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

The Financial System Stability Assessment found the financial sector to be vibrant, resilient, highly competitive, and well supervised and regulated. Stress tests showed credit institutions and insurers to be highly resilient to a variety of shocks. It also found a high degree of observance of the principles dealing with effective supervision by the three regulatory authorities—the Bank of Spain, National Securities Market Commission, and the Directorate General of Insurance and Pension Funds. The Committee on Payment and Settlement Systems Core Principles assessed that all principles are observed by the Real-Time Gross Settlement System.

Abstract

The Financial System Stability Assessment found the financial sector to be vibrant, resilient, highly competitive, and well supervised and regulated. Stress tests showed credit institutions and insurers to be highly resilient to a variety of shocks. It also found a high degree of observance of the principles dealing with effective supervision by the three regulatory authorities—the Bank of Spain, National Securities Market Commission, and the Directorate General of Insurance and Pension Funds. The Committee on Payment and Settlement Systems Core Principles assessed that all principles are observed by the Real-Time Gross Settlement System.

I. Economic and Financial Background

A. Macroeconomic Background

1. Spain has enjoyed a sustained period of economic growth and rising employment. Real GDP growth has averaged 3.6 percent a year since 1996, outstripping the euro-area average. In recent years, growth has been sustained by domestic demand, particularly private consumption and construction. The composition of growth has become increasingly unbalanced, however, with net exports making a large negative contribution since 2002.

2. The widening current account deficit reflects the persistent inflation differential with the euro area and an erosion of competitiveness. The cumulative headline inflation differential since European Monetary Union (EMU) qualification in 1997 amounts to about 9.5 percentage points and the productivity gap has widened.

3. Strong domestic demand has helped fuel a rise in house prices, which more than doubled in real terms between end-1997 and end-2005. To a considerable degree, the level of house prices can be explained by fundamentals, including low interest rates and rising employment, household income, and the number of households. Private and official analysts now suggest an overvaluation on the order of 25 to 35 percent. Nonetheless, the Bank of Spain thinks that the most likely scenario is one in which house price overvaluation is corrected gradually.2 Some signs of deceleration have appeared (the 12-month increase in house prices decelerated from 18.5 percent at end-2003 to 12 percent at end-2006Q1).

4. Monetary policy conditions in the euro area have been accommodative from Spain’s perspective, contributing to negative short-term real interest rates in Spain for the past three years. Despite relatively tight fiscal policy, Spanish inflation increased to 3.4 percent in 2005 (against a euro-area average of 2.2 percent).

5. Credit institutions have provided ample credit to the private sector in the past five years. Household (largely mortgage), construction, and real estate credit have expanded from about 40 percent to 53 percent of domestic credit between 2000 and 2005, more than offsetting a decline in credit to the public sector (Figure 1). Credit institutions’ exposure to the corporate sector includes equity participations as well as lending.

Figure 1.
Figure 1.

Spain: Distribution of Domestic Credit, 2000-05

Citation: IMF Staff Country Reports 2006, 212; 10.5089/9781451812152.002.A001

Source: Bank of Spain

B. Macroeconomic Risks

6. The erosion of competitiveness poses a risk of slower growth in the years ahead. Although short-term growth prospects remain strong, the external sector drag is around 2 percentage points.

7. Spain’s increasing reliance on external savings reflects the gap between rising investment and, in the past two years, declining domestic savings. Total investment rose from 21 percent of GDP in 1996 to 29.7 percent of GDP in 2005, among the highest rates of EU countries (Table 1). Construction has been the most rapidly growing component of investment, while consumption has also grown rapidly. Domestic saving was equivalent to 22.3 percent of GDP in 2005, resulting in an external current account deficit of 7.4 percent of GDP. Net portfolio flows were the primary external financing source in 2005, amounting to €40 billion (4.5 percent of GDP).

Table 1.

Spain: Main Economic Indicators, 2001–05

(In percentage change, unless otherwise indicated)

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Sources: IMF, World Economic Outlook and Information Notice System; and Fund staff estimates.

Figure for 2005 refers to y-o-y growth rate for March of 2005.

Based on national definition (i.e., the labor force is defined as people older than 16).

Excludes nonfactor services.

8. The rapid growth of credit to the housing and construction sectors raises some macroeconomic concerns. It feeds the house price boom and overall household debt, thus increasing credit institutions’ vulnerability in case of a sharp downturn in the housing market. Moreover, such a downturn would affect output and consumption, and could result in important second-round effects, such as increasing unemployment. All this could weaken households’ debt-servicing capacity, and dampen market appetite for credit institutions’ debt.

II. Financial System Institutions and Markets

9. Overall, the FSAP found the financial sector to be vibrant, resilient, highly competitive, and well-supervised and regulated. The strengths of the system are evident: a high degree of financial intermediation; the efficient allocation of savings; wide access to financial services; low intermediation margins; well-capitalized and professionally managed financial institutions; and a prudential supervisory framework that has been at the cutting edge of innovation, 3 e.g., by the dynamic loan-loss provisioning system put in place in 1999 (Appendix I). The payment and securities’ settlement systems are robust and well-integrated internationally. All this has allowed the financial system to develop and withstand substantial shocks, such as the financial disruption in Latin America of a few years ago.

A. Credit Institutions4

10. Following deregulation in the late 1970s, and Spain’s joining the euro area, financial services have expanded rapidly and the system is highly competitive (Figure 2). Following consolidation, the five largest credit institutions account for just under half of system assets. Credit institutions compete fiercely and offer a wide range of financial products. Efficiency indicators of Spanish credit institutions rank among the best, reflecting competition and a combination of strong volume growth and cost containment. At end-2005, the average cost-to-income ratio was below 57 percent, compared with 60 percent in the U.S. and an average of more than 63 percent in major EU countries.

Figure 2.
Figure 2.

Spain: Financial and Banking System Structure and Trends

(In percent, unless otherwise indicated)

Citation: IMF Staff Country Reports 2006, 212; 10.5089/9781451812152.002.A001

Sources: Bankscope, Bank of Spain, and ECB.1/ Deposit-taking institutions comprise commercial, savings and cooperative banks.2/ Number of branches per million inhabitants.

11. Along with commercial banks, the savings banks (cajas) have been a major force in extending services and in creating a highly competitive environment. Savings banks are subject to the same supervisory and prudential regime applied to all credit institutions. They have close ties with the communities and support social, cultural, and educational projects. They also have a large network of branches and a strong regional identity, and have increased their share of customer deposits from one-third in 1980 to more than one-half in 2005. Savings banks’ share in total credit to the private sector has also been increasing and is concentrated in lending to individuals and to small- and medium-size enterprises. Commercial banks dominate the investment and pension fund businesses, and have a larger portfolio of corporate loans.

12. The ownership structure of savings banks differs from that of commercial banks. Savings banks operate with no share capital and must allocate nonretained profits to social and welfare projects. (In recent years, about thirty percent of profits have been devoted to social projects.) Thus they are more reliant than commercial banks on retained earnings to meet their Tier 1 capital needs. Owing to their ownership structure, they cannot be bought by banks, though they can sell branches or other assets. They can merge with one another subject to approval of the Autonomous Communities, and can also buy other financial institutions including banks.

13. Commercial banks and savings banks also have different business strategies and risk profiles. In recent years, the larger banks have been expanding overseas, while the larger savings banks have been increasing their industrial participations. Nonetheless, all credit institutions have been aggressively expanding their mortgage portfolios.

14. Credit institutions have become highly integrated in international capital markets, as reflected in substantial cross-border financial flows. Their net debt with the rest of the world was €214 billion at end-2005. Cross-border inflows in 2005 were almost equally divided between portfolio flows (€15.5 billion) and foreign deposits plus interbank loans (€12 billion). The high degree of international integration of major Spanish credit institutions, especially with the EU and Latin America has led to close coordination between supervisors in the countries involved. Moreover, Spanish supervisors have been actively involved in ongoing EU efforts to strengthen arrangements dealing with crisis management and monitoring of risks in a cross-border context.

15. Spanish banks have expanded their assets abroad in two stages. Initially, they acquired large amounts of assets in emerging economies, especially in Latin America. In recent years, however, they have also increased their presence in other European countries, most notably the United Kingdom (Figure 3). (The increase in the share of the U.K. mainly reflects the acquisition of Abbey Bank by the Santander group in 2004.)

Figure 3.
Figure 3.

Credit Institutions’ Distribution of Foreign Assets by Geographic Areas, 2003 and 2005 1/

(In percent)

Citation: IMF Staff Country Reports 2006, 212; 10.5089/9781451812152.002.A001

Source: Bank of Spain.1/ Data as of March 2005.

16. The banking system’s exposure to loss of assets abroad has been declining since 2000.5 Exposure to loss was close to 5 percent of capital at end-March 2005, compared with 11.2 percent in December 2003. This reduction is partly due to much-improved economic conditions in Latin America. Furthermore, banks have taken measures to mitigate the risks of adverse events in Latin America, including by shifting their investments overseas from emerging markets toward more developed markets and hedging their exposures to currency movements. Banks weathered well the losses on their Latin American exposure in the late 1990s especially because these losses were well-provisioned, as required by Spain’s strict regulations.

17. Reflecting their strong retail orientation, deposits accounted for three-quarters of credit institutions’ total liabilities at end-2005, 55 percent of liabilities in resident deposits and 20 percent in non-resident deposits (Figure 4). Domestic credit has expanded even faster than deposits, increasing from 57 percent of assets in 2000 to about two-thirds of assets in 2005.

Figure 4.
Figure 4.

Credit Institutions: Composition of Assets and Liabilities, 2000 and 2005 1/

Citation: IMF Staff Country Reports 2006, 212; 10.5089/9781451812152.002.A001

Source: Bank of Spain.1/ Based on non-consolidated data

18. The rapid development of the securitization market has also facilitated the access of credit institutions to foreign savings. Credit institutions have established securitization funds, which in turn have issued their own securitization bonds, mostly held abroad. At end-2004, of the €122.5 billion of outstanding securitized bonds, 62 percent were held by foreigners, 34 percent by domestic financial institutions, and the remaining 4 percent by the nonfinancial resident sector.

Housing prices, household debt, and mortgage loans

19. As indicated above, in a context of declining interest rates and rising employment, mortgage loans have been growing rapidly for several years, accompanying a housing boom. Strong housing demand stemmed from the favorable macroeconomic environment and from immigration, the increased number of incomes per household, and a decline in the average household size (Figure 5).

Figure 5.
Figure 5.

Spain: Mortgage Rate, Unemployment Rate, Housing Price, and Wage Indexes

Citation: IMF Staff Country Reports 2006, 212; 10.5089/9781451812152.002.A001

Source: Bank of Spain.

20. Stress tests (see below) suggest that the financial system as a whole is well positioned to absorb a significant fall in housing prices. The resilience of credit institutions is underpinned by: (a) high loan provisioning and a good level of capitalization; (b) relatively low loan-to-value ratios on the outstanding loan portfolio (an average LTV ratio of 65 percent at end-2004); and (c) a moderate debt-to-income (DTI) ratio for the average household.

21. Nevertheless, LTV and DTI ratios have been rising, and the concentration of credit in the housing and construction sectors raises some concerns. DTI rose from 77 percent of disposable income in 2001 to 112 percent in 2005. Credit to housing and construction represented about half of private credit portfolios for banks and two-thirds for savings banks at end-June 2005.6 Despite recent rapid growth of mortgage securitization, most (80 percent) of the credit risk remains with the originating institution.7 Moreover, some institutions are likely to have additional risk arising from geographical loan concentration, such as second residences on the coast.

22. Strong competition has led banks and savings banks to aggressively market mortgage loans. The prevalence of mortgage loans at floating rates (over 95 percent of outstanding mortgage loans) means that households are already absorbing most of the interest rate risk. More recently, the maturity of mortgage products offered has increased markedly from a maximum of 10 years by 1985 to maturities currently offered of up to 50 years in a few cases. (The average duration of outstanding mortgage loans is 25 years.) New products, including interest-only mortgages, or long grace periods for payment of principal are increasing the riskiness of such loans. To discourage excessive risk-taking, the staff recommends tightening provisioning or capital requirements for non-traditional housing loans.

23. Many of the factors affecting house prices and the most effective measures that could be taken to dampen the rise in the medium term lie outside the purview of the FSAP. These include elements such as fiscal incentives that favor home ownership, and land policy, which creates perverse incentives to limit the supply of residential and commercial land. Moreover, renting is further constrained by legal difficulties to evict problem tenants and by the de facto minimum length of rental contracts (five years). The government has adopted several measures intended to boost the rental market and address the issue of land use.

24. The authorities are preparing a draft reform of the mortgage market that could help in making the market more flexible to changing price conditions. These include regulatory changes to streamline commissions for early amortization; a reduction and streamlining of legally established fees incurred when modifying a mortgage contract; and enhanced information requirements from credit institutions to their clients. The reform also aims at lowering the legal costs involved in mortgage refinancing, enhancing the repayment capacity of issuers of mortgage-backed securities, and reinforcing the independence of the appraisal companies.

25. While house price increases have slowed somewhat, the pace of mortgage and real estate lending has accelerated in the past two years to more than 20 percent a year. If this were to continue, a soft landing for the economy could be put in jeopardy. The increase in euro-area interest rates in recent months, if sustained, would help dampen both house price increases and credit demand in Spain. In this context, it would be helpful for the BE to complement its moral suasion by further tightening provisioning or capital requirements on housing and construction loans, especially non-traditional mortgages. While by itself this may have limited impact on credit growth, it would have a positive prudential effect.

