ALCALÁ, 9 28014 MADRID 1 MINISTERIO DE ECONOMÍA Y HACIENDA 25 – X - 2010 THE BANKING SYSTEM REFORM 1. Introduction Saving Banks (Cajas de Ahorros) play an essential role in the Spanish financial system and social network. From an economic point of view, they have been, throughout their history, a significant driving force for growth, savings, allocation of resources and financial inclusion. They have also grown to be an essential element for the credit access of households and firms. Another crucial aspect that explains the importance of saving banks for the Spanish society is their effect on the general interest through the compliance with their social duties. Indeed, the allocation of surpluses to the provisions of goods and services in the territories in which they are present is a very valuable complement of our welfare state. In general terms, saving banks as the rest of the Spanish banking sector, faced the first phases of the financial crisis, originated in August 2007, with outstanding resilience due to their so called “traditional” banking model based mainly on retail banking, the high quality of the Bank of Spain prudential supervision and a privileged position in terms of efficiency, profitability, and level of provisions and capital. Nevertheless, the persistence of the financial crisis together with the serious economic downturn have resulted in an intensively adverse environment for the Spanish financial sector and hence in lower levels of banking activity, difficulties for obtaining financing from international markets as well as an increase in the levels of delays in payments. Spanish entities have reacted to such conditions reducing operative costs, intensifying efforts to gain new deposits and reinforcing the quality of own funds. However, regarding saving banks, the financial crisis highlighted two main flaws. On the one hand, there is an excess of capacity and on the other hand there is a need for greater flexibility both in access to capital resources and in the adjustment processes. In such a context, Spanish saving banks have undertaken a restructuring process that already affects more than three quarters of the sector and that will result in a substantial reduction of the number of entities and hence in an increase of the efficiency and soundness of the saving banks sector. This has been a significant first step. Nonetheless, the current reform of the international financial system will result in new challenges in terms of higher capital requirements both in quantity and in quality. Spanish credit entities must be prepared to face the new requirements from a reinforced position to avoid losing competitiveness in the international arena. It is therefore a must that the regulation on saving banks is reformed in order to facilitate their access to external capital in the best possible conditions. Consequently, there is an urgent need to reform the saving banks model in order to guarantee their continuity and their contribution to the Spanish financial system. In such a context, the Spanish government has undertaken a wide-reaching reform of the saving banks in Spain through the approval of a Royal-Decree Law (Real Decreto Ley) for the reform of the legal framework of the Saving Banks. It is probably the most ambitious reform ever done in this sector. Indeed, the changes introduced guarantee the capacity of saving 25 – X - 2010 MINISTERIO DE ECONOMÍA Y HACIENDA ALCALÁ, 9 28014 MADRID 2 banks to keep working efficiently in our financial system, of which they account for close to 50%, while being able to adapt to the current challenges, with a high skilled management and strengthening their balance sheets with high quality capital. This reform is already operational. Specifically, the main objective of the reform is to strengthen saving banks so as to adapt them to the needs and challenges of the current financial situation by tackling their main structural weaknesses. This is done through two main channels: the reduction of the political influence at the same time as the governance structure is professionalized and, secondly, the enhancement of their capacity to raise external capital. 2. Strengthening the selection of management on the basis of professional criteria One of the main objectives of the reform is to make corporate governance more professional and transparent in line with the principles underlying corporate governance of banks. Indeed, the growing complexity of financial activity has also reached saving banks, traditionally focused on a retail-oriented business model. This requires management teams to be selected among the best professionals of each area and the main members of the governing bodies to have exclusive dedication to their obligations within the saving bank, aligning their personal objectives with the long-term interests of the saving bank and its social purpose. Such measures include: a) The ceilings on the voting shares for public entities within saving banks have been reduced from 50 percent to 40 percent. In cases where a saving bank has issued preferred stock with political rights, such ceiling would be reduced proportionately to take into account the political rights of the holders of such instruments. A fit and proper exam has been introduce for the representatives of regional governments so that they have to comply with requirements regarding good repute and sufficient experience to perform their duties. The Decree-Law therefore reduces the weight of the political influence in the governing bodies of the saving banks and guarantees that political representatives are also qualified to execute the responsibilities of their job. b) Along the same lines, the reform prohibits elected officials to be members of governing bodies. This ensures, not only a reduction of the political influence within the executive decisions of the entity, but also the exclusive dedication from the main members of the governing bodies to their duties within the saving bank. c) Dispositions on conflicts of interest have been included to rule out any possibility of misalignments of the personal interests of categories of staff that can potentially have a material impact on the soundness of the entity and on the long-term interests of the saving bank. d) New requirements on knowledge and expertise are included regarding control functions, directors and managers. e) Criteria on reputation and experience have been further strengthened through the establishment of a new Appointment and Remuneration Committee which is constituted in 25 – X - 2010 MINISTERIO DE ECONOMÍA Y HACIENDA ALCALÁ, 9 28014 MADRID 3 a way that enables it to exercise competent and independent judgment on appointments and therefore on the suitability of managers to perform their duties. f) To further guarantee the management of savings banks from an exclusively professional and efficient perspective, former administrative limitations to mergers within savings banks have considerably been reduced so that any refusal to authorize the merger should be justified on the basis of objective criteria. g) Finally, in order to give transparency and increase market discipline on saving banks’ corporate governance, they will publish annually a report on corporate governance. 