## _cr12137

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---

### Overview and context
- Report prepared by the Monetary and Capital Markets and European Departments; approved May 30, 2012.
- FSAP Update for Spain based on missions February 1–21 and April 12–25, 2012.
- Crisis drivers: domestic real estate boom-bust, weaknesses in the savings bank sector, shortcomings in policy and regulatory framework, over-reliance on wholesale funding.

### Banking sector restructuring: scope, measures, and progress
- Major restructuring underway: reform of savings banks’ legal framework and financial support from Fondo de Reestructuración Ordenada Bancaria (FROB).
- Vulnerable institutions have been resolved or are being restructured; recent measures target real estate developer loans.
- May 2012 provisioning decision: increase provisioning rates on performing real estate developer loans from 7 percent to 30 percent.
  - Highly capitalized banks with limited real estate exposures expected to meet requirements; other banks to be supported with a public capital backstop (injected as common equity or contingent capital).
- Authorities committed to comprehensive review of banks’ asset portfolios with third-party participation and independent audits.

### Key stress-test findings and system resilience
- Core system resilience:
  - Largest banks sufficiently capitalized and profitable, supported by internationally-diversified earnings and solid capital buffers.
- Vulnerable groups:
  - Group of banks (G3 and FROB-administered) where vulnerabilities are highest and public support is most critical.
  - Under the IMF adverse scenario, core Tier 1 capital (almost € 27 billion) would be essentially wiped out for these banks.
- Government capital support:
  - Government committed to a capital injection of about 2 percent of GDP (reported as € 19 billion in May 2012) to the fourth largest bank (to become state owned).
  - Separate reporting notes a fourth largest bank will have received government capital support (including conversion of FROB preference shares) of € 23.5 billion (about 2 percent of GDP) by end-July.
- Aggregate capital shortfalls:
  - To comply with a 7 percent core Tier 1 ratio post-shock, Spanish banking system aggregate capital needs amount to € 37 billion.
    - 80 percent of that € 37 billion attributable to banks in G3 and those being auctioned by FROB.
  - If a hurdle rate of 8 percent core Tier 1 were considered, total capital needs would reach € 45 billion, 75 percent of which is accounted by G3 and FROB banks.
- SCCA (seven large listed banks, ~40 percent of system):
  - Baseline joint potential capital losses average € 0.3 billion over 2012–13.
  - Severe adverse (double-dip) scenario: total expected loss of more than EU14 billion on average, with a peak in excess of € 21 billion at end-2012 at a 5 percent tail probability.
  - Resulting capital levels remain comfortably above stress-test hurdle rates for the sample.

### Liquidity findings and funding vulnerabilities
- ECB support and LTRO significant: Spanish banks have drawn extensively from the ECB, refinancing reaching almost 11 percent of total assets.
- Deposits account for about half of total system-wide funding.
- Loan-to-deposit ratios: G1 = 143 percent; G4 = 150 percent.
- Liquidity stress tests:
  - All firms but one pass the implied five-day cash flow test and the Liquidity Coverage Ratio (LCR) test.
  - One-third of firms (about 3 percent of system assets) affected in a very severe 30-day scenario assuming a 21.5 percent withdrawal of all deposits maturing within one year.
  - Two-thirds of sample banks—about half of banks in G1, G2, and G3—fall below the Net Stable Funding Ratio (NSFR) benchmark of 100 percent.
  - Maturity mismatches up to one year for almost all sample banks raise concerns about funding stability.

### Macro context, housing, and sectoral vulnerabilities
- Macroeconomic outlook:
  - Economy expected to contract by 1.8 percent in 2012 (baseline).
  - IMF baseline projects recession in 2012 and modest recovery in 2013; medium-term GDP growth to around 1.8 percent.
  - Unemployment at 24 percent and rising.
- Real estate and housing:
  - Construction and real estate loans grew to 43 percent of GDP in 2009 and were about 37 percent of GDP at end-2011.
  - Inventories estimated at 700,000–1 million units; market estimates suggest about four years to clear inventories.
  - Banks’ repossessed assets estimated at 200,000 units.
- Private sector leverage:
  - Total assets of Spanish banks (excluding foreign branches) about 320 percent of GDP (including international activities).
  - Loans to private sector in Spain account for 166 percent of GDP.
  - Household debt around 90 percent of GDP during boom years.
  - Corporate debt at 186 percent of GDP (excluding trade credits would be 135 percent of GDP).

### Detailed bank grouping, exposures, and capitalization
- Bank grouping (covers ~83 percent of domestic sector assets, excluding foreign branches):
  - G1 — Large internationally active banks: 2 banks; on a solo basis account for about 33 percent of banking assets.
  - G2 — Former savings banks not receiving state support: 7 banks; ~17 percent of domestic assets.
  - G3 — Former savings banks receiving state support: 7 banks; ~22 percent of sector assets; heavy real estate and construction exposure.
  - G4 — Medium and small private banks: ~11 percent of domestic assets.
- G3 specifics:
  - Highest exposure to real estate developer sector: 19 percent of loans to this sector; largest proportion in land loans.
  - Largest proportion of foreclosed assets; lowest capital base; loss making; least efficient.
- Provisioning and capital evolution:
  - Banks increased loan loss allowances by € 112 billion (11 percent of GDP) and raised Tier 1 ratio from <7 percent to >9 percent by end-2011.
  - Total gross direct government intervention (excluding guarantees) about € 34 billion (3 percent of GDP) as of April 2012, of which more than half has been recovered.
  - FGD industry contribution to fund FROB and resolution of three intervened institutions: about € 13 billion, could rise up to € 34 billion (3.2 percent of GDP) if asset protection schemes fully called.

### Provisioning, RDLs impact, and diagnostic outcomes
- RDL measures:
  - February 2012: RDL 02/2012 introduced higher provisions and specific capital buffers; compliance by end-2012 through earnings, asset sales, conversion of preferred shares/bonds into equity, and paying dividends in the form of new shares.
  - May 2012: RDL 18/2012 raised provisions on performing real estate developer loans from 7 percent to 30 percent.
- Combined nominal cost under RDLs:
  - Estimated at € 67.5 billion (€ 26.2 billion specific provisioning, € 32.1 billion generic provisioning, € 9.1 billion extra capital add-on).
  - Economic impact incorporated in stress tests reduced to € 57.6 billion after accounting for mitigants.
- Appendix Table 18 (selected figures, all RDL 02/2012 unless indicated):
  - Additional provisions required Total: 58,326 (G1: 11,124; G2: 10,896; G3: 19,160; G4: 10,310; FROB: 6,836).
  - Net impact of provisions for stress testing purposes Total: 48,436 (G1: 9,840; G2: 9,192; G3: 14,209; G4: 8,960; FROB: 6,234).
  - Additional capital requirement for stress testing purposes Total: 9,121 (G1: 0; G2: 893; G3: 2,065; G4: 2,601; FROB: 3,562).
  - Total impact (net of mitigants) of both RDLs for stress testing purposes Total: 57,557 (G1: 9,840; G2: 10,085; G3: 16,274; G4: 11,561; FROB: 9,796).

### System-wide recapitalization estimates and market views
- Market estimates of capitalization needs largely range from € 60−90 billion.
- Many market analyses apply a core Tier 1 requirement of 10 percent after losses.
- FSAP/IMF estimates: € 37 billion to meet 7 percent core Tier 1 post-shock; € 45 billion to meet 8 percent core Tier 1.
- Box 2 market table reference: 37 (Recapitalization Needs (In billions of euro) — as presented).

### Asset management, AMCs, and APS options
- Authorities required initial transfer of foreclosed assets into bank-specific asset management units.
- Institutional options:
  - Banks manage impaired assets directly or sell to specialized AMCs (private or public).
  - Government-owned centralized AMCs may be efficient when problem size is large or special powers are needed.
- Asset Protection Scheme (APS) option:
  - Guarantee by a third entity (e.g., FROB) on specified impaired asset portfolios; assets remain on banks’ balance sheets.
  - APS requires no pre-funding but increases public contingent liabilities.
  - Design must address moral hazard; fee structures or issuance of capital instruments in exchange for protection could be considered; such instruments could be structured to qualify as Core Tier 1 capital.

### High-priority recommendations and timeframes (select)
- Overall Financial Sector Stability — Immediate:
  - Finalize recapitalization of banks based on in-depth due diligence of loan portfolios (BdE, MdE).
  - Implement time-bound restructuring plans for banks reliant on state support (BdE).
  - Design and implement roadmap to deal with banks’ legacy assets (MdE, BdE).
- Land and price data — Near-term:
  - Establish a reliable and publicly available land and real estate property sale price database maintained by an official agency (MdE, BdE).
- Banking oversight — Near-term:
  - Change legal regime to prescribe sole roles of BdE in prudential oversight (MdE).
  - Amend legislation to give BdE operational independence in supervision (MdE).
  - Provide BdE effective powers to promulgate prudential rules and sanctioning (MdE, Government).
  - Require more frequent valuation of banks’ real estate portfolios (BdE).
- Crisis management — Immediate / Near-term:
  - Introduce special bank resolution tools (prompt recapitalizations, purchase and assumption transactions, bridge banks) and provisions for overriding shareholders’ rights (all agencies).
  - Further develop burden-sharing mechanisms between private and public sectors; clarify financial responsibilities of FROB and FGD (all agencies).
- Timeframe definitions:
  - “Immediate” is within one year; “near-term” is 1–3 years; “medium-term” is 3–5 years.

### Supervisory framework: strengths and shortcomings
- Strengths:
  - Highly experienced, respected supervisory staff; good information systems; thorough supervisory processes.
- Shortcomings:
  - Gradual corrective action allowed weak banks to continue operating.
  - Need to strengthen authority, processes, and accountability framework of the banking regulator.
  - Enhance regulatory independence of banking and securities regulators; address financial/budgetary independence limitations for insurance and securities regulators.
  - Strengthen insurance regulatory framework: current solvency regime (Solvency I) not risk-sensitive; Solvency II implementation will affect margins but industry appears comfortably solvent per QIS 5.
  - Improve supervision resourcing (DGSFP) and increase on-site inspections for ISPs (CNMV).

### Crisis management, resolution, and governance reforms
- Recommendations:
  - BdE to adopt a more structured, forward-looking prompt corrective action regime.
  - Clarify emergency liquidity assistance definitions and disclosure.
  - Introduce resolution tools aligned with international practice; enable allocation of losses to shareholders and creditors and allow overriding shareholders’ rights subject to legal protections.
  - Clarify roles of FROB (operational) and FGD (financing); consider identifying a resolution authority while BdE remains closely involved.
  - Review governance of FGD and FROB to avoid conflicts of interest; balance ex officio members and independent appointees.

### CCP, FMIs, securities, insurance, AML/CFT
- CCP contingency planning:
  - Develop coordinated contingency plans for potential CCP failure; conduct regular default-management stress tests involving participants and public authorities.
  - Plan BdE’s orderly exit from BME’s capital with clear communication.
- Securities markets (CNMV):
  - High implementation of IOSCO principles; increase on-site inspections; strengthen CNMV independence by removing MdE board representation and related pre-approvals.
- Insurance supervision (DGSFP):
  - Implement Solvency II, enterprise risk management, and macroprudential surveillance (including industry-wide stress testing).
  - Increase resources and explore alternative funding models for DGSFP.
  - Strengthen product disclosure and require statements to customers on policy value changes at least annually.
- AML/CFT:
  - A full AML/CFT reassessment required; authorities plan assessment under revised standards and discussions with FATF to schedule assessment in 2013.

### Risk Assessment Matrix — main threats (select entries with staff assessments)
- Continued weak growth and high unemployment:
  - Staff assessment: High; Likelihood: High.
  - Severe adverse scenario: cumulative output decline of 5.7 percentage points over 2012–13; expected impairment losses would amount to € 73 billion (about 7 percent of GDP); additional capital of € 18 billion needed to meet core Tier 1 ratio of 4 percent (€ 38 billion to meet 7 percent core Tier 1).
- Intensification of real estate price decline:
  - Staff assessment: High; Likelihood: High.
  - Rapid steep drops in house prices could escalate impairment losses and increase recapitalization needs.
- Spillovers and sovereign stress:
  - Staff assessment: High; Likelihood: High.
  - Banks’ exposure to domestic sovereign about one-and-half times their core Tier 1 capital; system vulnerable to shocks from major trading partners.
- Refinancing difficulties:
  - Staff assessment: Medium to High; Likelihood: High.
  - Significant refinancing needs in 2012 and 2013; deposit base flat/declining; heavy reliance on ECB funding; two thirds of sample banks face sustainability risk of current funding sources.

### Stress-test scenarios, methodology, and key macro assumptions
- Scenarios used (2012–13, end-2011 supervisory information; coverage >96 percent domestic assets excluding foreign branches):
  - Baseline: IMF World Economic Outlook Update (January 2012) consistent.
  - “IMF adverse” (double-dip): one standard deviation from baseline GDP growth trend over two years; cumulative GDP shock 5.7 percentage points.
  - “BdE adverse”: two-year real GDP growth reduced by 2.5 percentage points relative to IMF adverse.
- Real estate assumptions: cumulative additional nominal declines in house prices for 2012–13 range between additional 8 percent for baseline to 23 percent for IMF adverse.
- Selected macroeconomic values (Box 1 excerpts):
  - 2012 Real GDP (Baseline): -1.7
  - 2012 Real GDP (Adverse Scenario - BdE): -0.3
  - 2012 Real GDP (Adverse Scenario - IMF): -4.1
  - House price change (2012 Baseline): -10.6; IMF Adverse 2012: -19.9
  - Unemployment Rate 2012 baseline: 24.2
  - EURIBOR, 12 months 2012 baseline: 1.6

### Insurance sector highlights
- Profitability: insurers remained profitable with return on equity around 15 percent.
- Solvency I margins:
  - Life sector about 200 percent above required capitalization.
  - Non-life sector about 350 percent above required capitalization.
- Asset allocation: ~25 percent in sovereign debt; ~30 percent in corporate debt.
- Many investment-type policies include market value adjustment transferring market risk to policyholders.

