Miguel Fernández Ordóñez: Current status of the Spanish financial
system
Speech by Mr Miguel Fernández Ordóñez, Governor of the Bank of Spain, to the Council on
Foreign Relations, New York, 11 March 2011.
* * *
Let me thank the Council on Foreign Relations and Mr. Rubin for giving me the opportunity to
address this distinguished audience.
The current difficulties faced by certain Spanish savings banks have their roots in a long
expansion in the Spanish economy dating back from 1996 to 2006. It was a period of sharp
growth in employment, activity, and wealth. At the same time the budget deficit diminished
drastically and the level of public debt over GDP fell below 40%. However, the expansion
was also accompanied by some imbalances. House prices rose substantially; the current
account deficit climbed significantly, reflecting in part the loss of competitiveness, and in part
the need to fund investment rates that rose to around 30% of GDP, targeted not only on
increasing residential investment but also on investment in equipment and infrastructure;
Spanish households and firms increased their debt levels notably, in response to low interest
rates prompted by euro area membership, reflecting their asset purchases (real estate
assets in the case of households, and productive assets in the case of firms, coinciding with
a major internationalisation of Spanish corporations).
The big financial crisis that began in 2007 had a very limited impact on the asset side of
Spanish banks. In Spain, neither conduits nor SIVs (Structured Investment Vehicles) were
developed, because the Bank of Spain obliged banks to consolidate these vehicles and
required capital of them for the attendant exposures, which eliminated at root any incentive to
create these off-balance-sheet vehicles. Accordingly, Spanish banks had hardly any toxic
assets. They did not use the originate-to-distribute model to distribute credit risk but pursued
a retail banking strategy, in close proximity to bank clients, households and firms alike. On
the liability side, when the mistrust and uncertainty worsened, European banks began to
suffer the consequences, and their difficulties in raising funds increased. Nonetheless, the
long-dated maturities on these products in the past (around 10 years) meant that Spanish
banks did not undergo pressing short-term liquidity problems.
The financial crisis passed through rapidly to the real economy, with output slumping heavily
in late 2008 and over much of 2009. The economic downturn in Spain, and the subsequent
recession, impacted banks and progressively raised their doubtful assets and, therefore, their
provisioning requirements. Their volume of activity, and new lending in particular, decreased,
and the high profitability of Spanish deposit institutions seen so far, began to be eroded. The
impact of these developments was uneven, impacting with greater force those banks that
had most grown in the expansion and, in particular, a group of savings banks that had
concentrated a significant portion of their lending portfolio in financing real estate developers.
Expectations about house prices, which had started to lose momentum in 2006, changed
and prices began to fall, in a much more unfavourable macroeconomic setting and with
financial institutions much more cautious about extending credit given the rise in bad debts
and provisions, and the tightening of funding conditions.
In view of these problems, the Government and the Bank of Spain began to take decisive
measures to tackle this "classic" crisis based on credit to the real estate market and to the
abrupt change in cycle, as well as to the changes in the markets.
Firstly, to address the uncertainty on funding markets, a programme was set up that would
allow banks to issue debt with the backing of the State and the ECB started to inject liquidity
allowing full allotment. Secondly, the Fund for the Orderly Restructuring of the Banking
Sector (FROB) was created in 2009. With the FROB we anticipated the need to equip
ourselves with an instrument to carry out a far-reaching restructuring of the savings bank
sector.
The scale of the savings bank restructuring process has been huge. Of the 45 previously
existing savings banks, only 17 remain. The aims of the process were very clear. First, to
take advantage of the concentration processes to restructure assets and correct the
excessive fragmentation of this sector. Second, to reduce the excess capacity in the savings
bank sector. The adjustments are between 10% and 25% in the number of offices, and
between 12% and 18% in staff. Third, to reinforce the viability of the new institutions
(resulting from the mergers of several savings banks) with the resources and the
management capacity of the savings banks best placed to lead each of the concentration
processes. Finally, to ensure in the medium term that the lower number of institutions and
the diminished capacity will allow a reasonable level of profitability in step with the risks
incurred for the remaining institutions. To round off the adjustment, the legislation governing
savings banks was also amended in an attempt to make the management of these
institutions more professional and, most notably, opening them up to market discipline and to
the possibility of them raising capital (shares) to reinforce their solvency.
In short, the central aim of the efforts made by the Bank of Spain since 2009 has been to
restructure the balance sheets of banks, and of savings banks in particular. Spanish deposit
institutions have made an enormous write-down drive to date, this effort often going
unnoticed by certain observers of the Spanish banking system. Overall, provisions totalling
€91 billion which is a 9% of GDP, more than the cost of numerous bank crises experienced
by developed countries. These major provisions have been possible because Spanish
banks, with their retail business and the significance of their banking franchise, were able to
obtain high levels of profitability in the recent past, despite maintaining some of the lowest
levels of leverage among European banking systems and having to retain a portion of such
profits under the system of countercyclical provisions in place. On top of that, Spanish banks
have increased their capital buffer over minimum requirements by €53 billion - around 5% of
GDP - in the last three years.
