Spain banks must shore up profitability amid recession: European Commission

Spain's banks should rein in dividends or pay out a bigger chunk in shares to shore up their profitability as the recession grinds on, the European Commission said in a review of the sector seen by Reuters.

The EC warned that the banks still face challenges in a prolonged recession after cleaning up their books, but added that it did not expect to dole out more money to Spain to keep them afloat.

Spanish banks had improved capital levels and had better access to market funding than last year, the EC said in its second review of the industry since some weak lenders took European aid, seen by Reuters.

But it called on lenders to adopt prudent dividend policies to keep building up their capital buffers and said that the improvements in banks' funding access could be tough to sustain.

"Despite the significant progress, a degree of uncertainty exists on whether these improvements would consolidate, as banks' profitability remains under pressure," the EC said.

"The capacity to generate sustainable profits in a recessionary environment is now the main challenge to be faced by Spanish banks," it added.

The report follows a joint EC and European Central Bank visit to Madrid at the end of January after Spain took just over 40 billion euros ($53 billion) in European aid for its weakest lenders.

The lenders were laid low by a property bubble that burst five years ago, and some were unable to cope with a government-enforced clean-up of their soured real estate assets, leaving them short of capital.

The EC has so far praised Spain's progress in reforming its banking system, though it has warned that it still has work to do in setting up its so-called 'bad bank', which takes over the troubled property assets of bailed-out lenders.

The EC said in its review that it did not foresee further disbursements of aid for Spain, which had asked for up to 100 billion euros for its banks.

It said that the Spanish economy and banking sector were far from reaching projected adverse scenarios in a September health check of the industry by consultant Oliver Wyman.

The adverse scenario implied a cumulative drop in gross domestic product of 6.5 percent from 2012 to 2014, and losses of 209 billion euros in banks' credit portfolios in that period.

Spain's government expects GDP to fall 0.5 percent in 2013 and forecasts growth for 2014. ($1 = 0.7563 euros)

(Writing by Sarah White and Sonya Dowsett in Madrid; Editing by Hugh Lawson)