SAN Banco Santander SA

1.1 Introduction

The Santander Group is one of the world’s largest financial groups. It occupies a unique position in international banking, with a strong commercial franchise and a high degree of geographical diversification.

At year-end 2014 Santander was the largest bank in the eurozone and the eleventh largest in the world by market capitalisation: EUR 88,041 million.

Its corporate purpose is to perform all manner of activities, transactions and services proper to the banking business. Its business model is centred on commercial banking products and services designed to meet the needs of personal, business and corporate customers. It has a global network of 12,951 branches, the largest of any international bank, through which it serves more than 100 million customers. Its assets amount to EUR 1,266 billion and it manages funds totalling EUR 1,428 billion for all customer segments. The Group has 3.2 million shareholders and more than 185,000 employees.

Some 88% of its revenue comes from commercial banking.

The Group is highly diversified, with a presence in ten main markets, in which it has a significant share of business. The business is well balanced between developed and emerging markets.

Note: A detailed analysis of the Santander Group’s results for 2014 is given in the economic and financial statements included in the annual report.

Commercial activity and revenue

Total revenue was EUR 42,612 million, up 1.7% compared to 2013. Excluding the impact of exchange rates, the increase was 6.2%. This represents higher quality growth, based on increases in the more commercial drivers of the revenue line (net interest income and fee and commission income), together with a fall in gains/losses on financial assets and liabilities, which accounts for only 7% of Group revenue.

Costs grew below the Group’s average inflation, assisted by business combination synergies (Spain and Poland) and the three-year efficiency and productivity plan launched at the end of 2013. The Group’s cost-to-income ratio improved by 1.1 points to reach 47%, setting us apart from our rivals.

Pre-provision profit was EUR 22,574 million.

Credit quality

The Group’s non-performing loans (NPL) ratio fell to 5.19%, the first annual decrease (-42 basis points) since the start of the financial crisis. The NPL coverage ratio was 67% (65% in December 2013).

Loan loss provisions fell to EUR 10,562 million (-14.4%), assisted by the good performance of the United Kingdom, Portugal, Spain and Brazil. As a result, the cost of lending (measured as loan loss provisions for the last twelve months as a percentage of average loans and receivables for the same period) fell to 1.43% (1.69% in December 2013).

Attributable profit

The Santander Group continued to increase its profit and revert to normal levels of returns, posting attributable profit of EUR 5,816 million in 2014, up 39.3% on 2013, after adjustments for retrospective application of IFRIC Interpretation 21.

This strong growth is due to the good performance of the main P&L lines and the improvement in results in practically all the business units. Most noteworthy are the improvement in commercial revenue, which returned to growth after a fall in 2013, and the downward trend in loan loss provisions, which still have further to fall. In addition, costs were contained by the efficiency and productivity plan announced last year.

Of the total profit for 2014, 44% came from developing markets and 56% from mature markets.

Balance sheet strength

Improving the liquidity position has been a priority objective of the Group’s strategy in recent years and has been achieved thanks to the Group’s capacity to acquire deposits in the retail market through its extensive branch network and the broad, diversified access to wholesale markets provided by its subsidiaries model.

In 2014 the loan-to-deposit ratio and the ratio of deposits and mid-to long-term funding to loans remained at comfortable levels, both in the Group and in the main units.

We took advantage of the more favourable, lower interest-rate market environment to issue at longer maturities and increased the liquidity reserve to nearly EUR 230,000 million.

The Group ended the year with high capital levels, which we reinforced with the EUR 7.5 billion capital raising carried out in January 2015.

Following this operation, the Group has a phase-in CET1 capital ratio of 12.2% and a fully loaded capital ratio of 9.7%. These capital levels make Santander one of the world’s most strongly capitalised banking groups, considering our business model, geographical diversification and resistance to adverse stress scenarios.

Note: to comply with one of the EDTF’s disclosure best practices, details of capital requirements and RWAs and the factors that explain the changes for each risk type are given below. For more information on the capital requirements for each risk, see Chapter 5.5.3.

Flow Statement. Capital requirement for credit risk

Millions of euros

The increase in capital requirements for credit risk is attributable mainly to three factors: the impact of Basel III on deferred tax assets, the growth of the business in Brazil and the United States, and the effect of exchange rates.

