## cr17343

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### Progress in banks’ clean-up of NPLs and foreclosed assets
- For consolidated operations, the nonperforming loan (NPL) ratio for Spanish banks was 5.6 percent as of end-2016, close to the European Union (EU) average.
- For banking business in Spain, the NPL ratio declined from its 2013 peak of 13.8 to about 9.2 percent at end-2016.
- The provisioning ratio is about 45 percent of total NPLs (95 percent if collaterals are factored in).
- Total problem assets remain about 70 percent of their peak in 2013.
- Restructured loans totaled €116 billion as of end-December 2016, of which only half is reported as performing.
- NPLs are concentrated: exposures to residential mortgages and real estate-related firms account for about 57 percent of all NPLs.
- Land properties represent about 40 percent of total foreclosed assets, of which two-thirds are not in urban areas.
- Factors contributing to NPL reduction:
  - Economic recovery: GDP expanded by 3.2 percent annually during 2015–16 (up from 1.4 percent in 2014); unemployment, while still high at 19 percent, has dropped rapidly. Going forward GDP is expected to slow down around 2 percent.
  - Lower bank lending rates and expanded loan volumes due to improved market confidence and ECB funding (TLTROs).
  - Bank efforts: active loan restructuring, collateral foreclosure, sales, and development of NPL-management tools. Between 2014–2016 five institutions sold almost €50 billion of problematic assets (four banks explained most of these transactions).

### Remaining macrofinancial and structural risks affecting further cleanup
- Household and demographics:
  - Household debt is still around 100 percent of disposable income.
  - Population is aging; in 2014, 80 percent of households already owned their main residence, and 70 percent of them were over 45 years old (up from 65 percent in 2008).
  - Demand from nonresidents may not reverse this trend materially.
- Collateral and foreclosed assets characteristics:
  - Collateral properties and foreclosed assets could be between 8-10 years on average if disbursed during 2005–07.
  - Only about 26 percent of foreclosed assets are comprised of buildings and other completed real estate properties.
  - Land properties represent 40 percent of total foreclosed assets, of which two thirds are not urban properties.
- Sectoral concentration and SME vulnerabilities:
  - Excessive leverage remains concentrated in construction and real estate and low-income household segments.
  - Problem assets concentrated in banks with exposures to residential mortgages and real estate-related firms (about 57 percent of all NPLs).
  - SME NPL ratio remains high at 18 percent despite declines in 2016; SME restructuring processes are slow and many end in foreclosure.
- Restructured loans and redefault risk:
  - Total restructured credit to the resident private sector amounted to €116 billion in December 2016, of which almost 50 percent was reported as performing.
  - Banks report a high redefault rate of restructured loans.
- Macro-financial vulnerabilities:
  - Net international investment position (IIP) was about 86 percent of GDP.
  - Spain has a large negative net IIP mainly explained by government and corporate debt; sovereign-bank nexus is strong.

### Bank profitability, efficiency, and capital considerations
- Profitability subdued due to low interest rates and high NPLs hindering provisioning.
- NPL ratios negatively influence profitability and increase provisioning costs.
- Cost to income ratio is negatively related to profitability; cost efficiency matters.
- Stronger solvency (Tier 1 capital ratio) tends to be associated with better returns on assets and returns on equity.
- Banks need to accelerate removal of “toxic” assets within the next three to five years using ongoing economic growth and low interest rates.

### Bank of Spain: Revised Regulation on Credit Risk Analysis and Provision (Annex IX / Circular 4/2016)
- Effective since October 1, 2016; objectives to reinforce loan loss provision practices and strengthen credit risk management and collateral accounting.
- Transition toward IFRS 9 in 2018 guided (incurred loss model to be replaced by expected loss eventually).
- Alternative approach allowed for provisioning over unsecured portion based on minimum ratios defined by BdE between 3-21 months (previously full provisioning of unsecured part no later than one year).
- Require discounting maintenance and sell costs from collateral and foreclosed assets’ appraisal values or applying specific BdE-defined discounts between 20-60 percent.
- Align BdE loan classification with EBA by eliminating substandard rating and introducing “normal under special monitoring”; loans now: normal, normal under special monitoring, doubtful and loss.
- Boards and internal control functions involved in approval of accounting policies; periodic back testing and benchmarking of provisioning estimates required.
- Strengthen collateral valuation policies including minimum frequencies for updating collateral values.
- Regulatory follow-up: Royal Decree 638/2017 issued July 1, 2017 to complement BdE accounting rules.

### ECB Guidance to Banks on Nonperforming Loans (selected operational expectations)
- Applicable to all significant institutions supervised by the Single Supervisory Mechanism (SSM); covers NPL strategy, governance, operations, and forbearance.
- NPL strategy expectations:
  - Develop time-bound plans with clear NPL reduction targets and realistic but sufficiently ambitious horizons.
  - Four-step process: (i) Assess operating environment; (ii) Develop NPL strategy including options and quantitative projected NPL reductions; (iii) Prepare operational plan with time-bound objectives for at least one to three years; (iv) Embed NPL strategy into organization at all levels.
  - Banks with NPLs above EU average must present NPL strategies to their Joint Supervisory Teams in the first quarter of each year.
- NPL governance and operations:
  - Management should approve and regularly review NPL strategy and compare execution against plan at least quarterly.
  - Use workout units independent from origination; maintain granular up-to-date data and robust IT/automation; establish independent review functions.
  - Monitor via approved targets and KPIs including customer engagement and cash collection; implement early warning mechanisms and watch lists.
- Forbearance:
  - Implement well-defined forbearance policies aligned with viability; distinguish viable and non-viable forbearance.
  - Conduct affordability assessments before granting forbearance measures.
  - Provide consistent supervisory reporting and public disclosures on forbearance using a standardized template.