After the first crisis of mistrust, the Greek debt crisis, the Bank of Spain, within the European
Union, led the disclosure process through the carrying out and subsequent publication of
stress tests which, in a coordinated fashion, were conducted by the European supervisory
authorities. Spain, whose weight in the Community banking system is around 8%, was
represented in the stress tests by 27 banks, 30% of the total number analysed. This figure
meant that information on 90% of the Spanish system was disclosed, compared with the
minimum of 50% required by the European authorities. All listed Spanish commercial banks
and all savings banks were subjected to this exercise. Significantly, the exercise consisted of
very tough scenarios for Spain and it was carried out under the attentive eye and control of
the Spanish supervisor. For instance, it assumed that the Spanish economy was going to
undergo a second recession, with a cumulative fall in GDP of close to 3 percentage points.
This was far from the market consensus and the actual figures, given that the Spanish
economy ended 2010 with a growth rate of 0.6%. Further, the haircuts applied to assets were
most notable: 28% in the case of housing, 50% in that of uncompleted housing and 62% in
that of land prices. In addition, a fall in net operating income of 40% was assumed, one of the
most severe for all the countries involved in the exercise.
Let me insist on the rigor of our stress testing, as some have broadly criticised the test
because some banks from other countries were given a seal of approval only to collapse a
few months later. Not only we tested all the banks but the information published by Spanish
banks for the stress test was more detailed than that of the other countries. Our aim was to
enable analysts and investors to check the stress test for themselves and know what
volumes of problem exposures and expected portfolio losses were involved.
As a result of the measures mentioned (greater disclosure, amended regulatory framework
for savings banks and progress in restructuring), Spanish banks, not only the leading ones
but also a large number of medium-sized banks and savings banks, were once again able to
re-fund themselves on international wholesale markets, although the cost of funds continued
to reflect the sovereign risk premium.
The process of concentration and restructuring was making good progress as from last
summer, when the second episode of mistrust - the Irish crisis - struck around November
2010. The public debt markets tightened immediately and there was a resumption of mistrust
about the Spanish banking sector, doubts over the quality of its assets, the speed of savings
bank restructuring and the possible need for further public funds to redress bank balance
sheets, which in turn further strained the risk premium of the Kingdom of Spain.
Although there are important differences between Spain and Ireland in several dimensions,
the market perception of potential similarities between both economies, however distorted
this is, impacted us. In anticipation of further problems, the government and the Bank of
Spain, in its capacity as banking supervisor, understood the necessity to speed up the
strategy we had pursued to tackle the difficulties experienced by part of the Spanish banking
system. We insisted all the more on the need for institutions to be fully transparent
concerning potentially problem lending. Early this year we obliged all savings banks to
disclose their exposure to real estate developers, their non-performing loans, and the portion
of normal exposures under surveillance, their coverage and information as to what collateral
is backing such lending (land, housing under development, completed housing, etc.). They
were also asked to publish information on foreclosures, by collateral class, and on exposure
to households via house mortgages, along with the attendant loan-to-value ratios, although
this is not an area for concern.
Transparency and disclosure are very important but we believed it was not sufficient. We
have thus been working closely with the Vice-President on strengthening our banks'
solvency. A result of this has been the recently approved Royal Decree-Law, which we
believe is a definitive step and a crucial quantitative and qualitative leap forward in restoring
market confidence in Spanish banks.
The aims of the new Royal Decree-Law are very clear. The first is to reinforce the solvency
of all our banks, requiring them a level of core capital of 8% and because the doubts of
investors over a small group of unlisted banks with some need to resort to the wholesale
market, we are demanding of such banks 10% of core capital.
We publicly announced yesterday which banks need capital to reach the 8-10% level, and
how much capital they need. We have given them fifteen days to submit a recapitalisation
plan. Those intending to tap the markets will have until end-September to attain the new level
of capital. But we have made it very clear that if a bank believes it will be impossible to reach
these solvency levels, it can apply to the FROB for these funds. The capital shortfall is for a
maximum of €15.152 million, whereby the impact on public debt if the FROB has to be used
would be relatively limited. By the way, let me remind you that the Spanish public debt to
GDP ratio at the end of 2010 stood at 60%, well below those of other euro area countries.
Allow me to conclude by addressing some of the doubts raised by investors, which it is our
duty to try and resolve.
The first message I wish to convey is my absolute confidence in the Spanish banking
system's solvency. The measures we have taken in the past for their restructuring are
beginning to bear fruit (creation of banks, market orientation, downsizing, etc.) and the
recently adopted measures, specified yesterday, along with the pressure we are exerting on
our banks to increase their solvency, should raise confidence in our banks and dispel doubts
about their present and future situation.
It should be stressed that our asset valuation system is very demanding, both in terms of the
classification of problem assets and of provisioning and write-downs. Savings banks, with
exposure to the construction and real estate developers sector of €217 billion, have
€28 billion of doubtful loans, in which the borrower is not paying interest or repaying the
principal. As Banco de España requirements stand, banks have, in addition to the foregoing
amount, to record as problematic the assets foreclosed in payment of debts. Even more,
standard loans under special surveillance owing to weaknesses observed in them are also
considered as problematic. These rigorous asset classification criteria indicate that
potentially problematic assets at savings banks in credit to construction and real estate
developers are €100 billion, 46% of the total. The specific loan loss provisions set aside for
these problem assets account for 31% (if we added general provisions, the figure would be
38%). Obviously, the specific provisions considered to compute these figures are those
associated to this potentially problematic loans and not the total amount of specific
provisions.
