Spanish rules cushioned banks from the crisis, says top regulator

In an exclusive interview with Risk , José María Roldán, director-general of banking regulation at the Banco de España, explains how a unique regulatory framework has led Spanish banks to adopt prudent trading and risk management processes that paid off during the financial crisis.

The Spanish regulator's use of dynamic provisioning, which mandates banks to build up capital cushions during the good times to be drawn down during a recession, has attracted considerable international attention in recent months as policymakers look to mitigate the procyclical effects of Basel II capital rules.

José María Roldán, who also chairs the standards implementation group of the Basel Committee on Banking Supervision, believes dynamic provisioning was one of a number of regulatory practices that helped Spanish banks weather the storm. He explains how the Banco de España squares its provisioning rules with international accounting standards, which currently allow provisioning only for incurred losses on loan portfolios, and updates Risk on the central bank's views on key international debates following the financial crisis.

Risk: Spanish banks have performed comparatively well during the financial crisis. Would you attribute that to any particularities in the Banco de España's regulatory approach?

José María Roldán: Spanish banks were spared mainly because of their plain vanilla retail business model, but the other element is the protection offered by some sound regulatory practices. Firstly, dynamic provisioning gave Spanish banks an extra cushion to deal with the crisis, and, secondly, the practice of consolidating all instruments on the balance sheet, meaning they cannot hold structured investment vehicles off balance sheet. On top of that, I would add strong on-site supervision and the fact that the institutions were very prudent in liquidity management.

Risk: What would you say are the major challenges at this point in time facing Spanish banks and you as a supervisor?

JMR: The slump in the real economy is the biggest challenge, as banks assess how this is going to impact on profitability and provisioning. For us as supervisors, this phase of the crisis is basically just business as usual. We need to continue to make the financial system more resilient and we are working with Basel and Brussels in this direction, so that a crisis like the one we've just seen is not repeated in the future.

Risk: How concerned are you at rising non-performing loans, particularly in the real estate sector? Is there anything you as a regulator can do to mitigate this growing risk?

JMR: Rising non-performing loans, albeit a natural occurrence in an environment of deep slowdown in economic activity, are always a worrying development for any supervisor. In the Spanish case, we have experienced a rapid growth of non-performing loans in 2008 and the beginning of 2009, but this growth has slowed down somewhat in the past few months. It is important to note that not all loans are showing the same degree of deterioration, even in real estate-related loans. For instance, traditional, seasoned mortgage portfolios exhibit, even in the midst of the crisis, very low levels of non-performing loans.

Risk: The creation of a government rescue fund for banks on June 26 suggests there has been some recent deterioration in the financial strength of Spanish institutions. Who is in control of the fund and how will capital be dispersed?

JMR: The decisions at the fund will be taken by an eight-member board; five of them come from the Banco de España, including the vice-governor as chairman, and the other three come from the banking sector. It will be an effective tool in helping the restructuring of the banking sector. What is very clear is that, looking forward, there will be a reduction in the size of the financial sector worldwide. Although the Spanish banking sector, as a plain vanilla retail system, will not have the same level of de-leverage and reduction that we might see in other financial systems, we will also see pressure on profitability in the medium term. With this fund, we are facilitating the restructuring of the banking sector and I think it's a crucial instrument.

Risk: How would you rate the success of dynamic provisioning in Spain?

JMR: There is no silver bullet that would have prevented the crisis or avoided its impact and we will never find a single instrument that will solve all the complex issues we have seen. Dynamic provisioning is one tool that makes financial institutions more resilient in the case of a crisis and limits the pro-cyclicality in the financial system and regulations.

Risk: There is continuing dialogue with accounting standards boards about provisioning, as accounting rules are only supposed to allow provisions for losses already incurred on loan portfolios. How has the Banco de España been able to square its dynamic provisioning rules with accounting standards?

JMR: Dynamic provisioning is based on the collective assessment for impairment – meaning you have to evaluate the number of damaged loans in a portfolio you have not yet identified as being impaired. The International Accounting Standards Board (IASB) has announced it is moving towards a system of provisions based on expected losses, which we would welcome. There should be no contradiction between sound accounting standards and sound provisioning practices.

Risk: Do you think accounting standard setters have failed to properly understand the need for provisioning in the past?

JMR: Yes, I think the very narrow interpretation of the incurred loss model has been a problem. No-one wants profit manipulation and the cookie jar temptation should certainly be avoided, but on the other hand provisioning has been too pro-cyclical and there are indications that provisions should have been higher before the crisis. The sooner we have an indication of the future direction of accounting standards, the better.

Risk: You chair the Standards Implementation Group (SIG) of the Basel Committee, which until January was known as the Accord Implementation Group. Why was the name changed and how has the group's responsibilities changed?

JMR: One of the lessons of the crisis was that implementation of rules and standards is as important as the rules themselves. The crisis showed that looking at implementation of the standards is extremely relevant and also that, although Basel II is very relevant for the supervisory authorities, the world does not finish with Basel II. There are issues that are of interest to supervisors that go well beyond Basel II. The change of name indicates a broader reach; an example would be colleges of supervisors, which we previously looked at only from the perspective of co-ordination of Basel II implementation. Now we are looking at this with a wider perspective in terms of crisis situations and how colleges can help. We are looking not just at capital adequacy but also at issues such as remuneration. The SIG includes representatives from every banking supervisory authority on the Basel Committee.

Risk: The Basel Committee is undertaking a number of changes to the Basel Accord. Which do you believe to be most urgent and why?

JMR: I would say all the areas are relevant, but personally I would highlight the change in the treatment of the trading book, which was a major source of problems in this crisis. We are reinforcing the trading book regime with the proposals that we have made. The stressed value-at-risk measure is one of the ways we are doing this, but we are also introducing measures on re-securitisation, remuneration and disclosure.

A fuller version of this interview will appear in the September issue of Risk.

See also: Basel implementation chief: no need for Basel III
Raiders of the loss arc
Accounting boards: Spain's dynamic provisioning not the way forward
A vicious circle