Miguel Fernández Ordóñez: The real economy and the financial system -
the importance of reforms
Speech by Mr Miguel Fernández Ordóñez, Governor of the Bank of Spain, at the meeting on
the reform of the Spanish financial system, organised by Expansión and KPMG, Madrid,
23 February 2010.
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Firstly, I should like to thank Expansión for their kind invitation to speak today in this forum,
where matters of great importance for the future of the Spanish economy and financial sector
will be discussed.
The latest available figures suggest we are leaving the worst of the crisis behind. On the
international front, despite some isolated bouts of tension, financial market behaviour
continues to improve, the main developed economic areas have resumed positive growth
and the pace of expansion in the emerging economies has stepped up. Against this
background, and although doubts remain over the consistency of the recovery, the growth
projections of the main analysts and international agencies have been revised upwards.
In Spain, too, the latest indicators suggest the sharpest phase of the decline in output is
behind us. And, while with some delay compared with most of the developed economies, the
outlook is for the start of a gradual growth phase during this year, based on a continuing
positive contribution by external demand.
As I have said on previous occasions, the greatest cause for concern at present should not
be predicting exactly when positive quarter-on-quarter growth will resume, but rather
determining to what extent the Spanish economy is ready - or not - to move into a long
phase of robust growth.
During the last upturn, the Spanish economy built up some significant imbalances, such as
the excessive weight of real estate activities, a swollen external deficit, a relative loss of
competitiveness, and high corporate and household debt. Over the course of the crisis, some
of these imbalances have begun to be corrected, but others are still significantly holding back
a pickup in growth.
With the crisis, these pre-existing structural problems have been compounded by an
increase in unemployment to levels far higher than those of any other developed countries
and by the sharp deterioration in public finances. These are now undoubtedly the two main
problems affecting our economy.
To embark on a sustainable economic recovery, the imbalances built up by the Spanish
economy before and during the crisis must be reversed. Job destruction must be halted and
unemployment absorbed. And, further, an ambitious plan must be devised and set in place to
cut the budget deficit, to redress the financial position of the private sector and, in sum, to
mitigate all those structural shortcomings that are currently weighing on the recovery and
contributing to reducing the growth potential with which our economy will face the new
expansionary cycle.
To achieve these objectives, there has been insistence both in the Banco de España's
reports and in my regular appearances before Parliament on the need to undertake
wideranging reforms. The list is an extensive one and includes areas such as education, the
knowledge economy, the liberalisation of goods and services markets, the boosting of
competition in the network industries and the introduction of further improvements in the
house rental market.
However, I would like to stress two reforms which I consider most pressing and necessary:
budgetary consolidation policy and labour reform. The government has in recent weeks
tabled some proposals for reform which, in my view, are in the right direction. In respect of
public finances, a cut of €50 billion in overall general government spending has been
announced in the period up to 2013 and, within the framework of the so-called Toledo Pact,
an increase in the retirement age has been proposed that would contribute significantly to the
financial balance of the public pensions system.
The budgetary measures proposed are a significant public commitment by the government to
fiscal consolidation. For that very reason, it is now essential that these commitments should
be actually met, since otherwise Spain's credibility might be most adversely affected. As
regards the labour market, the social agents have reached a wage agreement and the
government has set out proposals for labour reform. Advantage should be taken of these
initiatives to adopt specific and ambitious measures that entail deep-seated changes in the
functioning of our labour market.
We stand at a pivotal juncture for our future, a point at which it is vital to radically change
certain things so that Spain may continue to converge on the core European countries. Some
of these reforms may require sacrifices, and it would therefore be best to have as broad a
consensus as possible. The effective adoption of these reforms is crucial for the economy in
general, but particularly so for the financial system. And if anything has been highlighted by
the current global crisis, it is the close relationship between economic growth and the
strength of the banking system. Two years on from the onset of the turmoil in summer 2007,
most Spanish credit institutions continue to show considerable soundness. Unlike in many
other countries, this has meant that practically no public aid has had to be used to bail out
banks, which has prevented adding a further burden to the problems stemming from the
recession. But the relationship between the economy and the financial system also works in
the opposite direction and, evidently, if the necessary measures for reactivating employment
growth within a reasonable time frame are not adopted, bad debts will continue to mount and
there will be more financial institutions facing difficulty in providing the financing needed for
economic recovery.
That our banking system has proven reasonably resilient during the international financial
crisis is due to various factors. These include prudent regulation, more intensive supervision
than that of other countries, a business model geared essentially to retail banking and sound
management at most banks. But let me also stress - as it seems to me an example of what
could be done now with the labour reform - that the government and the opposition, which
has supported it in Parliament, have expeditiously agreed on a series of high-quality financial
system reform measures that have proven most effective in preventing credit institutions'
problems from bringing the country's economy to its knees.
We should not forget that if, for instance, the legislation on the funds for the acquisition of
financial assets and on guarantees for bank and savings-bank bond issues had not been
approved, we would no doubt have witnessed a shut-down of wholesale funding on global
markets and an abrupt contraction in credit that would have led to a deep recessionary spiral.
Fortunately, this did not occur.
