuss this in early April.

My question is just about one of the potential sources of uncertainty, which is Brexit. [About 2] weeks, we may have some clarity, maybe not, but we maybe have, we may have some clarity over the coming next 2 months. And I think I was wondering whether maybe you could actually help us navigate the coming 2 months by maybe telling us how this range could be modified in case of a no-deal Brexit. We would end up in the lower bar, in the lower half of this, in the midpoint. So where, how do, how could a no-deal Brexit impact actually this RoTE target?

And related to this is also if you could actually rephrase a bit your hedging strategy in the pound. How, what's the length of this hedging, 1 or 2 years? What's a percentage of our earnings? And at which level, if you can actually have the hedge?

And the second question is on capital and maybe if you could, sorry, apologies if I missed it and you already said that, but if you could provide any guidance on the impact of IFRS 16. And I would like to know how is the management.

How are you actually thinking about the tradeoff between capital generation and capital volatility? You spend every year around 30 bps of capital in hedging your capital ratio, and obviously, if you reduce that, you could actually generate more at a cost. So another way to ask this question is whether you are willing to sacrifice capital volatility for higher capital generation.

[Ana Patricia Botín, Executive Chairman]

Okay. I'll try to complement my comments. I'd say on Brexit, I mean, definitely, I mean, the one thing which [indiscernible] not getting no-deal Brexit. A no-deal Brexit can create, obviously, a significant impact on the economy, and therefore, on our customers and on us.

Sorry, sorry, I'll start that again. Yes, I'll start with Brexit. On, Brexit does make a difference, but I'd say the scenario which we hope doesn't happen, which is the no-deal Brexit, because that would obviously impact the economy, our customers, and therefore, us as banks. So that is the one that would have a negative impact. We are not counting on a no-deal Brexit.

So we continue to plan for a UK economy, which is softer. Inflation is having an impact through the depreciation of the pound. We've been very prudent. We've grown our loans about 1% year-on-year. We are being prudent on our risk appetite. We have had especially higher cost this year, José Antonio mentioned, because of ring fencing.

And I'd say our focus in the UK is on profitability. We set as a range, as you know, for the 3-year plan, which was to be between 9% and 10%, and we are a bit more than 9%. And so we'll continue to be aiming to be above the cost of equity with probably less growth and this will have some impact on earnings. But that is really the plan. In terms of hedging, we hedged the pound for 2 years and we still have 1 more year of hedge, if I remember correctly.

[José Antonio Álvarez, CEO]

Yes.

[Ana Patricia Botín, Executive Chairman]

So we are hedged for the results for the next 12 months, so that would have no impact. In terms of capital, this is a change because we said above 11%, we're above 11%, but we do anticipate some volatility from quarter-to-quarter this year because of regulatory impacts. IFRS would be around 20 basis points, but it will depend on the outcome of the headquarters, which is in the press. It's public. So that will be around 20.

There's some other regulatory impacts this year, but we also have some positives. So you will see some volatility. And definitely, our aim is to be between 11% and 12% so we can have that added flexibility in terms of hedging for the future, which creates, we need some buffer there so we can manage that in a more, I'd say, in a more efficient way economically. So that is the goal, to be between 11% and 12%.

[José Antonio Álvarez, CEO]

No, it's okay. So the reason for the range between 11% and 12% is to gain some flexibility, as you said, yes.

[Operator]

The next question comes from Francisco Riquel from Alantra Equities.

[Francisco Riquel, Alantra Equities]

So follow-up on capital. You have changed the guidance today to the new range or for the medium term, looking for flexibility. But I wonder if you can comment on 2019, if we shall expect any change in the way you will allocate capital this year. You have been allocating it today to roughly on equal parts in between business growth, dividends and capital buffers. So if we shall expect any change this year.

In particular, for the dividend, if we need to be in the upper range of the new guidance before you considering an increase in the dividend payout or if we can see that earlier. And also if you can also update on the regulatory headwind, sorry, beyond IFRS 16, if we shall expect any other impact from any other issue there this year.

[Ana Patricia Botín, Executive Chairman]

So in terms of, we'll give you more detail. We still have a few months to Investor Day. As a reminder, we said, last year, we said we'd go to 2 dividends per year. We said that we would not do a scrip in 2019. These things, we will be updating the market in April, as I said. We are, we still have plenty of profitable growth opportunities, so we will be allocating some capital to growth, and we will accumulate some capital for the next year.

