Banco Popular and smaller savings bank Banco Mare Nostrum (BMN) said they were discussing joining to form Spain's fifth-biggest financial institution, in what could be the first of an expected wave of mergers as banks struggle with bad loans.
The banks said on Tuesday no decision had been taken on whether to combine their 230 billion euros (182 billion pounds) in assets. Banco Popular said it was one option among others it was considering in the context of the restructuring of Spain's financial sector.
Such a deal would help Banco Popular gain market share and close the gap with bigger competitors Santander , BBVA , CaixaBank and Bankia , while BMN needs to find a partner to boost its capital position and comply with banking regulations.
Spain in June sought a 100 billion euro credit line for its wobbly banking sector, hit by the end of a decade-long real estate boom in 2007. New solvency ratios dry in the Memorandum of Understanding for the aid are expected to result in a shrinking number of Spanish banks.
The government last Friday created a so-called bad bank to take over tens of billions of euros in defaulted loans and unwanted property to meet the conditions of the European rescue of the financial sector.
It is unclear yet whether Popular and BMN would participate in the bad bank, which depends on whether they need to be recapitalised by public money or not.
Both lenders were part of a group of seven banks identified in an independent, preliminary audit of the banking sector in June as likely to have capital shortfalls which need to be addressed through private or public funding.
Popular said it needed to find around 4 billion euros to comply with Spain's latest banking regulation, while Banco Mare Nostrum said it needed around 1 billion euros.
The final capital needs of each bank to clean up their balance sheets from toxic property assets will be known when the results of a new round of stress tests are published in the second half of September.
Sources involved in the talks said no final deal would be reached before then.
In June, consultancy firm Oliver Wyman said Spain's banks would need as much as 62 billion euros of extra capital from funds to be made available under a European rescue package. It is now in charge of carrying out the stress tests.
Analysts say the exercise will trigger a new wave of mergers in the sector, which already shrunk from 45 banks before the crisis to just 14 today.
"Spanish banks are under enormous pressure to move on with their consolidation process as a way to shrink their balance sheets, generate synergies and improve their solvency ratios," said Nuria Alvarez, analyst at Madrid-based brokerage Renta 4.
Nonetheless, Alvarez said she did not see Popular as a front runner in a new concentration process in Spain's banking sector because it recently bought out Pastor.
"Banco Santander, BBVA or even a sounder Kutxabank would make more sense for me to lead a new merger wave in the sector as they have the necessary muscle and capacity to absorb other entities", Alvarez added.
Shares in Popular were up 3.5 percent at 1.846 euros at 1012 GMT, outperforming Spain's blue chip index Ibex-35 <.IBEX>, which was up 1.4 percent.
(Editing by Julien Toyer and Jane Baird)