### FROB: restructuring, losses, and divestment priorities
- FROB supported consolidation: out of 13 merger processes that amalgamated 40 institutions, eight required FROB financial support.
- FROB’s cumulated losses over the past eight years amount to about €43.5 billion as of end-2016 (staff note: other text refers to cumulative exposure to losses of about €44 billion).
- Historical support and resources:
  - Government and deposit insurance injected €6.7 billion and €2.3 billion, respectively, to establish FROB.
  - During 2009–12 FROB supported the system with two programs (FROB 1 and FROB 2) amounting to €15 billion.
  - Under the ESM program BdE identified 10 banks required additional capital of €41 billion; eight institutions received public aid for about €39 billion (FROB 3), financed by the ESM.
- Divestment focus:
  - Ensure Bankia, after merging with BMN, is privatized by end-2019. Experiences elsewhere suggest similar privatization processes take no less than 18–24 months; early participation of an investment bank or international consulting firm as advisor is recommended.
- FROB holds contingencies of €1.4 billion related to guarantees against legal losses and some asset valuation issues.

### FROB programs, transactions and financial situation (summary figures)
- Aggregate across FROB 1, FROB 2, FROB 3, and SAREB (net): Total in € billion = 105.1.
- Merged institutions transferred to private investors totals: 52.9 (€ billion).
- Banks under FROB's ownership totals: 52.2 (€ billion).
- Grand total shown: 105.1 (€ billion).
- FROB invested €2.1 billion in Sareb in 2012 (45 percent of Sareb’s equity and subordinated debt).
- In June -2017, the state converted about €3 billion of its loans to FROB into equity; in 2012 debt conversion recapitalization was €27 billion.
- Main sources of losses: impairment of funds invested in restructuring NCG (now Abanca), Bankia, Catalunya, and Valencia amounting to about €38 billion.

### Sareb: performance, risks, and recommended oversight
- Created in 2012 to manage certain nonperforming assets totaling about €106.5 billion (acquired for €50.8 billion—52 percent discount).
- Between 2012–16, Sareb deleveraged and repaid senior debt of about 22 percent and 20 percent, respectively, and covered operating and interest expenses on senior debt.
- Generated revenues of about €17 billion during 2013–16; €9.9 billion applied to repay senior debt and the remainder largely covered operating and interest expenses on senior debt.
- End-2016 audited financial statements show accounting insolvency of €2.7 billion. For statutory purposes Sareb reports equity resources of about €4 billion (capital plus subordinated debt) because unrealized losses of about €5.3 billion related to swap adjustments and impairment do not count for corporate insolvency per Spanish accounting rules and a Royal Decree.
- Balance sheet snapshot (Initial Balance Sheet table):
  - Cash €4.8; Loans €39.4; Real Estate Owned €11.3; Total Assets €55.5.
  - Senior bonds €50.7; Subordinated Debt €3.6; Equity €1.2 (FROB €0.5; Private €0.7); Total liabilities €55.5.

### Sareb projections through end-2027 and key assumptions
- Baseline projections by end-2027:
  - Shareholders and subordinated debt holders would have access to €3.2 billion in cash after payment of senior bonds in full.
  - Repayment of interest on subordinated debt of about €0.6 billion.
  - FROB and private investors would recover about 79 percent of their nominal investment.
- Two key underlying assumptions (external models):
  - Real estate prices: Between 2017–28, residential and commercial real estate prices expected to increase by about 60 percent, and land prices by 95 percent compared to 2016 prices. This trend would allow Sareb to reverse in its equity account unrealized losses of €3.3 billion through end 2021.
  - Market activity: Gradual increase of retail housing market share through 2022; Spain’s estimated traded volume in euros of residential properties forecast to almost double between 2017–27; land market to pick up significantly during 2020–25.
  - Sareb created an NPL selling platform aimed at institutional investors.