Again, this is something which will give us added flexibility. In terms of the headwinds, we have IFRS 16. I forgot the numbers now. And we have a couple more things. There's a TRIM model and some other things that, as you know, are going on. We don't know exactly the timing of that. We expect it will be this year. It's, more than that is that we do get affected somehow by exchange rates.

These are the things that would create some volatility, and that's why over time, we are aiming to be in a range and then have some flexibility in terms of some of our strategies, for example, the FX hedging on the results, which, obviously, is costing us, I think this year, it's costing us 20 basis points in 2019? Sorry, 2018?

[José Antonio Álvarez, CEO]

No, less, less, a little bit less, Ana. so if I may, in allocating capital, the main change we have, probably you have seen, and I mentioned in the case of Spain, when we reduced the size of the loan book in CIB and corporates is we are aiming a lighter capital model, particularly in the corporate world. So we want to strengthen, we are strengthening our capabilities in CIB, in capital markets, in order to do so. So that's clear, and you continue to see that our business model is going to be lighter in capital, particularly in the large corporation CIB.

[Operator]

The next question comes from Vanessa Guy from JPMorgan.

[Vanessa Guy, JPMorgan]

I have 2 questions. The first one on Mexico. Given the political uncertainty, how should we think about this division in 2019? And also, what's the government's stance on the banking fees? And what potential impacts could we expect? Should they be capped at some level?

Then my second question is on Brazil. There's been some headlines that the government intends to reduce corporate taxes, and they plan to end the interest on capital tax deductibility. I was wondering how that could benefit Santander in Brazil.

[Ana Patricia Botín, Executive Chairman]

I visited Mexico and it was quite public. I had a long meeting with the new President. I believe that there will be changes and governments will introduce changes, both in Brazil and Mexico. Net-net, we're very bullish on both countries. Over time, I, on the commissions, there was nothing that I remember was said, but we are in conversations with the government relating certain improvements and trying to bring innovation and more benefits to consumers.

And again, I think this is something which is good for the economy over the medium term and so we eventually will benefit. I'm not seeing anything specific at this point that could make us worried about Mexico in the next 12 months at all.

On the contrary, it's a country where we've committed the biggest investment and we are continuing with that investment that we announced a couple of years ago because we are confident the country will continue to progress. In the case of Brazil, I think it's too early to tell, but I did meet with the new economics minister last week. It's an excellent team that is really focused on the right things.

And I'd say the most important thing in Brazil, it's not easy, but we again got quite a lot of reassurance that they have a plan and that they will be able to execute a plan, is pension reform. They are working on that for the next few months. And if that happens, Brazil, there are other reforms that they will work on, but net-net, I think this will be positive for the economy. I mean, and if pension reform happens, you can see 10 years of high growth in Brazil. Remember, Brazil has had negative growth for 3 years in a row, so 9% of GDP. So the upside and the change could be very significant. But the key is that we get pension reform implemented as soon as possible. I, on taxes in Brazil, I'm not aware that there's any...

[José Antonio Álvarez, CEO]

It's too early to tell the answer.

[Operator]

The next question comes from Alvaro Serrano from Morgan Stanley.

[Alvaro Serrano, Morgan Stanley]

Two questions. One on capital, a follow-up on capital. In the quarter on Q4, you built 10 basis points, which is your usual run rate, but there was a big rally in Brazilian bonds, which doesn't seem, it doesn't seem like it has the positive effect on the capital. So maybe can you clarify that?

And when I look at this year, you flagged, obviously, the headwinds, but is it possible that capital goes down below 11% versus the 11.03% fully loaded, with IFRS fully loaded? Is it possible you dip back below 11%, which I think could make some people nervous?

And just a follow-up from my credit colleagues on the AT1. You've put in your presentation that you plan to issue €1.5 billion, which seems to suggest you'll call at least 1 of the 2 AT1s, if you can confirm that. And the second question on your plan, 13% to 15% RoTE target. Obviously, the cycle, this uncertainty around the cycle, I'm just curious if you can expand of what kind of economic scenario beyond Brexit, which we don't know and we can only be helpful. But beyond that, what kind of cycle are you assuming, for example, in the U.S.? Because I saw the pickup in provisions. You've already flagged there was a change in accounting. But even above and beyond that €200 million, there is a pickup in provisions in Santander Consumer U.S.A. So if you can comment about the cycle, how you're seeing it and what you factor in.