### Covered bonds and structured funding (Box 4)
- More than 90 percent of mortgages funded via structured products (covered bonds and MBS); cédulas support 57 percent of total mortgage lending.
- FAAF fund: initially endowed with € 30 billion extended to € 50 billion; bought for € 19.3 billion in bonds; fund closed on March 30, 2012.
- Statutory over-collateralization requirement: 25 percent (of eligible share of cover pool consisting of first-lien mortgages).
- Legal limits on asset encumbrance: either 70 or 80 percent based on type of reference asset.
- Dependence on cédulas may create problems for unsecured creditors and increase public contingent liabilities under severe stress.

*Source: International Monetary Fund — Financial System Stability Assessment (FSAP) Update for Spain, approved May 30, 2012.*

### 2012. The views expressed in this document are those of the staff team and do not necessarily reflect

### SPAIN — Financial System Stability Assessment

### Overview and context
- Report prepared by the Monetary and Capital Markets and European Departments; approved May 30, 2012.
- Assessment summarizes the Financial Sector Assessment Program (FSAP) Update for Spain based on two missions: February 1–21 and April 12–25, 2012.
- The past four years saw an unprecedented crisis in the Spanish financial sector driven by a domestic real estate boom-bust, weaknesses in the savings bank sector, shortcomings in the policy and regulatory framework, and an over-reliance on wholesale funding.

### Banking sector restructuring: scope and progress
- A major restructuring of the banking sector is underway, including reform of the savings banks’ legal framework and financial support from the state-owned recapitalization vehicle Fondo de Reestructuración Ordenada Bancaria (FROB).
- Substantial progress has been made in addressing balance sheet weaknesses; the most vulnerable institutions have either been resolved or are being restructured.
- Recent measures target the most problematic part of banks’ portfolios (real estate developer loans).

### Key findings from stress tests and system resilience
- The FSAP team’s stress tests indicate:
  - The core of the banking system appears resilient, with the largest banks sufficiently capitalized and having strong profitability—reflecting solid capital buffers and robust earnings of internationally-diversified institutions.
  - There exists a group of banks where vulnerabilities are highest and public support is most critical; most of these banks have been acquired by other solvent entities or are in varying stages of restructuring.
  - The government committed to a capital injection of about 2 percent of GDP to the fourth largest bank (which will become state owned) to support its restructuring.
  - Continued efforts are needed to rebuild capital buffers; ECB long-term funding and improved liquidity positions provide temporary relief, but banks need to bolster balance sheets to re-access private funding markets.

### Recent policy measures and their intended effects
- May 2012 decision: increase provisioning rates on performing real estate developer loans from 7 percent to 30 percent.
  - Expected effect: provide adequate coverage for potential future losses in this portfolio.
  - Highly capitalized banks with limited real estate exposures are expected to meet these requirements; other banks will be supported with a public capital backstop (injected as common equity or contingent capital).
- Authorities committed to undertaking a comprehensive review of banks’ asset portfolios with third-party participation to determine further restructuring needs.

### Remaining vulnerabilities and near-term risks
- Despite targeted measures, further restructuring and recapitalization of some weaker banks may be needed due to deteriorating economic conditions and possible additional losses outside the addressed real estate developer loan portfolio.
- Caveats to the FSAP assessment include potential effects of lender forbearance on underlying data and the risk of a more severe downside macro shock than modeled.

### Financial oversight framework: strengths and shortcomings
- Strengths:
  - Supervisory agencies possess highly experienced and respected professional staff and are supported by good information systems and thorough supervisory processes.
- Shortcomings and recommended steps:
  - A gradual approach to corrective action allowed weak banks to continue operating, harming financial stability.
  - Need to strengthen the authority, processes, and accountability framework for the banking regulator to preemptively address risk build-up and take remedial action.
  - Enhance regulatory independence of the banking and securities regulators and address financial/budgetary independence limitations for the insurance and securities regulators, while ensuring adequate accountability.
  - Strengthen the regulatory framework for the insurance sector—current solvency regime is not risk-sensitive—and improve monitoring of risk build-up in the sector.

### Critical priorities for preserving stability and enabling recovery
- Full implementation of reforms, including:
  - Thorough independent valuations and a comprehensive diagnostic review of asset portfolios.
  - A credible public backstop for capital shortfalls and a clear strategy for providing that backstop.
  - Further restructuring of weaker banks as needed, including dealing with legacy assets.
  - An effective communication strategy that clearly sets out the timetable for diagnostics, recapitalization/backstop plans, and handling of impaired real estate exposures.

*Source: International Monetary Fund — Financial System Stability Assessment (FSAP) Update for Spain, approved May 30, 2012.*

### 8.      The conclusions above are necessarily tentative, given that the banking system

### _cr12137 - 8.      The conclusions above are necessarily tentative, given that the banking system

### Conclusions and policy urgency
- The conclusions are necessarily tentative because the banking system strategy is still being formulated amid the wider spread of turmoil in Europe.
- The analysis is a point-in-time assessment of current vulnerabilities and systemic resilience to a possible further deterioration in macroeconomic conditions.
- Authorities must continue to take decisive action to address weaker institutions and restore market confidence in Spanish banks.
- Delays could:
  - exacerbate the macroeconomic downturn,
  - erode market confidence,
  - damage stability more broadly.

### Consolidation of the banking sector (Figure 1 — key facts preserved)
- Asset shares (Spain only, for 2011) and sector composition:
  - Banco Santander: 18.9
  - BBVA: 14.9
  - La Caixa / Caixabank: 12.1
  - BFA-Bankia: 11.9
  - Catalunya Caixa / Caixa Catalunya: 2.5
  - Nova Caixa Galicia / Caixa Galicia: 2.5
  - Banco Sabadell: 5.6
  - Banco Popular: 5.5
  - Unicaja: 2.7 (Unicaja*)
  - Ceiss (Caja Duero/Caja España): 2.6
  - Banco Mare Nostrum: 2.4 (Banco Mare Nostrum*)
  - Ibercaja: 2.3
  - Bankinter: 2.1
  - Cajastur / CCM / Liberbank: 1.9
  - Total 14 large and medium-sized banks: 88.0
  - Small private banks: 3.1
  - All other non-foreign banks not included above: 5.1
  - Cooperative sector: 3.7
  - Total banking sector, excluding foreign bank branches: 100.0
- Note: Banks coded in red were intervened; banks in green were part of the institutional protection scheme; banks in orange have been intervened and were to have been auctioned, since put on hold.
- *These institutions have FROB support in the form of preference shares or contingent capital.

### High priority recommendations (Table 1 — recommendations and timeframes)
- Overall Financial Sector Stability
  - Finalize the recapitalization of banks based on an in-depth due diligence of the banks’ loan portfolios (BdE, MdE). — Immediate
  - Implement time-bound restructuring plans for banks reliant on state support, including measures to strengthen capital buffers, profitability, and governance practices (BdE). — Immediate
  - Design and implement a roadmap to deal with banks’ legacy assets (MdE, BdE). — Immediate
  - Establish a reliable and publicly available land and real estate property sale price database, to be maintained by an official agency (MdE, BdE). — Near-term
- Banking Oversight
  - Change the legal regime to clearly prescribe the sole and exclusive roles of the BdE in prudential oversight of financial institutions, avoiding inconsistency in the division of responsibilities (MdE). — Near-term
  - Amend legislation to give BdE operational independence in its supervisory function in line with its independence as a central bank (MdE). — Near-term
  - Amend the current legal framework for banking supervision to provide BdE with effective powers to promulgate prudential rules and sanctioning (MdE, Government). — Near-term
  - Require banks to value their real estate portfolios more frequently, especially during economic downturns, to ensure rapid adjustments to provisions (BdE). — Near-term
- Insurance Sector Oversight
  - Increase resources to strengthen supervisory effectiveness (DGSFP, MdE). — Near-term
  - Improve product disclosure requirements for life insurers (DGSFP). — Medium-term
- Securities Markets Oversight
  - Devote more resources to the supervision of investment services providers (ISPs), in particular for on-site inspections (CNMV). — Near- to medium-term
  - Strengthen the independence of the CNMV by removing (i) the role of the MdE in the authorization and sanctioning of ISPs; (ii) MdE representation in the CNMV board; and (iii) the need for pre-approval of the government for increases in human resources (MdE). — Medium-term
  - Use more proactively sanctioning powers in connection with breaches of conduct obligations (CNMV). — Near-term
- Payments and Securities Systems Oversight
  - Improve liquidity risk management of the central counter party (CCP) by regularly conducting stress-tests and providing access to central bank liquidity facilities (CNMV, BdE). — Near-term
  - Put in place coordinated contingency plans to deal with a potential financial failure of a CCP (MdE, CNMV, BdE). — Near-term
- Crisis Management
  - Introduce special tools to resolve banks, such as prompt recapitalizations, purchase and assumption transactions, and bridge banks, as well as related provisions for overriding shareholders’ rights and imposing losses on (left-behind) creditors (all agencies). — Immediate
  - Further develop burden sharing mechanisms between the private and the public sector in the restructuring and resolution of banks, by clarifying the financial responsibilities of the FROB and of the FGD, including through a contingency credit line from the State to the FGD (all agencies). — Near-term
- Timeframe definitions:
  - “Immediate” is within one year; “near-term” is 1–3 years; “medium-term” is 3–5 years.

### Macroeconomic context and shock chronology (Introduction)
- Real estate exposures and macro indicators:
  - Construction and real estate loans grew from 10 percent of GDP in 1992 to 43 percent in 2009, and amounted to about 37 percent of GDP at end-2011.
  - Economy expected to contract by 1.8 percent in 2012.
  - Unemployment is at 24 percent and rising, especially among the young.
  - Total assets of Spanish banks (excluding foreign branches) amount to about 320 percent of GDP taking into account international activities of the banks.
  - Loans extended to the private sector in Spain account for 166 percent of GDP.
- Crisis phases and effects:
  - Initial impact: relatively mild; loss of wholesale funding; authorities assisted bank funding rather than inject capital.
  - Second-round effects: sharp recession in 2009–10; construction collapse; unemployment soaring; restructuring and recapitalization scheme and tighter minimum capital requirements introduced.
  - Third phase: ongoing sovereign debt concerns and strong interconnection between sovereign and banking system.

### Risks, vulnerabilities, and sector dynamics
- Restructuring progress and residual problems:
  - Number of institutions reduced from 45 to 11 through interventions, mergers, or takeovers.
  - Despite consolidation and loss recognition, banks’ access to wholesale funding markets remains limited.
  - Banks exposed to further losses on loan portfolios, notably real estate and construction.
  - Deterioration in market perception of sovereign and bank risk increased pressure; many banks rely on wholesale markets for funding.
- Asset quality and credit conditions:
  - Nonperforming loans continued to increase, particularly driven by loans to construction and real estate developers.
  - Stock of repossessed assets increased to about 3½ percent of gross loans.
  - Growth in credit to the private sector fell sharply and turned negative.
  - Retail deposits declined slightly (4 percent on a y-o-y basis).
  - Spanish banks have drawn extensively from the ECB, with refinancing reaching almost 11 percent of total assets.
- Measures taken by banks and authorities (since crisis began):
  - Banks increased loan loss allowances by € 112 billion (11 percent of GDP) and raised their tier 1 capital ratio from less than 7 percent to more than 9 percent by end-2011, including capital injections by the state.
  - Total gross direct intervention by the government (excluding bond issuance guarantees) amounted to about € 34 billion (3 percent of GDP) as of April 2012, of which more than half has already been recovered.
  - Industry contribution via the Fondo de Garantía de Depósitos (FGD) to fund the FROB and resolution of three intervened institutions: about € 13 billion, which could rise up to € 34 billion (3.2 percent of GDP) if asset protection schemes are fully called.
- Recent regulatory and supervisory steps:
  - February 2012: RDL 02/2012 introduced higher provisions and specific capital buffers for banks’ outstanding real estate exposures; banks to comply by end-2012 through earnings, asset sales, conversion of preferred shares and bonds into equity, and paying dividends in the form of new shares.
  - May 2012: provisions on performing real estate developer loans increased from 7 percent to 30 percent in the RDL 02/2018; banks unable to comply will be supported with a public capital backstop (issuance of equity or contingent capital to FROB).
  - Comprehensive review of banks’ loan books and real estate assets to be conducted by auditors to increase transparency.
  - May 2012: government committed to a capital injection of € 19 billion (about 2 percent of GDP) to the fourth largest bank, which will become state owned.

### Condition of the financial sector — bank group segmentation and vulnerabilities
- Bank group definitions and shares (covering about 83 percent of the banking sector excluding foreign bank branches):
  - G1 — Large internationally active banks: 2 banks; on a solo basis (Spain activities only) account for about 33 percent of banking assets and almost half of the system at a consolidated level; only one third of their net profits are generated domestically.
  - G2 — Former savings banks not receiving state support: 7 banks; account for approximately 17 percent of domestic banking sector assets; lending focused on residential housing.
  - G3 — Former savings banks receiving state support: 7 banks; account for about 22 percent of sector assets; rely significantly on government/FROB for capital and liquidity support; heavy exposure to real estate and construction-related lending.
  - G4 — Medium and small private sector banks: account for approximately 11 percent of domestic banking assets; lending concentrated in the corporate sector, with real estate and construction exposures second only to G3.
- Loan exposure differences:
  - G3 has highest exposure to real estate developer sector: 19 percent of its loans made to this sector, with the highest proportion in land loans.
  - G1 and G2 have lower exposures and mainly to finished buildings.
  - G3 also has the largest proportion of foreclosed assets.
- Profitability and capitalization:
  - G1 profits augmented by diversified international businesses, which contribute some 75 percent of profits.
  - G3 has the lowest capital base, is loss making, and least efficient in terms of cost to revenue ratio.
  - G3 banks have a higher proportion of Tier 1 instruments (FROB 1 injections), which are not considered accounting capital.
- Ability to meet provisioning requirements:
  - G1 appears able to cover February provisioning requirements and expected to absorb additional May provisioning requirements on performing loans.
  - Some banks in G2 and G4 likely to come under pressure and may record overall losses in 2012.
  - G3 banks clearly face the biggest challenge.
- Funding composition (key points):
  - Deposits represent about half of total system-wide funding.
  - Loan-to-deposit (LTD) ratios: G1 = 143 percent; G4 = 150 percent.
  - Significant reliance on issuance of covered bonds (cédulas hipotecarias), particularly for G2 and G3, with many recent issues retained by banks for ECB refinancing.
  - Significant take-up of ECB LTRO across most banks; G3 and G4 are the biggest borrowers relative to their total funding needs.

