Front Matter Page

© 2013 International Monetary Fund

July 2013

IMF Country Report No. 13/205

Spain: Financial Sector Reform—Third Progress Report

This paper was prepared by a staff team of the International Monetary Fund. The paper is based on the information available at the time it was completed in July 2013. The views expressed in this document are those of the staff team and do not necessarily reflect the views of the government of Spain or the Executive Board of the IMF.

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Front Matter Page

SPAIN

Financial Sector Reform: Third Progress Report

July 2013

Prepared by Staff of the

INTERNATIONAL MONETARYFUND^*

Preface

Spain is undertaking a major program of financial sector reform with support from the European Stability Mechanism (ESM). On June 25, 2012, Spain requested financial assistance from the European Financial Stability Facility (EFSF) to support the ongoing restructuring and recapitalization of its financial sector. The reform program aims to

• better capitalize Spain’s banking system and reduce uncertainty regarding the strength of its balance sheets, with a view toward improving its access to funding markets; this in turn should help ease domestic credit conditions and thereby support economic recovery; the capitalization drive also aims to protect taxpayers by requiring weak banks to undertake private capital-raising efforts now before undercapitalization problems expand; and

• reform the frameworks for financial sector regulation, supervision, and resolution to enhance the sector’s resilience and avoid a re-accumulation of risks in the future.

The Eurogroup approved this support, with Spain’s commitments under the program outlined in the Memorandum of Understanding on Financial Sector Policy Conditionality (MoU) of July 20, 2012. In November 2012, responsibility for providing financial support for the program was transferred from the EFSF to Europe’s new permanent rescue mechanism, the European Stability Mechanism (ESM), without this assistance gaining seniority status.

This report provides information and analysis on the status of Spain’s financial sector reform program. The Ministry of Economy and Competitiveness, the Bank of Spain (BdE), and the European Commission (EC) requested that IMF staff provide such monitoring via quarterly reports, of which this report is the third. This monitoring is conducted as a form of technical assistance under Article V, Section 2(b), of the IMF’s Articles of Agreement. Views expressed in the report are those of IMF staff and do not necessarily represent those of the IMF’s Executive Board. Further information on the objective and scope of these reports is in the Terms of Reference (TOR). IMF staff is not a party to the MoU, nor responsible for the conditionality or implementation thereof.

The report is organized into two main sections:

• Macro-financial context. Macroeconomic and financial conditions in Spain will affect the reform program’s prospects for success, and vice-versa. Thus, as per the TOR for these reports, this section provides an update of recent macro-financial developments and key implications for the reform program.

• Progress on financial sector reforms. This section discusses progress on key measures under the reform program, as well as risks going forward and recommended actions to mitigate them. Further background on recent developments in the financial sector (e.g., trends in profitability and capital buffers) are provided in Annex 1.

Executive Summary

Implementation of Spain’s financial sector program remains on track. The vast majority of measures specified in the program have now been implemented, as envisaged under its frontloaded timetable. Most notably, actions to recapitalize parts of the banking sector and the asset transfers to SAREB have provided an important boost to the system’s liquidity and solvency. Major reforms of Spain’s financial sector framework have also been adopted or are in train.

Notwithstanding this progress, risks to the economy and hence to the financial sector remain elevated. Correction of Spain’s large external, fiscal, and financial imbalances is well underway, with policy actions at both the European and Spanish levels helping to ease market pressures over the last year. Nonetheless, further adjustment remains, and the process continues to weigh heavily on domestic demand, with output still shrinking and unemployment rising to record levels. Financial sector dynamics still contribute to recessionary pressures, with credit contraction accelerating, lending standards tightening, and lending rates to firms rising. Looking forward, growth may remain weak for some time unless further reforms to make the adjustment process less costly are adopted at both the European and Spanish levels. Further financial sector measures can significantly assist this effort, thereby supporting economic recovery and financial stability.

The report’s main findings and recommendations in key areas are as follows:

• Bank restructuring and resolution. Much progress has been made in repairing banks’ balance sheets. Further near-term priorities in this area include timely completion of burden-sharing exercises, which the authorities now expect to complete this summer, and the choice of strategies to maximize the value out of each state-owned bank under the FROB’s control.