Spain's system of specific provisions has been tightened to drive banks towards making
tougher and swifter provisions. A non-performing loan, once the value of the collateral has
been taken into account, should be fully provisioned in one year. Collateral value is
considered using significant haircuts, which range from 20% in the case of completed
housing to 50% in that of land. Provisioning must also be made for foreclosures, up to 30% if
they have been on the balance sheet for two years. The provisions are determined by means
of transparent parameters, compliance with which is obligatory for all banks. This means they
are not the subject of negotiation between bank managers and external auditors.
In sum, Spanish deposit institutions are not hiding potentially problem exposures, and nor
are the figures for losses small or the provisions made low or far removed from the fair value
of these assets. We are very transparent and rigorous in valuing assets and we will continue
to be so in the future.
Admittedly, 2011 is still going to be a difficult year for Spanish banks, with their net interest
margins under pressure owing to the higher marginal cost of funding and to rather flat
business volumes, and with the need to continue making loan loss provisions to write down
assets. However, banks have room for manoeuvre to combat these negative pressures on
profitability through acting on costs, which should begin to reflect the impact of the
restructuring processes. If provisioning requirements persist along with pressure on the
margin, the banks most affected should consider additional cost-containment measures.
Looking ahead, resumption of notable economic growth for 2012 and successive years, in
keeping with market consensus forecasts, together with the culmination of the savings bank
concentration and restructuring processes, bringing about synergies, cost cuts, efficiency
gains and a substantial reduction in the number of players, will all shape a positive scenario
for the recovery of profitability in the Spanish banking sector.
I should further point out that net interest income as a percentage of total assets in Spanish
banking business has not changed much over the past four or five years, with a ratio of
around 1.25%. True, there is more pressure on marginal rates, but their impact on average
margins is fairly slow. The marginal cost of funding has risen, but the average cost in 2010
was lower than that observed in the five previous years. Sometimes there is confusion
between new rates and average rates.
As regards funding, our banks have a relatively reasonable wholesale funding maturity
structure, with nearly half of the maturities after 2013. Around 20% of the debt issued on
markets matures this year. The recent measures to reinforce solvency should, along with
headway in restructuring, allow our banks to re-fund when the foregoing maturities fall due
without excessive strains, although probably at still-high costs. Evidently, there was a bout of
tension last year in the funding of Spanish banks when the wholesale markets practically
shut down following the Greek sovereign debt crises. Spanish banks - inevitably - resorted
to a greater extent to the ECB. Once the tensions began to evaporate, Spanish banks
immediately returned to the wholesale market to place covered bonds, senior debt and
guaranteed debt. This response by Spanish banks is very positive and shows their
willingness to cut to the full the resort to the ECB. Indeed, our ECB funding levels are
currently slightly below our relative weight in the euro area.
I have so far talked about those areas where we have risks and concerns. I would not wish to
wrap up without mentioning an area where we do not have problems. This is, namely, banks'
and savings banks' exposure to households via mortgage loans for house purchases. Other
countries have serious problems with their mortgages, but in Spain the doubtful assets ratios
ended 2010 at levels below 3% in this lending portfolio segment, which accounts for more
than one-third of the total portfolio. Elsewhere, in credit to construction and real estate
developers, bad debts are around five times greater. These mortgage default figures are
somewhat more than one percentage point lower than those observed in the early 1990s,
when we also had a recession combined with a real estate market crisis. And this is possible
with the unemployment rate currently around 20%. The explanation for this is that interest
rates on Spanish mortgages are currently below 3%, while in the early 1990s they were
around 14%, with an unemployment rate close to 24%. The fact that the average
loan-tovalue ratio stands at 62%, with only 3% of mortgages with an LTV above 100%, and the
widely rooted wish in Spanish society to own one's own house explain why the mortgage
portfolio is, in fact, the least risky of all Spanish deposit institutions' credit portfolios.
Conclusions
I could talk a good deal more about what we have done in Spain to tackle and resolve the
problems of our banking system. But I believe it would be much more interesting to listen to
your concerns and worries and try to allay them. I shall thus conclude that the steps taken by
the Spanish government and Parliament on fiscal consolidation, labour market reform and
pensions system reform, along with the changes I have explained to you in relation to
savings banks and the strengthening of banking solvency, should - little by little, since
confidence takes some time to pick up - afford us greater recognition by international
investors. Recently, in fact, we have seen how our sovereign spread has been converging
more towards the core euro area countries, distancing itself from those economies with
bigger challenges outstanding. Our firm commitment to transparency, to the rigorous
valuation of assets through a clear provisioning system and our significant increase in capital
requirements should contribute to fully dispelling doubts about the current situation of
Spanish banks and their medium-term prospects.
Thank you for your patience. I am at your entire disposal to respond to your questions.