### Risks and vulnerabilities to Sareb’s cashflow and objectives
- High sensitivity to asset price and loan recovery assumptions:
  - National housing prices index grew 2.2 percent between 2012–2016 and 4.5 percent between 2015–2016.
  - Sareb’s cashflow projections assume similar behavior between 2017–27; for 2024 forecasted housing prices expected to be above 4 percent, while some banks reportedly use an annual index of 3 percent for the next three years.
  - If Sareb’s total revenues were to be five percent lower than projected, it would come close to being unable to meet expected senior debt amortization.
- High operating and financial expenses:
  - Sareb would spend €9.1 billion on operating and financial costs until end of its life, or 22 percent of current total assets.
  - Interest rate risk currently mitigated by a swap contract that caps financial expenses through end-February 2023.
- Competition and sales timing:
  - Sareb faces strong competition from banks attempting to dispose legacy assets within the next three to five years per ECB guidelines; Sareb plans to dispose assets within 11 years.
  - Sareb expects capital gains above book value of about €12 billion by end-2027; faster bank disposals could affect expected price recovery.
- Transformation constraints:
  - Slow transformation of loans into REOs and land into developments due to borrower unwillingness and lack of readiness to change land use. Land accounts for almost one third of Sareb’s assets.
- Location concentration risks:
  - Between 2013–16, price of Sareb’s properties in eight premium provinces (37 percent of total stock) rose by 2.4 percent; declined by 15 percent in other 43 provinces (63 percent of total stock).
  - Weighted average price of Sareb’s total stock of REOs and collaterals declined by 8.8 percent in the same period.
  - Only 22 and 18 percent of Sareb’s loans and REOs, respectively, are in jurisdictions that saw price increases since 2012 (those with more than 250 thousand inhabitants).
- Market pressures and sovereign risk:
  - Continued operational losses and unwillingness of banks to inject capital could increase sovereign risks if public funds are needed to replenish Sareb’s resources, especially if Eurostat considers Sareb state-owned.
- Evolving customer preferences:
  - In 2016 the number of properties leased by Sareb rose to almost 4,600 units.

### Strategic importance, monitoring, and recommended oversight for Sareb
- Objective: dispose remaining €40 billion of assets to generate €52.5 billion through cash sales to repay remaining €41.7 billion of senior bonds held by banks and avoid activating the government guarantee.
- Recommendations:
  - BdE should bi-annually challenge Sareb’s cashflow projections using BdE’s internal macroeconomic projections (real estate prices, credit growth, unemployment) and adverse scenarios; Sareb should prepare alternative cashflow plans.
  - Set up a tripartite group (MdE, FROB, and Sareb) comprised of members independent of Sareb’s Monitoring Commission to objectively analyze and identify any needed mid-term corrections of Sareb’s business plans if adverse scenarios indicate high liquidity risk.
  - Monthly review of Sareb’s performance by its management board should be complemented by the two supporting work streams above.

### Policy recommendations (key)
- Enforce implementation of the ECB guidance on NPLs, including promoting banks’ disclosure of targets and progress. — SSM, BdE
- Improve recovery of viable businesses by enabling the stay and involvement of public creditors in all pre-insolvency processes and enhancing the OCAP process for SMEs; strengthen commercial courts by resourcing them better. — MoE, MoJ
- Review Sareb’s medium-term financial outlook based on adverse scenarios; set up an independent tripartite committee (BdE, MoE, and FROB) to work out any needed mid-course corrections. — MoE, BdE, (FROB)
- Ensure early participation of a financial advisor to facilitate privatization of the merged Bankia-BMN entity to facilitate FROB’s successful exit from its stake. — FROB
- Additional supervisory and disclosure measures:
  - BdE should produce its own projections of property prices to assess banks’ NPL reduction strategies.
  - Make mandatory standardized reporting forms for disclosure of progress on NPL reduction.
  - Apply a tough stance on ECB guidance implementation; set ambitious targets to reduce problem assets and attach prudential consequences for non-compliance.
  - Require banks with high migration of performing restructured loans into NPLs to review loan classification policies.
- Continued supervisory and regulatory monitoring:
  - Verify consistency across banks’ appraisals of loan collateral and foreclosed assets (CARC) and review banks’ internal methods for collective provisioning.
  - Proper implementation of Annex IX and full adoption of IFRS 9 to ensure timely recognition of losses on NPLs and foreclosed assets.
  - Full adoption of the ECB Guidance on NPLs with emphasis on banks’ submission of NPL strategies and targets, and loan restructuring policies to ensure only viable borrowers are restructured.
  - Accelerate NPL reduction using favorable macro conditions and low interest rates over the next three to five years, focusing on smaller institutions and SME exposures.
- Disclosure recommendations and market transparency:
  - Regularly disclose detailed information on progress by individual institutions.
  - Suggested quarterly disclosures: NPLs and foreclosed assets by asset type with level of provision, NPL trends, segregation of restructured performing and nonperforming loans by asset type; standardized reporting on banks’ NPL management strategy, goals, and targets.
  - Consider isolating in banks’ financial statements all accounts related to the independent unit managing NPLs to facilitate monitoring.

### Key aggregate legacy figures and balance-sheet exposures (end-2016)
- Banks, Sareb, and FROB still hold in their balance sheets assets associated with the recent banking crisis for around €303 billion, €83 billion, and €11 billion, respectively.
- Sareb’s initial portfolio: €106.5 billion of problem assets acquired for €50.8 billion.
- FROB cumulated losses as of end-2016: about €43.5 billion.
- FROB contingencies: €1.4 billion.
- Restructured loans as of end-2016: €116 billion.
- Sareb liabilities: about 4 percent of GDP.