[Ana Patricia Botín, Executive Chairman]

I'm going to start with the third one on the 13% to 14% and the cycle and José Antonio will answer the more detailed ones on capital and AT1. So the cycle, obviously, at some point, the cycle is going to turn. I mean, we are working on the assumption that 2019 will see some slowdown.

But actually, we see this as a positive because we have more sustained recovery. This is actually a scenario which is pretty good for banks because it could allow for a slower increase in rates but some increase in rates, which would be, should be good for margins, but should also be relatively good for the nonperforming loans, will continue to perform well, and finally, should lead to some increased demand for credit. So 2019, we see as, I'd say, relatively good even though a bit less growth overall.

One of our key markets, which is Spain, continues to be incredibly resilient. You've seen the great results of Spain this year. We're now, in the plan, we have around 2% growth. But given the strength in the numbers we saw, I think it was yesterday, on employment, creating 566,000 jobs last year, we're growing at double the rate of the European Union. And so I think Spain will do very well.

Brazil is supposed to be very well. So these are some of our big markets. So even though overall a bit less growth, I'd say positive for us and for banks and some of our key markets doing especially well. In the U.S., probably the U.S. might turn around in terms of, from positive to negative before Europe, before LatAm. But again, nothing major and nothing at this point for 2019 that would give us concern that the strong underlying commercial trends will continue.

In terms of the 13% to 15% RoTE, we'll give you more details again in Investor Day, what are the milestones to get us to those levels of profitability. So maybe, José Antonio, you want to answer the other one?

[José Antonio Álvarez, CEO]

Yes. You mentioned the Brazilian bonds as having an effect, the rally in Brazilian bonds as at the fourth quarter having an effect in the total capital ratio of the group. The portfolio of the Brazil bonds is relatively small. If I remember well in the last, in the fourth quarter, the positive from the AFS was like €200 million or something like that, so fairly small number. 1.5 basis points for the group is not a big impact.

When you say the volatility is through, and I mentioned that we're going to have some volatility, volatility coming from FX, volatility coming from an AFS, is true. Well, until now, as you know, we've been fairly conservative in hedging to protect the capital ratio, but it's true that we have some volatility there, yes.

In relation with the AT1s, our policy was stated several years ago. We made a relevant fact to the market saying that we call, were referring to all the hybrid instruments. We call or we don't call depending, basically, purely in economic terms and this policy is done.

[Operator]

The next question comes from Ignacio Ulargui from Deutsche Bank.

[Ignacio Ulargui, Deutsche Bank]

I just have one question on Brazil. We have seen a bit of a slowdown in NII in the Q-on-Q performance in local terms. Just wanted to, I mean, acknowledging that Brazil has had a great year in 2018 and 2017, how do you see the trends in terms of margins and loan growth going forward? And linked to that, what should we expect in costs in Brazil?

[Ana Patricia Botín, Executive Chairman]

I believe the slowdown is due to some financial, i.e., noncommercial factors in Q4. So nothing that concerns us at all in terms of the underlying trends. It is true that if the economy, as we expect, takes more speed, you'll see more growth coming from volumes and from margins because, as you know, margins expanded quite a lot and now are going to more normal levels.

So I'd say you've seen very good loan growth in Brazil in the year, and I think, in the quarter at double digit in most segments. And so I'd say that is where you're going to see the growth and that's what we expect. I mean, our total loans in Brazil is around €70 billion. I mean, this is a huge opportunity for growth.

Mexico is around €25 billion, I believe. So still relatively low numbers compared to the size of the economy and compared to the size of the Santander loan book. So I'd say Brazil, and probably also Mexico, will see more volume expansion, volume growth and margin expansion.

[Operator]

The next question comes from Mario Ropero from Fidentiis.

[Mario Ropero, Fidentiis]

I have 2 questions. The first one is on NII in Spain. Basically, by taking the fourth quarter level and multiplying it by 4, you already have plus 5.5% in 2019. So I wonder if you can give us any guidance or maybe to comment on how the different levers of NII could evolve in 2019.

And then the second question is on Brazil. I think Ana mentioned that you're expecting double-digit loan growth in Brazil. So I was wondering if you can comment whether you expect this double digit to feed into the bottom line or not, depending on how you see the different levers moving.

[Ana Patricia Botín, Executive Chairman]

Antonio, you want to take those?