Nonfinancial equity investments of credit institutions

26. Nonfinancial equity investments of credit institutions (industrial participations) represent a significant proportion of Spanish credit institutions’ activities. At end-2004, the value of the participations in listed and nonlisted companies by a group of 19 credit institutions—which held approximately 80 percent of CI assets—totaled more than€48 billion, equivalent to about half of those credit institutions’ regulatory capital.8 More than 80 percent of the participations are in listed companies, concentrated in utilities, energy, and telecommunications.

27. Industrial participations raise two concerns. First, returns on equity are relatively risky and volatile. While rising equity prices and dividends have made industrial participations a significant source of profits for credit institutions, a decline in equity prices would reverse these gains. Moreover, concentration in a few sectors or companies could add further volatility. Second, major participations in a single company raise the possibility of conflicts of interest and informational asymmetries for credit institutions relative to other investors. They could also lead to suboptimal lending by the credit institution to the company.

28. The BE is well aware of the risks stemming from CIs’ industrial participations and has required credit institutions to enhance the monitoring of these investments. The staff favors adopting the most conservative approaches to the treatment of industrial participations under Basel II.

29. Conflicts of interest can arise when CI directors or decision-making officers also serve as directors in an industrial company in which the CI has ownership. Limiting the possibility of CIs to hold controlling equity positions in nonfinancial companies should be considered, as well as introducing regulations to prevent a credit institution representative serving on the board of a nonfinancial company from taking part in the institution’s decisions vis-à-vis that company.

Vulnerabilities and stress test results

30. Spanish credit institutions show strong results overall, with low NPLs, comfortable provisioning and capital well above statutory minimums (Table 2). Reflecting the rapid expansion of credit, the capital adequacy ratio (CAR) for credit institutions fell slightly from 12.3 percent at end-2004 to 12.2 percent at end-2005. At the same time, NPLs, at 0.6 percent of total gross credit, are very low by international standards. NPLs are low for all categories of loans, ranging from 0.2 percent for mortgage loans to around 2 percent for consumer loans. Earnings are also at a comfortable level for both banks and savings banks.

Table 2.

Spain: Financial Soundness Indicators, 2001–05 1/

(In percentage change, unless otherwise indicated)

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Sources: Bank of Spain, and CNMV.

Deposit-taking institutions comprise commercial, savings and cooperative banks.

Based on consolidated data.

Nonperforming credit net of specific provisions and those general and statistical provisions not included in Tier 2 capital to total regulatory capital.

Large exposures as defined by EU Directive 2000/12, Article 48.

Data for December 2005 reflect the implementation of the new accounting rules (IFRS).

Liquid assets exclude equity investments and fixed income portfolio instruments.

Broad liquid assets include fixed and variable income portfolio instruments.

31. Core stress tests examined the impact of a variety of shocks on the seven largest financial groups, accounting for about two-thirds of system assets, and on credit institutions as a group.9 The stress tests were carried out jointly by the FSAP team, the BE and the group of systemically important credit institutions. The methodologies were agreed between the FSAP team and the BE; the BE and credit institutions provided all the data needed to carry out the analysis. The size of the shocks to market risks, interest rate risk, credit risk, and liquidity risk were calibrated on historical experience in Spain and were in line with those applied in FSAPs for other Euro area countries. In addition, the stress tests assessed the impact of several adverse macroeconomic scenarios on credit institutions: a drop in house prices in Spain and the UK; an increase in oil prices; a depreciation of the U.S. dollar against other currencies; and a crisis in Latin America, simulated by turmoil in capital markets in the region.

32. Overall, the system was found to be resilient and well-prepared to absorb the losses associated with large adverse single-factor shocks, as well as multiple shocks resulting from the adverse macroeconomic scenarios. This reflects a combination off actors, including the strong asset quality and capitalization of the systemically important credit institutions, their comfortable loan-loss cushion induced by the rigorous provisioning system, their sound risk management practices, and the fact that Spain has been enjoying an extended period of strong growth. The low loan-to-value ratio for housing loans and the large unrealized capital gains in the equity participations provide a substantial buffer for credit institutions against potential declines in housing and equity prices, respectively.

33. Stress tests indicated that credit risk is important for some credit institutions, but does not seem to pose a threat to capital adequacy. The most severe scenario of sustained deterioration in credit quality during a three-year window resulted in average losses equivalent to 13 percent of Basel regulatory capital. Similarly, liquidity risk was found to be small and large credit institutions were found to have a well-diversified pool of funding sources.

34. The savings banks generally showed greater sensitivity to adverse shocks and scenarios. This reflects their larger holdings of industrial participations relative to assets and regulatory capital, larger exposures to mortgage loans and real estate developers, and the slightly lower quality of their loan portfolios relative to banks (see Appendix II, Table 15).

35. The relatively low impact of stress tests under adverse scenarios reflects the soundness of the system, but also the relatively mild intermediate macroeconomic effects in terms of the decline in GDP growth and rise in unemployment that resulted from applying the shocks to the BE’s macroeconomic model. To explore further the resilience of the system, the staff carried out an illustrative exercise in which employment and growth are assumed to decline in line with what was observed in the 1992-93 downturn (when housing prices also declined). This exercise resulted in average losses of 16 percent of regulatory capital, and for the 12 most affected institutions (holding about 12 percent of system assets), the Basel CAR fell to a range between 4 and 8 percent.

B. Insurance and Private Pension Funds

36. The Spanish insurance market is the tenth 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. Assets managed by the insurance sector amounted to €192 billion atend-2005 (Table 3), of which 61 percent corresponded to life insurers. The industry is characterized by a well-developed infrastructure, and a sound regulatory and supervisory regime.

Table 3.

Spain: Financial System Structure, 2000–05

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Sources: Bank of Spain, CNMV, and DGSFP at the Ministry of Economy and Finance.

37. The insurance industry is solvent and profitable (Table 4) with assets covering technical provisions some 15 percent above the statutory level, and a surplus of 158 percent in its solvency margin. Stress tests for the insurance sector (Appendix II) generally indicate that the system would be resilient to a wide range of shocks. Besides a favorable macroeconomic performance, several factors have contributed to the sound growth and resilience of the sector: (a) the strengthening of asset-liability management techniques; (b) the industry’s conservative investment portfolio; (c) the limited credit risk transfer from the banking to the insurance sector; and (d) a public insurance consortium (Consorcio de Compensación de Seguros), which has helped private insurers to deal effectively with extraordinary and catastrophic risk and facilitated the orderly exit of weak insurers.

Table 4.

Spain: Insurance Sector Financial Soundness Indicators, 2001-05

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Source: Ministry of Economy and Finance.

38. The high quality of insurance supervision by the DGSFP has contributed to the stability and growth of the sector. The regulatory framework has provided appropriate mechanisms for insurers to calculate both the technical provisions and capital requirements linked to the solvency margin. These standards have been strongly enforced by the DGSFP.

39. Parallel to the development of the insurance sector as an asset class, private pension funds have emerged as an investment option for households. Between 1995 and 2005, the value of private pension funds’ portfolios increased from a small base, €13 billion, to €73 billion at end-2005 (8.1 percent of 2005 GDP). Over the same period, the number of fund participants rose from 1.8 million to 9.3 million. The growth in contributions has been helped by demographics, including immigration and rising labor force participation and employment. Further development of private pensions appears to be limited by the large compulsory public pension system and the life insurance sector, which provide alternative sources of income to retirees. Reflecting the conservative nature of their investor base, pension funds appear to have followed relatively risk-averse investment strategies, and therefore do not present a systemic risk.

C. Capital Markets10

40. Spain has a well-developed and rapidly growing capital market, comprising a full range of institutions and markets. The most important vehicles are collective investment institutions (CIIs), which managed assets valued at €323 billion at end-2005 (Table 3), comprising securities and money market mutual funds. In recent years, the assets managed by small investment service firms and individual brokers have been declining in importance owing to increased competition from credit institutions and CIIs. The growth of CIIs can be attributed to the promotion of these schemes by credit institutions as they compete for clients; the further liberalization and integration of Spanish capital markets into the international economy; and the recent global environment of low interest rates, which has pushed investors to seek alternative products that offer higher returns. In the past five years, 12 to 14 percent of household savings have been placed in investment funds.

41. Several markets and trading platforms deal with financial instruments. Variable income instruments are traded in the four stock exchanges (Madrid, Barcelona, Bilbao, and Valencia). AIAF Mercado de Renta Fija, is the market for private fixed-income. Government debt is traded in the Mercado de Deuda Pública en Anotaciones (Annotated Public Debt Market) and the electronic platforms MTS and SENAF. The Market for Financial Futures and Options (MEFF) trades futures and options on bonds, interest rates, the equity index IBEX-35, and equities.

III. Financial Sector Supervision11

42. Overall, the FSAP found a high degree of observance of the principles dealing with effective supervision by the three regulatory authorities—the Bank of Spain, National Securities Market Commission, and the Directorate General of Insurance and Pension Funds (DGSFP). The main recommendations for strengthening the frameworks even further include:

  1. While the FSAP did not find any instances of interference, the need to strengthen the independence of financial sector supervisors emerged as a common theme. Presently, all the regulators require specific delegation of authority to issue norms, and major violations must be formally sanctioned by the Ministry of Economy and Finance (ME) and the Council of Ministers. Going through the chain of norms (law, royal decree, ministerial order, circular) delays action. Thus, strengthening the powers of the supervisors in those two aspects would enhance their independence, improving observance of international standards. This would also be inline with ongoing EU initiatives to expedite passage of financial sector regulations.

  2. Formal independence of the DGSFP is particularly constrained because it is directly part of the ME. The FSAP team has provided a note on several alternative institutional arrangements for a more independent insurance supervisory authority.

  3. Delegate regulatory and sanctioning powers over credit institutions on prudential matters, including licensing and delicensing, from the ME and the Council of Ministers to the BE.

  4. The assessment also found room for improving cooperation and coordination among regulatory agencies.12 While there is high-level cross-membership on the Boards of the BE and CNMV, this should be complemented by a fully fledged cooperation arrangement that provides permanent and continuous high-level coordination among the heads of the three supervisors.

  5. The 17 Autonomous Communities (regional governments) have some regulatory and supervisory powers over saving banks. The BE in practice has all necessary prudential authority over credit institutions (as ruled over the years by the Constitutional Tribunal). Given the ongoing reforms of Autonomous Communities’ Statutes, it is important that these unambiguously preserve the current sole responsibility and powers of State-level supervisors regarding prudential supervision and regulation of financial institutions. This would also help ensure consistency with the present trend in European and international markets towards avoiding fragmentation and enhancing harmonization

43. Despite their overall good performance and strong market orientation, savings banks occasionally have had to deal with outside attempts to influence their commercial operations. Moreover, their structure limits their capacity to raise capital. Though they issue financial instruments, which both provide finance and a measure of how markets evaluate their performance, they lack the additional market signal that the price of a share (or cuota participativa) would provide. Therefore, it is crucial to ensure that they benefit from strong governance and market discipline. Some important steps, such as reducing the ceiling on public sector representation on boards, have been taken to improve corporate governance of savings banks since 2002, but it is still too early to see their full effects.13 In this connection, staff welcomes the current work that the government is undertaking to improve corporate governance, which will include both banks and savings banks.

44. The following recommendations would further improve the competitiveness and governance of the savings banks:

  • Ensure that the regulations issued since 2002 on corporate governance are fully implemented, strengthening them if required.

  • Over time, promote new means to raise high-quality capital in case of need, such as the issuance of cuotas participativas to the market.

  • Allow savings banks to merge freely within and across Autonomous Communities, provided the BE has ruled favorably on the viability of the merged institution.

  • Reduce over time the public sector representation ceiling, currently at 50 percent.

Insurance supervision

45. Notwithstanding the generally high quality of insurance regulation and supervision, the following recommendations would strengthen it further:

  • Separate the insurance supervisor from the ME. Experience worldwide suggests that a separate independent agency (i) has greater operational flexibility to develop, implement, and enforce regulatory policy; (ii) is better ring-fenced against outside interference—conditional on an adequate structure and accountability of the agency’s governing board; and (iii) by providing budgetary independence, would have better and more flexible access to highly skilled experts than a government department

  • Establish clear responsibilities and minimum expertise for the boards of directors and senior management of insurance companies, including in the use and risks of derivatives.

Securities market supervision

46. As per the main securities law (Ley del Mercado de Valores—LMV), securities markets are supervised by the CNMV, an autonomous public entity. It has responsibility for supervising the conduct of business of investment service providers and market operators, the clearinghouse and its members, and for licensing and prudentially supervising asset managers and collective investment institutions. Its main aims are to ensure the transparency of markets and to protect investors.

47. The CNMV conducts off-site and on-site inspections on a well-planned basis and has also developed a system for real-time monitoring of trading on regulated markets to detect possible abuses. Off-site inspections analyze the periodic reports required of regulated entities. On-site inspections are conducted according to an annual plan focused on areas of potential risks in the sector. They include verification of the entity’s compliance with prudential requirements.

48. The assessment under the IOSCO principles for securities’ market supervision found that securities’ market regulation and supervision by CNMV is generally sound and of a high standard. Nonetheless, additional attention in some areas is recommended, including:

  • To make them less vulnerable to outside influence, appoint members of the CNMV board to longer, non-renewable terms. Presently board members are appointed for four-year terms, renewable once.

  • To ensure consistency of requirements and ongoing oversight, the BE should routinely consult with the CNMV whenever a credit institution applying for a license intends to provide investment services.