### Insurance sector highlights
- Insurers remained profitable during the crisis with return on equity around 15 percent.
- Solvency margins under Solvency I:
  - Life sector: about 200 percent above required capitalization.
  - Non-life sector: about 350 percent above required capitalization.
- Introduction of Solvency II will impact solvency margins (magnitude unknown), but industry should remain comfortably solvent as suggested by the latest QIS 5 exercise.
- Asset allocation:
  - About a quarter of investment assets are in sovereign debt.
  - About 30 percent in corporate debt.
- Many Spanish investment-type insurance policies contain a market value adjustment provision that transfers market risk to policyholders.

*Source: _cr12137 - 8.      The conclusions above are necessarily tentative, given that the banking system*

### 26.      The economic environment increases the risks to corporate and household

### 26.      The economic environment increases the risks to corporate and household

### Economic context and outlook
- GDP is expected to contract by 1.8 percent in 2012.
- Unemployment is 24 percent and rising.
- Positive developments:
  - The current account deficit has fallen sharply.
  - Exports have been robust.
  - Structural reforms: labor market made more flexible; fiscal framework strengthened to bring autonomous communities’ budget under tighter central control.
- Main challenges:
  - Large-scale fiscal consolidation to come.
  - Market concerns and sovereign spread widening caused by external and domestic events (e.g., the difficult financial situation of the regions).
  - House prices sliding further.
  - Substantial bank and private sector deleveraging.

### Housing market and real estate stock
- House price dynamics and inventories:
  - Inventories estimated at 700,000–1 million units.
  - Market estimates suggest about four years to clear these inventories.
  - Sales prices are still 20–25 percent below asking prices.
  - Banks’ repossessed assets estimated at 200,000 units, raising risk of further price corrections.

### Household sector: indebtedness and vulnerabilities
- Household debt rose during the boom years to around 90 percent of GDP (not the highest in the Euro Area).
- Mortgage characteristics and mitigating factors:
  - 98 percent of mortgages are at variable rates.
  - Overall sharp drop in Euribor rates since the onset of the crisis has helped moderate debt service relative to income.
  - Uptick in interest rates over the past year offset by contraction in new mortgages (minus 42 percent year-on-year in March).
  - Restructuring of loans by banks and policy initiatives to lower debt service for the most vulnerable households.
  - Full recourse by banks (borrowers liable for full value of the loan including penalties and fees).
  - Relatively low loan to value ratios (on average 58 percent).
  - High and relatively well distributed wealth, albeit very concentrated in housing.
  - Country-specific buffers: family support and additional income from grey economy activities.
- Deterioration and sensitivity:
  - Debt servicing ability among households has deteriorated since 2008 and is expected to weaken further.
  - Sensitivity analysis (Box 1) findings:
    - Households are most vulnerable to rising interest rates; shares of vulnerable households and debt-at-risk increase fairly sharply under rising interest rate scenarios, with stronger impact on lower income households.
    - Income shocks have a moderate impact on debt servicing ability; rising unemployment has a similarly muted direct impact, possibly because shocks are partially absorbed by income of other household members and unemployment benefits.

### Distributional impact and outlook for households
- A difficult economic outlook in 2012 and 2013 is expected to further weaken households’ financial positions.
- A sharp decline in output growth would increase debt-at-risk, most severely affecting borrowers among the poor and the young.

### Corporate sector: debt and vulnerabilities
- Corporate debt levels and composition:
  - Corporate debt at 186 percent of GDP, highest in the Euro Area after Ireland.
  - Excluding trade credits, corporate debt would amount to 135 percent of GDP.
  - Spain would be close to the Euro Area average if real estate and construction sectors are excluded.
- Main risks:
  - Significant threat to financial stability due to weight of real estate and construction assets on banks’ loan books and continuing adjustment in these sectors.
  - Deleveraging process will continue and likely take a long time, leaving financial stress and corporate vulnerability elevated.
- Sensitivity analysis (Box 1) findings:
  - Corporate sector vulnerable to interest rate shocks.
  - SMEs exposed to domestic developments due to less-diversified income sources.
  - Recent decree creating a mechanism for payment to suppliers of sub-national governments (up to 3.5 percent of GDP) helps alleviate liquidity tensions at SMEs dependent on sub-national budgets.
  - Macroeconomic shocks would have the biggest impact on construction and real estate sectors; export sector remains resilient.

### Banking sector: baseline projections and scenario design
- IMF baseline growth scenario:
  - Projects a recession in 2012 and a modest recovery in 2013.
  - Real GDP growth expected to accelerate gradually to around 1.8 percent over the medium term, led by net exports.
  - Labor market reform expected to help contain costs and support export-led recovery.
- Scenarios for solvency stress testing (covering over 96 percent of domestic banking sector by assets, excluding foreign branches, over 2012–13 using end-2011 supervisory information):
  - Baseline: consistent with IMF World Economic Outlook Update (January 2012).
  - “IMF adverse” (double-dip) scenario:
    - One standard deviation from baseline GDP growth trend over two-year horizon.
    - Cumulative GDP shock under this scenario of 5.7 percentage points.
    - Sharp decline in output, further house price declines close to levels observed in 2002, and rising unemployment.
  - “BdE adverse” scenario:
    - Shock to two-year real GDP growth reduced by 2.5 percentage points relative to the “IMF adverse” scenario.
- Real estate assumptions across scenarios:
  - Cumulative additional nominal declines in house prices for 2012–13 range between an additional 8 percent for the baseline to 23 percent for the IMF adverse scenario.
- Sovereign valuation haircuts:
  - Banks hold about two-fifths of Spanish central government debt (about 8 percent of total banking system assets).
  - Market-implied haircuts applied to sovereign debt holdings other than held-to-maturity books, estimated based on forward term structure of sovereign CDS spreads as at end-2011.

### Stress testing methodology
- Three-pronged solvency testing approach:
  - Top-down balance sheet stress test by BdE on prudential data (“IMF TD model”).
  - Top-down balance sheet stress test by BdE using its panel regression model (“BdE TD model”).
  - Systemic Contingent Claims Analysis (“IMF SCCA model”) using market information to assess capital needs based on perceived solvency and implications for banks’ resilience to simultaneous shocks.
- Coverage and adjustments:
  - Tests incorporate additional provisioning requirements introduced in February and May (Appendix III).
  - Given significant ongoing restructuring, a longer horizon was not used though estimates are based on lifetime losses.

### Stress test findings: solvency and capital needs
- General conclusions:
  - Core of the system appears resilient, but vulnerabilities exist and lender forbearance is not explicitly addressed (may understate credit risk in some institutions).
- Bank group results:
  - G1 banks:
    - Appear sufficiently capitalized and profitable to withstand further deterioration.
    - Solid capital buffers and robust earnings from internationally-diversified operations.
  - G2 banks:
    - Resilient to adverse shocks up to a point.
    - As a group, comply with core Tier 1 capital hurdle of 4 percent under adverse scenario but show some capital need at a 7 percent hurdle rate.
  - G3 and FROB-administered banks:
    - Vulnerabilities highest and public support most critical.
    - Under the IMF adverse scenario, core Tier 1 capital (almost € 27 billion) would be essentially wiped out.
    - Several have received state support—five acquired or merged; others in various restructuring stages.
    - In May, the largest bank in this group requested capital support: conversion of € 4.5 billion of FROB preference shares into equity.
    - New management asked for capital support of € 19 billion from the government, of which about € 13.5 billion (post-tax) are earmarked to comply with new provisioning requirements and to cover potential future loan losses.
  - G4 banks:
    - Affected to a lesser extent; post-shock would require about € 2 billion to comply with a core Tier 1 capital ratio of 4 percent.
- Aggregate Basel III readiness and capital shortfall:
  - To comply with a 7 percent core Tier 1 ratio post-shock, Spanish banking system aggregate capital needs amount to € 37 billion.
  - 80 percent of that € 37 billion attributable to banks in G3 and those being auctioned by FROB.
  - If a hurdle rate of 8 percent core Tier 1 were considered, total capital needs would reach € 45 billion, 75 percent of which is accounted by G3 and FROB banks (Box 2 context).
- Sovereign risk caveat:
  - Impact of sovereign risk on non-banking income does not appear significant in tests, but widening sovereign CDS spreads since end-2011 are not reflected given test cut-off; banks could face additional losses beyond prescribed haircuts projected as at end-2011.

### SCCA results and joint solvency risk
- SCCA analysis covers seven large publicly-listed banks (about 40 percent of system, mainly in G1 and G4) and validates stress test findings.
- Outcomes:
  - Baseline conditions: joint potential capital losses average € 0.3 billion over 2012–13.
  - Severe adverse (double-dip) scenario:
    - Sample banks would experience total expected loss of more than EU14 billion on average, with a peak in excess of € 21 billion at end-2012 at a statistical probability of five percent or less (tail risk).
    - Resulting capital levels remain comfortably above all stress test hurdle rates.

### Liquidity stress testing and findings
- Liquidity testing approach:
  - Reverse stress tests and proxies for proposed Basel III liquidity measures.
  - Country-specific spreadsheet tool combined with BCBS-based liquidity reporting format; supplemented with balance sheet data of 29 institutions.
  - Tests conducted separately from solvency analysis; no separate foreign currency liquidity stress tests.
- Key findings:
  - ECB support measures have significantly alleviated difficult funding conditions.
  - Wide deposit base and retail-focused business model limit impact from wholesale market disruptions; retail funding historically robust.
  - All firms but one pass the implied five-day cash flow test and the Liquidity Coverage Ratio (LCR) test.
  - Overall liquidity shortfall remains contained for the 30-day test, with about one-third of firms (about 3 percent of system assets) affected in a very severe scenario assuming a 21.5 percent withdrawal of all deposits maturing within one year (Table 13).
  - Two-thirds of sample banks—about half of all banks in G1, G2, and G3—fall below the Net Stable Funding Ratio (NSFR) benchmark of 100 percent.
  - Maturity mismatches up to one year for almost all sample banks raise concerns about stability of current funding sources (Table 14).
  - G2 shows low pass rate for the 30-day cash flow test; reliance on long-term funding is lowest in G2.
  - High rate of acceptance of funds from ECB’s LTRO by G3 (and also G2) banks confirms liquidity reliance.

### Caveats and limitations of stress tests
- Feedback loops between banking distress and economic performance cannot be fully captured; severe loan contractions causing self-reinforcing domestic demand declines are not captured.
- One third of banks in the stress test sample no longer exist as stand-alone entities as of May 2012 due to restructuring; financial strength of merged entities may differ from sum of parts and is not captured.
- For banks under resolution/restructuring, additional costs beyond provisioning may be unknown and not incorporated (example: marking-to-market industrial participations in preparation for sale; proceeds likely used to retire debt and improve funding).
- Cross-border exposures:
  - Some banks have significant exposures to banking and non-bank private sectors abroad; domestic system most exposed to extreme credit and funding shocks to the United Kingdom and the United States, and to some extent to France and Germany.
  - Analysis of partial ring-fencing of profits in key host countries outside Europe suggests limited impact (0.5 percentage points of banks’ Core Tier 1 capital ratios or less).

*Italicized source attribution: Content derived from the specified IMF chapter/section.*

### 45.      Banks may not be able to rely on the issuance of structured finance products as a

### 45.      Banks may not be able to rely on the issuance of structured finance products as a

### Funding markets, covered bonds, and securitization
- Covered bonds (cédulas) facilitate cost-efficient funding over longer time horizons, but the required asset-backing entails overcollateralization requirements to help protect investors (Box 4).
- The retrenchment of mortgage credit continues to erode the stock of mortgages that support such over-collateralization, and it is anticipated that the issuance of covered bonds will continue to decline.
- Restarting securitization markets, which has traditionally been an important source of funding (Figure 13), will likely take time, as these markets are largely illiquid throughout Europe.
- Continued efforts towards greater transparency of underlying assets required for securitization will be key for investor confidence when market conditions improve.

### C. A Comprehensive Strategy to Address the Remaining Vulnerabilities
- As of May 2012, following mergers, acquisitions, and government interventions, the banking system comprises of 14 large and medium-sized banks (Figure 1).
- Together, these banks account for almost 90 percent of total system assets.
- Transformation from the pre-crisis situation of 45 former savings banks and 7 commercial banks to the current structure.
- The rest of the system comprises small private banks, international banks with operations in Spain, and the cooperative sector.

Key breakdown of the former larger group of institutions:
- The three largest banks (accounting for about 47 percent of the system) appear able to withstand a further deterioration in economic conditions.
- The fourth largest bank (12 percent of system assets) will have received government capital support (including conversion of FROB preference shares) of € 23.5 billion (about 2 percent of GDP) by end-July, becoming a majority state-owned bank.
- Two other banks (5 percent of system assets) are already under government administration and will need to be capitalized.
- Four banks (16 percent of total assets) have remained resilient without state support, though some may come under pressure meeting increased provisioning requirements and may record losses in 2012.
- The remaining four banks (about 9 percent of total assets) already rely on state support, either in the form of preference shares or contingent capital.