### Appendices — banks’ progress and sensitivities (high-level findings)
- NPL ratios and NPL to total assets reduced between 2013 and 2016 across many banks.
- Progress turning NPLs into foreclosed assets and reducing total NPLs and foreclosed assets observed.
- Tier 1 and Core Tier 1 capital rebuilt for many banks.
- Some banks face higher difficulty selling assets; unfinished structures and non-urban land remain a drag on balance sheets.
- Collateral reliance and sensitivity:
  - Even moderate shocks to collateral values (10–30 percent) significantly reduce coverage for some banks; strong shocks push some banks’ coverage below 100 percent.
- Individual significant institutions (SIs) show:
  - Coverage ratios relatively low for some banks, including when including foreclosed assets.
  - Foreclosed assets high when measured by the Texas ratio.
  - Loan to deposit ratios have not improved since the crisis.
  - Very low profitability (ROAE).
- Definition: The Texas ratio = (Impaired Customer Loans, Gross of Reserves + Foreclosed Assets) / (Reserves for Impaired Customer Loans + Tier 1 Capital + Provisions).

*Source: EXECUTIVE SUMMARY and selected sections (cr17343).*

### EXECUTIVE SUMMARY ___________________________________________________________________________ 4

### EXECUTIVE SUMMARY

### Progress in banks’ clean-up of NPLs and foreclosed assets
- For consolidated operations, the nonperforming loan (NPL) ratio for Spanish banks was 5.6 percent as of end-2016, close to the European Union (EU) average.
- For banking business in Spain, the NPL ratio declined from its 2013 peak of 13.8 to about 9.2 percent at end-2016.
- The provisioning ratio is about 45 percent of total NPLs (95 percent if collaterals are factored in).
- Total problem assets remain about 70 percent of their peak in 2013.
- Restructured loans totaled €116 billion as of end-December 2016, of which only half is reported as performing.
- NPLs are concentrated: exposures to residential mortgages and real estate-related firms account for about 57 percent of all NPLs.
- Land properties represent about 40 percent of total foreclosed assets, of which two-thirds are not in urban areas.
- Factors contributing to NPL reduction:
  - Economic recovery: GDP expanded by 3.2 percent annually during 2015–16 (up from 1.4 percent in 2014); unemployment, while still high at 19 percent, has dropped rapidly. Going forward GDP is expected to slow down around 2 percent.
  - Lower bank lending rates and expanded loan volumes due to improved market confidence and ECB funding (TLTROs).
  - Bank efforts: active loan restructuring, collateral foreclosure, sales, and development of NPL-management tools. Between 2014–2016 five institutions sold almost €50 billion of problematic assets (four banks explained most of these transactions).

### Remaining macrofinancial and structural risks affecting further cleanup
- Spanish household debt to disposable income is still around 100 percent.
- Population and properties are aging.
- Excessive leverage persists in some corporate sectors (construction and real estate) and low-income household segments.
- SME restructuring processes are slow; many end in foreclosure.
- Banks hold sizable performing restructured loans and significant variation in problem-asset size across institutions.
- Disclosure and classification risks: banks reporting high migration of performing restructured loans into non-performing should be required to review loan classification policies.

### FROB: restructuring, losses, and divestment priorities
- FROB has supported consolidation: out of 13 merger processes that amalgamated 40 institutions, eight required FROB financial support.
- FROB’s cumulated losses over the past eight years amount to about €43.5 billion as of end-2016.
- Historical support and resources:
  - Government and deposit insurance injected €6.7 billion and €2.3 billion, respectively, to establish FROB.
  - During 2009–12 FROB supported the system with two programs (FROB 1 and FROB 2) amounting to €15 billion.
  - Under the ESM program (reform program of up to €100 billion), BdE identified 10 banks required additional capital of €41 billion; eight institutions received public aid for about €39 billion (FROB 3), financed by the ESM.
- Divestment focus: ensuring Bankia, after merging with BMN, is privatized by end-2019. Experiences elsewhere suggest similar privatization processes take no less than 18–24 months; early participation of an investment bank or international consulting firm as advisor is recommended to facilitate FROB’s exit.
- FROB also holds contingencies of €1.4 billion related to guarantees against legal losses and some asset valuation issues.

### Sareb: performance, risks, and recommended oversight
- Sareb was created in 2012 to manage certain nonperforming assets totaling about €106.5 billion (acquired for €50.8 billion—52 percent discount).
- Between 2012–16, Sareb has deleveraged and repaid senior debt of about 22 percent and 20 percent, respectively, and covered operating and interest expenses on senior debt.
- Sareb’s revised business strategy is well designed, but cashflow faces implementation risks through 2027 and more immediately over the next four to five years.
- Key risks to Sareb’s cashflow and viability:
  - High sensitivity of cashflow projections to asset price and loan recovery assumptions.
  - High operating and financial expenses.
  - Tough competition from banks.
  - Need to transform loans into REOs and land into new developments.
  - Potential shifts in household preferences toward renting rather than buying.
- Systemic importance: Sareb’s remaining liabilities are about 4 percent of GDP and must remain manageable to avoid macrofinancial risk.
- Recommended oversight actions:
  - BdE should challenge Sareb’s cashflow projections using BdE’s internal macroeconomic projections (including real estate prices, credit growth, and unemployment) and adverse scenarios.
  - Set up a tripartite group (MdE, FROB, and Sareb) comprised of members independent of Sareb’s Monitoring Commission to objectively analyze and identify any needed mid-term corrections of Sareb’s business plans.