IV. Infrastructure

A. The Payment and Securities Settlement Systems

49. The Spanish payment system is fully integrated into the EU system. The single large-value interbank payment system—the Real-Time Gross Settlement System (Servicio de Liquidación del Banco de España—SLBE)—is connected to TARGET and is owned, operated, and controlled by the BE. A small-value payment system—the National Electronic Clearing System (Sistema Nacional de Compensación Electrónica—SNCE)—is operated by a private company (Sociedad Española de Sistemas de Pago) and overseen by the BE.

50. The assessment under the CPSS Core Principles found that all principles are observed by the SLBE. Nevertheless, a few recommendations have been made to improve the system further. In particular, the BE is encouraged to improve public accessibility to payment system information and the readability and transparency of its circulars. The SLBE procedures manual should give clearer guidance on the expected behavior of participants in emergencies—such as platform failures. Finally, statistics and reports on the BE’s oversight activities should be published periodically.

51. Securities transactions clear and settle through a national central securities depository and local securities settlement systems. The national central securities depository (known as Iberclear) consists of the Servicio de Compensación y Liquidación de Valores (SCLV) for securities other than public debt, and the Central de Anotaciones de Deuda del Estado (CADE) for public debt securities. Also, local securities settlement systems in Barcelona, Bilbao, and Valencia process transactions in securities listed only on the corresponding stock exchanges—mainly public debt of the Autonomous Communities.

52. The assessment of observance of the CPSS/IOSCO Recommendations for Securities Settlement Systems found that risks in the Iberclear securities settlement system are negligible, albeit minor improvements are feasible. There are still instances where the SCLV will credit securities to a buyer’s account even though the seller has failed to deliver the securities. (The authorities intend to correct this anomaly by mid-2006.) In addition, Iberclear should test its contingency plans and backup facility, as well as the participants’ backup sites, more frequently. Iberclear’s backup facility is 20 km from the main site and appears to rely on many of the same resources, which may represent a risk.

B. Dealing with Problem Financial Institutions

53. Current arrangements provide an effective framework for timely and orderly resolution of problem credit institutions. The BE relies mostly on moral suasion and the legal sanctions’ regime to elicit prompt corrective actions when problems emerge. The sanctions’ regime qualifies legal infractions as light, serious, and very serious. Penalties are tailored to the severity of infractions and range from private warnings to the revocation of banking licenses. The BE may impose sanctions to address light and serious infractions and recommend penalties to the ME in the case of very serious infractions. The revocation of a license rests with the Council of Ministers.

54. The law also establishes an extraordinary resolution mechanism, which may be activated with or without sanctions. In exceptionally grave cases, this mechanism enables the BE to appoint an official with veto powers over all the institutions’ operations (“interventor”) or to replace management and the board of directors.

Systemic liquidity and emergency liquidity support

55. In addition to standing facilities, the BE can provide emergency liquidity assistance to financial institutions, separately from the Eurosystem framework for monetary policy operations.14 When conducting monetary policy operations, the Eurosystem can only provide liquidity support to eligible counterparties whose financial soundness is one eligibility criterion, and the counterparty must provide adequate collateral. Rather, national central banks are responsible for financial stability, including providing emergency liquidity assistance to the credit institutions operating in their jurisdiction. If such assistance were to have significant euro area-wide implications the ECB’s Governing Council is to be consulted.

56. Like other central banks, the BE has deliberately kept some ambiguity about its emergency lending policies. It has provided general internal guidance on the conditions and circumstances under which decisions to extend discretionary liquidity support are made.15 However, this has not been disclosed.

Deposit insurance

57. The deposit insurance framework comprises three funds—for commercial banks, savings banks, and credit cooperatives—all operating under the same rules and procedures. Each fund covers up to €20,000 per depositor, the minimum threshold set by the EU. An umbrella agency administers the investment and use of the funds in accordance with statutory rules. The funds are governed by a board of eight members selected by the ME, four in representation of the BE, and four of the member institutions. The Deposit Guarantee Funds (FGDs) have a broad mandate; in addition to paying off insured deposits in failed institutions, they can contribute to the recapitalization of distressed banks under exceptional circumstances—under least-cost resolution rules—and at the direction of the BE.

58. In the few cases that the current deposit insurance framework had to be activated, it was effective. In the last 15 years, it has been used in cases affecting six banks and seven savings banks. For banks, various resolution mechanisms have been applied. For savings banks, deposit insurance operations have been exclusively to provide support to the institutions in the form of long-term low-interest loans; no payouts to depositors were necessary. For cooperatives, there are no reported cases of rescue operations by their FGD.

C. Accounting Standards and the Adoption of Basel II

59. Recent regulatory initiatives include accounting and reporting norms consistent with International Financial Reporting Standards (IFRS) and the adoption of Basel II guidelines. IFRS came into effect in Spain in June 2005 following the decision of the EC to adopt them.16 Implementation of Basel II is expected by 2007.

60. The larger Spanish credit institutions and the BE seem well prepared for the adoption of the Basel II credit and market risk framework. Much work has been done to collect the data and develop the models necessary for adopting the advanced internal ratings based (IRB) approach. The Spanish Confederation of Savings Banks (CECA) is developing a common risk management tool to facilitate cost sharing among its members. In most cases, models appear to be suggesting excesses of current capital, mainly because of lesser credit portfolio risks.17 This presents the authorities with the challenge of ensuring that models are thoroughly evaluated and validated. The BE is taking a conservative and measured approach to the implementation of international standards, to minimize the potential for undue reduction of capital or provisioning.

D. Transparency of Financial Policies

61. The evaluation of transparency of financial policies found a high degree of observance of the principles. Nevertheless, the assessment recommended a few improvements, including providing more extensive explanations on the objectives and operating procedures for banking supervision and making existing information on banking supervision more easily accessible on the BE’s website.

62. The Bank of Spain has already initiated an action plan to address the transparency recommendations. In the first phase, they will include:

  • Improving consistency between the Spanish and English versions of their web page.

  • Adding institutional information, such as the internal code of conduct for employees of the BE and the members of the Governing Council (Consejo de Gobierno) including their CVs.

  • Reorganizing and developing the website contents under bank supervision.

E. AML/CFT

63. An anti-money laundering and combating the financing of terrorism (AML/CFT) assessment was conducted by the Financial Action Task Force on Money Laundering (FATF) in September 2005. A draft mutual evaluation report will be considered for adoption by the FATF Plenary in June 2006. Once the report is adopted, FATF will forward a ROSC to the Fund which will subsequently be circulated to the Board for information.

F. Other Issues

64. A pyramid scheme scandal outside the financial sector was discovered in early May. Two firms encouraged small savers to purchase collectible stamps, promising them a better return than traditional investments. The stamps remained on deposit with the firm, which regularly paid the investor a guaranteed minimum return, apparently using the funds of new investors. Media reports put the number of affected small investors at more than 300,000 and the amounts involved at about €4–5 billion (0.4–0.5 percent of GDP). The activities of these firms are subject to consumer protection provisions included as clarified in the legislation on collective investments in tangible assets. Ongoing investigations also concern alleged money laundering. The authorities intend to review the operations and regulation of such firms, which fall outside the scope of financial sector regulators and supervisors.

ANNEX Observance of Financial Sector Standards and Codes—Summary Assessments

This annex contains summary assessments of five international standards and codes relevant for the financial sector. Given the size and importance of the financial sector in Spain, it was appropriate to assess observance of the main standards. The assessments have helped to identify the extent to which the supervisory and regulatory framework is adequate to address the potential risks in the financial system. The following detailed assessments of financial sector standards were undertaken.

  • The Basel Core Principles for Effective Banking Supervision (BCP), by Jorge Cayazzo (MFD) and Saul Carpio (U.S. Office of the Comptroller of the Currency);

  • The IAIS Insurance Core Principles (ICP), by Manuel Aguilera-Verduzco (Comisión Nacional de Seguros y Fianzas, Mexico);

  • The IOSCO Objectives and Principles for Securities Regulation, by Mohamed Ben Salem (Autorité des Marchés Financiers, France);

  • The Core Principles for Systemically Important Payment Systems (CPSIPS), by Marilyn Choy (Central Bank of Peru); and the Securities Clearance and Settlement Payment System (CPSSIOSCO—RSSS), by Larry Bergmann (U.S. Securities and Exchange Commission); and

  • The IMF Code of Good Practices on Transparency in Monetary and Financial Policies—Financial Policies, by Camilla Ferenius (Bank of Sweden).

In addition, FATF carried out an assessment of the AML/CFT standard.

The assessments relied on several sources including:

  • Self-assessments by the supervisory authorities;

  • Reviews of the relevant legislation, regulations, policy statements, and other documentation;

  • Detailed interviews with the supervisory authorities;

  • Meetings with the Bank of Spain, CNMV, DGSFP, Ministry of Economy and Finance, and other authorities; and

  • Meetings with financial sector firms and associations, and academics and constitutional lawyers.

Summary Assessment of Compliance with the Basel Core Principles for Effective Banking Supervision and Transparency of Banking Supervision

General

65. This section summarizes the assessment of the implementation by the BE of the Basel Core Principles as of November 2005. The assessment was conducted as part of IMFFSAP by a team that visited Spain during July and November 2005. It follows the Basel Committee’s methodology, and has been made on a qualitative basis using the assessors’ opinion as one of the main inputs. Evidence of supervisory practices and enforcement ability was based on an examination of key documents and discussions with BE senior staff. In addition, discussions were held with relevant government agencies as well as financial sector participants. The assessment team benefited from the full cooperation of its counterparts.

Main findings—summary

66. Bank supervision is effectively carried out by the BE and there is a high degree of compliance with the Basel Core Principles. The BE has developed an effective risk based supervisory prudential framework. This framework is underpinned by the BE’s longstanding professional credibility, recognized technical expertise and operational independence. These attributes enable the BE to have experienced supervisory personnel who maintain close supervision and effective communication with the industry. However, enhancements in some specific areas would be advisable.

67. The main findings of the detailed assessment of observance of the Core Principles (CPs) are stated under the following seven main groupings: (a) objectives, autonomy, powers, and resources; (b) licensing and structure; (c) prudential regulations and requirements; (d) methods of ongoing supervision; (e) accounting standards; (f) remedial measures; and (g) cross-border banking. Table 5 summarizes main recommendations to improve compliance with the Basel Core Principles.

Table 5.

Recommended Action Plan to Improve Compliance with the Basel Core Principles

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Objectives, autonomy, powers, and resources (CP 1)

68. At the national level the legal framework for regulation and supervision of credit institutions involves the Ministry of Economy and Finance (ME) and the Bank of Spain. In addition, each Autonomous Community is vested with legal authority to regulate and supervise CIs’ activities. The laws clearly articulate the responsibilities among the BE and the ME with respect to the supervision of the solvency, performance, and compliance with specific regulations governing CI. Additionally, each AC operates under its own legal framework, which in general provides ACs with licensing and sanctioning authority and power to oversee the activities of saving banks (cajas) and cooperatives headquartered in their respective jurisdiction, particularly with regards to corporate governance, consumer protection, transparency and dividend policies supporting social contributions (obra social).

69. In practice, coordination between the BE and the Autonomous Communities supervisory bodies appears to have worked smoothly overall. Looking to the future, eventual changes in the legal regime should clearly preserve the sole and exclusive roles of the BE in prudential oversight of financial institutions, avoid any possible inconsistency in the division of responsibilities, and enhance coordination of the supervisory bodies. This would help ensure that Spanish financial supervision is consistent with the present trend observed in European and international markets towards avoiding fragmentation and enhancing harmonization.

70. The BE has sufficient financial revenues to ensure the adequacy of resources to properly cover its operating expenses, including those required to fulfill supervisory and regulatory responsibilities. At the same time, current legal protection for supervisors provides an effective tool to shield supervisors from legal actions taken while carrying out their duties in good faith.

71. The current legal framework establishes the ME as the principal agency charged with issuing financial regulatory rules. The ME has delegated to BE the authority to issue regulations on specific areas, such as accounting standards and financial statements, certain solvency standards that are already largely specified in laws, and financial disclosure. Notwithstanding this delegation and the good cooperation among the agencies, there is a risk that the BE may be unable to respond adequately should there be conflicting interests between the institutional goals of the BE and the government, which could undermine BE’s supervisory independence. Consequently, the authorities should introduce changes to the current legal framework for banking supervision in order to transfer most regulatory powers currently under the ME to enable BE to promulgate prudential rules. Further, the authorities should consider granting the BE license revocation authority in appropriate circumstances.

Licensing and structure (CP 2–5)

72. The definition of banking activities and the proper use of the name “bank” are clearly established in the law. In addition, the requirements regarding licensing are complied with. Both the supervisory approach and the regulations in place ensure ongoing monitoring and foster proper control of CIs’ strategies and investment decisions. On-site examinations are designed to verify that regulatory limits are not exceeded and that the data submitted to the BE are accurate.

73. Given the ability that CIs headquartered in European Union members have to set up branches in other European Union members, the assessors encourage the BE to maintain a close relationship and coordination with other European supervisory agencies so as to ensure fit and proper test compliance when authorizing the entry of new CIs.

Prudential regulations and requirements (CP 6–15)

74. Prudential regulations and requirements are considered adequate and the BE is legally empowered to enforce them. Capital adequacy regulations in place provide a comprehensive prudential framework that not only adheres to international standards but also includes specifications that make it stricter in terms of capital composition vis-à-vis other developed countries.