### Provisioning, asset valuation, and diagnostic reviews
- The additional provisioning requirements adopted in 2012 address important concerns regarding exposures to the real estate developer sector.
- The balance sheet valuation of troubled assets has been brought closer to market value (with a coverage ratio of problematic exposure of about 50 percent) and expected migration of performing or refinanced loans into doubtful categories are largely accounted for.
- These changes imply an increase in the average coverage ratio of the real estate developer loan portfolio from 17 percent to 43 percent.
- Real estate exposures of banks differ by region and type and the current levels of provisioning may be conservative for some banks and less so for others.

Planned reviews and outcomes:
- Authorities committed to a comprehensive review of banks’ asset portfolios, with third-party participation.
- A top-down review by two independent firms is expected to provide an estimate of capital needs under stress scenarios by end-June.
- A thorough review by audit firms of all banks’ loan books and real estate assets should provide the basis for a comprehensive clean-up of the system, introduce an institutional framework for managing banks’ legacy real estate assets, and enhance market confidence.
- Full implementation of reforms, including a credible public backstop and an effective communication strategy, is critical for preserving financial stability.
- The authorities have pursued burden sharing between the public and private sectors, recently switching to greater reliance on public funding to avoid undermining viable banks.
- The timetable for the diagnostic and the strategy to address the potential implications needs to be spelled out, as well as a strategy for dealing with impaired real estate exposures.

### Management and transfer of foreclosed and impaired assets
- Authorities required all banks to make an initial transfer of foreclosed assets into bank-specific asset management units to improve management and effective disposal.
- Transfers within a bank group, consolidated for accounting purposes, do not change the risk profile and may require further provisioning if asset values decline further.
- Further steps to manage impaired assets depend on diagnostic review results; the diagnostic should provide guidance on transfer price if impaired assets were to be moved from balance sheets—it is critical that the assets are valued conservatively.

Institutional options for managing impaired assets:
- Banks can manage impaired assets directly, or sell them to one or more specialized, privately or publicly owned, asset management company(ies) (AMC).
- Experience suggests that government-owned centralized AMCs may be relatively more efficient when the size of the problem is large, special powers for asset resolution are needed, or the required skills are scarce.
- The scope of the AMC should be decided based on the nature and size of the problem; fixed assets such as foreclosed properties and loans that require foreclosure or settlement with debtors are good candidates for transfer to AMCs, and different specialized AMCs may take over separate categories of assets.

System-wide asset protection scheme (APS) option:
- A system-wide APS approach would be similar to that used by the FROB in resolving failed banks, but on a system-wide basis.
- A guarantee would be given by a third entity on specified portfolios of impaired assets (e.g., by the FROB), covering losses in excess of a certain amount and, possibly, up to a certain percentage.
- The assets subject to the APS would remain on the balance sheets of the banks; there would not be loss mutualisation mechanisms among banks as in an AMC structure.
- In light of such government guarantee, protected assets would benefit from lower risk weightings.
- This approach avoids infrastructure or operating costs typically borne for AMCs and potential political interference from a large-scale state-owned entity.
- APS would require no pre-funding (i.e., no immediate fiscal impact) but would imply an increase in public sector contingent liabilities.

Design considerations for APS:
- APS need to be designed carefully to address moral hazard concerns.
- Consideration might be given to the introduction of a given fee in exchange for the provided protection, as in the U.K.
- The beneficiary institution could pay the net present value of future fees through the issuance of capital instruments in favor of the institution providing the APS (either the FROB or the FGD).
- These capital instruments could be structured to qualify as Core Tier 1 capital.
- This approach could reduce a bank’s risk weighted assets while also increasing its quality capital.

### III. STRENGTHENING THE SUPERVISION OF THE FINANCIAL SECTOR
A. Microprudential and Macroprudential Regulatory Infrastructure
- Regulation and supervision of financial institutions and securities markets is performed by three main agencies: the BdE, the CNMV, and the Dirección General de Seguros y Fondos de Pensiones (DGSFP, acting within the Ministerio de Economía y Competitividad, MdE).
  - BdE: supervision of credit institutions.
  - CNMV: supervision of securities markets.
  - DGSFP: supervision of insurance companies and pension funds.
- Regional governments retain some regulatory and supervisory powers over savings banks operating in their jurisdictions, though these powers are less relevant after savings banks transferred banking business to commercial banks.
- Oversight and supervisory responsibilities regarding payments and settlements systems are the purview of the BdE and the CNMV, respectively.

Institutional arrangements and suggestions:
- In 2006, the authorities established Comité de Estabilidad Financiera (CESFI), represented by the three agencies with the State Secretary for Economic Affairs as Chair, to strengthen coordination on financial stability and crisis prevention and management.
- The LABE establishes the BdE’s responsibility for ensuring the smooth operation and stability of the financial system; BdE conducts analysis and monitoring of risks to the Spanish financial system and publishes a Financial Stability Report bi-annually and a Financial Stability Journal.
- The MdE houses the secretariat of CESFI and is responsible for cross-sector coordination.
- CESFI could be strengthened through a more structured and formalized decision-making process and could be the “platform” for the set-up of a macroprudential framework.

Credit registry improvements:
- A new project to improve the credit registry will facilitate both microprudential and macroprudential analysis.
- The BdE initiated a two-pronged project to collect credit information on a comprehensive scale, to be launched in 2014.
- Under this initiative, banks will report all transactions by any borrower, including non-residents, with one main aim being to capture credit risk transfers within banking groups.
- Features of the central credit register would be enhanced to ensure banks taking on credit risk have complete details about their customers, including on the encumbrance of collateral used for loans.

Savings bank sector and governance:
- Major progress achieved in reforming the savings bank sector; a clear strategy on governance structures needs to be designed.
- Spin-off of banking activities to commercial banks brings clarity to the supervisory framework (now within BdE remit) and market discipline.
- Current restructuring reduces excessive capacity; new requirements on governance and professionalism of management are welcome.
- In some cases savings banks will act as holding companies of commercial banks; in others they will become foundations with minority stakes.
- Overall strategy on the role of savings banks needs to be kept under review.
- Consideration should be given to adopting a special regime to transform savings banks into institutional investors with a view of becoming minority shareholders going forward.

B. Assessment of the Oversight Framework
- Main strengths: highly experienced and respected professional staff, good information systems, thorough supervisory processes.
- Remaining weaknesses include:
  - insufficient regulatory independence for the banking and securities regulators, and limitations on the financial/budgetary independence for the insurance and securities regulators;
  - lack of adequate authority and mandate for the banking regulator to address preemptively the build-up of risks in the system;
  - lack of a risk-based regulatory framework for the insurance sector (the current solvency regime is not risk-sensitive) and of proper monitoring of potential risk build-up in the sector due to out-dated solvency regime;
  - lack of a fully effective remedial action and sanctioning regime in banking supervision and limited use of on-site inspections in the securities supervision.

C. Regulation and Supervision of the Banking Sector
- The BdE’s slow approach in taking corrective action has allowed weak banks to continue to operate; corrective actions were recommended early but enforcement was gradual, contributing to growing vulnerabilities.
- The core supervisory process at the BdE is strong and supported by an experienced cadre of inspectors, as identified in the assessment of Effectiveness of Banking Supervision based on the Basel Core Principles (BCP).
- Regulatory capital and loan-loss provisioning requirements for real estate exposures have been tightened and further guidance on best practices for lending in this area has been provided.
- Authorities implemented measures to reduce incentives for equity investments in nonfinancial companies by banks and to manage related conflicts of interest, enhanced coordination and cooperation between financial sector regulators, and adopted additional requirements on internal controls.

Areas requiring improvement in supervisory practices:
- Timeliness of remedial action, operational independence concerning issuance of regulations and enforcement, and oversight of concentration risk and related party transactions.

Enhancing BdE’s independent authority:
- Sanctioning powers: legal framework for sanctions and regulatory powers does not create an environment conducive to independence; sanctioning proposals are made by the Governing Council of the BdE to the Minister of Economy, while the MdE has sanctioning power for very serious infractions and resolution capacity. Adopting a more flexible enforcement regime and more intensive use of sanctions is recommended.
- Regulatory autonomy: the MdE is the principal agency charged with issuing financial regulation; the BdE currently lacks authority to issue prudential regulations except where specifically delegated by law or the MdE. Establishing BdE’s regulatory powers directly by law—rather than through delegation by the MdE—is recommended.

Concentration risk and related party transactions:
- Regulatory framework and oversight were not sufficient to address significant build-up of risks, partly due to the corporate governance structure of savings banks and local characteristics leading to high sectoral (real estate) and geographical concentration.
- Linkages between industrial companies and banks remain; organizational structures are often complex and related parties difficult to detect.
- Application of an enhanced regulatory framework within Pillar 2 and more intensive monitoring under seguimiento continuado is a welcome development.
- BdE will need to apply special attention to ensure deficiencies in previous structures do not contaminate new banking organizations.

Real estate valuation practices:
- Given importance of real estate loans, measures to improve valuation practices should be considered.
- Difficulties in determining accuracy of real estate valuations weigh on perceptions of provisioning adequacy.
- Establishment of a comprehensive, reliable and publicly available land and real estate property price database—maintained by an official agency—would improve transparency.
- The database should record actual transaction prices, rather than mortgage amounts, and detailed information on respective properties.
- More frequent valuations by banks of their real estate portfolios, especially during downturns, would ensure rapid adjustments to provisions.

D. Supervision of Financial Market Infrastructures
- Overall, financial market infrastructures (FMIs) are well regulated and supervised.
- The BdE and the CNMV have the necessary tools and resources to discharge FMI oversight and supervision responsibilities and have induced changes over the past decade.
- Integration of European post-trading systems requires substantial changes in Spanish clearing, settlement, and registry systems, which are ongoing.
- In the next three years, the CNMV’s supervision methods will need adaptation to the new European regulatory and operational framework and to the future domestic FMIs’ organization.

CCP risk management and governance:
- Spanish CCPs benefit from robust financial risk management frameworks that could be further improved by better liquidity risk management and governance practices.
- Legal provisions, operational procedures, financial resources, and coordination arrangements are in place to deal with the default of a CCP’s participant.
- Liquidity risk management could be improved by regular liquidity stress-tests and access to central bank liquidity as soon as the on-going reorganization of clearing activities is completed.
- Governance arrangements of Bolsas y Mercados Españoles (BME) will need adaptation by ring fencing clearing activities, hiring independent board members, and overhauling the composition of their risk committee to comply with CPSS/IOSCO standards and the new European Market Infrastructure Regulation.

*Source: _cr12137 - 45.      Banks may not be able to rely on the issuance of structured finance products as a (IMF PDF content provided).*

### 67.      The authorities should consider developing coordinated contingency plans to

### _cr12137 - 67.      The authorities should consider developing coordinated contingency plans to

### CCP contingency planning
- Recommendation: Develop coordinated contingency plans to deal with a potential failure of a CCP, in line with ongoing discussions at the international level.
- Recommendation: Spanish CCPs should conduct regular default management stress-testing exercises with the involvement of participants and relevant public authorities to check readiness to handle crisis situations.
- Recommendation: Plan the orderly exit of the BdE from the BME’s capital, choosing the right moment and clearly explaining the reasons to avoid sending a wrong message to the market.

### Supervision of the insurance sector (DGSFP)
- Finding: Spain needs to implement new international prudential standards: the Solvency II capital requirements, enterprise risk management framework for solvency purposes, and a macroprudential surveillance system (including industry-wide stress testing).
- Finding: High degree of market participation by foreign insurers requires ongoing cooperation and coordination in supervising cross-border insurance groups and financial conglomerates.
- Finding: The budget allocated to DGSFP as part of the government budget has remained static, reducing supervisory intensity (fewer onsite inspections and limited offsite monitoring).
- Recommendation: DGSFP should increase its resources and explore alternative funding models, including being independent from the government to reduce dependence on the state budget.
- Recommendation: Strengthen product disclosure requirements for life insurance at the point of sale to include description of investment strategies used to provide guarantees; require special training for intermediaries selling products backed by complex investment instruments.
- Recommendation: Require insurers to provide a statement to customers on changes to their policy values, at least on an annual basis, because market value adjustment is prevalent on guaranteed products.

### Regulation and supervision of securities markets (CNMV)
- Finding: Spain exhibits a high level of implementation of the IOSCO principles; legal framework is robust and provides the CNMV with broad supervisory, investigative and enforcement powers.
- Finding: Arrangements for off-site monitoring and market surveillance are robust; thematic reviews and a new committee (the Grupo de Estabilidad Financiera) and annual strategic reviews support identification and monitoring of emerging and systemic risk.
- Weaknesses and recommendations:
  - Make more use of on-site inspections for all types of investment service providers, particularly credit institutions; spot checks on particular issues could be used.
  - Use sanctioning powers more proactively in case of breaches, in addition to remedial agreements; continue active referral of cases to criminal authorities to improve criminal prosecution of market abuse.
  - Address governance concerns about CNMV independence: participation of a MdE representative on the board; certain key decisions (authorizations and the imposition of sanctions for the most serious breaches) remain a responsibility of the MdE; requirement of governmental approval to hire additional personnel limits independence.

