Front Matter Page

© 2006 International Monetary Fund

June 2006

IMF Country Report No. 06/212

Spain: Financial System Stability Assessment, including Reports on the Observance of Standards and Codes on the following topics: Banking Supervision, Insurance Supervision, Securities Supervision, Payment Systems, Securities Settlement Systems, and Financial Policy Transparency

This Financial System Stability Assessment on Spain was prepared by a staff team of the International Monetary Fund and the World Bank as background documentation for the periodic consultation with the member country. It is based on the information available at the time it was completed on June 12, 2006. The views expressed in this document are those of the staff team and do not necessarily reflect the views of the government of Spain or the Executive Board of the IMF.

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Front Matter Page

INTERNATIONAL MONETARY FUND

SPAIN

Financial System Stability Assessment

Prepared by the Monetary and Financial Systems and European Departments

Approved by Ulrich Baumgartner and Alessandro Leipold

May 23, 2006

Contents

• Glossary

• Executive Summary

• I. Economic and Financial Background

  • A. Macroeconomic Background

  • B. Macroeconomic Risks

• II. Financial System Institutions and Markets

  • A. Credit Institutions

  • B. Insurance and Private Pension Funds

  • C. Capital Markets

• III. Financial Sector Supervision

• IV. Infrastructure

  • A. The Payment and Securities Settlement Systems

  • B. Dealing with Problem Financial Institutions

  • C. Accounting Standards and the Adoption of Basel II

  • D. Transparency of Financial Policies

  • E. AML/CFT

  • F. Other Issues

• Annex

• Observance of Financial Sector Standards and Codes—Summary Assessments

• Tables

• 1. Main Economic Indicators, 2001-05

• 2. Financial Soundness Indicators, 2001-05

• 3. Financial System Structure, 2000-05

• 4. Insurance Sector Financial Soundness Indicators, 2001-05

• 5. Recommended Action Plan to Improve Compliance with the Basel Core Principles

• 6. Recommended Action Plan to Improve Observance of the IAIS Insurance Core Principles

• 7. Recommended Action Plan to Improve Implementation of the IOSCO Objectives and Principles of Securities Regulation

• 8. Recommended Action Plan to Improve Observance of the CPSS Core Principles

• 9. Recommended Action Plan to Improve Implementation of the CPSS-IOSCO Recommendations for Securities Settlement Systems

• 10. Recommended Action Plan to Improve Observance of the IMF’s MFP Transparency Code—Banking Supervision

• 11. Recommended Action Plan to Improve Observance of the IMF’s MFP Transparency Code—Securities Market Supervision

• 12. Recommended Action Plan to Improve Observance of the IMF’s MFP Transparency Code—Deposit Insurance

• 13. Recommended Action Plan to Improve Observance of the IMF’s MFP Transparency Code—Payment System Supervision

• 14. Stress Tests for Credit Institutions, Sizes of Shocks

• 15. Summary of Stress Test Results for Credit Institutions

• 16. Summary of Stress Test Results for Insurance Firms

• Figures

• 1. Distribution of Domestic Credit, 2000-05

• 2. Financial and Banking System Structure and Trends

• 3. Credit Institutions’ Distribution of Foreign Assets by Geographic Areas

• 4. Credit Institutions: Composition of Assets and Liabilities, 2000 and 2005

• 5. Mortgage Rate, Unemployment Rate, Housing Price, and Wage Indexes

• 6. Overview of BME Holdings

• Boxes

• 1. Main FSAP Recommendation

• Appendices

• I. Loan-Loss Provisioning

• II. Stress Tests for Credit Institutions and the Insurance Sector

• III. Main Equity Markets and Instruments

Glossary

Executive Summary

Overall Spain’s financial sector is vibrant, resilient, highly competitive, and well supervised and regulated. The sector’s strengths are evident: a high degree of financial intermediation that contributes to the efficient mobilization and allocation of savings; low intermediation margins; well-capitalized and professionally managed financial institutions; and a prudential framework at the cutting edge of innovation. The expansion of Spain’s financial system accelerated since the country joined the euro area, in the context of a long period of strong economic growth and rising employment. Private sector lending has grown even faster than deposits, owing to strong credit demand, especially for housing loans, in an environment of very low interest rates (short-term rates are negative in real terms).

Real GDP growth has averaged 3.6 percent a year since 1996, sustained by domestic demand, particularly consumption and construction. Thus, the external current account deficit has widened, reflecting a persistent inflation differential with the euro area and eroding competitiveness. Foreign saving, at 7.4 percent of GDP in 2005, has been filling the gap between domestic savings and investment. Net foreign direct investment, however, was negative in 2005, reflecting a trend in Spain, as in the euro area generally.