Flow Statement. Capital requirement

for market risk, internal models

Millions of euros

Flow Statement. Capital requirement

for market risk, standardised approach

Millions of euros

The changes in capital requirements for market risk are mainly due to movements in the portfolios.

Flow Statement. Capital requirement

for operational risk

Millions of euros

2.1. Macroeconomic environment

In 2014 the world economy grew at a rate of around 3.3%, similar to 2013 but with important differences: on the one hand, the advanced economies as a whole experienced a marked recovery, off-set by a slowdown in the emerging economies. On the other hand, the differences in cyclical position became more pronounced, both among the advanced economies and also among the emerging countries:

2.2. 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 through Directive 2013/36 (CRD IV), which repeals Directives 2006/48 and 2006/49, and Regulation 575/2013 on prudential requirements for credit institutions and investment firms (CRR).

CRD IV was introduced into Spanish law through Law 10/2014 on the ordering, supervision and solvency of credit institutions, although the regulatory implementation of this law and possible circulars by Banco de España were pending at the date of this report. The CRR is directly applicable in Member States from 1 January 2014 and repeals those lower-ranking standards that entail additional capital requirements.

The CRR provides for a phase-in period that will allow institutions to adapt gradually to the new requirements in the European Union. The phase-in arrangements have been introduced into Spanish law through Bank of Spain Circular 2/2014, with implementation starting in 2014 and ending, in some cases, in 2024. The phase-in affects both the new deductions from capital and the instruments and elements of capital that cease to be eligible as capital under the new regulations. The capital conservation buffers provided for in CRD IV will also be phased in gradually, starting in 2016 and reaching full implementation in 2019.

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

In December 2011 the European Banking Authority (EBA) published a recommendation that imposed additional capital requirements on the main European banks. These requirements are part of a package of measures adopted by the European Council in the second half of 2011 aimed at restoring stability and confidence in the European markets. The banks included in the sample were

required to have a Core Tier 1 capital ratio, calculated according to EBA rules, of at least 9% at 30 June 2012. On 22 July 2013, following the publication of CRD IV and the CRR, the EBA issued a new recommendation, replacing the previous requirements with a capital floor expressed as a monetary amount equivalent to the amount needed in order to meet the 9% ratio at 30 June 2012. Following the decision of the EBA’s Board of Supervisors on 15 December 2014, the floors were abolished and a minimum CET1 ratio of 4.5% was established.

2.2.1. Regulatory changes in 2014

The pace of regulatory change remained intense during 2014. Further steps were taken to address the weaknesses identified in the recent financial crisis.

Regulatory activity was particularly intense in the Basel Committee’s ongoing review of the framework of capital requirements for credit, market and operational risk, both under the Standardised Approaches and in the Advanced Approaches. This review is expected to be completed during 2015 and the extent to which it succeeds will determine whether the prudential framework continues to rely on risk-sensitive requirements or gives greater emphasis to non-risk-sensitive measures such as the leverage ratio.

New publications by the Basel Committee

Over the course of 2014 the Basel Committee published the final versions of a number of consultation documents. These documents are as follows:

In addition, the Basel Committee published a number of consultative documents during 2014:

On its website, the Basel Committee has set out its work programme for 2015 and 2016. It highlights the following objectives:

The Santander Group has been actively involved in these consultations, responding to most of them individually and taking part in all the responses by banking associations (EBF, IIF, AFME, AEB, IBFED).

Changes in European regulation

In turn, in Europe, following approval of the regulation and directive that introduced the Basel III accord, the EBA continued to issue standards and guidelines to ensure harmonised implementation of the Pillar I and Pillar II minimum capital requirements in the European Union.

The following final documents deserve special mention:

The most important consultation papers in 2014 are the following:

In 2014 the EBA also published a series of guidelines, most notably the following:

The euro zone’s new Single Banking Supervisor, for its part, has expressed a wish to eliminate any divergence in the implementation of said requirements. All these initiatives will be decisive in reducing differences in capital charges that are not justified by differences in institutions’ risk profiles. This will help ensure a level playing field and greater comparability and so restore credibility to risk-sensitive measures.