• SAREB. SAREB’s management is appropriately giving high priority to addressing technical challenges associated with its start-up phase, including the completion of due diligence on SAREB’s assets and ensuring that these assets are properly serviced. However, SAREB’s business plan could usefully be based on more conservative projections for house prices, as these are still falling sharply and further correction is likely. Such a change in assumptions may imply the need to adjust elements of the business strategy once the due diligence exercise has better identified the current market values of each asset. Another priority is to ensure that SAREB’s governance arrangements sufficiently mitigate potential conflicts of interest.

• Ensuring adequate provisioning. Accurate loan classification and provisioning for loan losses is key to ensuring balance sheet transparency and restoring full confidence in the system. By recognizing losses on distressed assets whether or not banks sell them, adequate provisioning also ensures that banks have proper incentives to dispose of these assets, which helps free space on their balance sheets to expand lending to the growing parts of the economy. In this context, the BdE’s recent initiative to promote more consistent and accurate classification of refinanced loans is welcome.¹ Strong implementation of this exercise will be key to ensuring adequate provisioning.

• Maintaining capital. The program has provided an important boost to the system’s capital, such that all banks covered by the stress test exceeded regulatory requirements at end-March 2013 once the estimated effects of pending capital-augmentation measures (e.g., completion of burden-sharing exercises) are included. Nonetheless, with macroeconomic uncertainty still high, risks remain that banks may face pressure to support capital ratios by further accelerating credit contraction, with adverse effects on the economy. In this context, supervisory actions to strengthen solvency and reduce risks should prioritize measures that increase nominal capital over ones that reduce lending. Such measures include, for example, requirements to issue equity, as well as restrictions on cash dividends and bonuses, both of which should be tightly constrained given current risks. Consideration should also be given to increasing the quality of banks’ capital via the conversion of banks’ deferred tax assets (DTAs) into transferable tax claims, conditional on banks undertaking actions that have positive externalities in the current environment (e.g., more equity issuance, forgoing dividends for several years, stepping-up provisioning and disposal of distressed assets, and/or easing the pace of credit contraction). Bolstering the quantity and quality of capital through such measures should promote financial stability and help ease credit conditions and macroeconomic adjustment by both reducing banks’ funding costs and increasing their capital buffers over regulatory requirements.

• Further measures to ease credit conditions and support recovery. Efforts by the government to clear public sector arrears are welcome and should be furthered, as they promote financial stability by assisting the creditworthiness of suppliers and reducing their nonperforming loans. Other measures to explore include revenue-neutral tax reforms (e.g., less reliance on real estate transaction taxes) to reduce impediments to asset disposal.

• Measures at the European level. Measures at the European level are also key to supporting growth and financial stability. This includes moving faster to full banking union, which would help break the sovereign/bank loop by allowing Spanish firms to compete for funds on their own merits, independent of their country of residence; continuing monetary support from the European Central Bank (ECB); and keeping state-aided banks’ restructuring plans under careful review to ensure they are sufficiently flexible to changing circumstances and avoid any unnecessary constraints on the supply of credit.

• Savings bank reform. The draft law to reform the savings bank system—a welcome reform aimed at enhancing these banks’ governance and reducing risks to financial stability—has been transmitted to parliament. The priority now is to ensure timely adoption and strong implementation.

Contents

• THE MACRO-FINANCIAL CONTEXT

• PROGRESS ON FINANCIAL SECTOR REFORM

  • A. Bank Restructuring and Resolution

  • B. SAREB

  • C. Credit Conditions

  • D. Safeguarding Financial Stability and Supporting Economic Recovery

  • E. Structural Reforms to Promote More Resilience Going Forward

• ANNEXES

  • 1. Banking Sector Developments

  • 2. IMF Staff Views on Status of MoU Conditionality

• ANNEX TABLES

  • 1. Selected Financial Soundness Indicators, 2007-2013

  • 2. Monetary Survey, 2010-2018

• ANNEX FIGURES

  • 1. Nonfinancial Corporate’s Financial Positions

  • 2. Household’s Financial Positions

  • 3. Financial Market Indicators

  • 4. Credit Conditions