75. Spain traditionally has applied very strong loan classification and provisioning rules, as well as strong compliance procedures. This is done through both off-site credit risk follow up, mainly by way of a comprehensive credit risk register system, and significant presence in banks through on-site examinations. In adopting both international accounting standards and Basel II guidelines the BE is following a measured approach to minimize the potential for undue reduction of capital and provisioning.

76. The assessors encouraged the authorities to consider whether current conflict of interest policy guidelines adequately address potential conflicts. In particular, conflicts of interest stemming from the possibility that bank directors or officers could also serve as directors in an industrial company in which the bank has ownership and to which the bank extends credit or provides other financial services may warrant further consideration.

77. Supervisory tools to secure CIs’ prompt corrective actions rely mostly on moral suasion. In this context, there is a need to further buttress moral suasion by making supervisory expectations on best banking practices more explicit. One alternative is for the BE to issue guidelines on best banking practices, particularly those that foster effective risk management. Such guidelines may help strengthen the effectiveness of the BE’s moral suasion since the industry will have greater appreciation of the BE’s expectations and supervisory judgments will be more transparent. Standards may help reinforce communication between the BE and supervised institutions, particularly when discussing the need for corrective measures to achieve sound practices.

Methods of ongoing supervision (CP 16–20)

78. The Spanish supervision system is intense in terms of ongoing monitoring of CI policies, practices, and risk control management. This is reinforced with regular on-site inspection. The BE’s off-site supervision activities effectively complement on-site examinations, through the preparation and dissemination of a comprehensive risk analysis that guides on-site examinations. The BE’s on-site activities, particularly in the largest institutions, provide an effective means of validating supervisory information.

Accounting standards (CP 21)

79. While BE can use its influence and sanctioning authority to cause the removal of unfit external bank auditors, the assessors encouraged the authorities to consider seeking direct BE authority to remove external auditors.

Remedial measures (CP 22)

80. The Law of Discipline and Intervention assigns sanction authority to the ME and BE on the basis of severity of infractions: ME imposes sanctions on the gravest offenses at the proposal of the BE, and the BE imposes sanctions in less severe cases. While the current framework appears to be working well, it would be advisable for the authorities to consider delegating further sanction power to the BE to bolster moral suasion and enhance its effectiveness in enforcing safe and sound practices.

Cross-border banking (CP 23–25)

81. The BE has adequate systems in place to collect information from home country supervisors and parent bank organizations and should continue to evaluate the effectiveness and quality of information obtained to support supervisory efforts.

Authorities’ response to the assessment

82. The Spanish authorities wish to thank the members of the IMF assessment team for all their work to produce this report. They welcome the assessment recognizes that the Spanish supervisory system has a high degree of compliance with the Basel Core Principles and that Bank supervision is effectively carried out by the BE.

83. On a number of issues, however, the Spanish Authorities wish to qualify the IMF experts’ view, in particular regarding the recommendation to change the current division of competences between the Ministry of Economy and Finance and the Bank of Spain to strengthen the supervisory tools of the Bank of Spain; and the observations and recommendations on the role of the Autonomous Communities in the supervision of the Cajas.

84. On BCP 1(3), the Spanish authorities wish to comment the IMF assessment. The Spanish authorities consider, first, that the current legal framework has demonstrated its efficacy along the years due to the good cooperation between the ME and the BE and, second, that it is better suited to achieve the goal of effective banking supervision. Currently, the competences of the ME and the BE are clearly delimited: the Ministry of Economy and Finance elaborates prudential rules and the BE enforces those rules. Therefore, it is the government through the ME who creates the legal framework for banking supervision and there are good reasons for that. Firstly, as there is no single financial supervisor (like the FSA or BaFin) in Spain, the ME is the only institution which has a global view of the three financial sub-sectors: banking, insurance and securities, whose regulations are closely interlocked. Secondly, the ME is also the institution responsible for negotiating the EU legislation for financial services through its presence in Council discussions of Level 1Directives and Regulations, and its presence in the level 2 Committees (Banking Advisory Committee, European Securities Committee and the European Insurance and Occupational Pensions Committee). Finally, it is justified that the ME is in charge of issuing financial regulation because it can balance the need for an efficient supervision of credit institutions and the economic needs of the market, so as to avoid overregulation. Therefore, the Spanish authorities consider that the institutional framework does comply fully with BCP 1(3).

85. Further on BCP 1(3) and also on BCP 22, the Spanish authorities wish to comment on the assessors’ recommendation to grant the BE license revocation authority and delegate from the ME to the BE further sanctioning authority for the gravest infractions. According to the Spanish legal system, the power to license and sanction credit institutions belongs to the public administration. Those duties are determined by law and have to be exercised by the public administration in conformity with legal provisions and public interest. The Bank of Spain does not belong to the Spanish public administration. The Spanish legal system allows the delegation of public duties to non public bodies, such as the Bank. As a result, the Bank of Spain has been vested with the power to impose sanctions for light and serious infringements, while the power to impose sanctions for very serious infringements is the Ministry of Finance’s remit. Even in those cases the role of the Bank is of paramount importance since it proposes the actual sanction that will be imposed by the Minister. The system just described, where the Ministry of Finance grants licenses to credit institutions and imposes very serious sanctions does not prevent the Bank of Spain from acting independently when supervising credits institutions. Therefore, the current state of affairs does not demand any change in the system to better serve the principles included in the Constitution and the efficient supervision of credit institutions thereof.

86. On the assessment of BCP 1(1), the Spanish authorities wish to comment on the notion put forward by the assessors that there is a risk of overlapping in the exercise of supervisory and sanctioning authority between the BE and the CAs. There, is in our view, no possibility of overlapping of the national and regional legal frameworks. The basic national regulation obliges all the Cajas and the first final disposition of the LORCA (ley 31/1985) defines what is basic in the field of prudential supervision and direction of the activity of the Cajas. The ME and the BE are thereby entrusted with the functions of discipline, inspection and sanctioning of the cajas on matters of their competence and, in particular, those regarding monetary and financial policy, solvency and safety.

87. Other aspects of the supervision of the cajas are also considered basic as long as (1) they are needed to ensure the effectiveness of the state competences, (2) they are connected with the State’s general economic policy, (3) they have an effect in the monetary sector, or (4) they are of a nature that requires the existence of only one decision center.

88. CAs can only establish additional measures in matters of their competence, i.e, those that are not reserved to the State. There is therefore no possibility of conflict as the supervision and sanction on solvency matters belongs exclusively to the State. Therefore, the Spanish authorities believe that Spain complies with BCP 1(1).

89. On BCP 13, the Spanish authorities consider that, inside the current regulation, there already are criteria that define what the entities must do to identify, measure, monitor, and control “Other risks.” Regarding credit risk in particular, these criteria are extremely detailed in Annex IX of Circular 4/2004. That is, Spain does not rely on “best practices” guidelines, since those “best practices” have been elevated to a normative rank. Regardless of that, the BE, through its different publications and public interventions, has made recommendations in this field, including the ones attached to the requests made to the entities.

90. On BCP 24, the practice of the BE relies on parent credit institutions providing information on its subsidiaries, thereby allowing for remote inspections. However, this does not rule out direct contact and the exchange of information with other supervisors.

Summary Assessment of Observance of IAIS Insurance Core Principles

General

91. The assessment of observance of the International Association of Insurance Supervisors’ Insurance Core Principles (ICP) took into account the review of the following aspects: (a) an extensive self-assessment prepared by the Dirección General de Seguros y Fondos de Pensiones (General Directorate of Insurance and Pension Funds, DGSFP) based on the new version of the IAIS Insurance Core Principles and Methodology; (b) the Comentarios a la Autovaloración de la Dirección General de Seguros y Fondos de Pensiones sobre los “Insurance Core Principles” de la IAIS (Comments to the Self-Assessment of the General Directorate of Insurance and Pension Funds on the IAIS Insurance Core Principles); (c) Ley de Ordenación y Supervisión de los Seguros Privados (Private Insurance Organization and Supervision Law, LOSSP); (d) Reglamento de Ordenación y Supervisión de los Seguros Privados (Private Insurance Organization and Supervision Code, ROSSP); (e) Ley de Mediación de los Seguros Privados (Private Insurance Intermediation Law, LMSP); (f) Ley de Contrato de Seguro (Insurance Contract Law, LCS); and (g) relevant secondary regulations (Real Decreto, órdenes Ministeriales, Consultas, Criterios and Instrucciones) on the insurance activity issued by the Ministers Council (Consejo de Ministros), Ministry of Economy and Finance (ME), and the DGSFP.

92. The assessment process was conducted from June 22 to July 1, 2005. It evaluated the observance of the insurance regulatory framework with respect to the IAIS ICP. It also included a revision of the effectiveness of the insurance supervisory agency (DGSFP), which is part of the ME. The assessment process involved discussions with officers of the ME and the DGSFP, and meetings with private sector representatives from both industry associations and insurance companies.

Institutional and macro prudential setting—overview

93. With net premium income in 2004 of €45.5 billion, the Spanish insurance market is the tenth largest in the world and the sixth largest in Europe. Its importance is higher in the non-life sector in which is the eighth largest market globally and the fifth in Europe, while in the life sector it ranks sixteenth internationally and eighth in the European area. In terms of penetration and density, Spain ranks relatively low compared to the premium income analysis. Spain presents a penetration index of 5.77 percent of GDP, being ranked twenty seventh globally and fourteenth in Europe. With respect to density (€1,080 per capita), it ranks twenty-fourth internationally and fifteenth in Europe.

94. The Spanish insurance market is innovative and increasingly competitive, with important participation of banks and cajas in the distribution of life products. At the end of 2004, the insurance sector comprised 330 insurance entities: 227 insurance companies that accounted for 81 percent of total premiums written; 44 mutual societies, 18.5 percent; and 59 social mutual societies, with only 0.2 percent market share. Overall, the Spanish insurance industry is solvent and profitable. By the end of 2004, assets covering technical provisions exceeded by 15 percent the statutory level and the solvency margin surplus was 158 percent.

95. The Spanish market has developed a strong infrastructure to enhance its functioning. From the private side, several organizations have been created to support market development. And from the government side, the Consorcio de Compensación de Seguroshas helped private insurers to deal with extraordinary and catastrophic risks, and has facilitated the orderly exit of troubled insurers.

96. Looking at the shocks that the international insurance industry has faced in the past years, the Spanish insurance sector has demonstrated its resilience. The effect of the reduction of interest rates and the adverse movement in the equity markets have been absorbed smoothly. Additionally, since 2000 the non-life sector has maintained a clear growth path. In the case of the life sector, after a slowdown in 2003, the market has also resumed growth. Besides the positive effect of macroeconomic fundamentals, there seem to be several factors that could contribute to a stable and sound growth of the market: (a) the strengthening of asset-liability management techniques as part of the regulatory requirements and market practices; (b) the limited impact of interest rate guaranteed life products; (c) the conservative structure of the investment portfolio of the industry; (d) the limited credit risk transfer activity from the banking to the insurance sector; and (e) the effective functioning of a compensation mechanism to deal with catastrophic and extraordinary risks.

97. In the years to come, authorities will face the challenge to implement the outcome of the EU Solvency II Project, specifically on risk management and stress testing. In addition, insurance regulatory and supervisory authorities will face the challenge of implementing new international accounting standards on insurance that will be produced as part of the project conducted by the International Accounting Standard Board.

Main findings

98. The regulatory and supervisory scheme on insurance is comprehensive and has demonstrated to be effective. The evaluation shows that the majority of principles are assessed as observed or largely observed.

99. Overall, insurance regulation and supervision in Spain relies on a clear legal framework which already considers the implementation of most of the EU Directives on insurance. Spain has a professional and reliable judicial system. Additionally, alternative mechanisms for the resolution of conflicts, such as private arbitration, are usually used. The accounting and auditing professions are well-developed in the country. In general, accounting and auditing rules are in line with internationally accepted practices. There is also an organized actuarial profession.

Supervisory authority

100. The insurance supervisory authority (the DGSFP, which is part of the ME) has no legal powers to issue secondary regulation that are binding on the industry. As the DGSFP is not an independent agency, there is no regulatory governance scheme in place. Among others, there are no explicit procedures regarding the appointment and dismissal of the head of the supervisory body.

101. The current institutional arrangement for insurance supervisions seems to create obstacles to allocate enough resources and in a timely manner, in accordance with the risks the supervisory authority perceives. For the same reason, the institutional arrangement under which insurance supervision is conducted does not provide the required resources to attract and retain highly skilled personnel and to develop all the necessary supervisory infrastructure and tools.

Corporate governance, internal control and risk management

102. In general, neither general Law nor Insurance Law establishes requirements on corporate governance for insurance companies. The existing regulation is applicable only to a limited number of insurers listed in the Spanish stock exchange.

103. The regulatory framework does not establish specific requirements on risk assessment and management for insurers to recognize the wide range of risks that they face and to assess and manage them in an appropriate manner.

104. In addition, the insurance regulatory framework does not require explicitly that insurers be required to have an internal control framework that includes internal auditing, risk management systems, assessment of outsourced functions and a clear responsibility of the board of directors. The insurance supervisory authority has a limited capacity to conduct on-site processes with respect to the existence and adequate operation of this kind of policies and systems.

Group-wide supervision

105. Even though the insurance supervisory authority has established formal mechanisms with the banking and securities supervisors to create a general framework for coordination and collaboration on financial conglomerates supervision, in practice these agreements are limited to exchange of information on a case-by-case basis. There is no evidence of group wide analysis or group-wide supervision of financial conglomerates from the insurance standpoint.

