Mission Concluding Statement 

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

April 25, 2012

A Financial Sector Assessment Program¹ (FSAP) team led by the Monetary and Capital Markets Department of the IMF has visited Spain between February 1–21 and April 12–25, 2012, in order to conduct an update of the Fund’s 2006 assessment of the soundness and stability of Spain’s financial sector. Such assessments are undertaken about every five years. The following provides some initial findings from the mission. These findings are subject to further review, and will also serve as background to the Article IV discussions to be held with the IMF’s European Department in late spring 2012.

The Spanish authorities are focusing on strengthening the financial system, a crucial condition to support the broader process of economic recovery. A major and welcome restructuring of the savings bank sector is taking place, but the capacity to cope with the needed adjustments differs significantly across the system. The largest banks appear sufficiently capitalized and have strong profitability to withstand a further deterioration of economic conditions, but vulnerabilities remain in other banks that are reliant on state support, and the sector as a whole remains vulnerable to sustained disruptions in funding markets.

The assessment confirms the need to continue with and further deepen the financial sector reform strategy to address remaining vulnerabilities and build strong capital buffers in the sector. A carefully designed strategy to clean up the weak institutions quickly and adequately is essential to avoid any adverse impact on the sound banks. Furthermore, dealing effectively and comprehensively with banks’ legacy problem assets should be the priority of the next stage of the financial reform strategy.

1. The past four years have witnessed a crisis of unprecedented proportion in the Spanish financial sector in its history. While external factors contributed to the turmoil, significant risks posed by a real estate boom-bust cycle, which materialized in the savings bank sector, exposed weaknesses in the policy and regulatory framework and an over reliance on wholesale funding.

2. A major and much needed restructuring of the savings bank sector is now taking place in the aftermath of the real estate boom-bust cycle. Reforms to the savings banks’ legal framework together with financial support from the state-owned recapitalization vehicle (FROB) were instrumental in starting the much-needed reform process to restructure the banking sector. The number of institutions has been reduced from 45 to 11 through actions including interventions, mergers and takeovers. These actions have been focused on the weakest institutions, and 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.

3. Recently, loan loss provision requirements have been increased for the banks in anticipation of expected further credit losses related to the real estate sector and the weak macro-economic environment. It will be difficult for some banks to meet this new requirement, however, and the markets’ perception of rising sovereign and banking sector risk may put further strains on banks, especially those that face large wholesale funding needs.

4. The team's stress tests, which covered more than 90 percent of the domestic banking sector, showed that most banks would be resilient to large further shocks, although there were pockets of vulnerabilities. Lender forbearance—which the supervisory authorities have indicated they are monitoring closely—could not be fully incorporated into the stress tests due to lack of data—and this may have masked the extent of credit risk in some institutions. The team's results suggest:

• The largest banks appear sufficiently capitalized and have strong profitability to withstand the expected further deterioration of economic conditions. The solid capital buffers of most banks as well as the robust earning capacity of the internationally diversified large banks have 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. Five of them 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. To preserve financial stability, it is critical that these banks, especially the largest one, take swift and decisive measures to strengthen their balance sheets and improve management and governance practices.
• 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.

5. The authorities are, rightly, focusing on strengthening the banking sector. This is a crucial condition to support a broader process of economic recovery. There is an appropriate sense of urgency from the authorities, as well as an awareness of the need for a carefully designed strategy, given the potential implications on the public debt dynamics. Indeed, unless the weak institutions are quickly and adequately cleaned up, the sound banks will suffer unnecessarily by a continued loss of market confidence in the banking sector.

6. Dealing effectively and comprehensively with banks’ legacy problem assets should be the priority of the next stage of the financial reform strategy. There are a number of options for managing impaired assets including keeping these assets in the banks or setting up private or public specialized asset management companies. To give guidance on the best strategy for the Spanish banking system going forward, a comprehensive diagnostic of the impaired assets can be particularly useful.

7. The authorities are pursuing a strategy of burden sharing between the public and private sector to resolve the problem banks. Public resources are channeled through the FROB—the vehicle established by the State to foster such process—while private resources are drawn from the deposit insurance scheme, the FGD, which is funded by the industry. To avoid resolution costs becoming too high for the industry to bear, especially 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. The assessment of the financial oversight framework identified key strengths and weaknesses. The main strengths of the supervisory agencies are their highly experienced and respected professional staff supported by good information systems and thorough supervisory processes. The existence of a strong nexus among the authorities facilitates cooperation and the flow of information, and several recommendations made in the previous FSAP have been addressed. However, a number of weaknesses need to be addressed. These include the need to:

• Strengthen the regulatory independence for the banking and securities regulators and 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 out-dated solvency regime; and
• Strengthen the remedial action and sanctioning regime in banking and securities supervision.

¹ The FSAP exercise is mandatory for the 25 most interconnected economies in the world (which includes Spain). For these 25 economies, the FSAP is to be undertaken about every five years. For more information see a fact sheet on the FSAP