[José Antonio Álvarez, CEO]

So NII in Spain, we saw some expansion in the fourth quarter. We continue to see next year some growth in probably mid-single digit basically coming from the reduction in funding cost. It's expectable. We don't expect a big deal on the yield on the loans. The market remains fairly competitive. So probably to thinking around mid-single digit is something that is reasonable for next year coming basically from the funding side.

In Brazil, while, when, you have in the presentation the spread on loans in Brazil, yes, so it's like a 900 basis points or north of 900 basis points. There's more changes there, can affect significantly the NII generation. While I do expect, I don't know if in 2019, but in medium term, some margin compression in some products in Brazil. The market is becoming a little bit more competitive.

As you know, we've been gaining significant market share, and naturally, we have good competitors there that are reacting to our market share gains, particularly in segments like the consumer lending, auto lending and all these things may be the case, maybe not, yes, so I'm not sure, but there is a case for some margin compression there. It's also true that there is a case for margin expansion on the funding side.

As you know, the reserve requirements are extremely high in Brazil and may be the case that the 2 process goes together, or at least in the medium term, I would expect the 2 process to go together: one, some margin compression on the asset side, some margin expansion on the liability side, probably due to the [reduction] and reserve requirements. But as you can imagine, this depends on the regulatory environment and the competitive environment in Brazil in coming years. It's not next quarter. It is more if I look 3 years forward, yes.

[Operator]

The next question comes from Carlos Peixoto from Caixabank-BPI.

[Carlos Peixoto, Caixabank-BPI]

My question is, first question would be a bit of a follow-up on capital and on dividend. I did, I just wanted to make clear. Are you maintaining the full cash dividend policy that was mentioned last year for 2019 and going forward? Or are there any scrip dividends or something of that nature embedded here? How should we think about payout going forward and within the context of the targets for core Tier 1 that you mentioned basically?

Then a second question, with the, a bit on the outlook for 2019 in Spain. How do you expect, how do you see volumes evolving? And how do you see lower funding costs, particularly that were made on the 1, 2, 3 accounts? The renumeration, how do you see that feeding into the NII evolution in Spain in 2019?

[Ana Patricia Botín, Executive Chairman]

On dividends, obviously, we will discuss in more detail dividends in April. We are, at the moment, not changing what we already announced, which is a full cash dividend in 2019, no scrip, 2 dividends instead of 4. And we, for the 3-year plan, and we're not going to change this for now. I mean, we have to discuss this, but I'm not thinking about anything very different, but we need to discuss this with the board. We need to work a bit more on this. But as of now, as you know, we said 30% to 40% distribution from profits.

Sometimes, if there's a one-off or not, we might change that between underlying and net profit, but roughly 30% to 40% range payout. We are very comfortable with that dividend policy. And again, that's what we, again, I don't want to say in advance what we're going to say in April, but you shouldn't expect much change from that. In terms of the outlook for Spain, on margins, I think, José Antonio, you mentioned that already.

[José Antonio Álvarez, CEO]

Yes, I already mentioned.

[Ana Patricia Botín, Executive Chairman]

So it's more volumes and...

[José Antonio Álvarez, CEO]

The only thing is volumes. As I said, we expect some growth in volumes in the lending side, not that much because probably we're going to keep shrinking the balance sheet in CIB and institutional lending, yes? So probably, we're going to, we are already showing growth in SMEs and consumer lending, that there are 2 engines of the activity right now.

And probably, we will continue to see some growth in these 2 segments, while the other 2, institutional and CIB, continue to be flat at best or most likely reducing the size of the loan book, yes.

[Ana Patricia Botín, Executive Chairman]

Yes. Just on the 1, 2, 3, I mean, the 1, 2, 3 is a strategy, which is a customer loyalty, a customer relationship strategy. It's been very important over the last 3 years in Spain. The loyal customers have increased by 72%. And it's been the base of our growth in terms of we're doing 3 times more mortgages, 4 times more consumer lending. So it's really helped us to increase the business and relationships with our loyal customers and that is something which will continue, we believe, over the next 3 years. So it's not just about the margins, it's about all the business that we're doing with these 1, 2, 3 customers.

[Sergio Martínez, IR]

Thanks, everyone. We need to leave it here. And obviously, IR team is at your entire disposal today and this after for any follow-up. Thanks, Ana, José Antonio. See you next quarter. Thank you.

[Ana Patricia Botín, Executive Chairman]

Thank you.