Market analysis

106. The insurance supervisory authority does not conduct regular analysis of market conditions to identify main trends, scenarios and issues that could have an impact on the development and financial position and stability of the market. In this sense, the supervisory authority does not require insurers to engage in market-wide systematic reporting, or to analyze and monitor particular market-wide events of importance for the financial stability of the insurance market.

Investments and use of derivatives

107. The current regulatory framework does not include the obligation for insurers to have in place an overall strategic investment policy approved and reviewed regularly by the board of directors. In the same sense, the regulatory framework does not require that oversight of, and clear management accountability for, insurer’s investment policies and procedures remain ultimately with the board of directors.

108. Additionally, there is no explicit requirement for the board of directors to satisfy itself that it has the necessary expertise to understand the issues related to the use of derivatives, and to approve and review periodically a policy on their use. In addition, regulation does not require explicitly that insurers have in place risk management systems and audit procedures covering the risks from derivatives.

109. The regulatory framework does not require explicitly that insurance companies implement audit procedures to ensure the timely identification of internal control weaknesses and operating system deficiencies on investment operations, including contingency plans.

Licensing and suitability of persons

110. The regulatory framework does not include, neither for licensing nor for ongoing operation, specific fit and proper requirements for actuaries that will be in charge of the technical management of insurers, and for the staff involved with investment activities.

Anti-money laundering, combating the financing of terrorism (AML/CFT)

111. The supervisory authority undertakes examinations of insurers on the compliance with the AML/CFT requirements established in the Law. However, insurance agents and brokers are not required by regulation to adopt AML/CFT measures.

Table 6.

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

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Authorities’ response to the assessment

112. The DGSFP appreciates the quality, precision and rigorous analysis carried out by the IMF mission and the assessor in connection with the IAIS Insurance Core Principles observance assessment. In general, the DGSFP shares the contents of the assessment. However, it considers necessary to comment on some specific aspects.

Principle-by-principle assessment: Principle 18

113. Regarding Principle 18 on risk assessment and management, it is stated that the DGSFP does not check, as part of its supervisory process, the existence and adequate operation of policies and systems on risk assessment and management. The above-mentioned statement does not take into consideration on-site inspections carried out, which include actions oriented to control and verify financial and non-financial risks. Inspection plans include specific references to that kind of evaluation. Moreover, the Inspection Manual, in its section on internal control and risk assessment, includes a questionnaire on risk assessment by insurers.

114. The responses given in the self-assessment questionnaire may have lead to confusion with respect to the absence of an analysis on risk aggregation and risk interrelation. When at the self-assessment it is stated that no checks are performed with respect to the effects of different risks aggregations, it aims to underline that, up to date, there is a lack of a system to weigh and quantify in a reliable manner the impact of diversification, aggregation and correlation of risks, in order to measure the effect of specific risks in the global risk position of an insurance entity. We understand that, in no way, does this situation imply that risk management systems of supervised insurers are not verified.

The following regulatory initiatives already under way, or about to be launched, aim at bringing current regulations in line with IMF recommendations following the assessment of compliance with IAIS principles:

Principle 6. Licensing

115. Among the requirements that insurance companies must meet in order to obtain licensing, the regulatory framework does not specifically require the appointment of an insurance actuary, nor does it specify the latter’s qualifications, because Spanish regulations assign responsibility for the management of an insurance company to its directors. Spanish law, however, requires insurance companies to have an insurance actuary at their disposal. For instance, Article 29.1 of the Private Insurance Organization and Supervision Regulations (ROSSP) requires that the technical provisions be certified by an insurance actuary; the insurance company must therefore choose an insurance actuary and be accountable for the appointed actuary’s actions.

Principle 7. Suitability of persons

116. With regard to the suitability of insurance actuaries and, in particular, the requirement concerning the fitness of these professionals, it should be noted that in Spain, insurance actuaries are university graduates; hence, their fitness is demonstrated by their possession of a bachelor’s degree (licenciatura) in actuarial and financial sciences, issued by the Ministry of Education and Science. As to the requirement concerning the propriety of insurance actuaries, it is understood that insurance company managers are responsible for verifying compliance with this requirement, bearing in mind that the company is responsible for their actions. A forthcoming legislative amendment will include the requirement of propriety for insurance actuaries, although the insurance company that appointed the actuary remains accountable for noncompliance with this requirement.

Principle 9. Corporate governance

Principle 10. Internal control

117. Consideration is being given to a draft amendment to the ROSSP that provides for the establishment, documentation, and maintenance, at all times, of internal control procedures adapted to the company’s organization. In line with the principle of proportionality, it is recognized that the procedures implemented must take into account the company’s size and risk exposure; that notwithstanding, the application of the principle of proportionality can never lead to situations in which insured persons are unprotected. The draft amendment provides that ultimate responsibility for establishing the aforesaid procedures rests with the board of directors, and that the insurance company’s management is responsible for implementing them. Internal control will include supervision of the procedures, to be exercised by independent expert staff from the supervised areas, and the assessment of internal and external risks to which the company is exposed. Contingency plans must be established in case circumstances arise that could jeopardize the company’s viability. Lastly, the draft amendment provides that an annual report, containing an assessment by the board of directors of the effectiveness of the internal control procedures in place, identifying problems, and proposing solutions, is to be submitted by the company to the supervisory body.

Principle 21. Investments
Principle 22. Derivatives and similar commitments

118. With regard to investments (Principle 21) and financial derivatives (Principle 22), the text in preparation establishes clearly that responsibility for formulating and approving the investment policy rests with the insurance company’s board of directors, which must ensure the identification, follow-up, measurement, reporting, and management of risk. With regard to the use of financial derivatives and structured products, it will be necessary to provide clear, written rules on the usable categories, purpose, maximum positions, and authorized counterparties. The rules must provide for a sharing of the authorization, execution, and control functions, and for periodic documentation of all activities.

Principle 28. Anti-money laundering, combating the financing of terrorism (AML/CFT)

119. Article 2.1 of the Regulations contained in Law No. 19/1993, of December 28, 1993, on measures to prevent money laundering, approved by Royal Decree No. 925/1995, of June 9, 1995, provides that insurance companies are accountable for the actions of individuals and legal entities acting as dealers or intermediaries for them, an obligation that also applies to insurance brokers.

120. Since insurance brokers are independent from the insurance companies, a forthcoming legislative amendment will propose to maintain the aforesaid accountability of the companies for the actions of their agents, and will provide that insurance brokers remain directly bound by legal obligations with regard to specific measures to prevent money laundering, irrespective of the insurance companies for which they carry out trading activities. The latter provision will require the amendment of Article 2.1 of the aforesaid Law, which enumerates the parties required to comply with the provisions of that rule.

Summary Assessment of IOSCO Objectives and Principles of Securities Regulation

General

121. Spain has modernized the legal structure for financial services through several amendments to the main founding Law 24/1988 on the Securities Market known as the Ley del Mercado de Valores (LMV). As amended by these laws, the LMV simplifies and consolidates the laws affecting financial market institutions and related products.

122. The CNMV is the main regulator of all firms and individuals related to the securities market, notwithstanding the exclusive prudential oversight of the Bank of Spain (BE) over credits institutions involved in securities dealing and the role of the Ministry of Economy in licensing. Consultation with the CNMV occurs when the credit institution intends to dedicate a significant part of its business to the provision of investment services.

123. While generally reflecting the features of a sound financial market regulation, the Spanish regulatory framework could be further strengthened by granting the CNMV additional oversight and sanctioning responsibilities and by reinforcing the institutional and operational independence of the CNMV.

124. The president, vice president, and non-executive members of CNMV’s Board are appointed for four-year terms, renewable once. To increase independence, appointments should be for a longer term than the present four years, and should be non-renewable. In addition, although no evidence was found of inappropriate political interference in the CNMV’s decision-making process, it is recommended that the appointment of at least some non-executive members of the Board be made, drawing from varied constituencies, for example, academia or the private sector.

125. With regard to operational independence, important regulatory powers such as adopting new regulations in key operational areas of the securities field as well as the power to grant and withdraw licenses and to sanction very serious infractions to securities regulations remain the responsibility of the ME. Although the current framework does not result in gaps in oversight or regulation, compliance with international standards would be enhanced by vesting the CNMV with the power to design and adopt secondary legislation which would then be promulgated by the executive authorities, the capacity to grant and withdraw licenses to regulated entities and products; and with the power to sanction on administrative grounds any infractions of the securities law and regulations

Information and methodology used for assessment

126. Several sources were used in making this assessment: the Principles themselves, the Methodology for Assessing Implementation of the IOSCO Objectives and Principles of Securities Regulation (Assessment Methodology), the IMF Guidance Notes and Templates, and various IOSCO reports referenced in the Assessment Methodology and the Principles.

127. The assessment is based on meetings and discussions with the ME; senior CNMV staff responsible for each of the functional areas addressed by the Principles; staff of the BE (with respect to their roles in the securities framework); BME Spanish Exchanges (Bolsas y Mercados Españoles); and selected asset management and investment firms (and the related professional associations) representing different scales and complexity of financial services activity. Selected material was reviewed for the assessment, including the above institutions’ annual reports; laws, regulations, and published guidance; statistics on operations; published information on issuers; official registries of licensed institutions; published information on regulatory actions; CNMV responses to the IOSCO questionnaires; and other material submitted by the CNMV during the course of the onsite portion of the assessment.

Description of regulatory structure and practices

128. CNMV’s Board and Executive Committee. The CNMV is an autonomous public authority governed by a seven-member board (Consejo)18 chaired by a full-time president. A permanent Executive Committee (Comité Ejecutivo), comprising the president, vice president and the three full-time members of the Board, prepare the board agenda and exercise delegated powers.

129. Consultative committee. The CNMV also has a consultative committee chaired by the vice-president as a non-voting member. The committee is composed of 17 members representing secondary markets, issuers, investors and three Autonomous Communities. The committee must be consulted on CNMV’s circulars, on the imposition of sanctions for very serious infringements, on the licensing, delicensing, mergers and takeovers of investment firms, and on the authorization and revocation of authorization of branches of investment of non-EU members states.

130. Scope of competence. The CNMV prudentially supervises investment services providers (ESIs), regulates public offerings and takeover bids, oversees the financial information related to securities and supervises the marketing and distribution of financial instruments. The CNMV has also responsibility for custodians of securities and of assets of collective investment schemes, for clearing and settlement systems and related custodians, without prejudice to the BE’s functions and its specific role with respect to payment systems.

131. Sanctioning powers. The CNVM has somewhat restricted sanctioning powers, that have to be exercised after the non-binding advice of its consultative committee. The CNMV can only sanction light or serious breaches of relevant laws and regulations. With regard to very serious infringements, the CNMV prepares a report on the case and proposes a sanction for the ME to impose. Potentially criminal acts must be referred to the Public Prosecutor. The CNMV board must inform the BE of any sanction that it intends to apply to a credit institution.

132. Licensing. Licensing (and withdrawal of licenses) of ESIs is within the remit of the ME upon proposal of the CNMV. The ME will also retain licensing and delicensing powers over (a) insurance companies upon proposal of the DGFPS, and (b) credit institutions upon proposal of the BE.

133. Coordination with the Bank of Spain. Coordination with the BE and the CNMV is organized, in the case of day-to-day operations, through inter-staff contacts, information sharing, several coordinated data bases and regular monthly meetings. The CNMV maintains a registry of credit institutions involved in providing investment services that is publicly available on its website. The information on credit institutions is updated daily from a flow of information from the BE. The registry also includes the tariffs and the typical contractual documents as filed with the CNMV.

134. Cross-membership arrangements. Cross-membership of the supervisory authorities also fosters cooperation and aims at reinforcing information-sharing mechanisms among financial regulators. Thus, the vice president of the CNMV is an ex-officio member of the board of the Bank of Spain, and reciprocally, the deputy governor of the Bank of Spain is a member of the CNMV Board. However, cross-membership on boards does not apply to the insurance supervisor. Regular meetings of the heads of the three financial sector supervisors could facilitate institutional links and add certainty to the information-sharing mechanism.

135. Market operators and clearing and settlement systems are monitored through protocols that are subject to review by the competent authority, and those protocols (and any powers or actions with respect to their infraction) are regarded as founded in contract law and not in public law. Power to impose penalties or fines, and to suspend or prohibit the participation of any participants in the markets is the responsibility of the CNMV and ME. Without prejudice to the disciplinary powers of the CNMV and ME, persons included within the scope of the BME regulations are also held liable for any infractions under the applicable employment or professional regime. The law applicable to securities is largely contained in the main LMV as subsequently amended by following laws and as further completed by a Royal Decree transposing both the market abuse and the prospectus directives in order to bring the Spanish framework fully in line with the European directives. Applicable law is also found in certain related legislation, such as company law, bankruptcy law, commercial law, property law, penal law, and administrative codes.

136. As a member of the European Community, Spain also recognizes credit institutions and investment firms that enter Spain from other European Economic Area jurisdictions in which they are authorized either by exercising a right of establishment or a right to provide cross-border services.

General preconditions for effective securities regulation

137. Overall, Spain appears to meet the preconditions for an effective regulatory framework for capital markets and the provision of financial services. Such preconditions assume the existence of a legal framework that supports the integrity of contract and property rights, a legal structure that recognizes the instruments traded in the market and the rules that facilitate their trading, a commercial and insolvency regime that facilitates the taking of collateral, the use of clearing services, and the enforcement of guarantees, sound company law that protects investors, laws that support the ability to identify and protect client assets, reliable and consistent accounting standards, and the confidence of the marketplace that the rules will be consistently and equitably enforced and can be applied notwithstanding the bankruptcy of particular market participants. These assumptions are further premised on the assumption that the judicial, administrative, and regulatory authorities will reliably honor and equitably apply the rule of law. Certainty as to the application of the law, and confidence in its equity, is fundamental to the reliable functioning of markets and market confidence.

