APPENDIX I Loan-Loss Provisioning20
221. Spain has been pioneering the use of dynamic provisions since 2000, with modifications after the adoption of IFRS in 2005. Dynamic provisioning is a prudential tool to address the credit risk that builds up during credit boom periods, helping smooth loan-loss provisioning over the economic cycle and to enhance financial stability. The mechanism draws from the observation that credit growth, and the quality of loan portfolios, exhibit strong cyclical fluctuations. During the upturn, credit tends to grow above trend and NPLs decline. During the downturn, these trends are reversed. Using historical experience, dynamic provisioning recognizes that credit losses can be properly accounted and provisioned in a statistical sense as soon as the risk (or the incurred loss) appears in the balance sheet.
222. Under the Spanish provisioning system, banks are required to register two types of loan-loss provisions: the generic, g, and the specific, s, whose effects can be proxied by the following formulas: g = αΔL + βL - s and s = γΔP where L is the total value of the loan portfolio, ΔL is the change in total loans, and ΔP is the change in problem loans. The generic provision is applied to homogeneous groups of risks. The vectors of the provisioning parameters α, β, and γ, are set by the Bank of Spain based on historical information on loan impairment and losses-given-default for specific loan categories (i.e., homogeneous groups of risks), albeit credit institutions are allowed to use their own estimates, subject to approval. Generic provisions accumulate in a generic fund G, which is required to remain within the following limits:. 0.33 αL ≤ G ≤ 1.25 αL.
223. In a given quarter, total required provisions, p, are the sum of the generic and the specific provisions: p = g + s = αΔL + βL. The term αΔL is common in traditional provisioning rules. The novelty of Spain’s dynamic provisioning system is the addition of the second term (βL), which captures the latent risk (inherent risk or incurred although not yet individually identified losses) of the loan portfolio and fluctuates with the business cycle. During the economic upturn, the latent risk of the loan portfolio tends to exceed the specific provision(s), causing an increase in the generic fund. A positive generic provision is considered a cost for the bank, and registered against income on a quarterly basis. During an economic downturn, the generic provision is negative and is registered as bank revenue (as long as it has a positive balance).
224. The more recent provisioning system is similar to the system associated with the initial regulation implemented in 2000, except for changes in the provisioning parameters (which are generally stricter under the new regulation) and the limits to the generic fund (which are lower under the new regime). The effects of the new regulation on provisioning levels of individual credit institutions will depend on the specific characteristics of their loan portfolios. On impact, however, the new regulation is expected to release provisions for the system as a whole, as a result of the combined effects of the reduction in the cap on the generic fund, and the large amount of provisions accumulated in the system.