At the same time, regulators have been working on designing and implementing effective crisis management frameworks that will make it possible for any institution to be resolved at no cost to the taxpayer and without causing systemic risk. At the international level, the FSB has made progress with the crisis management framework to be applied to G-SIBs. A new feature of these frameworks is the requirement for a minimum loss-absorbing capacity enough to recapitalize an entity in case of resolution (TLAC). A proposal was released for consultation in November. An impact and market study will be conducted during 2015, with a view to completing the definition and calibration of the new ratio by the end of the year.

In Europe, the European Crisis Management Directive was passed in May 2014. Member States must implement it by January 2015. This directive marks a major step forward in the orderly resolution of financial institutions in Europe and has helped to break the link between banking risk and sovereign risk by requiring that bank creditors be the first to absorb losses, thus minimising the risk that public funds will be used to resolve banking crises.

As in Europe, during 2014 there were regulatory developments relating to the implementation of Basel III in other countries in which the Group is present.

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

The Santander Group companies which, on account of the nature of their activity, are included in the prudential scope of consolidation for the purposes of calculating the capital ratio are consolidated using the global consolidation method, except for jointly controlled entities, which are consolidated using proportionate consolidation. All the companies that do not have to be consolidated on account of their activity are included using the equity method and so are treated as equity exposures.

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

3.2 Disclosure criteria used in this report

Below are details of the types of information where the discrepancies between the regulatory information shown in this report and the information shown in the annual report and the accounting information can be seen most clearly:

Note: To comply with one of the EDTF’s best disclosure practices, the reconciliation of the public balance sheet to the non-public balance sheet is shown below

3.3. Substantial modifications due to changes in the scope of consolidation and corporate transactions

1) Sale of Altamira to Apollo

On 21 November 2013 the Group announced that it had reached a preliminary agreement with Apollo European Principal Finance Fund II, a fund managed by subsidiaries of Apollo Global Management, LLC, for the sale of the platform responsible for Banco Santander, S.A.’s loan recovery management in Spain and the management and marketing of the properties resulting from this activity (Altamira Asset Management, S.L.). On 3 January 2014 the Group announced that it had sold 85% of the share capital of Altamira Asset Management, S.L. to Altamira Asset Management Holdings, S.L., an investee of Apollo European Principal Finance Fund II, an entity affiliated to Apollo Global Management, LLC (Apollo), for EUR 664 million, generating a net gain of EUR 385 million, which is recorded at its gross amount in the consolidated income statement for 2014 under “Gains on derecognition of assets not classified as non-current assets held for sale”. Following this transaction, the Group retains the abovementioned real estate assets and loan portfolio on its balance sheet, while the assets are managed from the platform owned by Apollo.

2) Acquisition of businesses in Nordics from GE Money

On 23 June 2014 the Group announced that Santander Consumer Finance, S.A., Banco Santander’s consumer finance unit, had reached an agreement with GE Money Nordic Holding AB to buy the latter’s business in Sweden, Denmark and Norway for approximately EUR 693 million (SEK 6,408 million). The acquisition was completed on 6 November 2014, once the necessary authorisations had been obtained.

3) Agreement with Warburg Pincus on the custody business

On 19 June 2014 the Group announced that it had reached an agreement with FINESP Holdings II B.V., a subsidiary of Warburg Pincus, to sell a 50% stake in Santander’s custody business in Spain, Mexico and Brazil, valuing the business at EUR 975 million. The Group will retain the remaining 50%. The sale is subject to regulatory approval, which, according to the agreement, must be obtained in the first half of 2015.

4) Acquisition of Carfinco in Canada

On 16 September 2014 Banco Santander announced that it had reached an agreement for the acquisition of the listed Canadian auto financing company Carfinco Financial Group Inc. (“Carfinco”) for CAD 298 million (approximately EUR 210 million at the date of the announcement). The board of directors and the shareholders meeting of Carfinco have approved the transaction. Subject to regulatory authorisation, the transaction is expected to be completed in the first quarter of 2015.

5) Alliance with CNP in the insurance business

On 10 July 2014 Banco Santander announced that it had reached a definitive agreement with the French insurance company CNP by which CNP will acquire a 51% stake in the three insurance companies (Santander Insurance Life Limited, Santander Insurance Europe Limited and Santander Insurance Services Ireland Limited), based in Ireland, that distribute life and non-life products through the Santander Consumer Finance network.

