Peer Review of Spain Review Report 27 January 2011 Peer Review of Spain Review Report Table of Contents Foreword 3 Glossary 4 Executive summary 5 1. Recent market developments and regulatory issues 9 2. Real estate markets and financial stability 17 3. Regulatory framework for industrial participations 20 4. Regulation, supervision, and governance of savings banks 22 5. Inter-agency coordination and supervisory autonomy 25 6. Insurance supervision 28 7. Securities settlement systems 30 Annex: Spain peer review – Selected FSAP recommendations 34 2 Foreword The peer review of Spain is the second country peer review under the FSB Framework for Strengthening Adherence to International Standards. 1 FSB member jurisdictions have committed to undergo periodic peer reviews focused on the implementation of financial sector standards and policies agreed within the FSB, as well as their effectiveness in achieving the desired outcomes. As part of this commitment, Spain volunteered to undertake a country peer review in 2010. This report describes the findings and conclusions of the Spain peer review, including the key elements of the discussion in the FSB Standing Committee on Standards Implementation (SCSI) on 13 December 2010. The draft report for discussion was prepared by a team chaired by Alexander Karrer (Federal Department of Finance, Switzerland) and comprising Francisco José Barbosa da Silveira (Central Bank of Brazil), Robert M. Schenck (Federal Reserve Bank of Atlanta, USA), Arun Pasricha (Reserve Bank of India), Constant Verkoren (DNB, Netherlands), and Mike Chee Cheong Wong (Monetary Authority of Singapore). Costas Stephanou (FSB Secretariat) provided support to the team and contributed to the preparation of the peer review report. The analysis and conclusions of the peer review are largely based on the Spanish financial authorities’ responses to a questionnaire designed to gather information about the initiatives undertaken in response to the relevant FSAP recommendations. 2 The review has benefited from dialogue with the Spanish authorities as well as discussion in the FSB SCSI and in the FSB Plenary. 1 A note describing the framework is at http://www.financialstabilityboard.org/publications/r_100109a.pdf. 2 The FSAP report for Spain is available at http://www.imf.org/external/pubs/ft/scr/2006/cr06212.pdf. 3 Glossary BCBS BCP CADE CCP CESFI CNMV CPSS CRD CRE DGSFP EC ECB EU FAAF FSAP FROB IAIS ICP IFRS IOSCO IRB LTV MEF MiFID MoU NPL OTC RRE SCLV SIP SME TAC TRMC Basel Committee on Banking Supervision Basel Core Principle Central Public Registry for public debt Central Clearing Counterparty Financial Stability Committee National Securities Markets Commission Committee on Payment and Settlement Systems Capital Requirements Directive Commercial Real Estate Directorate General of Insurance and Pension Funds European Commission European Central Bank European Union Financial Assets Acquisition Fund Financial Sector Assessment Program Fund for the Orderly Restructuring of the Banking Sector International Association of Insurance Supervisors Insurance Core Principle International Financial Reporting Standards International Organization of Securities Commissions Internal Ratings-Based approach (Basel II) Loan-to-Value (ratio) Ministry of Economy and Finance Markets in Financial Instruments (EU Directive) Memorandum of Understanding Non-Performing Loan Over-the-Counter Residential Real Estate Securities Clearance and Settlement Service Institutional System of Protection Small and Medium-sized Enterprise Technical Advisory Committee (Iberclear) Technical Risk Management Committee (Iberclear) 4 FSB country peer reviews The FSB has established a regular programme of country peer reviews of its member jurisdictions. The objective of the reviews is to examine the steps taken or planned by national authorities to address IMF-World Bank Financial Sector Assessment Program (FSAP) recommendations concerning financial regulation and supervision as well as institutional and market infrastructure. FSB member jurisdictions have committed to undergo an FSAP assessment every 5 years, and peer reviews taking place typically around 2-3 years following an FSAP will complement that cycle. A country peer review evaluates the progress made by the jurisdiction in implementing FSAP recommendations against the background of subsequent developments that may have influenced the policy reform agenda. It provides an opportunity for FSB members to engage in dialogue with their peers and to share lessons and experiences. Unlike the FSAP, a peer review does not comprehensively analyse a jurisdiction's financial system structure or policies, nor does it provide an assessment of its conjunctural vulnerabilities or its compliance with international financial standards. Executive summary Spain underwent an FSAP in 2006, in which the IMF assessment team concluded that “Spain’s financial sector is vibrant, resilient, highly competitive, and well-supervised and regulated.” The main challenges in the areas of financial regulation and supervision were related to the need to address the risks posed by rapid credit growth, especially in the housing sector; address the risks associated with banks’ large equity investments in nonfinancial firms; enhance the regulation, supervision and governance of savings banks (cajas); and improve inter-agency coordination and supervisory