Table 7.

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

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Authorities’ response to the assessment

138. The authorities broadly agree with the assessment and welcome the fact that the Spanish regulatory system has a very high degree of compliance with the IOSCO Objectives and Principles. They have the following comments:

  • Regarding Principle 1 (the responsibility of the regulator should be clear and objectively stated), measures will be taken in the near future to enhance the role of the CNMV when credit institutions intend to provide investment services.

  • Regarding Principle 2 (the regulator should be operationally independent and accountable in the exercise of its functions and powers), the authorities are aware of the importance of the process of designation of the board members. Current legislation does not impede board candidates to be drawn from the private sector or the academia. The LMV only requires them to be experts in the field of the securities markets. Hence the recommended plan of action is not relevant in this regard. Measures will be taken to lengthen the current four-year term of appointment of board members and make the term non-renewable.

    With respect to the possibility of adopting secondary legislation, the CNMV does in fact decide on the technical aspects of financial regulation. However, there are political decisions that can only be taken by the parliament and the government. In addition, there are advantages from the fact that the ME proposes financial regulation as it is the only institution that has an overview of the three financial sectors—banking, insurance, and investment services—whose regulations are closely interlocked. The ME is also the institution responsible for negotiating the EU norms for financial services through its presence in European Council discussions of Level 1directives and regulations, and its presence in the Level 2 committees (European Banking Committee, European Securities Committee, and the European Insurance and Occupational Pensions Committee). Finally, it is justified that the ME is in charge of issuing financial regulation because it can balance the need for an efficient supervision of credit institutions and the economic needs of the market, so as to avoid overregulation.

    With regard to sanctioning powers, it should be noted that under the Spanish legal system, the sanctioning power lies with the government, the only entity with democratic legitimacy to carry out that function. Therefore any delegation of this duty to non-governmental bodies, such as the CNMV, has to be carried out carefully. As a result, decisions on the most serious infractions are the responsibility of the ME. The CNMV retains a key role in those cases since it proposes the sanction.

  • The same argument applies to Principle 3 (adequate powers and resources of the regulator) where it is recommended that the CNMV grant licenses to investment firms. The power to grant licenses is of a public nature and therefore has to be carried out by the public administration in conformity with legal provisions and the public interest. In addition, it is the CNMV that proposes to the ME that a certain entity be licensed. Therefore, the present state of affairs does not pose any risk to the independence of the CNMV in the exercise of its duties nor to the adequate functioning of the system.

  • The authorities disagree with the assessment that Principle 8 (the regulator should have comprehensive inspection, investigation and surveillance powers) is “broadly implemented” rather than “fully implemented.” The issue at stake is whether the CNMV can in practice inspect regulated entities on an unannounced basis, even if this power is not explicitly mentioned in our law. Article 85 of the LMV gives the CNMVs weeping inspection powers and does not impose any minimum prior notice to the regulated entities. Consequently, the CNMV is authorized to carry out inspections without prior notice, as indeed it has done over the years on several occasions.

Sul Assessment of Core Principles for Systemically Important Payment Systems and Recommendations for Securities Settlement Systems

A. Payment Systems

General

139. The assessment of the Systemically Important Payment System (SIPS) in Spain against the Committee on Payment and Settlement Systems (CPSS) Core Principles covered one system: Servicio de Liquidación del Banco de España—SLBE (a Real-Time Gross Settlement System—RTGS). It did not assess Spain’s link to the Trans-European Automated Real-Time Gross Settlement Express Transfer system (TARGET).19

140. The methodology for the assessment was derived from the Guidance Note for Assessing Observance of Core Principles for Systemically Important Payment Systems (CPSIPS) of the IMF and the World Bank of August 2001. The assessment involved discussions with members of the staff of the Banco de España (BE) and meetings with commercial banks. The assessment was conducted during the FSAP mission to Spain in June-July 2005.

141. The assessment benefited from a self assessment by the BE and the assessment of the Euro Large-Value Payment System against the core principles published by the European Central Bank. It was based also on relevant laws and regulations of the BE and on information available on the website of the BE.

Institutional and market structure

142. The SLBE is the only systemically important payment system. The SLBE is a Real-Time Gross Settlement (RTGS) system owned, operated, and controlled by the BE. It is the Spanish component of the TARGET, and settles both domestic and cross-border operations.

143. Law 41/1999 of November 12 (the Settlement Finality Law) provides the general legal framework for the payment and securities settlement system. The law states their revocability and finality of payment orders and recognizes the legal validity of clearing agreements. It also establishes the procedures and consequences of legal insolvency, and covers clearing agreements, transfer orders, and the collateral deposited in the system. The law establishes expeditious proceedings for the execution of collateral in case of default. Insolvency proceedings do not have retroactive effects on payment orders or collateral that have been put through the payment system.

144. The BE regulates the SLBE through circulars, technical applications (aplicaciones técnicas), and communications. Circulars are published in the Official Gazette (Boletín Oficial del Estado) and at BE’s website.

145. The SLBE is an open system with participation of credit institutions established in any European Economic Area country, and investment service institutions that are subject to prudential supervision. Treasury departments of central and regional governments and clearing houses such as the stock exchanges and IBERCLEAR, that are subject to oversight, also participate in this system.

146. There are 184 direct participants (33 branches of foreign institutions) and 36 indirect participants in the system. Direct participants have to open a centralized account on the books of the BE (RTGS account) for the settlement of transactions, and can act both on their own behalf and on behalf of their customers.

Main findings

147. The BE is an important player in the payment system and has a well-established and cooperative relationship with the financial sector. Its role and responsibilities are clearly defined in the law, including the oversight function.

148. The legal framework is sound: the Settlement Finality Law is fully enforceable. Irrevocability and finality are clearly defined in the law and in the regulations of the system, and they are also ensured even in the event of insolvency of a participant. The relevant rules and regulations of the SLBE system are contained in a number of documents issued and modified by the BE. Although rules and regulations address all the relevant aspects of the system, they are contained in a number of circulars which are quite difficult to follow, so it is recommended that the BE consolidates its payment circulars to improve readability and transparency for participants. BE staff has indicated that efforts in this direction are in progress.

149. The infrastructure for clearing and settlement of payments is well-developed, modern, and functional. The SLBE has systems that offer protection against liquidity and credit risks, such as queuing mechanisms, intraday credit and bilateral and multilateral algorithms. The needs of the users are accounted for in the development of the payment infrastructure. The introduction of the liquidity reservation facility is an example of requirements fulfilled by the BE. However, the BE should monitor the use of this facility to avoid possible discrimination against certain payments that may have to wait until the end of the day to be settled and to make sure that it does not unduly prevent the central bank from debiting accounts during the day.

150. There are contingency plans to assure continuity in the SLBE. However, the procedures in the manual of the SLBE should give clearer guidance on the expected behavior of participants in case of emergency situations. For instance, the procedures in case of failure of the platform of a participant or the SLBE should be clearly established. Although the BE conducts regular testing of the contingency plan with the cooperation of system participants, it is recommended to establish that participants have in place clear internal policies and procedures, and carry out operating audits. A periodic review of the IT infrastructure by participants to avoid operational risks is recommended. The distance of the external backup center from the main site should also be evaluated to make sure that it is sufficient in case of events such as natural disasters or terrorism.

151. The BE complies with its oversight function to ensure the safety and efficiency of payment systems. Oversight is based on data analysis, the analysis of payment instruments and new developments and self-assessment under international standards, among other aspects. As a result of its oversight activities the BE produces statistics and reports. It is recommended that this material be disseminated and published periodically.

Table 8.

Recommended Action Plan to Improve Observance of the CPSS Core Principles 1/

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All CPSS principles were rated as observed. The recommended actions are relatively minor measures that could be taken to make the SLBE even more robust

Authorities’ response to the assessment

152. The authorities thank the IMF team and the assessor for all the work undertaken and welcome its assessment, with which it is in broad agreement. The minor shortcomings pointed out in the assessment, that do not prevent the full observance of the Core Principles, have been addressed by the authorities and appropriate measures are being implemented to tackle the issue in the first half of 2006. Given BE’s membership in the Euro system, some issues mainly to improve the payment system’s business continuity, are being tackled collectively.

B. Securities Clearance and Settlement Systems

General

153. As part of the Financial Sector Assessment Program, an assessment was conducted of the observance of the CPSS/IOSCO Recommendations for Securities Settlement Systems by the securities clearance and settlement infrastructure in Spain.

154. Prior to the mission, the CNMV made a thorough self-assessment of the Iberclear system, which was used as the basis for this assessment.

Scope of the assessment

155. The assessment covers Iberclear, the securities settlement system (CSD) for a broad range of securities, including public sector and corporate debt, and equities. Almost all securities (more than 99 percent) in Spain are dematerialized in Iberclear. The residual securities are immobilized in this CSD.

156. Iberclear operates two platforms for securities clearance and settlement:

  • SCLV for securities other than public and private debt. It provides delivery versus payment on a gross-net basis (model 2 DVP). The multilateral net positions on the cash side are settled in accounts at BE.

  • CADE for public and private debt securities. It provides trade-for-trade settlement (model 1 DVP). The cash leg is settled in accounts at BE.

Institutional and market structure

157. Capital markets in Spain are large and sophisticated. In terms of stock market capitalization, the Spanish exchanges ranked fourth in Europe in 2004 (after London, Euro next, and Deutsche Boerse); in terms of the value of bond trading in 2004, the Spanish markets ranked first in Europe. (Data source: World Federation of Exchanges, Annual Report and Statistics 2004.)

158. BME is the holding company for all of the Spanish markets and securities settlement systems. As such Iberclear is a wholly owned subsidiary of BME.

159. All stock exchange transactions are submitted to Iberclear as “locked-in” trades and settled via Iberclear’s systems. Transactions in public and private debt are submitted to Iberclear through electronic trading platforms and as over-the-counter trades between participants. The total value of all trades settled in Iberclear systems in 2004 was€82,798 billion: €1,505 billion in equities, and €81,293 billion in debt.

Regulatory structure and practices

160. The Securities Markets Act (Ley del Mercado de Valores—LMV) establishes the principles and contains the main provisions regarding clearance and settlement systems, including the creation of Iberclear. The regulation governing Iberclear was approved by the Ministry of Economy and Finance upon the advice of the CNMV. The CNMV is responsible for the supervision of Iberclear pursuant to Article 84 of the LMV. CNMV’s supervision over Iberclear and its participants includes oversight of their processes and activities, and review and approval of Iberclear’s bylaws and rules. Iberclear, in turn, supervises the activities of its participants. If Iberclear detects any circumstance that could indicate a violation of rules or deviation from the principles underlying securities market regulation, it will bring this immediately to the attention of the CNMV.

161. The BE also has a significant role in the oversight of the clearance and settlement system. This stems from its responsibility to prevent systemic risk in the financial system, and its responsibility for the payment system in which the cash portion of all securities transactions are settled. The BE is also a substantial user of Iberclear’s CADE system in conducting monetary operations and is the supervisor of credit institution participants in Iberclear.

162. The CNMV and the BE have cross-representation on each other’s board of directors, and the LMV directs CNMV and BE to coordinate their actions where their areas of authority overlap. In addition, the Director General of the Treasury General Directorate sits on the CNMV Board.

Information and methodology used for the assessment

163. The assessment was based on the self-assessment conducted by the CNMV using the CPSS/IOSCO assessment methodology for Recommendations for Securities Settlement Systems. Discussions were held with the CNMV, Iberclear, BME, Treasury, and some market participants. Relevant statutes, rules, regulations, audit reports, and business plans were also reviewed and discussed.

164. Although the self-assessment by the CNMV contained a discussion of the systems of MEFF Clear (the central counterparty for derivatives) in the context of Recommendation 4, it was decided to postpone the assessment of MEFF Clear until later in the year after CNMV performs a self-assessment using the CPSS/IOSCO Recommendations for central counterparties.

Main findings
Legal risk (Recommendation 1)

165. There is a consistent set of laws, regulations, and contracts that forms the legal foundation for clearance, settlement, and custody of securities. All relevant laws and regulations are publicly available. Customer assets are protected against the bankruptcy of Iberclear participants. Other key issues, such as dematerialization, netting, and securities lending arrangements are well regulated. All laws, regulations, and contractual arrangement sare fully enforceable.

166. Transactions submitted to the Iberclear systems are deemed to be irrevocable, and are final when settled in the system. Cancellations on the ground of the zero hour rule in the bankruptcy law cannot be raised against them retroactively. The legal structure supports the validity of delivery versus payment.

167. Potential conflicts of law are reduced by requiring all settlement agents to be Spanish participants. With regard to assets that may be held in other CSDs, Iberclear requires legal opinions on foreign and domestic law to address potential conflicts.

Pre-settlement risk (Recommendations 2-5)

168. Matching and confirmation are well established on the stock exchanges and electronic markets, as are trades in the over-the-counter market. More than 99 percent of trades settle on a rolling basis by T+3. Incentives are in place to achieve timely settlement, and settlement failures are closely monitored. There is an active securities lending market.

Settlement risk (Recommendations 6-10)

169. More than 99 percent of securities in Spain are dematerialized. The other securities, mostly private debt, are immobilized in Iberclear.