### Policy recommendations (key)
- Enforce implementation of the ECB guidance on NPLs, including promoting banks’ disclosure of targets and progress. — SSM, BdE
- Improve recovery of viable businesses by enabling the stay and involvement of public creditors in all pre-insolvency processes and enhancing the OCAP process for SMEs; strengthen commercial courts by resourcing them better. — MoE, MoJ
- Review Sareb’s medium-term financial outlook based on adverse scenarios; set up an independent tripartite committee (BdE, MoE, and FROB) to work out any needed mid-course corrections. — MoE, BdE, (FROB)
- Ensure early participation of a financial advisor to facilitate privatization of the merged Bankia-BMN entity to facilitate FROB’s successful exit from its stake. — FROB
- Additional supervisory and disclosure measures:
  - BdE should produce its own projections of property prices to assess banks’ NPL reduction strategies.
  - Make mandatory standardized reporting forms for disclosure of progress on NPL reduction.
  - Apply a tough stance on ECB guidance implementation; set ambitious targets to reduce problem assets and attach prudential consequences for non-compliance.
  - Require banks with high migration of performing restructured loans into NPLs to review loan classification policies.

### Key aggregate legacy figures and balance-sheet exposures (end-2016)
- Banks, Sareb, and FROB still hold in their balance sheets assets associated with the recent banking crisis for around €303 billion, €83 billion, and €11 billion, respectively.
- Sareb’s initial portfolio: €106.5 billion of problem assets acquired for €50.8 billion.
- FROB cumulated losses as of end-2016: about €43.5 billion.
- FROB contingencies: €1.4 billion.
- Restructured loans as of end-2016: €116 billion.
- Sareb liabilities: about 4 percent of GDP.

*Source: EXECUTIVE SUMMARY (cr17343).*

### 11. Despite the progress made, several challenges remain that may affect all banks’ ability

### cr17343 - 11. Despite the progress made, several challenges remain that may affect all banks’ ability

### Remaining challenges to reducing problem assets
- Household balance-sheet and demographics
  - Household debt is still around 100 percent of disposable income and population is aging.
  - In 2014, 80 percent of households already owned their main residence, and 70 percent of them were over 45 years old (up from 65 percent in 2008).
  - Demand from nonresidents may not reverse this trend materially.
- Characteristics of collateral and foreclosed assets
  - Properties are aging; if most problematic loans were disbursed during 2005–07, collateral properties and foreclosed assets could be between 8-10 years on average.
  - Older properties tend to be more difficult to dispose, require higher maintenance fees, and have lower recovery value.
  - Only about 26 percent of foreclosed assets are comprised of buildings and other completed real estate properties.
  - Land properties represent 40 percent of total foreclosed assets, of which two thirds are not urban properties.
- Sectoral concentration of stress
  - Excessive leverage remains concentrated in some corporate sectors (construction and real estate) and low-income household segments.
  - The size of problem assets varies significantly across banks and is concentrated in those with exposures to residential mortgages and real estate-related firms, whose NPLs represent about 57 percent of all NPLs.
  - These banks face higher reserves and capital needs, weaker profitability, and high loan to deposit ratios that increase susceptibility to market risks.
- SME sector and loan restructuring
  - Slow restructuring of SME loans: during 2016 the NPL ratio for SMEs declined more than for larger corporations, but it remains quite high (18 percent).
  - SMEs dominate employment and private sector activity in Spain, are more dependent on bank financing, and may need larger restructuring to adapt to a more demanding environment than before the crisis.
  - There is a risk that SME exposures are left to be resolved by economic recovery or end with collateral foreclosure.
- Restructured loans and redefault risk
  - In December 2016, total restructured credit to the resident private sector amounted to €116 billion, of which almost 50 percent was reported as performing.
  - Banks report a high redefault rate of restructured loans.
- Macro-financial vulnerabilities
  - Spain has a large negative net international investment position mainly explained by government and corporate debt, even with a current account surplus in recent years.
  - Net IIP position was about 86 percent of GDP and the sovereign-bank nexus is strong.

### Bank profitability, efficiency, and capital considerations
- Profitability has remained subdued partly due to the low interest rate environment and high NPLs hindering provisioning.
- NPL ratios negatively influence profitability: unproductive assets are costly to maintain and drive up provisions.
- Cost to income ratio is negatively related to profitability (cost efficiency matters); more efficient banks are more profitable.
- Stronger solvency measured by Tier 1 capital ratio tends to be associated with better returns on assets and returns on equity.
- Banks need to take advantage of ongoing economic growth and low interest rates to accelerate removal of “toxic” assets within the next three to five years.

