Spain: Financial Sector Assessment, Preliminary Conclusions by the Staff of the International Monetary Fund

IMF News, April 25, 2012

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Mission Concluding Statement dated April 25, 2012.
A Financial Sector Assessment Program (FSAP) team led by the Monetary and Capital Markets Department visited Spain between February 1–21 and April 12–25, 2012, to update the Fund’s 2006 assessment of the soundness and stability of Spain’s financial sector.
The assessment covers about every five years for the 25 most interconnected economies (FSAP exercise is mandatory for the 25 most interconnected economies in the world (which includes Spain)).
Findings are preliminary, subject to further review, and will inform Article IV discussions with the IMF’s European Department in late spring 2012.

The past four years witnessed a crisis of unprecedented proportion in the Spanish financial sector. External factors contributed, but significant risks arose from a real estate boom-bust cycle that materialized in the savings bank sector, exposing weaknesses in policy and regulatory frameworks and an over reliance on wholesale funding.
Strengthening the financial system is identified as a crucial condition to support the broader process of economic recovery.

A major restructuring of the savings bank sector is underway. Reforms to the savings banks’ legal framework together with financial support from the state-owned recapitalization vehicle (FROB) were instrumental in starting the restructuring.
Institutional consolidation statistics and timeline:
- Number of institutions reduced from 45 to 11 through interventions, mergers and takeovers.
- By the end of 2012, institutions representing about 15 percent of the system with total assets equivalent to over 50 percent of GDP will have been resolved.
The capacity to cope with needed adjustments differs significantly across the system.

Loan loss provision requirements have been increased in anticipation of expected further credit losses related to the real estate sector and the weak macro-economic environment.
Some banks will find it difficult to meet the new provisioning requirement.
Priority recommendation: Dealing effectively and comprehensively with banks’ legacy problem assets should be the priority of the next stage of the financial reform strategy.
Options for managing impaired assets include:
- Keeping impaired assets in the banks.
- Setting up private or public specialized asset management companies.
A comprehensive diagnostic of impaired assets is recommended to guide the best strategy for the Spanish banking system going forward.

The largest banks appear sufficiently capitalized and have strong profitability to withstand a further deterioration of economic conditions.
Vulnerabilities remain in other banks that are reliant on state support; the sector remains vulnerable to sustained disruptions in funding markets.
Stress test coverage and caveats:
- Stress tests covered more than 90 percent of the domestic banking sector.
- Lender forbearance could not be fully incorporated into the stress tests due to lack of data; this may have masked the extent of credit risk in some institutions.
Stress test findings:
- Solid capital buffers of most banks and robust earning capacity of internationally diversified large banks reduced system-wide solvency concerns to a relatively low-probability event of a confluence of adverse macroeconomic developments.
- A group of ten banks, most of which have received state support and are in varying degrees of resolution strategy, were identified as being vulnerable.
- Of these ten banks: five have been acquired by or merged with other solvent entities; three are in the process of being auctioned; and the remaining two have submitted business plans that have been approved by the central bank.
- Although liquidity positions have improved and ECB long-term funding brings a reprieve, Spanish banks need to continue to build their capital buffers so that they can freely access private funding markets.

Authorities are pursuing a strategy of burden sharing between the public and private sector to resolve problem banks.
- Public resources are channeled through the FROB (vehicle established by the State).
- Private resources are drawn from the deposit insurance scheme, the FGD, which is funded by the industry.
Recommendation on funding mix:
- To avoid resolution costs becoming too high for the industry to bear in a reasonable time period, greater reliance on public funding may be needed, after exhausting options for private recapitalization, to preserve financial stability and to avoid excessive deleveraging.

Strengths:
- Highly experienced and respected professional staff in supervisory agencies.
- Good information systems and thorough supervisory processes.
- Existence of a strong nexus among the authorities facilitating cooperation and information flow.
- Several recommendations from the previous FSAP have been addressed.
Weaknesses and areas needing strengthening:
- Strengthen the regulatory independence for the banking and securities regulators and address the lack of financial/budgetary independence for the insurance and securities regulators.
- Strengthen the authority for the banking regulator to address preemptively the build-up of risks in the system.
- Strengthen the regulatory framework for the insurance sector (the current insurance solvency regime is not risk-sensitive) and the monitoring of potential risk build-up in the sector due to an out-dated solvency regime.
- Strengthen the remedial action and sanctioning regime in banking and securities supervision.

Continue and further deepen the financial sector reform strategy to address remaining vulnerabilities and build strong capital buffers.
Implement a carefully designed strategy to clean up weak institutions quickly and adequately to avoid adverse spillovers to sound banks.
Prioritize comprehensive handling of legacy problem assets, supported by a diagnostic of impaired assets.
Ensure swift and decisive measures to strengthen balance sheets, and improve management and governance practices in vulnerable banks, especially the largest among them.
Consider greater reliance on public funding for resolution after exhausting private recapitalization options to preserve financial stability and limit excessive deleveraging.

Preliminary conclusions of the IMF staff mission, April 25, 2012.