By Jeannette Neumann 

MADRID--Spain's modest economic recovery hasn't reversed a slump in the bread-and-butter business of its banks: loans.

Each of Spain's five big banks has seen total loan volumes fall over the past 12 months through September. At the Spanish unit of Banco Santander SA, the country's largest bank by market value, the total dropped 5.1% during that period.

Banks across Europe are struggling to expand lending despite efforts by authorities to cut the cost of borrowing and stoke demand for loans in a region that hasn't moved full-throttle beyond recent recessions. Investors, analysts and policy makers are monitoring lending in Spain and across the eurozone for signs of a healing economy.

Executives at Santander and other Spanish banks said they don't expect total loan volumes to increase before late next year.

One hurdle to loan growth is unemployment and its effect on mortgages, which make up a substantial portion of many banks' loans. Mortgages account for 31% of Santander's loans and 43% at Caixabank SA, the third-largest lender by market value.

The country's banks issued 19,323 home mortgages in September, the peak month this year, a far cry from the record 129,128 in September 2005, at the height of the building boom.

Then the boom went bust, as property developers began to default on loans, pushing some regional savings banks toward collapse. Spain borrowed about EUR41 billion ($50.8 billion) in European Union funds in 2012 to bail out those troubled lenders.

Spain's unemployment rate has declined only modestly from its 26% level in mid-2013, when the economy emerged from its second recession in five years. Even with the economy expected to expand 1.2% this year and 1.7% next year, according to the European Commission, the unemployment rate is projected to be about 22% in 2016.

Some banks are shifting their focus to business loans, cutting interest rates and attempting to attract new borrowers.

The volume of loans issued for less than EUR1 million, a proxy for borrowing by small and medium-size businesses, increased 8.2% in the first 10 months of this year compared with a year earlier, according to Spain's central bank.

The competition to tap small and medium-size businesses, though, makes it harder to turn a profit. Santander Chief Financial Officer José Antonio Álvarez, speaking during the bank's third-quarter-results presentation in November, said the bank was under some pressure to lower borrowing rates for business loans.

César Pontvianne, head of Plásticos Dúrex, a Salamanca-based company that produces plastic car parts, said interest rates for a roughly EUR500,000, two-year loan have dropped to about 3% compared with about 5% a year ago.

"I'd never even heard from these banks before," Mr. Pontvianne said, "and then, all of the sudden, they were on our doorstep."

Spanish banks "have lost a lot of clients. And a lot of mortgage volume, " said Contenur SL Chief Executive Officer Iñigo Querejeta. The company is based on the outskirts of Madrid and exports garbage containers to 20 countries. Banks "are willing to lend money in conditions we haven't seen for the last six or seven years."

At the same time, bank lending to bigger businesses is in decline. The volume of loans over EUR1 million fell 21% in the first 10 months of this year compared with the year-ago period. That is partly because Spanish businesses have been able to issue bonds, instead of relying on bank loans as they did during the depths of the country's downturn, said Francisco Riquel, an analyst with Madrid-based financial-services firm N+1 Group. That shows investors have some confidence in Spain's recovery, but it means banks are deprived of a source of profits, he said.

Even as the volume of new loans picks up in some areas, that isn't enough to offset the pace at which borrowers pay down existing debts. Santander's Spanish unit reported a 73% jump in new mortgage issuance and a 34% rise in business loans in the first nine months of 2014 compared with a year ago, even as overall loans decreased.

"We still have a level of debt that's too high, especially among businesses," said Jordi Fabregat, a finance professor at Esade business school in Barcelona.

Big Spanish banks reported solid net profits in the third quarter, but that was thanks in large part to gains in bond trading, a volatile source of income.

Lenders will have to compensate for lower loan volumes by continuing to close offices, cut staff and pay less to depositors, Mr. Fabregat said.

Some analysts and investors said the pressure to increase lending could have a negative effect on credit quality.

"Experience shows that when there's tough competition for assets, to give credit in this case, and quickly, banks tend to relax their risk analysis," said Juan José Toribio, an economics professor at IESE business school in Madrid and a former head of financial policy in Spain's Finance Ministry.

"Having liquidity doesn't mean I'm going to give a bad loan," Caixabank CEO Gonzalo Gortázar said during a third-quarter earnings presentation. "If they don't pay back the loan, I've done a bad deal."

Banks trying to boost loan volumes are likely to start targeting smaller companies, analysts and economists said. Nearly 90% of businesses in Spain have fewer than nine employees, according to the Organization for Economic Cooperation and Development.

An increase in loans to these companies could help sustain Spain's recovery, Mr. Toribio said.

But as a whole they are considered riskier clients, in part because they have less financial cushion against potential losses.

Write to Jeannette Neumann at jeannette.neumann@wsj.com

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