In December 2014, once the regulatory authorisations had been obtained, CNP acquired 51% of the capital of the three insurance companies for EUR 297 million, thus gaining control. The agreement also includes deferred payments to CNP in 2017 and 2020 and deferred collections for the Group in 2017, 2020 and 2023, depending on the business plan.

The abovementioned agreement includes a distribution agreement for the sale of life and non-life insurance products for 20 years, renewable for 5-year periods, through the Santander Consumer Finance network, for which the Group will receive commissions on market terms.

To reflect this deal the Group recognised a gain of EUR 413 million, which is recorded under “Gains on derecognition or disposal of assets not classified as non-current assets held for sale”, of which EUR 207 million relate to the recognition at fair value of the 49% interest retained by the Group.

6) Agreement with Banque PSA Finance

The Group, through its subsidiary Santander Consumer Finance, S.A., and Banque PSA Finance, the vehicle finance unit of the PSA Peugeot Citroën Group, have signed an agreement for the joint operation of the vehicle finance business in twelve European countries. Under the terms of the agreement, subject to certain circumstances and conditions, the Group will finance this business from the date of completion of the deal, expected in 2015 or early 2016.

Additionally, in certain countries the Group will purchase part of Banque PSA Finance’s current loan book. The deal also includes a cooperation agreement for the insurance business in all these countries. The transaction is subject to approval by the relevant regulatory and competition authorities.

The necessary regulatory authorisations to start activities in France and the United Kingdom were obtained in January 2015.

7) Agreement with El Corte Inglés

On 7 October 2013 the Group announced that through its subsidiary Santander Consumer Finance, S.A. it had entered into a strategic agreement with El Corte Inglés, S.A. in the field of customer finance, which included the acquisition of 51% of the shares of Financiera El Corte Inglés E.F.C., S.A., with El Corte Inglés, S.A. retaining the remaining 49%. The deal was completed on 27 February 2014, once it had received clearance from regulators and competition authorities. Santander Consumer Finance, S.A. paid EUR 140 million for the 51% stake in Financiera El Corte Inglés E.F.C., S.A.

4.1. Structure and policy of the Pillar III Disclosures

The Pillar III Disclosures are prepared in order to meet the obligations established in Part Eight of the CRR on disclosure by institutions.

The Santander Group’s Pillar III Disclosures are divided into 14 sections and five appendices. The first four chapters describe material events affecting the Group that occurred in 2014, the macroeconomic and regulatory environment, the scope of application and the background to Pillar III in the Santander Group. The fifth chapter provides full information on capital, including qualitative information on the capital function in the Group and quantitative information on the Group’s capital base and capital requirements.

Chapters 6 to 12 describe the risk function in the Group and provide detailed information about credit risk, market and ALM risk, operational risk, liquidity and compliance risk, and reputational risk. Chapter 13 describes the Internal Control function in the Group. Chapter 14 contains information on remuneration policy. Lastly, the Appendix includes a glossary of terms to facilitate understanding of the report.

4.2. Transparency enhancements

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

The conclusions and best practices included in the “Review of the Pillar 3 disclosure requirements - consultative document”, published by the Basel Committee on 9 September 2014 (the final version of which was published on 28 January 2015), have also been taken into account.

The enhancements introduced as a result of these recommendations and comments are detailed below:

4.3. Governance: approval and publication

Under the formal disclosure policy approved by the board of directors on 28 April 2009, the Santander Group must publish the Pillar III Disclosures at yearly intervals, following approval by the Group’s board of directors. Prior to approval by the board of directors at its meeting on 23 February 2015, the Pillar III report was approved on 19 February 2015 by the Santander Group’s audit and compliance committee.

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

4.4. Background on the 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 the Santander Group. The CRR is applicable at consolidated level to the whole Group.

The 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 that are included in the scope of consolidation for accounting purposes under Bank of Spain Circular 4/2004.

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

The companies for which a different consolidation method is used, based on the regulations applied, and the equity investments that are deducted from capital are listed in Appendix I, distinguishing between financial institutions and insurance companies in which the Group has a significant ownership interest. As of the reporting date, both types of investment are exempt from deduction pursuant to article 48 of the CRR. A complete list of the companies that comprise the Santander Group is appended to the Notes to the Group’s consolidated financial statements.