autonomy. The FSAP also identified steps to further strengthen insurance supervision and securities settlement systems. The Spanish financial system weathered the initial brunt of the financial crisis relatively well compared to other advanced countries, primarily due to a strong regulatory stance and sound supervision, as well as an efficient, retail-oriented bank business model (see section 1). The strong regulatory framework was effective in cushioning the financial system, thereby allowing the authorities and financial institutions more time to plan appropriate responses. The successful use of dynamic provisions during the crisis to cover the credit losses that built up in bank loan portfolios is particularly relevant given ongoing discussions at the international level about moving towards an expected loan loss provisioning regime. The financial crisis had significant after-effects since it led to the bursting of the real estate bubble that had built up prior to the crisis. In that context, the risks identified in the FSAP relating to rapid credit growth in the housing sector and to the regulation, supervision and governance of the cajas have materialised. Credit institutions were over-exposed to the construction and property development sectors and experienced a sharp decline in credit growth and increase in non-performing loans. Savings banks have been particularly hit and are undergoing significant restructuring and downsizing. The business outlook is tempered by compressed net interest margins and higher loan losses, against a backdrop of a multi-year 5 fiscal adjustment process, continued deleveraging by households, high unemployment, and subdued economic growth. Identifying future sources of growth for Spain and its financial system will be especially important following the severe contraction of the real estate sector. FSB members welcome the strong actions taken to date by the Spanish authorities to address financial system vulnerabilities and urge them to continue on this path, especially in view of recent market developments. In particular, the tightening of prudential regulations, the stricter and more transparent approach employed by Spain compared to other countries in the 2010 EU stress tests, as well as the interventions by the Bank of Spain in two credit institutions, sent a strong signal to market participants and may thus have facilitated the restructuring process. Enhanced disclosures in perceived problem areas can play a valuable role, and the FSB commends the Spanish authorities for the importance they have given to transparency. The authorities have made good progress in addressing several FSAP recommendations. They have tightened regulatory capital and loan loss provisioning requirements for real estate exposures, and provided further guidance on best practices for lending in this area; implemented measures to reduce incentives for equity investments in nonfinancial companies by banks and manage related conflicts of interest; introduced reforms to strengthen corporate governance and the ability to raise capital from external sources for savings banks; enhanced coordination and cooperation between financial sector regulators; adopted additional requirements on internal controls, investment, and adequate verification of the risk management processes of insurers; and improved the functioning of securities settlement systems. However, such determined actions became necessary partly because of the delay in addressing earlier the structural weaknesses of savings banks highlighted in the FSAP. A key lesson from the Spanish experience therefore is the importance of responding promptly to FSAP recommendations to ensure financial stability. Spain’s experience has brought to the forefront the high loan exposures to real estate and construction, which were created in response to an economy-wide boom in that sector (see section 2). Many credit institutions adopted similar business strategies during the boom by aggressively expanding their activities in this area, resulting in system-wide overcapacity and asset concentrations. Micro-prudential measures were an important, albeit insufficient, buffer against the risks emanating from such activities. A variety of micro- and macro-prudential policy measures are needed to address the build-up by banks of real estate exposures, coupled with sufficient supervisory independence and powers to be able to calibrate them appropriately. Different jurisdictions have addressed this issue using both demand and supply side measures that have varied widely in their scope and intensity. These often extend beyond prudential measures, depending on national circumstances and political economy trade-offs, and can include monetary policy and fiscal reform among others. The equity investments of large Spanish banks in nonfinancial companies (“industrial participations”) have dropped in relative terms, although they remain high compared to other developed countries (see section 3). These participations are often intrinsically linked to, and supportive of, nonfinancial companies’ business models and strategies, making them difficult to untangle. The FSB is of the view that large industrial participations by banks not only create potential conflicts of interest, but may also pose concentration, reputational and systemic risks. Further regulatory efforts may therefore be necessary to ensure that