### Bank of Spain: Revised Regulation on Credit Risk Analysis and Provision (Annex IX / Circular 4/2016)
- Effective since October 1, 2016, amendments to Annex IX aim to include recent developments in banking regulation and best practices in credit risk management and accounting.
- Objectives and key provisions
  - Reinforce loan loss provision practices by strengthening credit risk management and classification, and accounting basis of loan collateral.
  - Initiate a transition towards the adoption of IFRS 9 in 2018; while the “incurred loss” model is yet to be replaced by “expected loss,” the new requirements guide development of banks’ methods for individual estimates of specific provisions and internal methods for collective estimates of specific and generic provisions.
  - Meanwhile banks may continue using an alternative approach to calculate provisions over the unsecured portion of loans, based on minimum ratios defined by BdE between 3-21 months (before these amendments banks were required to fully provision the unsecured part of loans no later than one year).
  - Induce banks to discount maintenance and sell costs from loan collateral and foreclosed assets’ appraisal values based on their recent experience; alternatively, banks must discount from collateral and foreclosed asset valuation a set of specific factors defined by BdE that vary between 20-60 percent.
  - Align BdE’s loan classification categories with those of the European Banking Authority (EBA) by eliminating the substandard rating and introducing a performing category “normal under special monitoring”; loans now can be classified as normal, normal under special monitoring, doubtful and loss.
  - Involve banks’ board of directors and internal control function in approval of accounting policies, monitoring implementation of Annex IX, and validation of internal methods for collective provisioning; internal control function expected to check quality and consistency of databases supporting these methods.
  - Require periodic back testing and benchmarking of provisioning estimates against actual losses observed.
  - Strengthen collateral valuation policies including minimum frequencies for updating collateral values, more demanding for doubtful and loss loans.
- Regulatory follow-up
  - On July 1, 2017 Royal Decree 638/2017 was issued to complement the BdE accounting rules of Annex IX of Circular 4/2016.

### ECB Guidance to Banks on Nonperforming Loans (selected operational expectations)
- Scope and structure
  - Applicable to all significant institutions supervised by the Single Supervisory Mechanism (SSM); covers NPL strategy, governance, operations, and forbearance; NPLs and non-performing exposures (including NPLs, foreclosed assets) are used interchangeably.
- NPL strategy expectations
  - Develop time-bound plans with clear NPL reduction targets and realistic but sufficiently ambitious horizons.
  - Four-step process: (i) Assess operating environment (internal capabilities, drivers, past outcomes, operational capacities, external conditions, capital implications); (ii) Develop NPL strategy including options (hold/forbearance, active portfolio reductions, change of exposure type, legal options) and targets (qualitative operational capabilities and quantitative projected NPL reductions over short, medium, long-term); (iii) Prepare operational plan with time-bound objectives for at least one to three years, activities by portfolio segment, staffing, infrastructure, budget; (iv) Embed NPL strategy into organization at all levels.
  - Banks with NPLs above EU average must present NPL strategies to their Joint Supervisory Teams in the first quarter of each year.
- NPL governance and operations
  - Management should approve and regularly review NPL strategy and compare execution against plan at least quarterly.
  - Use workout units independent from origination and differentiated by NPL life-cycle phase; maintain granular up-to-date data and robust IT/automation.
  - Establish independent review functions in the internal control framework.
  - NPL monitoring should be based on approved targets and KPIs (including customer engagement and cash collection).
  - Implement early warning mechanisms and watch lists with periodic reports on migration of arrears.
- Forbearance
  - Implement well-defined forbearance policies aligned with viability; distinguish viable and non-viable forbearance.
  - Conduct affordability assessments before granting forbearance measures.
  - Provide consistent supervisory reporting and public disclosures on forbearance (credit quality, effectiveness, ageing profile) using a standardized template.

### Policy recommendations and critical next steps
- Continued supervisory and regulatory monitoring
  - Spanish authorities and SSM need to continue promoting and monitoring the banks’ clean-up process by building on recent measures.
  - Verification of consistency across banks’ appraisals of loan collateral and foreclosed assets (CARC) and review of banks’ internal methods for collective provisioning are critical.
- Implementation priorities for banks
  - Proper implementation of Annex IX of the Circular and full adoption of IFRS 9 to ensure timely recognition of losses on NPLs and foreclosed assets.
  - Full adoption of the ECB Guidance on NPLs, with emphasis on banks’ submission of NPL strategies and targets, and loan restructuring policies to ensure only viable borrowers are being restructured.
  - Accelerate NPL reduction using favorable macro conditions and low interest rates over the next three to five years, with particular focus on smaller institutions and SME exposures.

*Source: INTERNATIONAL MONETARY FUND*

### 15. While the two steps above are likely to address/factor in most of the challenges

### 15. While the two steps above are likely to address/factor in most of the challenges

### Banks’ compliance, supervisory stance, and NPL strategies
- Critical actions for authorities:
  - Challenging the banks’ strategies by taking a holistic view of potential market demand and property price developments, and ensuring banks’ plans are evaluated using independent information.
  - Including macroeconomic variables such as the unemployment rate in baseline scenarios to challenge optimistic real estate price developments.
  - Ensuring the most problematic banks are addressed first by prioritizing banks with high NPLs, higher Texas ratio (after including foreclosed assets), weaker profitability, and high reliance on ECB funding.
  - Encouraging a firm pace of bank balance sheet cleanup to be completed before the expiration of the ECB’s long-term support; targets should be ambitious and failure to comply should have prudential consequences.
  - Regularly disclosing detailed information on progress by individual institutions to accelerate legacy asset cleanup and increase market transparency and discipline.
- Suggested disclosures (quarterly and easily accessible):
  - NPLs and foreclosed assets by asset type (corporate, SMEs, mortgage, consumer) with level of provision, NPL trends, and segregation of restructured performing and nonperforming loans by asset type.
  - Summary information, under a standardized reporting form, on banks’ NPL management strategy, goals, and targets.
  - Consider isolating in banks’ balance sheet and income statement all accounts related to the independent unit managing NPLs (including NPLs, foreclosed assets, provisions, and operating expenses) to separate and facilitate monitoring of performing portfolios.
- Fostering further loan restructuring:
  - BdE should assess whether the overall framework and banks’ internal policies to restructure SME loans are suitable.
  - Consider passing detailed guidelines to standardize operational loan restructuring processes if internal procedures explain the still high level of SME NPLs.
  - Banks reporting high redefault rates of restructured loans should be required to change internal loan restructuring policies and procedures.
- Note: This may require an update of Circular 5-2011 of BdE.