At 31 December 2014, under the Rule Five of Bank of Spain Circular 3/2008, the subsidiaries Santander Leasing S.A., E.F.C.* and Santander Factoring y Confirming S.A. E.F.C.* 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.

In some jurisdictions, limitations have been imposed on dividend payments under the new, much stricter capital adequacy regulations. However, the Santander Group is unaware of any practical or legal impediment to the transfer of funds from Group subsidiaries to the parent in the form of dividends, loans or advances, repatriation of capital or in other forms

Santander is among the banks that have not requested state aid in any of the countries in which it has a presence.

Note: These companies, being specialised lending institutions, are excluded from the scope of the CRR and the CRD and are still subject to Bank of Spain Circular 3/2008.

Qualitative aspects of capital are also covered. Specifically, the chapter explains the role capital plays in the Santander business model, how capital is managed, and the organisational model supporting the capital function.

Chapters 6 to 12 explain in detail how each of the main risks affecting the Santander Group’s activity is managed and monitored.

5.1. Introduction

The Group’s capital is managed in an integrated way, so as to protect the Bank’s solvency, meet regulatory requirements and maximise profitability, guided by the strategic objectives and risk appetite set by the board of directors. The following policies, which together make up the Group’s capital management framework, have been established to achieve this objective:

Santander defines capital risk as the risk that the Group or any of its companies has insufficient quantity or quality of capital to meet the expectations of its stakeholders in accordance with its strategic plan. The main objectives are as follows:

5.2. Capital function

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

5.2.1. Organisation

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

5.2.2. Capital governance

To ensure the proper exercise of the capital function, both in terms of decision making and in terms of supervision and control, the Santander Group has developed a structure of responsive and efficient governance bodies, which secure the participation of all the areas concerned and ensure the necessary involvement of senior

management. Because of the Group’s characteristic subsidiaries structure, the governance structure of the capital function has to be adapted to preserve the subsidiaries’ capital autonomy, while allowing centralised monitoring and coordinated management at Group level.

To achieve this, the corporate-level governance structure is replicated in each subsidiary, with a similar structure and functions. There are also committees that have responsibilities both at parent company level and also for coordination at Group level. The local committees must report to the corporate committees as and when required on any relevant aspects of their activity that may affect capital, so as to ensure proper coordination between the subsidiaries and the corporate level.

5.3. Capital management

The goal of capital management in the Santander Group is to guarantee the entity’s solvency and maximise its profitability, while ensuring compliance with internal capital targets 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

Economic capital

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 “hurdle rate” or “minimum return” to be achieved and can be used to compare the activity of the different business units and analyse their efficiency.

Return on risk-adjusted capital (Rorac)

The return (understood as net profit after tax) on internally required economic capital. Given this relationship, any increase in economic capital means a decrease in 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.

Using Rorac allows the Bank to manage its activities better, assess the true return on its businesses considering the risks assumed and be more efficient in its investment decision making.

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 greater than the Bank’s cost of capital, and will destroy value in the opposite case. Value creation measures the risk-adjusted return in absolute terms (currency units) and so is complementary to the Rorac perspective.

Expected loss

The loss due to default that we expect to have, on average, over the course of a business 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.

There are two levels of capital management in the Group:

5.4. Capital management priorities in 2014

Details of the most significant actions taken in 2014 are given below:

Acquisition offer to minority shareholders in Santander Brazil

On 18 September Banco Santander formally launched an offer to acquire the 25% of its subsidiary in Brazil not held by the Santander Group through an exchange of Banco Santander Brazil shares for shares of Banco Santander. The offer was not subject to a minimum level of acceptance.

The offer was accepted by 13.65% of the minority shareholders of Santander Brazil, bringing the Santander Group’s interest in Santander Brazil to 88.30%.

To carry out the exchange, 370,937,066 new shares were issued, representing approximately 3.09% of the share capital at 15 September, the date on which the issue was approved at an Extraordinary General Meeting.

