OREANDA-NEWS. A Madrid court's ruling that interest rate floor clauses widely used by Spanish banks in retail mortgage loans lacked transparency and were abusive will heap more pressure on banking sector margins, says Fitch Ratings.

Under the ruling, made on 7 April, banks will have to compensate customers for excess interest paid since May 2013. The larger and some mid-sized domestic banks have set aside reserves in anticipation of this outcome, and the potential for sizeable shortfalls at these banks is small. For example, Banco Popular, Bankia and Caixabank have fully reserved for floor-related compensation payments, and Bankia and Caixabank eliminated floor clauses from their mortgage contracts in 2015. We think smaller, less diversified institutions, notably local rural "cajas", are more vulnerable due to their high dependence on interest income as a source of revenue.

Retail mortgages represent about 40% of total domestic lending in Spain. Most are extended at floating rates tied to Euribor, which is negative. The floors prevented loan rates from falling below a certain level, meaning that customers did not benefit from the full decline of the reference rate and banks were able to hold margins at a higher level.

The ruling is not yet definitive and some banks may appeal against the sentence in the supreme court. But whatever the outcome, we think it will be very difficult for banks to continue to make use of floor clauses. Margins have been falling at Spanish banks for some years, largely due to loan deleveraging and declining interest rates. In 2015 the Spanish banking sector reported an average 12% decline in net interest income from domestic operations. Low interest rates and weak demand for housing loans - where stocks continue to fall by an annual average 4% for the sector - are making it all the harder for Spanish banks to boost net interest margins. Lower funding costs and new lending to SMEs and corporates are only partly compensating for this.

We anticipate a further round of cost-cutting measures to be announced throughout the sector, following the lead of Santander, BBVA and Unicaja and others. We also expect banks to continue to develop fee-based products to compensate for interest margin pressure. Larger domestic banks, including Caixabank, Bankia, Popular, Ibercaja and Kutxabank, benefit from a broader range of fee-based activities, particularly investment, pension fund and insurance products. Their well-established franchises mean they have some pricing power. Smaller banks are far less diversified and we expect them to be particularly vulnerable to margin compression.

Our 2016 Outlook Report for Spanish banks highlighted that 2016 would be a challenging year for revenue generation, with margins under pressure, sluggish net loan growth and reduced carry-trade opportunities. Ratings assigned to several Spanish banks are sensitive to profitability pressure.