industrial participations do not generate such risks, and that exposures continue to decrease in an 6 orderly fashion. The authorities agree that proper monitoring and supervision of these participations is required, although they believe that there exist few alternative domestic sources of equity finance and that such investments have had clear benefits in terms of the growth and competitiveness (including internationally) of the private sector. The comprehensive reform of cajas introduced in 2010 addresses FSAP recommendations related to strengthening corporate governance and their ability to raise capital from external sources (see section 4). However, it is too early to judge its effectiveness since most integration processes were only recently initiated. Savings banks have traditionally played an important role in several European countries. Although the forms such institutions take vary considerably from one country to another, they are often characterised by distinct business models (in terms of lending and/or funding) compared to commercial banks and by unique challenges with respect to governance and their ability to raise capital from external sources. One key lesson from Spain’s experience is that such institutions should follow very conservative risk-taking policies when they lack access to external capital sources. The FSAP recommendations on strengthening the autonomy of financial regulators (particularly on insurance) and delegating to them the authority to issue norms and to sanction violations have not been taken up by the authorities (see section 5). While it is understood that further delegation of relevant powers to regulators raises some difficulties under Spanish law, the observations made by the FSAP - regarding the risks of political interference in the future or undue self-restraint of supervisors in the presence of insufficient independence - remain valid. Similar issues essentially apply to the appointment of CNMV board members for longer, non-renewable terms. In this context, it is worth noting that the authorities were considering prior to the crisis the possibility of modifying the structure for financial supervision in Spain in order to create a so-called “twin peaks” system (i.e. separate institutions responsible for prudential supervision and for market conduct). This reform was put on hold as a result of the financial crisis and pending changes in the EU-wide supervisory architecture. It is recommended that, when markets are less volatile, the authorities reconsider the current institutional framework taking into account the relevant FSAP recommendations. There is a wide range of practices and views across FSB jurisdictions regarding the optimal structure of supervisory arrangements. While the financial crisis highlighted some important lessons on financial supervision, it did not resolve the debate on the appropriate institutional design of the supervisory structure. Moreover, the need to extend the regulatory perimeter and to develop macro-prudential policy frameworks has complicated this debate. Although there is no single optimal structure and different organisational models have their own pros and cons, it is essential that the relevant authorities be able to work together and exchange information. Organisational structures are secondary to ensuring that these agencies have the tools and powers to intervene when necessary, and the willingness and independence to do so. In addition, the respective responsibilities of authorities need to be clear; in particular, it is critical to have clarity on who among the authorities is in charge in the event of a crisis. With regard to insurance, the forthcoming implementation of Solvency II will likely address FSAP recommendations on fit and proper requirements, risk management systems, and the actuarial function (see section 6). In the meantime, the DGSFP could consider establishing general requirements on corporate governance that are comprehensive and applicable to all insurers, including non-listed ones, and additional specific requirements on boards of 7 8 directors regarding their understanding of the use of derivatives. There may also be a need for the authorities to consider whether the resourcing of DGSFP is sufficient to carry out its ambitious mandate going forward, particularly once Solvency II is implemented. Finally, with respect to securities settlement systems (see section 7), the proximity of Iberclear’s backup site to the main site may need to be re-examined for operational risk purposes. Iberclear may also need to ensure that its participants have access to backup systems and that these are regularly tested both with its main data site and with its backup site. The intention by the authorities to shift finality towards time of settlement and to establish a CCP for stock exchange clearing and settlement is welcome and would bring Iberclear’s post-trade practices in line with EU common standards and practices. 