Issues of contingent convertible securities (CoCos)

Banco Santander S.A. issued CoCos on three occasions in 2014, with the aim of strengthening its Additional Tier 1 capital:

In March it issued EUR 1,500 million of CoCos, with an annual coupon set at 6.25% for the first five years, after which it will be reviewed, applying a margin of 541 basis points on the 5-year mid-swap rate. The securities will convert into new ordinary shares of Banco Santander if the Common Equity Tier 1 capital ratio of the Bank or its consolidated group, calculated in accordance with the CRR, falls below 5.125%.

In May it issued USD 1,500 million of CoCos, with an annual coupon set at 6.375% for the first five years, after which it will be reviewed, applying a margin of 478.8 basis points on the 5-year mid-swap rate. The securities will convert into new ordinary shares of Banco Santander if the Common Equity Tier 1 capital ratio of the Bank or its consolidated group, calculated in accordance with the CRR, falls below 5.125%.

Lastly, in September it issued EUR 1,500 million of CoCos, with an annual coupon set at 6.25% for the first seven years, after which it will be reviewed, applying a margin of 564 basis points on the 5-year mid-swap rate. The securities will convert into new ordinary shares of Banco Santander if the Common Equity Tier 1 capital ratio of the Bank or its consolidated group, calculated in accordance with the CRR, falls below 5.125%.

Capital increase (January 2015)

In 2015 Banco Santander carried out a capital increase of EUR 7,500 million through the issuance of 1,213 million shares, disapplying pre-emption rights for current shareholders. The capital increase was carried out via an accelerated bookbuilding offer directed at institutional investors. The new shares started trading on 13 January 2015.

This capital strengthening will allow the Bank to benefit from the expected strong growth in its main markets in 2016 (GDP increase of around 3%), taking advantage of organic growth opportunities and increasing lending and market share. It will also allow early compliance with the Basel III capital requirements, permitting full implementation from 2015 even though not required until January 2019.

In 2015, following this capital increase, the Bank will reach a fully loaded capital ratio of around 10%. This will make Santander one of the world’s most strongly capitalised banks, given that its geographical diversification and retail business model ensure low volatility of results, as was confirmed in the ECB’s recent asset quality review and stress tests.

Corporate transactions

The main capital gains in 2014 came from the sale of Altamira (EUR 385 million net), the IPO of SCUSA (EUR 730 million net), the modification of pension commitments in the United Kingdom (EUR 224 million) and the transactions related to the insurance businesses (EUR 250 million net).

On the other hand, charges totalling EUR 1,589 million, net of taxes, were recorded for restructuring costs, impairment of intangible assets and other provisions and write-downs. The impact of these amounts on earnings is therefore nil.

5.5. Pillar I regulatory capital

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

In Spain, the regulations on the calculation and monitoring of minimum capital have been actively updated ever since Basel II came into effect. The capital requirements directive and regulation implementing the Basel III agreement, which will entail higher capital requirements for credit institutions, were approved on 27 July 2013 and apply from 1 January 2014.

5.5.1. Eligible capital

Total shareholders’ equity, after retained earnings, was EUR 91,664 million, an increase of EUR 7,185 million, or 9%, compared to the previous year.

Over the course of 2014 various issues of ordinary shares were made to meet the demand from shareholders who opted to receive dividends in shares under the Santander Dividendo Elección (scrip dividend) programmes. Thus, a total of 880,057,105 shares were issued for the four scrip dividends in the year – two for the third and fourth dividends of 2013 and two for the first and second dividends of 2014 – with combined take-up of 87.1%.

In addition, 370,937,066 shares were issued in September for the exchange of shares arising from the acquisition offer to minority shareholders of Banco Santander Brasil, S.A.

Valuation adjustments are up EUR 3,295 million, with a marked positive impact of exchange rates on the value of the investments in foreign subsidiaries (partly hedged) and the valuations of portfolios, especially fixed-income. As a result of all the above, equity at year-end is EUR 80,806 million, up EUR 10,479 million, or 15%, on the previous year. Adding the EUR 7,500 million from the capital increase in January, equity rises to EUR 88,306 million.

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

Note: To comply with some of the transparency improvements recommended by the EBA, a list of the instruments included in the capital base is included in Appendix II.

Common Equity Tier 1 (CET1) capital comprises the elements of Tier 1 capital, after applying the prudential filters and the deductions from CET1 and after applying the threshold exemptions specified by the CRR. The CRR provides for a phase-in period that will give institutions time to adapt to the new requirements in the European Union. The phase-in arrangements have been introduced into Spanish law through Bank of Spain Circular 2/2014.