170. Iberclear realizes delivery versus payment in both systems that it operates. SCLV is a model 2 DVP system for all securities other than public and private debt. CADE is a model 1 DVP system for debt.

171. Final settlement occurs before or at the end of the day in both systems. Real-time finality can be achieved in the CADE system during the day.

172. Trades are irrevocable and unconditional from the moment that they are reported to the Iberclear system. The settlements of the trades are final at the moment that the securities are transferred on Iberclear’s books. All trades settle in central bank money.

173. Iberclear’s financial resources are sufficient to complete settlements in the case of default by its participant with the largest settlement obligation. Its guarantee fund collects collateral on the assumption that all buyers and sellers default on a single settlement day, assuming normal market conditions. No participant has ever defaulted on the cash side.

174. Iberclear is never exposed to principal risk, with a minor exception. While the SCLV platform is designed to avoid overdrafts in securities accounts, there are instances where SCLV will credit securities to a buyer’s account even though the selling participant has failed to deliver the securities. This creates a temporary short position in the selling participant’s account. Because of Iberclear’s risk control mechanisms, the potential loss has been negligible, however.

Operational risk (Recommendation 11)

175. Iberclear systems function well (99+ percent uptime), and there is a backup site, and fold-over to the backup site takes two hours. However, Iberclear has not tested its contingency plans with participants in the past year. Iberclear should test its contingency plans more frequently, including with participants’ backup sites. In addition, it should evaluate whether the 20 km proximity to the backup site is sufficient, and the actual independence of critical services (electricity, etc.) between the two sites.

Custody risk (Recommendation 12)

176. Customers are legally protected against the insolvency of Iberclear and its participants. Customer securities are required to be segregated from participant securities on Iberclear’s books, and these positions are reconciled daily. In the case of a participant’s insolvency, a customer can request that its securities be transferred to another participant. An investment compensation scheme covers obligations to customers up to €20,000. The entities authorized to hold securities in custody are subject to the supervision of the CNMV or the BE.

Other issues (Recommendations 13-19)

177. Iberclear is a wholly owned subsidiary of BME. However, processes are in place so that users are consulted and can make known their views about Iberclear policies and operations. Iberclear has a board of directors that represents its users, and who must be approved by the CNMV. It is recommended, however, that CNMV review the participation of its representative on the Iberclear board. The BME is in the process of becoming totally demutualized, which may complicate the governance structure.

178. Iberclear’s access rules are disclosed to all potential applicants, and are objective, asare the rules for termination of membership. While membership is open to non-Spanish firms, a participant must have an account at BE to settle transactions. Iberclear’s fees and penalties are published to members.

179. Information exchanged with participants currently uses proprietary formats that are not translatable into international formats. Iberclear is in the process of providing a common communication protocol that will employ international standards.

180. Supervision of Iberclear is well-established and rigorous. There is close cooperation between CNMV and BE. It is recommended that the Memorandum of Understanding between CNMV and BE regarding coordination of activities be made public. CNMV is also able to cooperate with foreign authorities regarding the conduct of market participants.

181. Iberclear has a number of links with foreign CSDs. In all cases, Iberclear obtains opinions of counsel on the relevant Spanish and foreign laws. In all links, only free-of payment transfers of securities are permitted, and no provisional transfers are allowed.

Table 9.

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

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Authorities’ response to the assessment

182. The Spanish authorities thank the assessor for his analysis and concur with his evaluation, but wish to make the following comments:

Recommendation 9

183. The rules of the clearing and settlement system prohibit participants from having debit balances and no participant has ever had a net overdraft. Bearing that in mind, possible, exceptional short positions that are temporarily held by private customers should not be confused with debit balances on the accounts of participants (namely, institutions participating in Iberclear), which are prohibited. In addition, it should be noted that the system does not recognize securities with economic and political rights in excess of the recorded totals for each issue.

184. Regarding the actions recommended for eliminating possible debit balances, it should be noted that the rules prohibit such balances on participants’ accounts. With respect to temporary short customer positions, the Iberclear Strategic Plan includes the T+3 repurchase mechanism, anticipated for the second quarter of 2006, which will totally eliminate these positions.

Recommendation 15

185. The composition of the TAC and its regular meetings guarantee that all direct participants have detailed information on Iberclear activities and projects. With respect to the customers of these participants, Iberclear is beginning to engage in more dissemination activity, in addition to the existing customer care procedures, whereby, on an ongoing basis, the different departments respond to inquiries by phone or through the mailbox on their website.

Recommendation 16

186. Since the IMF FSAP mission to Spain, there have been developments in at least partial compliance with the recommended actions. The “Unified Matching System” (SUC)—Transfers (03/07/05) and SUC—Loans (November 21, 2005), which use SWIFT communications based on ISO standard 15022, are already on stream. In addition, the third part of this project (SUC—Fixed Income), which is structured in three stages (the first of which was published on February 8, 2006), is scheduled to take effect over the first semester of 2006. Therefore, the requirement for using international communication standards is already over 75 percent implemented.

Recommendation 18

187. Since the IMF FSAP mission to Spain, there have been developments in at least partial compliance with the recommended actions. On September 22, 2005, the CNMV Executive Committee approved the work plan for conducting an on-site supervision mission to Iberclear, which began on October 19, 2005, with the collaboration of Banco de España. The basic purpose is to verify compliance with the functions assigned to Iberclear in the standards, including its supervisory functions.

Summary Assessment of Observance of the Code of Good Practices Ontransparency in Monetary and Financial Policies

A. Transparency of Financial Policies: Banking Supervision

General

188. The assessment of transparency in banking supervisory policies covers primarily the Bank of Spain (BE); other agencies with responsibilities in bank oversight (the Ministry of Economy and Finance—ME—and the Autonomous Communities—ACs) were also examined with a focus on transparency in the institutional framework.

Main findings

189. Spain follows high standards of transparency in its banking supervisory policies. The BE has taken several initiatives over the last five years to enhance transparency, leading to observance of almost all the practices of the Code of Good Practices on Transparency in Financial Policies. While room for further refinement exists with regard to both clarity of objectives and public communication, these are improvements at the margin.

Clarity of roles, responsibilities, and objectives

190. The legal and institutional framework for banking supervisory policy is defined in several legal texts, at both the national and regional level. The law clearly articulates the responsibilities of the BE and the ME with respect to banking regulation and supervision; the ACs’ role in the supervision of savings banks is defined under each Community’s statute. There is some room to enhance transparency with respect to savings bank oversight, as overlapping national and regional legal frameworks can create uncertainty on the respective authority of the BE and the ACs.

Open process for formulating and reporting policies

191. There is a high degree of openness in the process of formulating and reporting banking regulation and supervision policies. The BE publicly announces and explains significant changes in financial policies through a variety of means, including the Annual Report, the web site, information notes, monthly publications and press releases. For proposed substantive technical changes to the structure of financial regulations, there is a presumption in favor of public consultations. The legislative framework requires processes of public debate and specific negotiations, with consultations with affected sectors.

192. There is scope for strengthening transparency in the relationship between the BE and other financial agencies. Bilateral memoranda of understanding on information sharing and consultation between the BE, the CNMV, and the DGSFP exist but only their existence, not their content, has been made public.

Public availability of information

193. The BE maintains a comprehensive public information program. It disseminates policy decisions and policy announcements, provides information on the operating framework and functions, publishes texts of major speeches by senior officials, data, and research reports, arranges seminars and maintains the contact with the media. Senior financial agency officials are ready to explain the objective(s) and performance to the public, and have a presumption in favor of releasing the text of their statements to the public. The BE website is available in both Spanish and English. The English version of the site, however, could be updated more regularly. General information on supervisory policies would also be more easily accessible if posted on the banking supervision section of the website.

Accountability and assurances of integrity

194. Transparent mechanisms for accountability and assurances of integrity of the BE have been put in place. These include regular appearances before Parliament and parliamentary committees; attendance as required of cabinet meetings and meetings of the Council of Fiscal and Financial Policy of the Autonomous Communities (Consejo de Política Fiscal y Financiera de las Comunidades Autónomas); and regular reporting through the Annual Report. Internal governance procedures necessary to ensure the integrity of operations, including internal audit arrangements, as well information about legal protections for officials and staff of financial agencies in the conduct of their official duties, are publicly disclosed through the Annual Report and the website. The BE has a Code of Conduct, which should be made publicly available to ensure transparency.

Table 10.

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

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Authorities’ response to the assessment

195. The authorities are in broad agreement with the assessment. However, as regards cooperation with the ACs (point 5.2), they note that the State and the ACs have regulatory, supervisory and sanctioning powers within their corresponding areas of responsibilities, and no overlapping arises between the national and the regional legal framework. Each AC operates under its own legal framework. At the same time, the laws clearly articulate the responsibilities of the BE and ME with respect to the supervision of the solvency, performance, and compliance with specific regulations governing credit institutions.

B. Transparency of Financial Policies: Securities Markets Supervision

General

196. The assessment of transparency in securities markets oversight covers the National Securities Market Commission (Comisión Nacional del Mercado de Valores—CNMV).

Main findings

197. The transparency of the CNMV compares well with international standards. The CNMV has taken several initiatives to enhance transparency. For instance, it publishes an Annual Report on the Securities Markets as well as a separate Annual Report on supervision activities. There remains some scope for enhancing its public communications program.

Clarity of roles, responsibilities, and objectives

198. The roles, responsibilities, and objectives of the CNMV are clearly defined in the Securities Market Law and discussed through various media. The law also outlines the broad modalities of accountability; procedures for appointment, terms of office, and any general criteria for removal of the heads and members of the governing bodies; and the framework for the relationship with other financial agencies.

Open process for formulating and reporting policies

199. There is a high degree of openness in formulating and reporting securities markets policies. The CNMV publicly announces and explains significant changes in financial policies through the Annual Report, the website, and press releases. The CNMV’s Annual Report on Activities discusses its functions, activities, and procedures, and includes an internal audit report. For proposed substantive technical changes to financial regulations there is a presumption in favor of public consultations. Transparency could be enhanced in the procedures for information sharing and consultation with other Spanish financial agencies, as formal agreements exists but their text has not been released to the public.

Public availability of information

200. The CNMV maintains an active public information program. This includes a website in both Spanish and English, an Annual Report on Activities, an Annual Report on the securities market, market studies, statistical information on market entities, a weekly bulletin, public events such as seminars and conferences, relations with the press, an Investor Complaints Service, and an extensive program of investor education. CNMV officials are ready to explain their institution’s objective(s) and performance to the public, and do so in various speeches. However, there is no presumption in favor of releasing the text of their statements to the public.

Accountability and assurances of integrity

201. Transparent mechanisms for accountability and assurances of integrity exist for the CNMV. The CNMV is required by law to present a report on its activities and on the situation of the organized financial markets to the Parliamentary Committee on Economics, Trade and Finance, and the CNMV President to appear before such a committee to discuss the report. Internal governance procedures necessary to ensure the integrity of operations, including internal audit arrangements, as well as information about legal protections for officials and staff of financial agencies in the conduct of their official duties, are publicly disclosed through the annual report and the website.

Table 11.

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

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Authorities’ response to the assessment

202. The authorities are in broad agreement with the assessment, and a number of measures have already been adopted in line with the recommended plan of action:

  • (6.1.3) Documents providing interpretation of CNMV rules have been posted on the website (Criterios en el Ambito de la Autorización y Registro de los Fondos de Inversión and Criterios sobre la Aplicación de la Nueva Normativa de Mercados Primarios).

  • (6.3) A new section of CNMV’s website (comunicaciones) is being set up which will contain, among other things, the speeches and statements of CNMV’s senior officials.

203. The authorities are also considering options to publish the text of existing MoUs with other national authorities (6.1.5), CNMV’s internal procedures (6.1.1), and the notes to the financial statements (8.2.1).

C. Transparency of Financial Policies: Deposit Insurance

General

204. The assessment of transparency in deposit insurance policies covers Spain’s three Deposit Insurance Funds (Fondos de Garantia de Depósitos—FGDs)—one for banks, one for savings banks, and one for credit cooperatives. The FGD Management Company (AIE) was established in 2000 to manage and administer the funds’ capital.

Main findings

205. Deposit insurance policies are broadly consistent with good transparency practices. Annual reports are issued for each of the three funds as well as the Management Company. Transparency would benefit from a more proactive approach to public information, notably with regard to accountability and assurances of integrity.

Clarity of roles, responsibilities, and objectives

206. The roles, responsibilities and objectives of the deposit insurance are clearly defined in the law and further described in the funds’ annual reports and website. The law also outlines the broad modalities of accountability; procedures for appointment, terms of office, and any general criteria for removal of the heads and members of the governing bodies and the framework for the relationship between financial agencies.

Open process for formulating and reporting policies

207. FGD policies, including annual contributions by member institutions and bank resolution policies and procedures, are publicly available and well explained. The system for the protection of deposits and other insured assets is disclosed in the relevant laws and regulations and on FGD’s website. Formal procedures for information sharing and consultation with other financial agencies are also available on the website.

Public availability of information

208. Extensive information on deposit insurance is available through the website and the annual reports. In addition to the financial statements, the annual report includes an update on bank restructuring activities, payoffs, and other statistical data. The FGD website is available in both English and Spanish. The office responds via e-mail, fax or telephone to any question by the general public related to the mandate of the FGD. Senior officials of the FGD have the authority to explain their policies, objectives and performance to the public. This has not occurred in practice, however, other than through the website, because no perceived need for doing so has arisen.