1. Recent market developments and regulatory issues Financial system structure Spain’s financial system is primarily bank-based, with 87% of system assets belonging to credit institutions. As of year-end 2009, there were 353 credit institutions comprised primarily of commercial banks, savings banks (“cajas de ahorros”), and cooperatives. The total assets of those institutions were about €3.7 trillion (351% of Spain’s GDP), of which 61% and 35% were held by commercial banks and cajas respectively. All credit institutions are subject to the same supervisory and prudential regime. Commercial banks follow the universal banking model and provide traditional banking services and products, as well as pension and mutual funds management, insurance, private equity and venture capital services, factoring, and leasing. Domestic banks are generally listed on the domestic capital markets and are engaged heavily in retail banking. The degree of sector concentration has remained relatively unchanged in recent years, with the top 5 banks accounting for 44% of total domestic sector assets in 2009. Despite the entry of European banks after Spain joined the European Union (EU) in the 1980s, foreign banks remain minor players representing around 7% of system assets. Conversely, the foreign operations (primarily in the form of subsidiaries) of Spanish banks account for around 24% of their total consolidated assets, and are located mostly in Latin America and the UK. Savings banks are nonprofit credit institutions that play a significant social welfare role in their respective home regions and supply nearly half of the credit issued to the country’s private sector. Although they are allowed to pursue the same range of activities as commercial banks, they do not have shareholders. There are different groups of stakeholders to whom the law provides representation in the savings banks’ governing bodies, including regional governments (“autonomous communities”), depositors, founders, and employees. While cajas are allowed to be shareholders in banks, the banks traditionally could not purchase capital participations of cajas. The savings banks sector, which is quite heterogeneous in terms of the size and activity of different entities, is currently changing dramatically as a result of restructuring and consolidation efforts that are actively supported by the authorities (see section 4). Spain has relatively developed capital markets, with financial instruments traded in a variety of platforms and settlement infrastructures (see section 7). Debt securities markets have traditionally played a relatively small role in the financing of domestic corporations as these entities have preferred to use bank loans and/or internally generated funds. The Spanish stock exchanges’ market capitalization (almost €1 trillion at end-2009, or 95% of GDP) is concentrated in a small number of stocks, with institutional investors playing a dominant role in the market for fixed income securities. The Spanish insurance market is the eleventh largest in the world and the sixth largest in Europe by net premium income. It is also very competitive with relatively low levels of concentration. The assets managed by the insurance sector were €243 billion at the end of March 2010, dominated by life insurers. The industry is characterized by a well-developed infrastructure and a generally high quality regulatory and supervisory regime (see section 6). Private pension funds have also started to develop in recent years, albeit from a low base. 9 Regulatory framework and crisis response The regulatory framework changes since the FSAP, and the Spanish authorities’ response to its recommendations, need to be considered in conjunction with the global financial crisis that began in the second half of 2007. As in many countries, the crisis highlighted policy and structural weaknesses that are currently leading to the restructuring of parts of the Spanish financial system and to the reform of financial regulation and market practices. The Spanish financial system weathered the initial brunt of the financial crisis relatively well compared to other advanced countries, primarily due to the Bank of Spain’s strong regulatory stance and sound supervision, as well as an efficient, retail-oriented bank business model that is based on proximity to customers (as opposed to “originate-to-distribute”). Spanish banks entered the crisis with robust capital and strong counter-cyclical loan loss provisioning buffers. 3 They were largely shielded from the subprime mortgage crisis due to low exposure to complex structured products as the Bank of Spain’s regulations discouraged investments in such products and the creation of off-balance structured investment vehicles and conduits. The Financial Stability Committee, which was established in 2006, proved to be a useful means of coordination and decision making among the various regulatory agencies during the crisis (see section 5). As part of their early crisis response, the Spanish authorities adopted the following main measures:  Creation of the Financial Assets Acquisition Fund (FAAF) in October 2008 to purchase high quality assets from credit institutions operating domestically as a way of providing liquidity for their activities and fostering credit to the private sector. The FAAF, which stopped operating in early 2009, purchased around €19 billion of assets via four market auctions.  Approval of a series of government guarantees by the Spanish government, starting in early 2009, for new senior debt issuance by domestic credit institutions to help boost liquidity and jump start lending. While the maturity of these instruments generally ranges between three months and three years, guarantees could be extended to instruments with a maturity of up to five years. The total amount of guaranteed issues up to July 2010 had reached €56 billion, and the European Commission (EC) authorised the extension of the scheme at least until end-2010.  