### Financial situation of FROB, contingencies, and divestment plans
- Role and programs:
  - FROB supported restructuring through programs during 2009–12:
    - FROB 1: integration of 25 cajas into 7 new banks, which received €9.7 billion in public aid in preferred shares.
    - FROB 2: recapitalization of 4 banking groups with €5.7 billion in common shares.
    - In 2012, under the ESM program, FROB borrowed about €41 billion from the government and launched FROB 3 (direct recapitalization, Asset Protection Scheme, protection against contingent liabilities).
  - FROB invested €2.1 billion in Sareb in 2012 (45 percent of Sareb’s equity and subordinated debt).
- Cumulative losses and recapitalization:
  - FROB exposed to losses of about €44 billion on a cumulative basis.
  - In June -2017, the state converted about €3 billion of its loans to FROB into equity; in 2012 debt conversion recapitalization was €27 billion.
  - Main sources of losses: impairment of funds invested in restructuring NCG (now Abanca), Bankia, Catalunya, and Valencia amounting to about €38 billion.
- Current risks and divestment:
  - Bankia merged with BMN creating a bank of about €230 billion in assets; private investors hold around 35 percent of total shares.
  - Uncertainty as of December 2016 on legal contingencies faced by FROB regarding guarantees granted to acquirers of resolved banks, including potential losses from rulings on floor clauses of bank mortgages.
- Recommendation:
  - Ensure Bankia, after merger with BMN, is privatized by end-2019; experiences indicate similar processes take no less than 18–24 months.
  - Early participation of an investment bank or international consulting firm as advisor to facilitate privatization to help FROB exit its Bankia stake.

### FROB programs and transactions (summary figures from Table)
- Aggregate across FROB 1, FROB 2, FROB 3, and SAREB (net): Total in € billion = 105.1 (transfers to private investors and FROB-owned banks combined as presented).
- Specifics excerpted:
  - Merged institutions transferred to private investor totals (sum row): 52.9
  - Banks under FROB's ownership totals (sum row): 52.2
  - Grand total shown: 105.1
- Source note: In € billion (Source: FROB, Sareb and staff calculations)

### Progress by Sareb in asset recovery and challenges going forward
- Initial scope and ownership:
  - Sareb created in 2012 to manage nonperforming assets of about €106.5 billion (€50.8 1billion, after discount).
  - Foreclosed assets exceeding €100,000 and loans to real estate developers exceeding €250,000 were included.
  - 55 percent of Sareb’s capital belongs to Spanish banks (including Deutsche) and insurers; the rest owned by the Spanish government through FROB.
  - Private shareholders and FROB purchased Sareb’s subordinated debt in similar proportion to capital ownership; the state guaranteed Sareb’s senior bonds.
- Financial performance and operations (2013–16):
  - Sareb deleveraged and repaid senior debt by about 22 percent and 20 percent, respectively.
  - Generated revenues of about €17 billion during 2013–16; €9.9 billion applied to repay senior debt and the remainder largely covered operating and interest expenses on senior debt.
  - Most sales were retail assets managed by four servicers; in 2016 annual asset sales to institutional investors increased by 67 percent.
- Balance sheet snapshot (Initial Balance Sheet table):
  - Cash €4.8; Loans €39.4; Real Estate Owned €11.3; Total Assets €55.5.
  - Senior bonds €50.7; Subordinated Debt €3.6; Equity €1.2 (FROB €0.5; Private €0.7); Total liabilities €55.5.
- Accounting and solvency:
  - End-2016 audited financial statements show accounting insolvency of €2.7 billion.
  - For statutory purposes Sareb reports equity resources of about €4 billion (capital plus subordinated debt) because unrealized losses of about €5.3 billion related to swap adjustments and impairment do not count for corporate insolvency per Spanish accounting rules and a Royal Decree.

### Sareb projections and key assumptions through end-2027
- By end-2027 baseline projections:
  - Shareholders and subordinated debt holders would have access to €3.2 billion in cash after payment of senior bonds in full.
  - Repayment of interest on subordinated debt of about €0.6 billion.
  - FROB and private investors would recover about 79 percent of their nominal investment.
- Two key underlying assumptions (models by external providers):
  - Evolution of real estate prices: Between 2017–28, residential and commercial real estate prices expected to increase by about 60 percent, and land prices by 95 percent compared to 2016 prices. This trend would allow Sareb to reverse in its equity account unrealized losses of €3.3 billion through end 2021.
  - Gradual increase of retail housing market share through 2022 with support of its four servicers; forecasts assume Spain’s estimated traded volume in euros of residential properties would almost double between 2017–27, and land market would pick up significantly during 2020–25.
  - Sareb created an NPL selling platform aimed at institutional investors.

