Public Information Notice No. 12/59

Public Information Notice: IMF Executive Board Discusses 2012 Financial System Stability Assessment with Spain

June 8, 2012

On June 8, 2012, the Executive Board of the International Monetary Fund (IMF) discussed the Financial System Stability Assessment with Spain.¹

Background

The past four years have witnessed a crisis in the Spanish financial sector unprecedented in its modern history. The initial impact of the global financial crisis was relatively mild—the banking sector weathered the first wave with sufficient capital and provisioning buffers, even as wholesale funding markets came under acute pressure. However, the second-round effects were severe, causing a sharp recession and soaring unemployment. The crisis exposed the weak lending practices during the economic upswing, particularly among the former savings banks.

The restructuring of the banking sector initially proceeded slowly. The reforms to the legal framework for savings banks and the financial support provided by the state were instrumental in starting the bank restructuring and consolidation process. However, progress was slowed by the institutional constraints and the complexities of the governance arrangements for savings banks. Moreover, some of the weak entities were merged into larger but still weak ones, while delays in taking corrective action meant that vulnerabilities were not addressed or were allowed to grow.

As a result, the quality of banks’ assets continued to deteriorate, exacerbating the credit crunch, and reliance on ECB funding grew as they lost market access. Nonperforming loans continued to rise, particularly driven by loans to construction and real estate developers. The stock of repossessed assets also increased, while growth in credit to the private sector fell sharply and turned negative. The ECB’s three-year Long Term Refinancing Operation has provided significant temporary relief, but has also increased the interconnectedness between banks and the sovereign. Most of this funding has been used to substitute short-term repo funding, repay debt, buy sovereign paper, and build up precautionary cash buffers.

The resilience of individual banks to the crisis has been markedly different. This is largely attributable to differences in their business models, management quality, and risk management philosophies. While the economic environment increases the risks to corporate and household balance sheets and, consequently, to the soundness of the banking sector, the core of the system appears resilient. The largest banks have solid capital buffers and robust earnings from their internationally-diversified operations to weather further deterioration in economic conditions. Most of the banks where vulnerabilities seem highest and where public support seems most critical have already been acquired by other solvent entities or are in varying stages of restructuring. Notwithstanding these measures, further restructuring of the weaker banks is needed. Unless, the non-viable banks are resolved, the sound banks will continue to be penalized by across-the-board tighter regulations and expensive funding, with the risk of undermining financial stability and delaying economic recovery.

The authorities have recently accelerated the financial sector reforms. In February 2012, higher provisions and specific capital buffers for banks’ outstanding real estate exposures were introduced. In May, provisions on performing real estate developer loans were further increased. The government committed to a capital injection of about 2 percent of GDP to the fourth largest bank, which will become state-owned. A comprehensive and forward-looking review of banks’ loan books and real estate assets will be conducted by third parties to increase transparency.

Executive Board Assessment

Executive Directors commended the Spanish authorities for the significant progress made in consolidating the banking sector and addressing balance sheet weaknesses amidst challenging economic conditions. Directors welcomed in particular the acceleration of reforms in recent months, including the increase in provisioning requirements, targeted support for bank recapitalization, and the decisive actions to address the weaker institutions. Noting the rapidly evolving situation in Spain and the euro area, Directors urged the authorities to act swiftly and spare no effort to restore confidence in the financial system and to preserve financial stability.

Directors noted the staff’s finding that the core of the banking system is likely to prove resilient to further shocks, but that vulnerabilities remain and, given deteriorating macroeconomic prospects and extreme market pressures, weaker banks will require further restructuring. They stressed, however, that in light of high uncertainty and ongoing complex reforms, the results of the stress tests should be used with care and communicated to the public with greatest clarity. Directors emphasized that the stress tests do not attempt to represent the full scope of capital needs given, for example, possible costs associated with restructuring. They underlined the critical importance of fully implementing planned reforms and putting in place a credible plan for public support, while retaining flexibility to deal with unforeseen developments. Directors agreed that the immediate priorities are to strengthen capital buffers and formulate a strategy to deal with banks’ legacy assets, guided by an in-depth due diligence of banks’ loan portfolios. They also underscored the need for an effective communication strategy, spelling out key reforms and timetables.

Directors welcomed the authorities’ intensified efforts to address weaknesses in the financial oversight framework. They highlighted the urgency of amending the resolution framework and strengthening the procedures for bank liquidation. Directors urged further efforts to enhance the central bank’s supervisory and enforcement powers, and to improve governance arrangements more generally.

Directors looked forward to the conclusions of the due diligence of Spanish banks’ loan portfolios by auditors, and to a comprehensive discussion of macro-financial developments in Spain during the forthcoming Article IV consultation.

¹ The Financial Sector Assessment Program (FSAP), established in 1999, is a comprehensive and in-depth assessment of a country’s financial sector. FSAPs provide input for Article IV consultations and thus enhance Fund surveillance. FSAPs are mandatory for the 25 jurisdictions with systemically important financial sectors and otherwise conducted upon request from member countries. The key findings of an FSAP are summarized in a Financial System Stability Assessment (FSSA), which is discussed by the IMF Executive Board. In cases where the FSSA is discussed separately from the Article IV consultation, at the conclusion of the discussion, the Chairperson of the Board summarizes the views of Executive Directors and this summary is transmitted to the country’s authorities. An explanation of any qualifiers used in a summing up can be found here: http://www.imf.org/external/np/sec/misc/qualifiers.htm.