Provision of financial support to small and medium-sized enterprises and the self- employed via the Instituto de Credito Oficial, a public financial agency.  Introduction of more stringent loan loss provisioning requirements for credit institutions (see section 2). 3 Dynamic, or so-called statistical, loan loss provisions were introduced in Spain in 2000 and revised in 2004. In contrast to specific provisions based on incurred losses, dynamic provisions are based on estimated credit losses at portfolio level and have the effect of building a buffer of extra provisions in good times, based on the buildup of credit risk over this period, which can be used to cover credit losses during bad times. See “Dynamic Provisioning: The Experience of Spain” by Saurina (World Bank Group Crisis Response Note 7, July 2009, available at http://rru.worldbank.org/documents/CrisisResponse/Note7.pdf ) for details. 10 [...]... Bank of Spain, in addition to review and formal agreement of the institution’s board of directors (without participation of the relevant manager or director), is required before granting any borrowing facilities to the directors and managers of credit institutions, as well as to legal entities that they are involved with Credit institutions are also required to report semi-annually to the Bank of Spain. .. supervision of financial conglomerates  Principle 1 (Clarity of responsibilities of the regulator): Cooperation between the Bank of Spain and the CNMV in the discharge of their respective functions could be further enhanced by including CNMV’s assessment of the program of activity of credit institutions that intend to provide investment services  Principles 2 (Independence and accountability of the regulator)... institutions in Spain It will also reduce the number of employees and branches of cajas by an average of 15% and 20% respectively Currently, 13 mergers are in process involving 38 cajas totalling around €1.2 trillion in assets, 8 of which have required FROB funds of around €10.6 billion Caja Castilla-La Mancha was intervened by the Bank of Spain in March 2009, and received €4.1 billion of aid from the... calling for suspension of bank officers  Principle 3 (Supervisory Authority): Implement an institutional arrangement for insurance supervision that enables: (i) strengthening of regulatory governance in terms of independence of the supervisory body (i.e., the establishment of procedures regarding the appointment and dismissal of the head of the supervisory authority and members of the governing body);... appropriate for the sound management of the credit institution Lessons and issues going forward 19 Article 120 of Directive 2006/48/EC sets a limit of 15% of the credit institution’s regulatory capital for any individual participation in nonfinancial entities, and a limit of 60% for the entire portfolio of equity holdings 20 The supervisory approach of the Bank of Spain is described in more detail in... recommendations An assessment of corporate governance related issues is also a key component of ongoing supervision of credit institutions by the Bank of Spain 20 In addition, it is worth noting that the Bank of Spain had established, even prior to the FSAP, prudential controls aimed at preserving the independence of the decision taking processes in credit institutions 21 Through these requirements, the... real estate repossessions While reporting of such figures at system-wide level by the Bank of Spain is comprehensive and granular 5 , there is scope for improved and more consistent disclosure practices on loan restructurings, debt-forequity swaps, and real estate repossessions by individual banks Figure 1: Evolution of credit growth and of non-performing loan rate in Spain All credit institutions Credit... light of the lessons from the crisis Both of these regulations focus on ensuring adequate assessment of the capacity of borrowers to repay loans, the role of collateral in underwriting and risk management practices, as well as conditions that must be considered when restructuring loans In addition, Spain is involved in EU-wide efforts to better regulate responsible lending practices The result of such... preservation of stakeholders’ rights and the continuity of social functions 24 In order to avoid the actual choice between these four options being based on fiscal considerations, the tax treatment has also been adapted to guarantee that all types of structures are treated symmetrically 23  Integrate part of their operating structure (at least 40% in terms of capital and profits) in a group of cajas using... recognized the overall strength of the Spanish financial sector and found a high degree of observance of principles dealing with effective supervision, it made several recommendations applicable to the three regulatory authorities - namely, the Bank of Spain, the National Securities Markets Commission (CNMV), and the Directorate General of Insurance and Pension Funds (DGSFP) of the MEF The most important . Peer Review of Spain Review Report 27 January 2011 Peer Review of Spain Review Report Table of Contents Foreword. systems 30 Annex: Spain peer review – Selected FSAP recommendations 34 2 Foreword The peer review of Spain is the second country peer review under