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

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

Tier 2 capital includes the following items, among others:

Table 5. Flow Statement. Regulatory capital

Thousands of euros

Between 2013 and 2014 total eligible capital increased by EUR 6,700,946 thousand.

In addition to the abovementioned movements in accounting capital, which explain the main changes in the issued share capital and minority interests during the year, the changes in regulatory capital also include the estimated cash dividend for 2014, in the amount of EUR 1,014,056 thousand, which brings the attributable profit net of dividends to EUR 4,801,979 thousand.

The goodwill and intangible assets which, under the CRR transitional arrangements, are no longer deducted from CET1 capital but from AT1 capital amount to EUR 5,718,079 thousand at 31 December 2014. This movement offsets the increase in goodwill due to exchange rates and the acquisition offer to minority shareholders of Banco Santander Brasil, S.A. during the year.

Qualifying Additional Tier 1 instruments increased in 2014 mainly due to new issues of contingent convertible securities (CoCos), which at 31 December 2014 were valued at EUR 4,235,483 thousand and which replace issues that did not qualify under the stricter Basel III criteria and that were redeemed during the year. The decrease in subordinated debt is mainly due to redemptions during the year and loss of eligibility for inclusion in regulatory capital.

5.5.2. Deployment of advanced approaches and supervisory approval

The Santander Group intends to adopt the Basel II advanced internal ratings-based (AIRB) approach over the next few years for substantially all its banks, until more than 90% of net exposure in the loan book is covered by this approach.

Success in meeting this target in the short term will depend on new acquisitions and the need for supervisors to coordinate internal model validation processes. In some of the countries in which the Group operates, the legal framework for supervisors is the same as in Europe, based on the capital requirements directive.

In other jurisdictions, however, the internal model validation process is subject to the framework of collaboration between home country and host country supervisors, each acting under different legislation. In practice, this means having to adapt to different criteria and timetables to gain approval for the use of advanced approaches on a consolidated basis.

Santander continued to pursue this objective during 2014 through its plan to gradually implement the necessary technology platforms and methodological improvements to be able to gradually apply the advanced IRB approach for the calculation of regulatory capital in the rest of the Group’s units.

Regulatory approvals obtained in 2014

The Santander Group currently has supervisory approval for the use of advanced approaches for the calculation of regulatory capital requirements for credit risk for the parent and the main subsidiaries in Spain, the United Kingdom, Portugal, Germany and Mexico and for the global corporates portfolio of Brazil, Chile and the United States. Various regulatory approvals for the use of advanced approaches were obtained in 2014:

As regards the rest of the geographies in America, plans remain in place to migrate the businesses in Santander Brazil towards AIRB approaches, while Santander México is continuing its efforts to complete its plan to adopt advanced approaches for the retail portfolios. In Chile, capital regulations will remain based on Basel I until local laws are changed to allow the use of advanced IRB approaches for the calculation of capital requirements at local level. Despite this limitation, Santander is continuing to work internally to request approval once regulatory conditions allow. Lastly, as regards the United States, plans are being reinforced to prepare the application for supervisory approval for the main subsidiaries once conditions are optimal.

In Europe, Santander Totta (Portugal) is completing its plans to deploy advanced approaches, while in Poland a detailed plan has been established to obtain supervisory approval in the medium term. The United Kingdom has placed the focus on the SME portfolio, with the aim of strengthening growth in this business segment, while waiting to be able to complete the rollout plans, which include credit cards and the consumer finance unit.

Lastly, in other jurisdictions in which the Group has a presence for consumer finance products, after obtaining approval for a significant percentage of the business in Germany, attention is now directed to obtaining supervisory approval for the rest of the exposures, notably mortgages. Work is under way to obtain supervisory authorisation for a representative portion of the businesses in the Nordic countries and develop the rollout plan for the acquisitions made in 2014. Consumer Spain expects to be able to complete the sequential implementation plan by obtaining approval for the SME portfolio in the near future.

The portfolios with authorisation for the use of IRB models represent 53% of the Group’s total credit exposure³.

