Provisioning for the future

A growing number of regulators have highlighted dynamic provisioning as a means of lessening pro-cyclicality in the financial system. José Mar√≠a Rold√°n, director-general of banking regulation at the Banco de Espa√±a and chair of the Standards Implementation Group of the Basel Committee on Banking Supervision, talks to Joel Clark about Spain's approach and the need for an overhaul of loan loss provision rules

The Spanish financial system has come under intense scrutiny in recent months, as global supervisors look to understand why the country's top banks appear to have navigated the financial crisis in better shape than many of their competitors in Europe. While other financial institutions reported a succession of eye-catching losses for 2008, Spain's top two banks bucked the trend, with Banco Santander and Banco Bilbao Vizcaya Argentaria (BBVA) reporting profits of EUR8.88 billion and EUR5.39 billion, respectively. Both results were down on the previous year, but neither institution has suffered the kind of fall from grace experienced by a long list of other European banks.

No single factor is responsible for the positive performance of the Spanish banks, but the country's regulatory framework seems to have contributed to the situation. Not only is Spain one of the few European countries where financial supervision is undertaken entirely by the central bank, the Banco de Espana, but its financial institutions are also subject to several rules not widely enforced elsewhere on the continent. Most significantly, Spanish banks have been required since 2000 to build up capital buffers during times of economic growth that can be drawn on during a downturn - a practice known as dynamic provisioning. Additionally, the Banco de Espana has made it unattractive for Spanish banks to create off-balance-sheet vehicles - a factor it believes prevented them from incurring heavy losses.

Dynamic provisioning has been widely discussed in recent months, as policy-makers have looked for ways to counteract the perceived pro-cyclicality of capital adequacy and accounting rules. Under Pillar I of Basel II, for instance, banks must set risk weightings according to credit quality. This means they are required to hold less capital during good times, but must raise capital levels as credit quality deteriorates - a factor that may encourage them to rein in lending, exacerbating any downturn.

Regulators have recognised dynamic provisioning could work as a supplement to risk-based capital adequacy rules by allowing banks to build up buffers in good times that can be eaten into during recessions. But they have struggled to square it with international accounting standards, which only allow banks to make provisions on the basis of losses already incurred on loan portfolios. Dialogue between accountants and supervisors on the revision of loan loss provision rules is now stronger than ever, with a project to revise International Accounting Standard (IAS) 39 - which prohibits provisioning on the basis of expected losses - currently under way.

Jose Maria Roldan, director-general of banking regulation at the Banco de Espana in Madrid, welcomes the progress made so far, and believes now is the time for accounting and loan loss provisions to be better co-ordinated. "The very narrow interpretation of the incurred loss model has been a problem. No-one wants profit manipulation but, on the other hand, provisioning has been too pro-cyclical in this crisis. The sooner we have an indication of the future direction of accounting standards, the better," he says.

Nonetheless, he believes Spain's dynamic provisioning rules, as they stand, are compliant with IAS 39. That's because the calculation of provisions is derived not from an expected loss model, but from a backward-looking assessment that uses historical data to determine provisions. "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. There should be no contradiction between sound accounting standards and sound provisioning practices," he notes.

As chair of the Standards Implementation Group (SIG) of the Basel Committee on Banking Supervision, Roldan would be closely involved in drawing up parameters for any new international capital buffer rules, as well as implementation of the guidelines.

But despite his enthusiasm, Roldan admits dynamic provisioning has not completely isolated the Spanish banking sector from the financial crisis, and the worst may be yet to come as the effects of the recession take their toll on the Spanish economy. "For Spanish banks, the slump in the real economy is the biggest challenge at the moment, as they assess how this is going to affect profitability and provisioning," he says.

Those challenges were very much in evidence in the financial results of BBVA and Santander for the first half of 2009. Although both banks continued to see steady profits, they reported steep rises in domestic non-performing loans (NPLs), many linked to Spain's troubled real estate sector. BBVA's domestic NPLs rose from EUR2.49 billion in the first half of 2008 to EUR7.80 billion in the first half of 2009, while Santander's NPLs rose from EUR9.68 billion to EUR21.75 billion over the same period.

"Rising NPLs, albeit a natural occurrence in an environment of deep slowdown in economic activity, are always a worrying development for any supervisor," says Roldan. But he adds not all loans are showing the same degree of deterioration: "Traditional seasoned mortgages, even in the midst of the crisis, exhibit very low levels of NPLs. At the other end of the spectrum, for institutions with poor risk selection processes and low-quality collateral, the environment is going to prove challenging."

Both Banco de Espana and the Spanish government have stepped up crisis management activities in recent months. In July, the central bank announced Spanish financial institutions no longer have to provision for the full value of NPLs where an effective guarantee is provided by a mortgage on a completed property. Instead, the provision will now be calculated as the difference between the loan value and 70% of the value of the mortgaged property. The allowance will not be applied to loans made to real estate developers, as a property under development is not considered guaranteed in the same way as a completed property.

Despite relaxation of the rules, the overall effect on the size of provisions is likely to be minimal, as the central bank has simultaneously strengthened provisioning requirements for consumer credit. "We have told banks there are areas where their historical experience may indicate they need to be more aggressive - for instance, in consumer or credit card loans. We are not trying to boost profit or capital adequacy: it's about having lower provisions in the portfolios where they are not needed and higher provisions in the portfolios where they are needed," says Roldan.

Beyond provisioning, Banco de Espana is also taking the lead in distributing capital from a new rescue fund for the banking sector, announced by Spain's Ministry of Economy and Finance on June 26. The so-called Fondo de Reestructuracion Ordenada Bancaria (Fund for the Orderly Reconstruction of the Banking Sector) has an initial budget of EUR9 billion and will be managed by an eight-member board, comprising five representatives from Banco de Espana (including Roldan) and three representatives from the banking sector. "There will be a reduction in the size of the financial sector worldwide, and although the Spanish banking sector won't see the same level of deleveraging as other financial systems, there will be pressure on profitability. The fund will be an effective tool in facilitating the restructuring of institutions that face profitability problems," explains Roldan.

On top of these domestic issues, Roldan also has a busy international agenda as the Basel Committee works its way through a large number of changes to Basel II in light of the financial crisis. But he is adamant there are other important regulatory priorities beyond Basel II for both banks and their supervisors - and this was one of the reasons for the change in the name of the Accord Implementation Group to the SIG at the start of 2009. Having chaired the group since 2007, Roldan believes there is an emerging consensus on the need to look beyond capital adequacy rules when learning lessons from the crisis. "The crisis showed that looking at implementation of the standards is extremely relevant and also that, although Basel II is very relevant for supervisors, the world does not finish with Basel II," he says.

As an example of the broader reach of the new group, he points to the introduction of colleges of supervisors for the oversight of cross-border banks - something the Accord Implementation Group had only ever examined in the context of Basel II. "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 other key issues such as remuneration," says Roldan.

Beyond the Basel Committee, Roldan is keeping an eye on developments in Brussels as the European Commission (EC) drafts proposals for an overhaul of the derivatives market and the framework of financial supervision. Having chaired the Committee of European Banking Supervisors from 2004 to 2005, and as a continuing member of the group, he welcomes a proposal by the EC in May to enhance the authority of the so-called level-three committees and give them more binding powers (Risk August 2009, pages 21-23). "The level-three committees were very useful when they were created and have allowed us to make a lot of progress, but at the same time they have their limits. Now we are moving one step further to reinforce this co-operational hub, but it's very clear the national supervisors will remain the main authorities," Roldan explains.