Accountability and assurances of integrity

209. A formal policy on public communications by senior FGD officials, including their appearance before parliament, would enhance transparency. No specific rule requires the appearance of FGD officials before designated public authorities to report on the funds’ activities and performance. More transparent accountability rules would be especially relevant in the event of bank restructuring actions by the FGD.

210. Information on FGDs’ internal governance procedures could also be enhanced. Given the reduced size of their administrative units, the funds do not have an internal audit. Internal governance procedures are not made public, and information on standards of conduct of personal financial affairs is not publicly disclosed by means other than legislation. Better information on internal governance procedures would be particularly important due to potential conflicts of interest of financial institutions’ representatives in FGD’s management committees.

Table 12.

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

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Authorities’ response to the assessment

211. The authorities are in broad agreement with the assessment but note that with reference to principle 7.4.2, they do not see a need to be more proactive in providing public information on deposit insurance because by law, the banks are obliged to do so. They point out that the cost of providing additional information to the public would be high in relation to its benefits. The authorities agree that in general, a well designed information program can enhance public confidence in credit institutions, but note that in the case of Spain, public confidence is already high and the launch of an information program on deposit insurance could have the opposite effect, that is, weaken confidence.

212. With regard to principle 8.1, the authorities are of the view that since the President of the FGD Management Company is the BE Deputy Governor, the BE has sufficient information about the funds that can be used as needed during appearances before parliament. The authorities consider the possibility of differences in opinion between the FGD and the BE on bank restructuring issues to be theoretical, as four of the eight members of the Management Committee are BE representatives, and the President, who is the BE Deputy Governor, has a deciding vote.

213. Regarding public disclosure of internal control regulations (8.2.2), the authorities are of the view that the composition of the governing bodies of both the funds and the Management Company ensure the transparency of, and control over, their actions.

D. Transparency of Financial Policies: Payment Systems Supervision

General

214. This assessment relates to the transparency of BE policies with respect to payment systems oversight. It encompasses Spain’s contribution to the oversight of pan-European systems such as TARGET, Clearnet, and Euroclear, as well as the oversight of purely domestic systems such as the SLBE for large-value payments and the SNCE for low-value payments for which the Bank of Spain bears sole responsibility.

Main findings

215. The BE adheres to almost all transparency practices with regard to payment systems oversight. Several initiatives have been taken in the last five years to enhance transparency. For example, the BE issues occasional payment system articles in the biannual Financial Stability Review and has an informative and up-to-date payment systems section on its website. Some room for further refinement exists with regard to public communication.

Clarity of roles, responsibilities, and objectives

216. The objectives, functions, and responsibilities of payment system oversight, as well as the authority to conduct financial policies, are detailed in the law. The objective to promote the smooth functioning of the payment system through efficiency and security is recognized in both national and regional legislation. The law also outlines the broad modalities of accountability; procedures for appointment, terms of office, and any general criteria for removal of the heads and members of the governing bodies and the framework for the relationship between financial agencies.

Open process for formulating and reporting policies

217. There is a high degree of openness in the process of formulating and reporting payment systems oversight policies. The BE publicly announces and explains significant changes in financial policies through a variety of means, including the Annual Report, the web site, information notes, monthly publications, and press releases. For proposed substantive changes to relevant regulations there is a presumption in favor of public consultations. The legislative framework requires processes of public debate and specific negotiations, with consultations with affected sectors. In addition, the payment system decisions are discussed with the involved financial entities (about 20 member banks and the three associations) in a high level payment systems group, chaired by the BE Director General, that have met regularly (twice a year) for about three years.

Public availability of information

218. The BE maintains a comprehensive public information program. It disseminates policy decisions and policy announcements, provides information on the operating framework and functions, publishes texts of major speeches by senior officials, data, and research reports, arranges seminars and maintains the contact with the media. Reporting on major developments with regard to payment systems, however, is not on a regular basis. Senior financial agency officials are ready to explain the objective(s) and performance to the public, and have a presumption in favor of releasing the text of their statements to the public.

Accountability and assurances of integrity

219. Transparent mechanisms for accountability and assurances of integrity of the BE have been put in place. These include regular appearances before Parliament and parliamentary committees; attendance as required of cabinet meetings and meetings of the Consejo de Política Fiscaly Financiera de las Comunidades Autónomas. There is no periodic reporting on payment systems oversight, however, since the Annual Report describes the operation of payment systems but not oversight activities. Internal governance procedures necessary to ensure the integrity of operations, including internal audit arrangements, as well as information about legal protections for officials and staff of financial agencies in the conduct of their official duties, are publicly disclosed through the Annual Report and the website. The BE has a Code of Conduct, which should be made publicly available to ensure transparency.

Table 13.

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

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Authorities’ response to the assessment

220. The authorities are in broad agreement with the assessment. Appropriate measures are being implemented to tackle the recommended action plan.

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.

APPENDIX II Stress Tests for Credit Institutions and the Insurance Sector

Credit Institutions

225. In coordination with the FSAP team, the BE and a group of systemically important credit institutions carried out several stress test exercises.21 The stress tests were designed to assess the resilience of the banking system to key risk factors, and covered market risks, interest rate risk, credit risk, and liquidity risk.22 A variety of techniques were used, including sensitivity analysis to single and combined risk factors, and scenario analysis. The scenario analysis considered four adverse cases: (a) an increase in oil prices to US$80per barrel; (b) a two-year cumulative drop in real house prices in Spain and the United Kingdom, by 21 and 28 percent, respectively; (c) a 30-percent depreciation of the U.S. dollar against other currencies; and (d) a crisis in Latin America, which entailed a political crisis ina key country, transmitted to other countries in the region (to which Spanish banks are exposed) via turmoil in capital markets and international contagion.23 Cross-sector risks were assessed through parallel stress tests on a sample of insurance companies, and the results added to those of their related credit institutions.

226. Core stress tests were conducted by a sample of systemically important credit institutions using their own internal models (bottom-up approach), while applying the same methods and shocks. The sample covered the seven largest financial groups, comprising 37 institutions and roughly two-thirds of system assets. These banking groups have been identified as candidates for the implementation of IRB models under Basel II, and involve all the risks arising from the overseas exposures and the bulk of market risks in foreign currencies.

227. Complementary stress tests on key sources of risk were conducted by the authorities and the FSAP team for credit institutions as a group (top-down approach). These exercises covered credit risk, liquidity risk, and equity-price risk in the banking book. Emphasis was placed on the assessment of risks associated with credit institutions’ exposures to the domestic housing market.

228. Equity price risk from industrial participations held in not-for-sale portfolios by the larger credit institutions was found to be sizeable but not a threat to capital adequacy due to large unrealized capital gains. An exercise based on a sample of 19 credit institutions representing roughly 80 percent of system assets, indicated that a 30-percent decline of equity prices would generate losses equivalent to 8.6 percent of regulatory capital (14.3 percent for the sampled savings banks). Large unrealized capital gains at current market prices in most systemically important credit institutions offer a margin against an eventual decline in equity prices. Nevertheless, six banks and four savings banks jointly accounting for 37 percent of assets in the sampled institutions would incur a net loss, even after taking into account unrealized gains, with an average impact of 5.4 percent of regulatory capital (13.3 percent in the worst case) (Table 6). Equity price risk in the trading portfolios was negligible because of their small size.

229. Credit risk was found to be important for some credit institutions, but did not seem to pose a threat to capital adequacy. Sensitivity analysis for credit risk based on an increase of the probabilities of default (PDs) of mortgage and commercial loans by 200 and 100 percent, respectively, from their end-2004 levels indicated that all of the systemically important credit institutions would be able to absorb the losses without falling below the required minimum 8 percent Basel CAR. A more severe scenario of sustained deterioration in credit quality during a three-year window was also considered, exploiting information on loan quality during the economic downturn of the early 1990s. Shocks to the PDs of specific portfolio categories were set to their average values during 1992-2004 plus two standard deviations, and losses given default (LGDs) were stressed to capture their typical deterioration during the downturn of the cycle.24 resulted in average losses equivalent to 13 percent of Basel regulatory capital. Such a shock would result in a decline in the average CAR of a sample of the larger CIs, from 12.7 percent at end-2004 to 11.0 percent. Four credit institutions representing 5 percent of system assets would see their CARs drop to around 7 percent.

230. Estimates of credit risk associated with the scenarios showed that the system would also be resilient to falling house prices, rising oil price, depreciation of the U.S. dollar and a crisis in Latin America. Among these estimates, the largest effect would come from a drop in house prices in Spain, as assessed by the FSAP team using dynamic panel models. Average estimated losses would be equivalent to 11 percent of CAR with a maximum of 27.4 percent. The effects were generally larger for the savings banks, reflecting their relatively larger exposures to mortgages and construction loans. The losses associated with an oil price increase would average less than 7 percent of regulatory capital and those with a depreciation of the U.S. dollar 5 percent of regulatory capital. Losses estimated by the participating credit institutions and BE in the event of a crisis in Latin America were less than 1 percent of regulatory capital.

231. Liquidity risk was found to be small and the large credit institutions have a well diversified pool of funding sources. An exercise to assess liquidity risk at the system level indicated that all maturing liabilities within a month plus 20 percent of demand deposits can be covered by projected sources of funds and available fixed income securities, while variable income securities provide an additional cushion. In addition, an innovative exercise designed by Bank of Spain indicated that the systemically important credit institutions have in place contingency liquidity plans that would allow them to cope with a withdrawal of 39 percent of their maturing time deposits and 10 percent of their demand deposits within a month, without cutting back their normal operations, even if they were to lose access to the interbank market. For some of those institutions, however, the contingency plans relied heavily on the issuance of covered bonds, a strategy that could entail risks should market sentiment or liquidity conditions deteriorate on a more systemic basis, especially given Spain’s increasing dependence on capital inflows, the size of the current account deficit, and views about the behavior of the housing market in Spain.

232. Market risks for the systemically important credit institutions were negligible, reflecting the small size of their trading portfolios and the active use of risk limits and controls by the large credit institutions. (On average, the trading portfolios of the participating credit institutions amounted to about 6 percent of their assets.) Most credit institutions have hedged their interest rate and exchange rate risk. Interest rate risk in the entire positions of systemically important credit institutions was also found to be small, in part reflecting the predominance of loans at floating rates.

Insurance sector

233. Stress tests within the insurance sector, conducted by 27 insurers, covering 50 percent of the non-life market and 62 percent of the life market, showed that the system is resilient to a wide range of shocks. Nevertheless, there were differences between life, non-life, and mixed insurers:25

  • The first set of stress tests incorporated shocks similar to those applied to credit institutions. For the sector as a whole, the largest impact would come from a fall in real estate prices of 17 percent, which would reduce insurers’ capital (i.e., share holders’ equity) by 5.6 percent. For life insurers, the largest impact would come from a downward parallel shift of the yield curve by 200 basis points, which would reduce capital by 25 percent. For non-life insurers, the largest impact would come from a parallel shift upward of 200 basis points in the yield curve, which would reduce capital by 10 percent (a large share of assets is in fixed-income securities, such as treasury bonds). For mixed insurance companies, the real estate shock would have the greatest impact on capital.

  • The second set of stress tests dealt with insurance-specific risk factors. For the sector as a whole, the largest impact on capital (a decrease of 4 percent) would come from underwriting risk (a 15-percent shock to mortality or survival rates). For life insurers, the largest impact on capital (a decrease of 18 percent) would result from an increase of 15 percent in the mortality rates. For non-life insurers, the largest impact on capital (a decrease of 7.3 percent) would result from a 10-percent increase in the average claim in the case of “mass events.”26 For mixed insurance companies, the largest impact on capital (a decrease of 1.3 percent) would come from an increase in the average claim for peak events.

Table 14.

Spain: Stress Tests for Credit Institutions, Sizes of Shocks

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Sources: Bank of Spain, and IMF staff estimates.Sensitivity analysis to multiple risk factors was also considered, entailing a combination of the shocks marked with (*).

Applied to trading portfolios (i.e., actively traded assets and liabilities).

For British pound exposures, the shock to volatility of long term interest rates was set to 25 b.p.

The increase in corporate bond spreads was as follows: 15 b.p. for corporate bonds rated AAA through A; 100 for bonds rated BBB; and 300 b.p. for bonds rated below BBB.

Table 15.

Spain: Summary of Stress Test Results for Credit Institutions 1/

(In percent)

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Sources: Bank of Spain and staff estimates.

Unless otherwise indicated, the stress tests were applied to a sample of seven banking groups covering 37 credit institutions and roughly two-thirds of system assets (“Participating CIs”), to the entire banking system using aggregate data (“Total system), and to a sample of 86 credit institutions covering 94 percent of system assets (“Total system”).

Applied to 10 credit institutions (roughly one-third of system assets) with insufficient unrealized gains to cover the equity losses implied by the shock to equity prices. Losses are net of unrealized gains on equity investments not marked-to-market.

Applied to the equity portfolios not marked-to-market of a sample of 19 credit institutions covering roughly 80 percent of system assets. Based on a three-month 99.5 percent VaR.

Losses are in deviations from the baseline scenario.

The multiple factor sensitivity included: an increase, positive tilt in interest rates in euro and U.S. dollars (30 b.p.; 100 b.p.), an increase, negative tilt in British pounds (100 b.p.; 30 b.p.), and a 30 percent across-the-board drop in equity prices.

Based on the Basel CAR definition, which includes the statistical provision as part of own resources.

For comparability with other FSAPs, the impact on after-tax profits does not take into account the available statistical provisioning fund, described in Appendix I. If the results took the fund into account, the effect on after-tax profits would be smaller.