### Crisis management and resolution
- Finding: BdE has flexible powers to deal with weak banks, but the framework could be strengthened by a more structured and forward-looking approach for prompt corrective actions.
- Recommendation: BdE should consider an array of measures tied to predefined overall risk categories, contact other relevant authorities as appropriate, and retain flexibility to decide on measures.
- Recommendation: Further specification and some public disclosure of emergency liquidity assistance features (definitions of “solvent bank,” “systemic importance,” and “temporary liquidity support”) would enhance certainty.
- Recommendation: Introduce resolution tools in line with recent international practices; new legislation should:
  - Emphasize public interest objectives (protecting financial stability).
  - Enable allocation of losses to shareholders and creditors (prompt recapitalizations, purchase and assumption transactions, and bridge banks).
  - Allow overriding shareholders’ rights where necessary, subject to strict legal protection and ex post judicial review.
  - Consider depositor preference and an administrative-based framework for orderly liquidation of failed banks.
- Finding: Authorities are pursuing burden sharing between public and private sectors using the FROB (public vehicle) and FGD (deposit insurance). Since 2011, significant costs have been shifted to the industry via contributions to the FGD.
- Caution: If resolution costs become too high for the industry to bear in a reasonable time, viability of healthier institutions may be at risk; temporary public funding may be needed and should be devised to recoup costs ex post.
- APS use: Authorities used APS (asset protection scheme) to facilitate takeovers of weak banks; first-loss tranche typically set equal to provisions already accumulated by the weak institution. Consider revising features (e.g., higher first-loss threshold) to incentivize efficient management of covered assets.
- Governance concerns:
  - Active bankers’ presence in FGD and FROB governing bodies gives appearance of conflicts of interest.
  - Recommendation: Review governance to avoid conflicts; strengthen checks and balances to avoid group-think (e.g., balance ex officio members from MdE, Ministerio de Hacienda y Administraciones Públicas and BdE with executives and/or other independent members appointed by the authorities).
- Medium-term reform:
  - Need to realign and streamline institutional framework for resolution.
  - Clarify separate functions and overlapping powers/structures of FROB and FGD; define roles as operational and financing arms in resolution.
  - Identify a resolution authority, ensuring timely and effective crisis action and appropriate accountability.
  - BdE should remain closely involved; Government should preserve overarching mandate of preserving financial stability.

### AML/CFT
- Finding: Last AML/CFT assessment by FATF was in September 2005; a full AML/CFT reassessment is required under IMF Board decisions regarding incorporation of AML/CFT into the FSAP.
- Status and plan: Authorities prefer to undertake the AML/CFT assessment under the revised standards; they are in discussions with FATF to schedule the assessment sometime in 2013. A ROSC will be forwarded to the Fund and circulated to the Board upon adoption of the mutual evaluation report by the FATF Plenary.

### Sensitivity and scenario analyses of household and corporate indebtedness (Box 1) — methodology and key results
- Methodology:
  - Household analysis based on BdE’s 2008 Survey of Household Finances extrapolated to 2011; a household is classified as vulnerable (borrower-at-risk) when the debt service burden is above 40 percent.
  - Household shocks considered within a year: (i) increase in interest rate of 100 and 200 basis points; (ii) decline in household income by 5, 10 and 20 percentage points uniformly across households; (iii) increase in unemployment rate by 1, 3 and 5 percent; (iii) decline in house price by 10, 20, and 30 percent.
  - Firm analysis based on BdE’s Central de Balances as of 2010 (sample of more than 8,000 Spanish NFCs representing more than 50 percent of total assets of all Spanish NFCs or about 35 percent of GDP). Shocks: interest rate increases of 100, 200, and 300 basis points; profit declines of 10, 20, and 30 percent; scenario aligned with bank solvency stress tests.
  - Firm vulnerability measured by interest coverage ratio (ICR): a company is vulnerable when ICR < 1. Exposure at default (debt-at-risk) is proportion of total debt held by unviable firms.
- Key macroeconomic assumptions (Box Table 1 excerpt; In percent):
  - 2009 Real GDP: -3.7
  - 2010 Real GDP: -0.1
  - 2011 Real GDP: 0.7
  - 2012 Real GDP (Baseline): -1.7
  - 2012 Real GDP (Adverse Scenario - BdE): -0.3
  - 2013 Real GDP (Baseline): -2.5
  - 2013 Real GDP (Adverse Scenario - BdE): -0.7
  - 2012 Real GDP (Adverse Scenario - IMF): -4.1
  - 2013 Real GDP (Adverse Scenario - IMF): -1.7
  - Harmonized Index of Consumer Prices: -0.2 (2009), 2.0 (2010), 3.1 (2011), 1.8 (2012 baseline), 1.6 (2012 BdE adverse), 1.6 (2013 baseline), 1.2 (2013 BdE adverse), 1.1 (2012 IMF adverse), 0.2 (2013 IMF adverse)
  - Gross Disposable Income 1/: 0.9 (2009), -2.4 (2010), 0.4 (2011), 0.2 (2012 baseline), -1.3 (2012 BdE adverse), -0.3 (2013 baseline), -2.4 (2013 BdE adverse), -1.3 (2012 IMF adverse), -4.6 (2013 IMF adverse)
  - Unemployment Rate: 21.6 (2009), 23.8 (2010), 23.5 (2011), 24.2 (2012 baseline), 24.5 (2012 BdE adverse), 25.0 (2013 baseline), 26.6 (2013 BdE adverse)
  - EURIBOR, 12 months: 2.0 (2009), 1.6 (2010), 1.5 (2011), 1.6 (2012 baseline), 1.5 (2012 BdE adverse), 2.6 (2013 baseline), 2.5 (2013 BdE adverse)
  - Housing Prices: -5.6 (2009), -5.6 (2010), -2.8 (2011), -10.6 (2012 baseline), -3.1 (2012 BdE adverse), -19.8 (2013 baseline), -3.6 (2013 BdE adverse)
- Corporate sector sensitivity (Box Table 2 — selected results, In percent, otherwise indicated):
  - Baseline interest coverage ratio: 3.4
  - Share of financially distressed firms (baseline): 23.4
  - Share of debt at risk (baseline): 45.4
  - Interest rate shock — 100 bps: Interest coverage ratio 2.7; Share of financially distressed firms 26.3; Share of debt at risk 49.7
  - Interest rate shock — 200 bps: Interest coverage ratio 2.3; Share of financially distressed firms 29.8; Share of debt at risk 56.8
  - Profit shock — 10 percent decline: Interest coverage ratio 3.0; Share of financially distressed firms 24.1; Share of debt at risk 45.7
  - Profit shock — 20 percent decline: Interest coverage ratio 2.6; Share of financially distressed firms 25.1; Share of debt at risk 46.3
  - Profit shock — 30 percent decline: Interest coverage ratio 2.2; Share of financially distressed firms 26.3; Share of debt at risk 51.8
  - Combined shock (200 bps increase in interest rate and 30 percent decline in profit): Interest coverage ratio 1.5; Share of financially distressed firms 36.4; Share of debt at risk 61.1
- Household sector sensitivity (Box Table 3 — selected results, In percent, unless otherwise stated):
  - Baseline (Household Survey 2008 extrapolated to 2011): Ratio of debt payment to household income 18.1; Share of distressed household 16.5; Share of debt at risk 45.9; Debt at risk not covered by household assets (in percent of total household loans) 1.1
  - Interest rate shock — 100 bps: Ratio 19.5; Share of distressed household 19.6; Share of debt at risk 54.6; Debt at risk not covered 2.4
  - Interest rate shock — 200 bps: Ratio 20.6; Share of distressed household 22.1; Share of debt at risk 58.0; Debt at risk not covered 2.5
  - Interest rate shock — 300 bps: Ratio 22.0; Share of distressed household 27.0; Share of debt at risk 61.8; Debt at risk not covered 2.5
  - Income shock — 5 percent decline: Ratio 19.1; Share of distressed household 18.4; Share of debt at risk 48.1; Debt at risk not covered 1.1
  - Income shock — 10 percent decline: Ratio 20.2; Share of distressed household 20.1; Share of debt at risk 50.4; Debt at risk not covered 1.2
  - Income shock — 20 percent decline: Ratio 22.7; Share of distressed household 27.6; Share of debt at risk 57.5; Debt at risk not covered 1.4
  - Unemployment shock — 1 percent increase: Ratio 18.2; Share of distressed household 17.6; Share of debt at risk 45.9; Debt at risk not covered 1.1
  - Unemployment shock — 5 percent increase: Ratio 18.3; Share of distressed household 18.3; Share of debt at risk 46.3; Debt at risk not covered 1.1
  - House price shock — 10 percent decline: Debt at risk not covered 1.5 (other columns n.a.)
  - House price shock — 20 percent decline: Debt at risk not covered 1.8 (other columns n.a.)
  - House price shock — 30 percent decline: Debt at risk not covered 2.3 (other columns n.a.)
  - Combined shock (10 percent decline in household income, 200 bps increase in interest rate, 20 percent decline in house prices and 5 percent increase in unemployment rate): Ratio 23.0; Share of distressed household 26.5; Share of debt at risk 62.8; Debt at risk not covered 3.5
  - Baseline extrapolated Household Survey 2008 to 2011: Ratio 18.3; Share of distressed household 21.8; Share of debt at risk 40.0; Debt at risk not covered 2.0
  - Extrapolated interest rate shock — 100 bps: Ratio 23.1; Share of distressed household 28.8; Share of debt at risk 58.9; Debt at risk not covered 3.7
  - Extrapolated interest rate shock — 200 bps: Ratio 24.7; Share of distressed household 31.6; Share of debt at risk 62.7; Debt at risk not covered 3.8
  - Extrapolated combined shock (10 percent decline in household income, 200 bps increase in interest rate, 20 percent decline in house prices and 5 percent increase in unemployment rate): Ratio 27.7; Share of distressed household 36.1; Share of debt at risk 67.3; Debt at risk not covered 5.1

*Source: IMF staff and BdE material contained in the supplied chapter.*

### Box 2. Spain: Market Estimates of Bank Recapitalization Needs

### Box 2. Spain: Market Estimates of Bank Recapitalization Needs

### Market estimates and headline figures
- Market estimates of potential capitalization needs for the banking system largely range from € 60−90 billion.
- Many market analyses apply a core Tier 1 capital requirement of 10 percent after taking into account losses from adverse scenarios.
- Recapitalization needs (reported in the source table) include a figure: 37 (Recapitalization Needs (In billions of euro) — as presented in the source table).

### Main drivers of estimated capital shortfalls
- Losses associated with real estate exposures, incorporating RDL 02/2012 and RDL 18/2012.
- Deterioration in the mortgage and SMEs loan portfolios, reflecting the worsening economic environment.
- The inability of many banks to organically generate pre-provision income sufficient to cover expected losses (net of outstanding specific and general provisions), typically over a two-year period.

### Methodological and assumption notes used by market analyses
- Estimates do not differentiate between banks that have been/are in the process of being resolved, and also take into account asset protection schemes.
- Many analyses assume the same probability of default (PD) and loss given default (LGD) across banks.
- Most market analyses apply a core Tier 1 capital requirement of 10 percent after taking into account losses from adverse scenarios.
- Table and study sources cited in the original material: Various bank and rating agency reports.

### Cross-border spillover risks and network analysis (Box 3 summary relevant to recap needs)
- Spanish banks have large foreign claims of US$1.55 trillion.
- Network analysis (based on Espinosa-Vega and Solé (2010) methodology) uses bilateral exposures across 30 countries and capital data as at end-September 2011; a consistent definition of capital (Tier 1) is used for all countries.
- Three simulations are explored:
  - Simulation 1: interbank exposures only.
  - Simulation 2: potential exposures at default (outstanding derivative contracts or contingent liabilities).
  - Simulation 3: knock-on effects of banking sector distress on the non-bank and sovereign sectors.
- Key shock assumptions used in the network analysis:
  - For the credit shock, a loss given default of 100 percent is assumed on interbank exposures.
  - Non-bank exposures suffer losses of 50 percent.
  - Public sector exposures suffer losses of 20 percent.
  - For the funding shock, a withdrawal of 35 percent is assumed on interbank funding.
  - A haircut of 50 percent is assumed on forced asset sales.

### Quantified exposure and vulnerability findings
- Spanish banks’ credit exposures to banks in the United Kingdom and United States totaled US$462 billion (43 percent of GDP) as at end-September 2011.
- Total exposures to derivatives or contingent liabilities in the United Kingdom and United States: US$1.13 trillion.
- Total exposures to nonbanks in the United Kingdom and United States: US$1.06 trillion.
- Total exposures to sovereigns in the United Kingdom and United States: US$343 billion.
- Impact statements:
  - A credit-only or credit-and-funding shock through the interbank markets of the United Kingdom and United States would be contained to 20 percent or less of capital.
  - Knock-on effects from derivatives/contingent liabilities, nonbank, and sovereign segments could be significant.
  - Spain’s system is almost as vulnerable to credit and funding shocks from France and Germany.
  - Extreme tail shocks from other major countries would generate impairments of less than 40 percent of Tier 1 capital.
- Results are sensitive to shock assumptions, though the relative importance of systemic countries remains the same.

### Ring-fencing considerations and effects on large Spanish banks
- Ring-fencing by host countries can limit transfers of income, capital and liquidity within banking groups during stress.
- Examples during the crisis: regulators in Croatia, Poland, and Turkey recommended against distribution of profits by subsidiaries of foreign banks.
- The two largest Spanish banks derive about one quarter of their income (averaged over the last five years) and almost one-fifth of their assets from operations outside the EU.
- Analysis based on June 2011 EBA stress testing outcomes (baseline and adverse scenarios) and methodology of Cerutti et al. (2010):
  - Assumes partial ring-fencing of bank operations outside the EU, where only projected profits within the group may be re-allocated from outside Europe.
  - Under partial ring-fencing, the two banks’ Core Tier 1 capital ratios would be 0.3−0.5 percentage points lower (at end-2013) compared to if there was no ring-fencing, suggesting the impact would be limited.

