Critics attack dynamic provisioning following Spanish bank results

Spanish banks this week reported third-quarter earnings that featured sharp increases in loan loss provisions at a time when the economy continues to sour - nothing unusual in that, perhaps, but critics of the country's approach to loan losses have seized on the results.

"This is no surprise. We knew this was coming. What it reveals is that all the stuff we've been told about the great Spanish system was a load of manure," says the head of one European accounting regulator.

Unlike the rest of the European Union, where accounting standards require banks to set aside provisions only when the value of a loan has been damaged, the Spanish system of dynamic provisioning - which is overseen by the Bank of Spain rather than accounting authorities - forces banks to build up reserves in advance. As such, it has been championed by Spanish officials and by banking regulators elsewhere as a counter-cyclical alternative to the status quo - a way to ensure that banks aren't hit by rising loss reserves at exactly the time their lending powers are needed to help stimulate an ailing economy.

But the Spanish system currently appears to be acting in a pro-cyclical way, with reserves rising steeply while profits slide and the economy contracts. The country's three largest lenders all reported much higher provisions this week, with Santander's rising from €1.76 billion to €2.94 billion, while those at BBVA climbed from €917 million to €1.74 billion and Banco Popular saw provisions jump from €110.7 million to €386.6 million. BBVA financed the increase by selling Spanish property assets.

The accounting regulator argues that the true scale of the problems in Spanish loan portfolios has been masked by the dynamic provisioning system, which requires the banks to make reserves based on past loss experience: "When times are going well, they will report lower profits than they're really making and when times are worse they will report more profits than they're really making. So the results seem relatively insensitive to the cycle, but only as long as the economy doesn't perform significantly worse than you've seen in the past - and guess what: they're now living through something which is significantly worse than anything they've seen before," he says.

Spain's central bank doesn't see it that way. "It is true that Spanish banks are making big provisions now, but this is logical because the volume of bad loans is increasing. The provisioning effort would be bigger without the anti-cyclical provisions accumulated during the previous years of high growth, which provides an important buffer," says an official at the Bank of Spain.

The system's counter-cyclical credentials are also defended by Pauline Wallace, a partner at PricewaterhouseCoopers (PwC) in London: "There is certainly a counter-cyclical element, because at the time recession first bites, you will have more provisions than you would otherwise have - you will have built up provisions at a time when the economy is good. But you could never have such huge provisions that they would not need replenishing in a recession of this magnitude," she says.

However, she also notes that PwC as a firm doesn't support dynamic provisioning as an alternative to the current system of incurred loss accounting because it hands what should be a regulatory task - ensuring that banks hold enough capital - to accountants.