### Risks and vulnerabilities to Sareb’s cash flow and objectives
- High sensitivity to asset price and loan recovery assumptions:
  - National statistics: national housing prices index grew 2.2 percent between 2012–2016 and 4.5 percent between 2015–2016.
  - Sareb’s cashflow projections assume almost similar behavior between 2017–27; for 2024 forecasted housing prices expected to be above 4 percent, while some banks reportedly use an annual index of 3 percent for the next three years.
  - Sensitivity example: If Sareb’s total revenues were to be five percent lower than projected, it would come close to being unable to meet expected senior debt amortization, potentially increasing financial costs and carrying cost of assets.
- High operating and financial expenses:
  - Sareb would spend €9.1 billion on operating and financial costs until end of its life, or 22 percent of current total assets.
  - Interest rate risk currently mitigated by a swap contract that caps financial expenses through end-February 2023.
- Tough competition:
  - Sareb is the largest holder of legacy assets but faces strong competition from banks attempting to dispose legacy assets within the next three to five years per ECB guidelines; Sareb plans to dispose assets within 11 years.
  - Sareb expects capital gains above book value of about €12 billion by end-2027; faster bank disposals could affect expected price recovery.
- Slow transformation of loans into REOs and land into developments:
  - Constraints include unwillingness of borrowers to restructure and allow collateral repossession and lack of readiness in communities to change land use from rural to urban.
  - Land accounts for almost one third of Sareb’s assets.
- Location concentration risks:
  - Between 2013–16, in weighted average terms, price of Sareb’s properties in eight premium provinces (37 percent of total stock) rose by 2.4 percent; declined by 15 percent in other 43 provinces (63 percent of total stock).
  - Weighted average price of Sareb’s total stock of REOs and collaterals declined by 8.8 percent in the same period.
  - Only 22 and 18 percent of Sareb’s loans and REOs, respectively, are in jurisdictions that saw price increases since 2012 (those with more than 250 thousand inhabitants).
- Market pressures and sovereign risk:
  - Despite accounting rules protecting it from technical insolvency, continued operational losses and unwillingness of banks to inject capital could increase sovereign risks if public funds are needed to replenish Sareb’s resources, especially if Eurostat considers Sareb state-owned.
- Evolving customer preferences:
  - Spanish households traditionally have high propensity to buy rather than rent; in 2016 the number of properties leased by Sareb rose to almost 4,600 units.
- Sensitivity analysis:
  - Figure 3 indicates revenues (baseline vs alternative) and final cash position across 2017–2021 with notable divergence under alternative scenarios (values shown in euro millions in source charts).

### Sareb’s strategic importance and downside risk monitoring
- Objective and challenge:
  - Main objective is to dispose remaining €40 billion of assets to generate €52.5 billion through cash sales to repay remaining €41.7 billion of senior bonds held by banks to avoid activating the government guarantee.
  - Sareb’s total or partial failure to achieve goals could add to existing public debt.
- Recommendations:
  - BdE’s bi-annual assessment of Sareb’s cash flow projections: BdE should challenge Sareb’s projections using internal macroeconomic projections (real estate prices, credit growth, unemployment) and adverse scenarios; Sareb should prepare alternative cashflow plans.
  - If BdE’s adverse scenario indicates high liquidity risk, consider mid-term corrective measures via a tripartite group (MdE, FROB, and SAREB) comprised by members independent of its Monitoring Commission to objectively analyze and identify needed mid-term corrections in Sareb’s business plans.
  - Monthly review of Sareb’s performance by its management board should be complemented by the two supporting work streams above.

### Appendices — Banks’ progress and sensitivities (high-level findings)
- NPL ratios and NPL to total assets have been reduced between 2013 and 2016 across many banks (charts provided).
- Progress turning NPLs into foreclosed assets and reducing total NPLs and foreclosed assets observed (charts provided).
- Tier 1 and Core Tier 1 capital have been rebuilt for many banks (charts provided).
- Some banks face higher difficulty selling assets; unfinished structures and non-urban land remain a drag on balance sheets (charts provided).
- Collateral reliance and sensitivity:
  - Collateral coverage and NPE coverage metrics indicate that even moderate shocks to collateral values (10–30 percent) significantly reduce coverage for some banks; strong shocks push some banks’ coverage below 100 percent (charts provided).
- Individual significant institutions (SIs) show:
  - Coverage ratios relatively low for some banks, including when including foreclosed assets.
  - Foreclosed assets high when measured by the Texas ratio.
  - Loan to deposit ratios have not improved since the crisis.
  - Very low profitability (ROAE).
- Definition noted: The Texas ratio = (Impaired Customer Loans, Gross of Reserves + Foreclosed Assets) / (Reserves for Impaired Customer Loans + Tier 1 Capital + Provisions).

*Source: IMF staff report (content unit: cr17343 - 15. While the two steps above are likely to address/factor in most of the challenges).*

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_Source: https://www.imf.org/-/media/files/publications/cr/2017/cr17343.pdf_