*Source: Box 2 and Box 3, _cr12137.*

### Box 4.  Covered Bond Markets

### Box 4.  Covered Bond Markets

### Overview and market structure
- More than 90 percent of all mortgages in Spain are funded in the form of structured finance products, namely, covered bonds (cédulas hipotecarias) and mortgage-backed securities (MBS).
- Cédulas support 57 percent of total mortgage lending.
- The primary market was supported at the initial stages of the crisis by the creation in October 2008 of the Fondo de Adquisicion de Activos Financieros. The fund was initially endowed with € 30 billion extended to € 50 billion, and bought for € 19.3 billion euro in bonds at a maximum of 3 year maturity from 54 institutions. The fund was officially closed on March 30, 2012.
- On-market issuances have been made during periods of relative calm (e.g., in September 2011 or January/February 2012), and are typically by relatively large entities.
- The role of cédulas has changed from predominantly a tool for balance sheet management to one of liquidity management—many of the recent issuances have been retained by banks to for refinancing operations with the ECB (including the two LTRO auctions to date).

### Funding dynamics and market access
- Diminished capital market access has limited the utilization of capital markets for mortgage market funding amid sovereign risk concerns and the availability of funding for consumers has remained subdued.
- As a result, funding costs for new (eligible) mortgage loans via capital markets are likely to rise, putting pressure on the deposit base and alternative sources of funding.
- The decline in lending has even exceeded the growing tendency of issuers to buy back outstanding debt for purposes of liquidity operations with the ECB.

### Over-collateralization, legal limits, and asset encumbrance
- The retrenchment of mortgage credit continues to erode the over-collateralization of cédulas that protects investors.
- Some banks have already reached their statutory limits (25 percent over-collateralization of the eligible share of the cover pool consisting of first-lien mortgages) as new mortgage lending (after accounting for pre-payments and write-offs) has not been sufficient to offset current rates of mortgage amortization.
- Although a bank may, if necessary, substitute part of these issuances for credit claims and release the mortgages underlying the cédulas, the reversal in credit growth remains the key issue.
- Note: The legal limit of asset encumbrance is either 70 or 80 percent based on the type of reference asset underlying the covered bonds.

### Risks to unsecured creditors and public contingent liabilities
- The dependence on cédulas could potentially create problems for unsecured claims under severely stressed conditions.
- Structured finance techniques facilitate cost-efficient funding over time horizons that exceed the short-term maturity of unsecured borrowing in wholesale markets. However, the required asset-backing entails high over-collateralization requirements, which curtails the scope for asset recovery by non-collateralized creditors in the event of resolution.
- In Spain, cédulas have a senior claim on the entire eligible mortgage portfolio of issuers, rather than a ring-fenced asset pool as in other jurisdictions. Thus, these instruments could compromise the issuer’s' ability to satisfy the claims from unsecured creditors, including depositors.
- Such limited recourse may entail higher contingent liabilities to the deposit insurance scheme (i.e., to the industry as a whole and, ultimately, on the government) as a greater share of the issuer’s balance sheet is subject to creditor claims that displace some recovery value that would otherwise be available under resolution.
- As a result, a wider set of creditors could be exposed to balance-sheet vulnerabilities arising from unrealized losses due to large exposures to cyclical industries.

### Key findings and implications
- More than 90 percent of mortgages funded via structured products; cédulas account for 57 percent of mortgage lending.
- Statutory over-collateralization requirement: 25 percent (of eligible share of cover pool consisting of first-lien mortgages).
- Legal limits on asset encumbrance: either 70 or 80 percent depending on reference asset.
- FAAF fund endowment and operations: initially endowed with € 30 billion extended to € 50 billion; bought for € 19.3 billion euro; fund closed on March 30, 2012.
- Recent market behavior: issuances retained for ECB refinancing including LTRO operations; on-market issuances in September 2011 and January/February 2012.

*IMF staff analysis as presented in Box 4. Covered Bond Markets*

### 1. Already charged in 2011 P&L10 26 ...11 ...

### _cr12137 - 1. Already charged in 2011 P&L10 26 ...11 ...

### Provisioning, forward-looking measures, and capital add-ons
- 1. Already charged in 2011 P&L: 10 26 ...11 ...
- 2. Use existing generic provision: 12 3 38 3 5
- 3. To charge/charged in 2012 P&L: 48 71 38 35 57
- 4. Own funds: 30 ...24 50 38 
- Sequence of digits shown: 10010010099100
- Impact of "forward looking" measures: Sum of 3 and 4 (as percent of 2011 pre-prov. profit): 125 61 101 351 149
- Impact of capital add-ons: Capital add-on (as percent of Tier1 capital): 1/7 4 10 11 10

### Funding liquidity (Table 7 — Sources of the Banking Sector, in percent of total)
- Sources: BdE; and IMF staff estimates. 1/ Excludes LTRO funding.
- Proportions by source (columns G1, G2, G3, G4, Total) — selected items preserved as presented:
  - Long-term / Other Central Banks / 20222
  - Senior debt: 83 84 6
  - Other (Securitizations): 113 22
  - Short-term Cash: 51 21 3
  - Intragroup (bank) funding: 20001
  - Secured: 15491110
  - Unsecured: 20021
  - Deposits (Total): 42 59 51 56 50
  - Demand deposits: 17 24 19 19 19
    - Retail customer deposits: 12 19 15 14 14
    - Non-financial (and non-SME) corporate customer deposits: 33143
    - Financial (bank- and non-bank) customer deposits: 11111
    - Sovereign (government, CB, supranational) customer deposits: 11211
  - Term deposits: 25 35 32 37 31
    - Retail customer deposits (term): 12 27 26 25 21
    - Non-financial corporate customer deposits (term): 43354
    - Financial customer deposits (term): 23122
    - Sovereign customer deposits (term): 72344
  - Contingent liabilities: 8 14 7 10 9
  - Total: 100 100 100 100 100
  - Proportion of long-term funding (in percent): 26 22 30 21 26

### Financial soundness of non-banking sectors (Table 8 — selected indicators)
- Sources: BdE; and the IMF Corporate Vulnerability Utility on a consolidated basis.
- Insurance sector:
  - Solvency ratio 1/: 2.8 2.7 2.6 2.6 2.7 ......
  - Profitability (return on average equity): 21.7 22.1 26.4 14.7 14.2 ......
- Corporate sector:
  - Total debt as a percentage of GDP 2/: 88.0 121.0 131.7 136.4 139.3 140.3 135,0
  - Total debt as a percentage of equity 3/: 151.4 124.9 126.0 124.6 119.2 119.8 118.1
  - Profitability (Ordinary net profit over equity) 3/: 13.8 13.9 13.9 12.4 9.3 9.2 8.7
  - Debt service (interest only) coverage 3,4/: 7.2 4.4 3.6 2.9 2.9 3.2 ...
  - Number of applications for protection from creditors 5/: 927 916 1,033 2,894 5,057 ......
- Household sector:
  - Debt as a percentage of GDP: 71.8 85.7 88.6 88.8 90.9 91.6 88.2
  - Debt as a percentage of disposable income: 110.3 134.0 139.0 135.1 132.0 136.7 133.1
  - Debt service burden to total disposable income: 14.2 15.8 17.4 18.2 17.0 15.6 15.1
  - Interest burden as a percentage of total disposable income: 4.1 5.0 6.5 7.5 6.3 4.3 4.3
  - Financial savings ratio as a percentage of GDP: -1.3 -1.7 -1.9 0.2 5.9 3.1 3.5
- Real estate sector:
  - House price inflation 6/: 13.9 10.4 0.7 -5.4 -4.2 -1.7 -6,6
- Monetary private sector 7/: 60.1 59.6 59.2 58.4 60.4 ......
  - o/w Domestic households: 33.6 33.8 33.7 33.9 34.2 ......
  - o/w real estate: 26.5 25.9 25.5 24.5 26.3 ......

### Macroeconomic scenarios for solvency stress tests (Table 9)
- Source: BdE. 1/ Fourth quarter average.
- Variables and scenario values (columns: 2011, 2012, 2013; Baseline, BdE Adverse, IMF Adverse):
  - Real GDP growth (in percent): 0.7; 2012: -1.7; 2013: -0.3; BdE Adverse 2012/2013: -2.5/-0.7; IMF Adverse 2012/2013: -4.1/-1.6
  - GDP deflator (in percent): 1.4; 2012: 1.0; 2013: 1.0; BdE Adverse: 0.6/0.5; IMF Adverse: 0.0/-0.5
  - Nominal GDP growth (in percent): 2.1; 2012: -0.7; 2013: 0.7; BdE Adverse: -1.9/-0.2; IMF Adverse: -4.1/-2.2
  - 3-month Euribor rate (in percent): 1.4; 2012: 0.9; 2013: 0.8; BdE Adverse: 1.4/1.3; IMF Adverse: 1.9/1.8
  - 12-month Euribor rate (in percent): 2.0; 2012: 1.6; 2013: 1.5; BdE Adverse: 2.1/2.0; IMF Adverse: 2.6/2.5
  - HICP change (in percent): 3.1; 2012: 1.8; 2013: 1.6; BdE Adverse: 1.6/1.2; IMF Adverse: 1.1/0.2
  - Unemployment rate (percent of labor force): 21.6; 2012: 23.8; 2013: 23.5; BdE Adverse: 24.2/24.5; IMF Adverse: 25.0/26.6
  - Exchange rate (USD per euro): 1.4; 2012: 1.3; 2013: 1.3 (same for scenarios)
  - Madrid Stock Exchange Index price change (in percent): -14.6; 2012: -1.3; 2013: -0.4; BdE Adverse: -21.3/-0.4; IMF Adverse: -51.3/-0.4
  - Credit growth to other resident sectors 1/ (in percent) — Households: -1.5; 2012: -3.8; 2013: -3.1; BdE Adverse: -4.9/-5.8; IMF Adverse: -6.8/-10.5
  - Credit growth to Non-Financial Firms: -3.6; 2012: -5.3; 2013: -4.3; BdE Adverse: -5.6/-3.8; IMF Adverse: -6.4/-3.0
  - House price change (in percent): -5.6; 2012: -5.6; 2013: -2.8; BdE Adverse: -10.6/-3.1; IMF Adverse: -19.9/-3.6
- Scenarios defined: Baseline; BdE Adverse; IMF Adverse

### Solvency stress test results (Table 10 and Table 11)
- Source: BdE estimates based on IMF stress test guidelines.
- Capital hurdles and outcomes (select figures):
  - Capital Hurdles: Total capital (8 percent); Tier 1 (6 percent); Core Tier 1 (4 percent); Core Tier 1 (7 percent)
  - Reported headline ratios (percent): Total capital: 11 12 15 889 (format as presented); Tier 1: 8 9 13 81010; Core Tier 1: 8 10 11 667; Core Tier 1 (7 percent): 14 16 17 16 16 16
  - Reported ratios (another block in table): Total capital (8 percent): 12.2 14.6 19.9 7.5 7.6 8.0; Tier 1 (6 percent): 12.1 13.9 19.1 7.0 7.1 8.3; Core Tier 1 (4 percent): 9.8 12.5 17.7 6.4 6.7 7.7; Core Tier 1 (7 percent): 25.4 29.5 37.1 18.5 18.8 19.7
- Memo item: Impairment losses before taxes (in billions of euro): -46.4 -55.6 -73.1 -46.7 -49.1 -55.3
- Amount Needed to Bring Capital Up to Defined Capital Adequacy Ratio Post Stress Test Shock (In billions of euro): presented for BdE Top-Down and IMF Top-Down (table indicates amounts but specific cell values are given in Table 11)
- Table 11 (BdE Top-Down by bank grouping) — selected figures preserved as presented:
  - Available Capital (As at end-2011, in billions of euro) and Groupwise Capitalization (Weighted average as at end-2011, in percent) shown across groupings G1 G2 G3 G4 FROB Not grouped Total with cell values such as:
    - Total capital: 11.6 15.4 12.6 11.5 13.6 13.3 ...
    - Tier 1: 10.0 12.7 9.9 10.8 11.3 12.3 ...
    - Core Tier 1: 8.5 11.6 5.8 9.4 7.1 12.9 ...
  - Groupwise capitalization (Weighted average as at end-2011, in percent) — Average marginal increase memo items: Baseline 31.1 percent; BdE Adverse 29.6 percent; IMF Adverse 27.1 percent
  - Core Tier 1 capital needed sensitivity: Average marginal increase to previous amount of Core Tier 1 capital needed to reach defined capital adequacy ratio, for every 1 percentage point increase in requirement above 7 percent. (IMF Adverse referenced)

### Market-implied expected losses and tail risk (Table 12)
- Source: IMF staff estimates.
- Joint Market-Implied Expected Losses below End-2011 Capital Levels (with Sovereign Risk) — Average values in each forecast period, in billions of euro (sample of seven publicly listed banks):
  - Forecast period blocks with values (Baseline / BdE / IMF) and standard errors in parentheses, for multiple forecast periods:
    - 0.19 0.27 0.30 (standard error)(0.05)(0.05)(0.06)
    - 0.20 0.16 0.20 (standard error)(0.08)(0.04)(0.05)
    - 0.18 0.37 0.40 (standard error)(0.03)(0.05)(0.06)
    - 2.93 7.62 8.12 (standard error)(0.56)(1.28)(1.89)
    - 2.11 9.93 10.09 (standard error)(0.57)(1.48)(2.92)
    - 3.75 5.31 6.16 (standard error)(0.55)(1.08)(0.86)
    - 3.27 13.75 14.19 (standard error)(0.48)(3.60)(3.69)
    - 2.11 21.03 21.41 (standard error)(0.44)(6.30)(6.41)
    - 4.44 6.47 6.98 (standard error)(0.51)(0.90)(0.97)
  - Time horizons and risk metrics referenced: until end-2013; 2012 Q1  2013 Q4; until end-2012; until end-2013; 95 Percent Conditional Value-at-Risk (Extreme Tail Risk) 2012 Q1  2013 Q4 until end-2012; 95 Percent Value-at-Risk (Tail Risk) 2012 Q1  2013 Q4 until end-2013
  - Scenarios: Adverse; 50th percentile (Median) 2012 Q1  2013 Q4 until end-2012 until end-2013