Buoyant domestic demand has been associated with a boom in the housing market. House prices rose by 104 percent in real terms between end-1997 and end-2005. A substantial part of this increase can be explained by fundamentals, including the low interest rate environment and rising employment, household income, and the number of households. Nevertheless, despite some signs of a slowdown in the rise in house prices, private and official analysts now estimate overvaluation on the order of 25 to 35 percent, relative to end-2005 levels.

Credit has grown much faster than GDP and credit institutions have been relying heavily on cross-border capital flows. Increased credit to the corporate and household sectors has more than offset a decline in credit to the public sector. Portfolio flows were the primary external financing source in 2005, amounting to €40 billion (4.5 percent of GDP). Financial institutions attracted large amounts of funds, mainly by issuing fixed-income instruments.

Household debt rose from 45 percent of disposable income in 1993 to 112 percent of disposable income in 2005, above the average for the euro area, but below that of Germany, the United Kingdom, and the United States. Although households maintain strong net wealth positions, a large share of their assets is in real estate, which has benefited from the surge in prices. Mortgage credit—almost exclusively at variable rates—has grown rapidly in recent years, partly fueled by the longer maturities offered by financial institutions and the low real interest rates. Credit to real estate developers and construction companies has also grown rapidly.

Stress tests showed credit institutions and insurers to be highly resilient to a variety of shocks, including rising interest rates, a fall in house prices, a drop in equity prices, and a sharp depreciation of the U.S. dollar against other currencies. The results suggest that credit institutions would be able to absorb the losses associated with large adverse shocks without systemic distress. This reflects multiple factors, including the strong capitalization of the systemically important credit institutions, their sizeable loan-loss provisions as required under Spain’s rigorous provisioning framework, their overall sound risk management practices, and the fact that Spain has been enjoying an extended period of strong growth.

Nevertheless, an adverse macroeconomic scenario would intensify the risks associated with the housing boom. A slowdown of domestic demand for housing would affect output and consumption, and eventually lead to higher unemployment—construction itself accounts for 14 percent of employment—that would weaken household debt-servicing capacity. It could also dampen market appetite for credit institution debt.

The double-digit growth of credit over the last five years, led by housing-related credit, is cause for concern. Thus, the FSAP attaches high priority to moderating credit expansion and mitigating credit risk. On the monetary side, the projected gradual cooling off of the housing market and domestic demand depend on rising interest rates, as tighter prudential rules alone are unlikely to be sufficient. A gradual increase in euro-area interest rates—if decided by the ECB—would help in dampening both house price increases and credit demand in Spain. In addition, staff supports the concerns expressed in the Bank of Spain’s (BE) 2005 Financial Stability Report about non-traditional mortgage products. Additional prudential measures with respect to these mortgages are recommended.

Some of the larger credit institutions have relatively large equity investments in nonfinancial companies (these holdings are called “industrial participations” in Spain). To mitigate the risks inherent in equity investments, and considering the substantial changes that are taking place within the regulatory framework (capital adequacy and accounting rules) the BE should implement additional regulatory measures to reduce the incentive for industrial participations, such as adopting the most conservative approaches under Basel II.

Notwithstanding the overall strengths of financial system supervision, the FSAP makes several recommendations applicable to all three supervisors:

• Further strengthening the independence of the three financial sector regulators by delegating the authority to issue norms and sanction violations from the Ministry of Economy and the Council of Ministers to the respective agencies. This would help minimize any chance of political interference in the future—although the mission found no instances of this—or undue self-restraint of the supervisors.

• Create an institutional mechanism for regular and continuous high-level coordination among the Bank of Spain, the National Securities Commission (CNMV), and the Insurance and Pensions supervisor.

• Ongoing reforms of the Statutes of the regional governments (Autonomous Communities) should clearly maintain the State-level supervisors’ sole responsibility and powers regarding prudential supervision and regulation.

Notwithstanding savings banks’ overall strong performance and growing market share, structural features (they are similar to foundations and do not have private owners) make strong governance particularly important. Several actions could help in maintaining the savings banks’ strong market orientation:

• Ensuring that initiatives to improve corporate governance of all credit institutions are fully implemented, strengthening them if needed.

• Promoting new means to raise high-quality (Tier 1) capital, such as issuing cuotas participativas¹ to the market.

• Allowing savings banks to merge freely within and across Autonomous Communities.

• Reducing over time the public sector representation ceiling on savings bank boards, currently at 50 percent.

Box 1 presents these and other main FSAP recommendations.