By geography, the biggest contributors are Spain (24%) and the UK (27%), followed by Portugal (3%), Mexico (2%) and the large corporates portfolios of Chile, Brazil and the US (4%), Consumer Germany (2%) and Consumer Spain (1%).

Of the remaining exposure, for which capital requirements are currently calculated using the standardised approach, 65% is subject to plans to implement advanced approaches, the goal being to secure supervisory approval for the use of IRB models for the calculation of capital requirements for 90% of the total exposure. The rest of the portfolios not included in the IRB rollout plan do not currently entail material exposures and are being analysed to assess whether or not they should be included in that plan. The following chart shows the distribution of the credit risk exposure by type of approach to the calculation of capital requirements.

As regards the other risks explicitly addressed in Pillar I of the Basel Capital Accord, since December 2009 the Santander Group has had permission to use its internal model for the calculation of capital requirements for price risk in the trading book, foreign exchange risk and commodity risk for the risk positions of Banco Santander, S.A.

Since the statement of shareholders’ equity at December 2010, the Group obtained approval to use internal models for the calculation of capital requirements for trading portfolio price risk and foreign exchange risk for the risk positions of Santander Totta, S.A., Banco Santander Totta International Bank, Inc. and in Chile for the risk positions of Banco Santander Chile, S.A., Santander Investment Chile, Limitada, Santander S.A. Agente de Valores and Santander S.A. Corredores de Bolsa.

Since 2012 the Group has had regulatory permission to use internal models to calculate capital requirements for price risk in the trading book and foreign exchange risk arising from the risk positions of Banco Santander México, S.A. and Casa de Bolsa Santander, S.A. de C.V. The Group is currently awaiting regulatory approval from the Bank of Spain and BACEN for the use of the internal model.

Lastly, the Santander Group obtained regulatory approval for the corporate methodology, allowing it to calculate the default and migration (IRC) risk surcharge and the stressed VaR for market risk in the trading book.

For operational risk the Santander Group currently uses the standardised approach to the calculation of regulatory capital. For 2015 the Group has decided to continue the project aimed at moving towards an advanced measurement (AMA) approach, for which it already meets most of the regulatory requirements, as most of them already apply under the standardised approach. It should be stressed, however, that the short-term priority in operational risk management continues to be mitigation.

Santander’s view of internal models

One of Santander’s main corporate objectives is to enable its subsidiaries to become leading institutions in their markets, adopt the most advanced return- and capital-based management systems currently in existence, and put themselves in the best possible position to succeed in the new competitive environment, which is increasingly complex and demanding.

Santander is convinced that internal models are key to achieving that objective, despite the criticism they have received from various circles and geographies and the current of opinion in favour of abandoning internal models and returning to a standardised approach closer to Basel I. In our view this would be highly unadvisable and would certainly be a backward step after the major advances made in recent years. Using internal models makes it

possible to improve risk management overall and adapt capital requirements more closely to reality.

Further progress is needed at an international level to iron out any differences that might affect competition and ensure a level playing field across all jurisdictions. Some of the mechanisms supporting the whole modelling process still need adjusting; but it is crucial that institutions continue to invest in improving them and that supervisors reinforce supervision and consistency of standards.

5.5.3. Capital requirements

This section gives details of capital requirements by risk type and portfolio (see Table 7) and by geography (see Table 8). In Table 7 it can be observed that capital requirements decreased by 15.7% compared to 2013, while the distribution by Pillar I risk type is similar to last year: credit risk 82%, market risk 6% and operational risk 12%.

The main factors explaining the increase in risk-weighted assets compared to the previous year, from EUR 506.5 billion to EUR 585.8 billion, are the increase in capital requirements in the other exposures segment, under the standardised approach, and the increases in the corporates and other retail segments, both under the IRB approach.

The increase in capital requirements for credit risk under the standardised approach was due mainly to the increase in the other exposures category.

In Group units subject to the IRB approach, capital requirements increased by 12.9%, due mainly to the growth of EAD (+10.2%) and a higher capital-to-exposure ratio in the corporates segment.

Capital requirements for market risk are up 9.7%, due above all to the increase in capital requirements for position risk in the trading book under the standardised approach. Lastly, capital requirements for operational risk are up 6.1% at EUR 5,596 million.

For more details on the reasons for these changes, see sections 5.5.3.3. and 5.5.3.4.