### Reverse and standard liquidity stress tests (Tables 13 and 14)
- Sources: BdE estimates based on IMF stress test guidelines.
- Reverse stress tests of liquidity risk — 5- and 30-Day Implied Cash Flow Analysis (Table 13) — selected figures:
  - Total / Average per bank / Original assumptions:
    - Original assumptions: 1 3.4 0.17 0.17 11.4 13.6
    - Alternative 1: no withdrawal of retail deposits ("stable deposits"): 0 n.a. 0.00 n.a. 0.0 13.6
    - Alternative 2: application of MTM haircut on sovereign debt: 1 3.4 0.18 0.18 11.4 13.6
  - 30-Day Test block original assumptions: 8 27.6 3.32 0.42 21.5 3.3
    - Alternative 1: 0 n.a. 0.00 n.a. 6.1 3.3
    - Alternative 2: 8 27.6 3.26 0.41 21.5 3.3
  - Output metrics shown: Number of banks below benchmark; Percent of illiquid banks in sample; Shortfall (In percent of total sample assets included in the liquidity tests); Cumulative withdrawal of deposits 1/ (In percent of total deposits); Cumulative Loss of Wholesale Funding 1/ (In percent of total wholesale funding)
- Liquidity stress test — Quasi-Basel III and maturity mismatch analysis (Table 14) — selected figures:
  - Ratio range categories: <0.25, 0.25-0.50, 0.50-0.75, 0.75-1.00, >1.00
    - Number of firms: ........29
    - In percent of banks: 100.0
  - Memo item - BCBS Monitoring Exercise (2012):
    - Global (BIS) sample (205 firms): 15.0 45.0
    - European sample (EBA - 157 firms): 5.0 34.0
  - Maturity tenor distribution references: Less than 1; Within 1-3; Within 3-6; Between 6-12; After 12
    - Number of firms: 29 26 27 27 ...
    - In percent of banks: 100.0 89.7 93.1 93.1 ...
    - In percent of sample assets: 100.0 69.5 98.9 95.8 ...
  - Maturity Mismatch (Liabilities>Assets) 2/ measures:
    - Quasi-Liquidity Coverage Ratio (LCR): 40.0 and 61.0 shown in table context
    - Quasi-Net Stable Funding Ratio (NSFR): 25.0

### Risk Assessment Matrix — Main threats and staff assessments (Appendix I)
- Nature/Source of main threats, overall level of concern, likelihood of severe realization in next 1–3 years, expected impact on financial stability if realized:
  1. Continued weak growth and high unemployment
     - Staff assessment: High; Likelihood: High
     - Key points:
       - Spain may not recover pre-crisis growth rates; weak growth and high unemployment may persist.
       - ECB monetary policy remains accommodative but funding costs for Spain remain high.
       - Weak loan demand and bank deleveraging adversely affect banks’ incomes.
       - Severe adverse scenario envisages output declining by a cumulative 5.7 percentage points over 2012–13 (equivalent to a one standard deviation shock) amid fiscal adjustment and rising funding costs.
       - Expected impairment losses would amount to € 73 billion (about 7 percent of GDP); additional capital of € 18 billion would be needed to meet a core Tier 1 ratio of 4 percent (€ 38 billion to meet a core Tier 1 ratio of 7 percent)—in line with the Basel III transition schedule at end-2018.
  2. Intensification of the decline in real estate prices
     - Staff assessment: High; Likelihood: High
     - Key points:
       - Real estate prices have declined sharply and may overshoot current estimates given large stock of unsold units.
       - Banks with significant repossessed assets may hold fire sales; large real estate companies may face bankruptcy.
       - Deterioration in asset quality would further increase recapitalization needs.
       - While many banks are sufficiently capitalized for assumed shocks, rapid steep drops in house prices could escalate impairment losses and adversely impact banks.
  3. Spillovers: Deteriorating Euro Area growth and worsening of Eurozone crisis
     - Staff assessment: High; Likelihood: High
     - Key points:
       - Plummeting confidence, sovereign market strains, bank funding pressures, and further fiscal austerity could produce very weak Euro Area growth.
       - Banks’ direct exposure to other peripheral countries is limited, but exposure to the domestic sovereign is about one-and-half times their core Tier 1 capital.
       - Portugal is the fifth largest exposure for the Spanish banking system; system also exposed to banks and non-bank private sectors in other EU countries.
       - Shocks to sovereign debt holdings in AfS and trading books yield marginal valuation haircut impacts on capital.
  5. Difficulty in meeting banks’ refinancing needs
     - Staff assessment: Medium to High; Likelihood: High
     - Key points:
       - Significant refinancing needs in 2012 and 2013, clustered in specific months; market access may be closed or only at very high cost.
       - Deposit base flat or declining; heavy reliance on ECB funding.
       - Counterparties may impose severe haircuts; covered bonds and securitizations have been downgraded or placed on watch.
       - Liquidity positions improved via ECB long-term funding, but worsening markets could increase collateral haircuts.
       - Sustained inability to refinance through interbank markets could be disruptive; orderly deleveraging unlikely.
       - Banks resilient to short-lived cash flow shocks, but two thirds of sample banks face sustainability risk of current funding sources and considerable maturity mismatches expose system to sustained funding market disruptions absent central bank access.

### Stress test matrices and methodology summary (Appendix II)
- Appendix Table 15 — Summary of Banking Sector Stress Tests: Solvency Risks
  - Domain assumptions:
    - Top-Down by Authorities: Commercial banks and intervened savings banks; over 96 percent of sector; supervisory data as at end-2011; scope: legal entity; risk horizon: 2 years under crisis conditions; BdE macro-financial panel regression model (estimates capital shortfall) without behavioral adjustments; scenarios include “double-dip” recession and more adverse escalation; sovereign risk reflected in valuation haircut to AfS and trading/MtM holdings; extra provisioning and capital add-on due to regulatory changes; Basel II transitioning to Basel III with 4 percent CT1 hurdle.
    - Top-Down by FSAP Team: All publicly listed banks with sufficient pricing history; about 45 percent of sector; public market and statutory data as at end-2011; IMF balance sheet approach; Systemic CCA model; similar risk horizon and scenario definitions.
  - Results summary:
    - Post-shock, more than a third of banks would not comply with Basel III hurdle requirements until end-2013 irrespective of top-down model choice.
    - BdE model projects impairment losses of around € 73 billion under IMF adverse scenario, generating capital shortfall about € 18 billion compared with Core Tier 1 hurdle of 4 percent.
    - SCCA results indicate tail risk: in IMF adverse scenario sample banks would experience a shortfall of more than € 14 billion on average (peak in excess of € 21 billion at end-2012) at a statistical probability of five percent or less.

- Appendix Table 16 — Summary: Detailed assumptions for testing solvency risk
  - Scenarios specified: (i) Baseline; (ii) “IMF adverse” (≈ 1 std. dev. of two-year cumulative growth rate over last 30 years); (iii) “BdE adverse” (≈ ... as presented)

*Source: BdE; and IMF staff estimates.*

### 0.3 std. dev.)

### _cr12137 - 0.3 std. dev.)

### Macroeconomic and financial variables, satellite models, and loss factors
- Macroeconomic/financial variables considered: GDP (nominal and real), unemployment, inflation, interest rates, and credit growth, conditional on scenario. Models run by the BdE for all variables with the exception of credit growth for the IMF TD model.  
- Aim: ensure consistency with other European FSAPs (and with European/CEBS/EBA stress tests).  
- (Risk) factors assessed: Loss rates, Profitability, Fixed Income Holdings, Taxes.  
- Credit losses:
  - Based on satellite models for probability of defaults (PDs) and NPLs developed by BdE staff (BdE TD model) and IMF staff (IMF TD model), respectively, depending on scenario.
  - PDs are point-in-time and LGDs are based on previous EBA exercises and regulatory reporting LGDs.
- Profitability (interest income, interest expenses, net fee and commission income, other income, and operating expenses):
  - Based on satellite model.
  - For the IMF TD model, all elements of banking profits (except “other income”) estimated via historical return on assets (RoA) of the banking sector. “Other income” changes with nominal GDP in the IMF TD model.
- Trading income:
  - In the IMF TD model, based on satellite model consistent with evolution of banking income (a decline in nominal GDP growth is assumed to result in a commensurate deterioration of trading income).
  - Trading income is another element of the P&L account estimates in the BdE model.
- Sovereign and financial sector debt holdings:
  - Haircut on holdings in the banking (AfS only) and trading books based on market expectations over two years after controlling for changes of market valuation using density forecasts of forward contracts on the 3-year sovereign CDS spread over an estimation period between 2010 and 2011, as developed by Fund staff.
- Tax assumption:
  - 30 percent in case of positive profit, zero otherwise.
  - Tax credit after the first year of the stress period is taken into account under both TD models.

### Regulatory standards, RWAs, and capital treatment
- Capital requirements and changes in RWAs:
  - All hurdle rates meet (and to some extent exceed) the capital adequacy regiments under the Basel III implementation schedule (i.e., increasing from 2013 onwards).
  - Hurdle rates: Tier 1 and total capital adequacy ratio (CAR) set at 8 and 6 percent (consistent with Basel III), whereas the hurdle rate of core Tier 1 exceeds Basel III at 4 percent in both stress years.
- Changes in risk-weighted assets (RWAs):
  - RWAs for credit, market and operational risk are kept constant since QIS results for Spanish banks show little RWA sensitivity under CRD-3/4, and PD/LGD values at end-2011 are calibrated “through-the-cycle” and set to down-cycle values, respectively.
  - Off-balance sheets assets—ex-post credit conversion factors (CCFs) of exposures set to 40 percent (consistent with 38.5 percent in the EBA stress test).
- Phase-out of non-core Tier 1 and Tier 2 capital elements:
  - 10 percent (p.a.) of non-eligible capital subject to overall phase out in 2013.
  - Portion of capital subject to phase out matched to QIS-6 results for Group 1 (large banks) and Group 2 (smaller banks) at 26.8 percent and 16.6 percent, respectively.
  - The two largest banks are considered Group 1 banks, whereas all others are treated as Group 2 banks to determine the proportion of capital to be phased-out.
  - Phase-in of capital deductions for core Tier 1 capital does not apply to the two-year stress test horizon.

### Behavioral adjustments and business strategy assumptions
- Dividend pay-out rules (similar to Basel III minima):
  - Dividend pay-out dependent on capitalization under stress:
    - 0 percent if total capital buffer of banks 0.5 percentage points and less above 8 percent;
    - 40 percent in case capital buffer is more than 2.5 percentage points (reflects magnitude of proposed “capital conservation buffer” under Basel III).
- Credit growth:
  - Based on satellite model that closely follows nominal GDP.
- Other business strategy considerations:
  - No consideration of interim raising of capital until end-2013 considered in calculations.

### Output template and sample treatment
- Output template: limited to aggregate figures, but includes some dispersion of results.
- Outcome by diagnostics groups: G1-G4, FROB-intervened. No estimation of satellite models on a group-wise basis.
- Banks that are below the regulatory minimum are not excluded from the sample; however, in the IMF TD model, capital cannot become negative.
- Number of banks defaulting and capital needs based on evolution over time; banks below the regulatory minimum are not excluded from the sample.

### Liquidity risk tests: definitions and other assumptions
- 5-day test (Consecutive outflow of liabilities over five days)
  - Asset side (liquid assets after haircuts and one-off sale):
    - (i) cash and cash-equivalent positions (haircut: 0 percent)
    - (ii) government debt holdings and other exposure with zero percent risk-weighting (0)
    - (iii) investments (securities) other than government debt (20)
    - (iv) trading securities other than government debt (20)
    - (v) derivatives (50)
    - (vi) high-quality investment securities (4)
    - (vii) secured assets with residual maturity of up to one month (e.g., reverse repos), excluding intragroup funding (1)
  - Liabilities (cash outflows):
    - (i) demand deposits and term deposits with residual maturity of up to one month (5 percent per period, except from sovereigns (0 percent) and financials (bank- and non-bank) with residual maturity of up to one month (1))
    - (ii) term deposits with residual maturity of more than one month (0)
    - (iii) secured/unsecured wholesale funding with residual maturity of up to one month (5/15)
    - (iv) intragroup funding and commitments (5)
    - secured/unsecured wholesale funding with residual maturity of more than one month (0)
    - central bank funding (0)
    - long-term funding (0)
- 30-day test (One-off aggregate outflow of liabilities for 30 days)
  - Asset side (liquid assets after haircuts and one-off sale):
    - (i) cash and cash-equivalent positions (haircut: 0 percent)
    - (ii) government debt holdings and other exposure with 0% risk-weighting (0)
    - (iii) investments (securities) other than government debt (10)
    - (iv) trading securities other than government debt (40)
    - (v) derivatives (50)
    - (vi) high-quality investment securities (5)
    - (vii) secured assets with residual maturity of up to one month (e.g., reverse repos), excluding intragroup funding (40)
  - Liabilities (cash outflows):
    - (i) demand deposits and term deposits with residual maturity of up to one month (40 percent, except from sovereigns (0) and financials (bank- and non-bank) with residual maturity of up to one month/greater than one month (75/30))
    - (ii) term deposits with residual maturity of more than one month (0)
    - (iii) secured/unsecured wholesale funding with residual maturity of up to one month (40/50)
    - (iv) intragroup funding and commitments (20)
    - secured/unsecured wholesale funding with residual maturity of more than one month (0)
    - central bank funding (0)
    - long-term funding (0)
- 5-day test/30-day test (alternative scenarios)
  - Same as above except:
    - government debt holdings and other exposure with 0% risk-weighting (4) ("sovereign risk scenario")
    - demand deposits and term deposits with residual maturity of up to one month (0 percent, except from financials (bank- and non-bank) (5/1) [5-day test]; demand deposits and term deposits with residual maturity of up to one month (8 percent, except from sovereigns (0) and financials (bank- and non-bank) (75/30) [30-day test]).
- Liquidity Coverage Ratio (LCR) — short-term resilience to potential liquidity disruptions:
  - Stock of high-quality liquid assets would need to cover 30-day net cash outflows.
  - Assets that remain liquid under stress:
    - (i) government debt holdings and other exposure with zero percent risk-weighting (0)
    - (ii) high-quality bonds and covered bonds (rated 'AA-' and higher) (15)
    - (iii) sovereign, central bank and PSE assets qualifying for 20 percent risk-weighting (15)
  - Outflows/inflows assumptions include percentages for retail, wholesale, secured funding, margin calls, derivative market value changes, contingent liabilities, and distribution assumptions (exact values preserved in the source).
  - No inflows from interbank lending in times of stress, and no consideration of access to ECB liquidity.
- Net Stable Funding Ratio (NSFR) — long-term structural ratio:
  - Required stable funding: detailed categories with assigned percentages (0 percent, 5, 20, 50, 65, 85, 100, 10).
  - Available stable funding: categories with percentages (100, 90, 80, 50, 0).
  - No inflows of interbank lending in times of stress; no consideration of access to ECB liquidity; share of 'stable deposits' (50 percent).
- Basic assumptions for implied cash flow tests:
  - 10 percent of liquid assets (generating cash inflows) are encumbered, i.e., used as collateral to receive funding (with the exception of cash/cash-equivalents);
  - no offsetting cash inflows from wholesale lending (at contractual maturities);
  - no inflows of interbank lending in times of stress;
  - no consideration of access to ECB liquidity.

