Bank of Spain was one of toughest pre-crisis regulators, report argues

A Bank of Spain report argues that before the financial crises, the institution implemented some of the toughest banking supervision measures in Europe. 

But the report says the enforced counter-cyclical provisions were still set too low to enable all Spanish banks to cope with the losses that appeared from 2008 on. Financial supervisors in all countries lacked macro-prudential measures and early warning systems to deal with financial crises, the report says. It also argues that Spanish supervision was to some extent weakened from 2004 by European Union legislation to transpose the International Accounting Standards, or IAS, into member states’ legal systems.

The Report on the financial and banking crisis in Spain, 2008–2014, says before the financial crisis began, the central bank’s approach “was essentially micro-prudential in approach, concentrated on ensuring that individual financial institutions were solvent and sound”. The bank had “no regulatory elements in place at the time that could ensure a correct link between macro-prudential and micro-prudential supervision”, the report says.

But this omission was due to the “low level of implementation at an international level” of financial early warning systems and macro-prudential measures, the report argues. These omissions “limited the possibility of earlier measures being taken to ward off the crisis on both a national and a global scale”.

In mid-2000, the Bank of Spain introduced new counter-cyclical provisioning requirements for Spanish banks. The report says it was concerned both by the pro-cyclicality of Spanish banks’ previous credit risk provisions and by possible future developments.

Financial institutions had to ensure they could “cover at all times the expected loss through the cycle on the loan portfolio”. The “relatively straightforward” requirements meant banks had to make additional provisions against expected losses when the economy was growing. They then had to release the provisions when non-performing loans began to emerge in a downturn.

The bank’s counter-cyclical provisions were “an innovation in the Spanish and international accounting and regulatory world”, the report says. “In general, they were not well received by international or other jurisdictions’ accounting regulators, as they surpassed the concept of incurred losses.” Spanish lenders also opposed the regulations, “as they feared their book profits would decline”, the report says.

Watered down

These measures were weakened when European Union regulations obliged Spain to adopt the International Accounting Standards for banks. The incorporation of IAS “was a significant change, especially for a country such as Spain where the banking supervisor had standard-setting powers for the supervised banks”.

The report says “IAS put the emphasis on financial reporting being useful for investors”, whereas in the previous Spanish accounting regulations “the emphasis was on protecting funds entrusted to institutions and, especially, retail customer deposits”. Accordingly, the report argues, “European regulations amended the principle of prudent valuation that had hitherto been the guiding principle of accounting regulations for banks in Spain”.

The Bank of Spain “decided not to abandon the counter-cyclical provisions” to avoid further fuelling the cyclical upturn, but had to adapt them to the IAS principles, the report says. “Spanish banks built up counter-cyclical provisions up to the end of 2007, when the stock [of provisions] peaked at around €26 billion [$31 billion].” The provisions amounted to between 15% and 20% of banks’ net operating income, the report notes.

Calibration problems

Despite its criticisms, the report notes the introduction of IAS only led to a “slight dip” in 2005 in the increase in counter-cyclical provisioning. The stock of provisions otherwise grew continuously from 2001 to the end of 2007, the report says.

But the provisions had been “calibrated on the basis of the credit cycle that preceded Spain’s entry into the euro area”. This period included the 1993 recession that “was considerably less acute than the double-dip recession that commenced in 2008”. Consequently, many banks had provisioning stocks that were not big enough to offset the bad assets created by the financial crises, the report says.

Nonetheless, the central bank’s counter-cyclical provision requirements “helped some banks to reinforce their robustness”, the report says. They also reduced the amount of funds that had to be injected into the bailed-out Spanish banks.

The Bank of Spain also took a tougher line before the crisis on “special investment vehicles”, or SIVs, the report says, “unlike other jurisdictions with major international banking systems”. A central bank circular from 2004 barred lenders from including SIVs in their scope of consolidation.

This meant they had to be “taken into account for the purposes of calculating the necessary own funds and capital requirements”. The report contrasts the Spanish approach with that of the US authorities. It says the creation of off-balance sheet SIVs “contributed to the development of operations involving the transformation and securitisation of sub-prime loans, which were at the source of the collapse of Lehman Brothers and of the international propagation of the crisis”.

The Bank of Spain was led from July 2000 to July 2006 by Jaime Caruana, who since April 2009 has been general manager of the Bank for International Settlements. Miguel Ángel Fernández Ordóñez was then president of the bank until June 2012.

Caruana appeared in the Spanish parliament in July to give evidence to a commission investigating the country’s bank bailouts.