3. Strengthening the ability of savings banks to raise external top quality capital The reform also amends another of the main flaws that the current crisis has highlighted regarding saving banks, their inability to issue capital. Indeed, the former regime has proven incapable of providing the saving banks with an efficient capitalisation instrument to meet the strong growth that the sector has experienced over the last decade or the recapitalisation needs originated in the current crisis. Several measures are put in place to enhance the capability of saving banks to raise external top quality capital in the form of equity, in conditions equivalent to those of commercial banks. On the basis of this reform saving banks will have four alternatives that improve their ability to raise capital: a) Maintain their existing saving bank structure, with widened possibilities to issue preferred stock (cuotas participativas) with political rights. The objective of the reform regarding preferred stock is double: making it a more attractive instrument for investors both national and international and guaranteeing that they are eligible instruments to be considered as high quality own funds. Prior to this reform, saving banks could only issue preferred stock without any political rights and subject to limits on the amount of preferred stock that a person or group of people could hold. This of course limited the attractiveness of the instrument and therefore the ability to issue it in efficient, competitive conditions. Now, saving banks will have the possibility to incorporate voting rights to the preferred stock issued in proportion to the share that they represent on total equity. Stocks can be issued up to a maximum of 50% of total equity of the Saving Bank. The new regime eliminates any limitation on the total of preferred stock that an individual or group of individuals can hold. It also strengthens the principle of liberty of issuance removing the need for any administrative authorisation. Finally, an in order to further increase the attractiveness of preferred stock, the decree-law includes a disposition to recognise and give the maximum legal certainty to the representation rights of the instrument holders in the government bodies of the saving bank, just like in the case of a bank. 25 – X - 2010 MINISTERIO DE ECONOMÍA Y HACIENDA ALCALÁ, 9 28014 MADRID 4 b) Saving Banks can integrate part of their operating structure -at least 40%- in a consolidated group (Sistema Institucional de Protección, SIP). The Institutional System of Protection (ISP), established by Decree-law 6/2010 offers an effective instrument to bring together a group of credit entities in order to pool their risk management strategies and develop risk sharing strategies. In the special case of saving banks, this system is organised around a central entity in the form of a commercial bank which will pool their risk management strategies, risk sharing and will have full access to financial markets, including raising capital. Thus, the ISP increases the ability to access markets in order to obtain equity. The reform strengthens the commitment on stability and permanency of the entities forming the ISP. With than in mind, the Bank of Spain must asses the suitability of an entity leaving the group on the basis of the soundness both of the individual entity and the system as a whole. To avoid the distortion of the nature of the saving banks that participate in the ISP through the loss of control over the central entity, globally, the capital participation of all of them in the ISP should not fall below 50 percent. It is possible though that the participation falls below that threshold but, in that case, the Saving Banks will have to transform into a foundation and transfer its financial activity to the commercial bank acting as the central entity. This system therefore tackles the problem of issuing capital while preserving the special nature of Saving Banks. c) Saving Banks can opt to transfer its financial activity to a bank in which they hold a majority stake. The decree-law establishes two new organisation models for the activities of Saving Banks. The first new alternative envisages the indirect exercise of the Saving Bank’s financial activity through a bank. This entails that while the Saving Bank maintains its legal nature, the financial activity will be conducted by the bank which has the ability to access markets in order to obtain equity. In order to safeguard the nature of the Saving Bank, its capital participation in the bank should not fall below 50 percent. In cases where the Saving Bank does not meet such requirement it will have to transform into a foundation and transfer its financial activity to the commercial bank through which it has been exercising its financial activities. This system therefore tackles the problem of issuing capital while preserving the special nature of Saving Banks. The Saving Bank will remain in charge of social investments. d) Finally, as another totally new alternative, Saving Banks can renounce to their nature, transform into a foundation and transfer their financial activity to a commercial bank in which they will have a stake which, in this case, can be below 50%. 25 – X - 2010 MINISTERIO DE ECONOMÍA Y HACIENDA 5 4. Fiscal Treatment In order to avoid that the choice of one of these four alternatives is based on other factors than efficiency, the fiscal treatment of Saving Banks has also been adapted so as to guarantee that all the types of structure are treated symmetrically. The Foundation will be in charge of social investments. 5. Srengthening the resilience of savings banks Finally, the decree-law takes a further step in order to strengthen the resilience of credit entities in terms of liquidity and credit growth. Taking into consideration international developments regarding liquidity and leverage ratios, two new requirements have been introduced: a) A new liquidity requirement: A key characteristic of the financial crisis was the inaccurate and ineffective management of liquidity risk. In recognition of the need for credit entities to improve their liquidity risk management and control their liquidity risk exposures, the decree-law includes a new liquidity requirement in order to avoid maturity mismatches and to guarantee a correct management of Saving Banks liquidity. b) Limits to Saving Banks leverage: One of the underlying features of the crisis was the build up of excessive leverage in the banking system. During the most severe part of the crisis, the international banking sector was forced by the market to reduce its leverage in a manner that amplified downward pressure on asset prices, further exacerbating the positive feedback loop between losses, declines in bank capital, and the contraction in credit availability. Regarding Saving Banks, the decree-law introduces a leverage ratio requirement that is intended to put a floor under the build- up of leverage, thus helping to mitigate the risk of the destabilising deleveraging processes. The Bank of Spain will be empowered to further specify such measures in order to be in line with international developments. ALCALÁ, 9 28014 MADRID . of the underlying features of the crisis was the build up of excessive leverage in the banking system. During the most severe part of the crisis, the. and the system as a whole. To avoid the distortion of the nature of the saving banks that participate in the ISP through the loss of control over the