### The BdE top-down model: structure and limitations
- Framework:
  - Satellite models generate idiosyncratic variables using macro-financial variables derived from BdE macro models.
  - Independent panel data estimations map projections of key macroeconomic variables into bank-specific profit and loss numbers, focusing on five headline items: net interest income, net fees and commissions, operating expenses, and PDs for different loan types (mortgages, real estate developers, and corporate credit).
  - Credit losses estimated using regressions linking NPLs (based on forecasted PDs) and periodic exposures to broad asset classes to macro indicators (e.g., real GDP growth, house prices).
- Limitations:
  - Estimations do not account for feedback effects between bank behavior and the real economy.
  - Consider only average market value changes of banks’ exposures (e.g., as credit losses rise, spreads on risky lending change uniformly).

### Incorporation of Royal Decree Laws (RDL 02/2012 and RDL 18/2012)
- Inclusion: Potential impact of RDL 02/2012 (issued February 3, 2012) and RDL 18/2012 (issued May 12, 2012) taken into account in FSAP solvency stress tests.
- Timeline:
  - Comprehensive capital assessment for all three top-down approaches completed with impact of RDL 02/2012.
  - Upon announcement of requirement to set aside an additional € 30 billion in provisions against performing real estate exposures (RDL 18/2012) on May 11, 2012, the stress test exercise was repeated only for the BdE TD model.
- RDL 02/2012 coverage:
  - Problematic real estate loans and foreclosed loans and real estate assets amount to about € 175 billion.
  - Performing real estate loans around € 148 billion.
  - Requires banks to provision more adequately against potential additional losses associated with real estate loan books.
- Combined nominal cost under both RDLs:
  - Estimated at € 67.5 billion (€ 26.2 billion for specific provisioning, € 32.1 billion for generic provisioning, and € 9.1 billion of extra capital add-on).
  - Some additional requirements absorbed by banks through existing provisions and/or as part of capital planning until end-2011, reducing the estimated economic impact incorporated in the stress test to € 57.6 billion.
- FROB support and market response:
  - The FROB has offered equity capital or contingent convertible bonds to banks unable to meet new standards; many firms preferred to restructure business activities or merge with other institutions.

### Appendix Table 18: Impact of RDLs on income statement and balance sheet (selected figures)
- Additional provisions required (all RDL 02/2012 unless indicated otherwise):
  - G1: 11,124
  - G2: 10,896
  - G3: 19,160
  - G4: 10,310
  - FROB: 6,836
  - Total: 58,326
- Of which: for impaired loans (companies):
  - Total: 7,415 (G1: 1,810; G2: 1,135; G3: 2,242; G4: 1,316; FROB: 912)
- Of which: for substandard loans (companies):
  - Total: 8,142 (G1: 1,258; G2: 1,578; G3: 3,441; G4: 905; FROB: 960)
- Of which: for normal loans (companies):
  - Total: 7,958 (G1: 1,481; G2: 1,691; G3: 2,447; G4: 1,469; FROB: 870)
- Of which: for normal loans (companies) [RDL 18/2012]:
  - Total: 24,169 (G1: 4,500; G2: 4,446; G3: 8,722; G4: 3,971; FROB: 2,530)
- Of which: for foreclosed properties (companies):
  - Total: 10,383 (G1: 2,028; G2: 1,996; G3: 2,230; G4: 2,607; FROB: 1,522)
- Of which: for foreclosed properties (individuals):
  - Total: 259 (G1: 475; G2: 0; G3: 78; G4: 42; FROB: 42; note: entries reflect source table layout)
- Existing provisions applied to mitigate impact:
  - Total: 9,890 (G1: 1,284; G2: 1,704; G3: 4,951; G4: 1,350; FROB: 602)
- Net impact of provisions for stress testing purposes:
  - Total: 48,436 (G1: 9,840; G2: 9,192; G3: 14,209; G4: 8,960; FROB: 6,234)
- Additional capital requirement for stress testing purposes (1/):
  - Total: 9,121 (G1: 0; G2: 893; G3: 2,065; G4: 2,601; FROB: 3,562)
- Total impact (net of mitigants) of both RDLs for stress testing purposes (2/):
  - Total: 57,557 (G1: 9,840; G2: 10,085; G3: 16,274; G4: 11,561; FROB: 9,796)
- Memorandum items (as reported by banks) — Impact of RDL 2/2012:
  - of which: additional provisions impacting P&L: Total 14,740 (G1: 4,885; G2: 2,864; G3: 3,476; G4: 3,516; FROB: n.a.)
  - of which: additional provisions covered by own funds: Total 9,208 (G1: 0; G2: 1,859; G3: 4,986; G4: 2,363; FROB: n.a.)
- Realized and planned coverage of additional provisions reported by banks (In percent):
  - of which: already charged in P&L at end-2011: 10 (G1: 26; G2: 12; G3: 0; G4: n.a.)
  - of which: use of existing provisions: 12 (G1: 33; G2: 8; G3: 35; G4: n.a.)
  - of which: charged to P&L until end-2012: 48 (G1: 71; G2: 38; G3: 35; G4: 57; FROB: n.a.)
  - of which: own funds: 30 (G1: 0; G2: 24; G3: 50; G4: 38; FROB: n.a.)

### Rationale for treatment of RDLs in stress testing
- Provisioning for normal loans and additional provisions for substandard loans:
  - Performing and substandard loans account for part of loan losses under stress; impairment losses below the sum of required coverage (30 percent on average) of normal loans and new provisions for substandard loans (between 20 and 80 percent depending on type of real estate collateral) trigger additional provisions unless general provisions exhausted.
  - Existing stock of specific provisions for substandard loans is included in general provisions for mitigation purposes.
- Additional provisions on doubtful loans and foreclosed properties:
  - Calculated as additional impairment losses in P&L as one-off expense during the first year of the forecast horizon and included by adding to total expected losses.
  - Residual mitigation from general provisions is taken into account for final estimate of additional provisions required.
- Capital add-ons for substandard and doubtful loans and foreclosed land and housing under construction:
  - Apply to banks whose capital buffers at end-2011 were insufficient to cover national minimum coverage requirements (65 and 80 percent for substandard and doubtful loans; same for foreclosed assets).
  - Required capital add-on defined within national capital adequacy framework as capital shortfall of reported capital principal over regulatory minimum vis-à-vis additional capital principal needed to reach specified coverage rates.
  - For the stress testing exercise (specified based on Basel III capital definition), any identified capital shortfall under capital principal was treated as Tier 1 capital — a highly conservative assumption.

*Source: IMF/BdE FSAP stress test appendices as provided in the content unit.*

### 86.      The calculation of haircuts under different adverse macro scenarios is based on

### _cr12137 - 86.      The calculation of haircuts under different adverse macro scenarios is based on

### Methodology for calculating sovereign bond valuation haircuts
- Valuation of government bonds uses forward-looking information from CDS markets and changes in the term structure of the applicable risk-free rate.
- Future sovereign bond prices over a forecast horizon (e.g., up to five years) are calculated using:
  - the end-year risk-free rate, and
  - a density forecast of expected default risk based on the empirically derived probability distribution of the forward rates on sovereign CDS contracts at different maturities.
- For Spain, the most liquid bonds at maturities of one, three, five, seven and ten years were considered; the three-year maturity group is taken as representative of the average duration of banks’ government bond holdings.
- The general methodology was also applied to the FSAP stress testing exercises for Germany and the United Kingdom in 2011.

### Application and scenarios
- Haircuts applied to the trading book and available-for-sale (AfS) portfolios of sample banks for key rate durations across the entire interest rate term structure using end-2011 market data.
- Severity assumptions depend on the chosen scenario:
  - Baseline scenario: current market expectations.
  - Adverse scenario: a high-percentile density forecast of the historical variation of forward contracts on sovereign CDS.
- For the FSAP solvency stress tests (forecast horizon of two years, 2012 and 2013):
  - Maturity-matched haircuts applied at the 75th percentile of the density forecast of idiosyncratic credit risk.
  - A general interest rate shock of 50 basis points.
- In Spain, estimation of haircuts was extended beyond the original five-year tenor to include all key rate durations of the interest rate term structure beyond one year.

### Key parameters and notes
- Confidence levels/density percentiles referenced in Appendix Table 19 include the 75th percentile, 90th percentile, and 95th percentile, as well as current expectations based on end-year forward prices.
- Table notes:
  - Values are in percent, relative to December 31, 2011.
  - Current expectations reflect market expectations at end-2011 (without considering past CDS dynamics).
  - The adverse scenarios were generated from historically derived density forecasts at different percentiles.
  - Table reflects any marginal haircuts to bonds valued at market prices as of end-2011.
  - Country-specific shock combined with a common interest rate shock of 50 bps.

### Appendix Table 19 — Spain: Sovereign Debt Haircuts with Common Interest Rate Shock (In percent, relative to December 31, 2011)
- 1 Year maturity (2012, 2013, 2014, 2015, 2016):
  - 1.22; 1.22; 1.15; 1.54; 0.84
  - 1.36; 1.42; 1.36; 1.80; 1.15
  - 2.62; 2.67; 2.58; 3.18; 2.26
  - 3.80; 3.85; 3.73; 4.48; 3.30
- 3 Years maturity (2012, 2013, 2014, 2015, 2016):
  - 2.95; 3.26; 2.83; 2.41; 1.60
  - 3.35; 3.83; 3.42; 3.02; 2.43
  - 6.83; 7.42; 6.82; 6.27; 5.42
  - 10.02; 10.70; 9.94; 9.26; 8.18
- 5 Years maturity (2012, 2013, 2014, 2015, 2016):
  - 4.36; 3.90; 3.46; 3.03; 2.15
  - 5.22; 4.97; 4.55; 4.16; 3.66
  - 10.94; 10.50; 9.89; 9.35; 8.59
  - 15.37; 14.79; 14.05; 13.42; 12.49
- 7 Years maturity (2012, 2013, 2014, 2015, 2016):
  - 5.98; 5.51; 5.02; 4.56; 3.60
  - 6.81; 6.64; 6.22; 5.85; 5.45
  - 14.02; 13.67; 13.06; 12.54; 11.91
  - 20.36; 19.85; 19.08; 18.46; 17.64
- 10 Years maturity (2012, 2013, 2014, 2015, 2016):
  - 8.93; 8.37; 7.80; 7.25; 6.10
  - 11.78; 11.67; 11.12; 10.64; 10.32
  - 23.44; 23.07; 22.30; 21.67; 21.09
  - 29.00; 28.51; 27.67; 27.02; 26.33

- Additional block (unclear maturity grouping in table but preserving values as presented) — 1 Year (2012–2016):
  - 2.38; 2.39; 2.32; 2.69; 2.02
  - 2.91; 2.85; 3.26; 2.65; 1.11
  - 4.07; 3.99; 4.55; 3.69; 2.22
  - 5.16; 5.05; 5.74; 4.66; 3.27
- Additional block — 3 Years (2012–2016):
  - 4.55; 4.83; 4.43; 4.05; 3.31
  - 6.24; 5.87; 5.51; 4.99; 2.46
  - 9.41; 8.89; 8.40; 7.65; 5.45
  - 12.28; 11.62; 11.02; 10.08; 8.20
- Additional block — 5 Years (2012–2016):
  - 7.80; 7.40; 7.01; 6.65; 5.89
  - 10.09; 9.74; 9.41; 8.99; 3.66
  - 14.70; 14.19; 13.75; 13.11; 8.60
  - 17.91; 17.29; 16.77; 15.99; 12.50
- Additional block — 7 Years (2012–2016):
  - 13.68; 13.31; 12.93; 12.57; 11.81
  - 15.93; 15.61; 15.32; 15.02; 5.46
  - 21.29; 20.83; 20.43; 19.96; 11.92
  - 25.99; 25.41; 24.93; 24.31; 17.65
- Additional block — 10 Years (2012–2016):
  - 17.76; 17.36; 16.94; 16.55; 15.73
  - 22.90; 22.82; 22.47; 22.17; 21.96
  - 30.42; 30.18; 29.68; 29.28; 28.90
  - 34.01; 33.67; 33.09; 32.64; 32.16

*Source: Appendix Table 19 as provided in the content unit.*

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