That does not mean that credit standards are the same now as before the crisis. One of the
most notable consequences has been the increase in risk aversion, which stood in the
previous upturn at very low levels. This increased risk aversion translates into much stricter
lending policies. As a result many companies, particularly small and medium-sized ones (for
various reasons, such as the fact that they are not audited and are generally less capitalised
than large companies), have seen their ability to obtain funding restricted, occasionally
beyond what may be considered reasonable. The Official Credit Institute's programmes,
aimed at smoothing small and medium-sized companies' access to credit, have attempted to
correct this market failing. Further work along these lines should be pursued, improving
where possible the workings of these programmes and increasing their volume if necessary.
Yet I must urge credit institutions to be responsible, as I have on previous occasions.
Evidently, at a time such as the present, they must be particularly careful and, naturally, not
extend credit to companies that are not solvent; but nor must they forget that should they fail
to lend but a single euro to companies that are solvent, they will only be making things
difficult for themselves.
Another example of progress in financial reform backed by broad Parliamentary consensus
has been the approval of legislation whose aim is to restructure the financial system at the
least cost to taxpayers and in the shortest time possible, observing the constitutional
distribution of powers, so that all institutions in the system are in a position to provide credit
to households and firms when the recovery arrives.
So that ailing institutions may urgently embark on restructuring and integration processes or
so that control may promptly be taken of institutions that are non-viable, Parliament - once
again with the agreement of the party in government and of the main opposition party - has
provided the Banco de España with the necessary instruments, namely the Fund for the
Orderly Restructuring of Banks (FROB), for these processes to proceed normally and without
risks to the stability of the system.
According to the law regulating it, the FROB may engage in two types of actions. The first
involves pushing through and facilitating the restructuring of those banks that evidence
pressing viability problems. In this type of situation, FROB regulations stipulate taking control
of the institution and replacing its directors, by the FROB itself. The new directors shall draw
up a report on the institution's situation, submitting a restructuring plan for the approval of the
Banco de España. This plan shall include merger measures, spin-offs or, where appropriate,
the winding-up of the institution, adhering to competition law and seeking at all times to
minimise the potential cost of the measures for the public coffers. So far, this exceptional
decision to take control and replace directors has only been unavoidable in one instance,
prior to the approval of the FROB. If at any point it were necessary to adopt this decision at
any other institution, rest assured that the Banco de España, thanks to the creation of the
FROB, will act with all due diligence.
The FROB legislation not only provides the Banco de España with the necessary tools to act
when there are serious problems of viability, but also provides for a second course of action,
of a preemptive nature, geared to preventing these problems from materialising. With the
approval of the FROB, institutions and their managers were urged to assess their own
situation and to adopt the decisions needed to ensure their viability, preventing the more
traumatic effects that might stem from supervisory intervention, both for the institution itself
and for economic activity in the regions in which it pursues its business.
This second means by which the FROB may act involves supporting integration processes
between institutions which, without being in serious danger, are seeking to improve their
efficiency, streamline their management and re-scale their productive capacity. When the
FROB undertakes such "pre-emptive" action, the Banco de España is entrusted with
ensuring that the operations approved have a sound business plan that contributes to
strengthening our financial system and that is accompanied by measures aimed at a realistic
adjustment of bank resources to the new market conditions, using in this connection the
smallest volume of public funds possible.
Unlike cases in which institutions are taken under control and their directors replaced, and
where decision-making is entirely the prerogative of the Banco de España, authority to
pursue this second course of action lies with credit institutions and, in the case of savings
banks, authorisation by the regional government is also required.
In this pre-emptive phase, it is not the role of the Banco de España to decide which
integration processes should go ahead, but to examine rigorously the proposals received. In
its capacity as the supervisor of banking system solvency, the Banco de España has been
entrusted by the legislature with evaluating, on the basis of strictly professional criteria and
irrespective of any other personal or collective interests, whether the plans submitted offer
sufficient guarantees of soundness and viability.
Allow me to convey to you my assessment of how the integration processes under way are
progressing under the application of the "pre-emptive" measures of the FROB. First, I view
most favourably the fact that, shortly after the approval of the FROB, a sizeable number of
savings banks set about working to seek solutions based on mergers and restructuring. But it
is also clear that some of these processes are being delayed longer than would be desirable.
I must therefore call once again for responsibility on the part of those banks that have
incurred the biggest delays: they should examine their situation realistically and consider
forthwith viability strategies in the search for solutions conducive to creating stronger
institutions that are better able to provide households and firms with the credit flows they
demand. I likewise call on the sense of responsibility of certain regional governments and
urge them to ensure there are no further delays or obstacles to processes that may
strengthen the institutions operating in their regions.
The progress brought about by this series of reforms approved with broad Parliamentary
consensus does not mean that our financial sector does not face significant challenges
ahead. During the last upturn households and firms rapidly incurred debt, a process matched
by exceptionally high credit growth rates. This setting was conducive to an increase in the
size of the banking sector, to the point of reaching a dimension which now, with a much less
favourable outlook, will hardly be sustainable.
The lower growth in demand compared with the previous stage, combined with the process
of corporate and household deleveraging, will entail a fall in the volume of activity. To this
can be added various factors which in the near future will act to squeeze unit margins, such
as low interest rates, increased bad debts, higher capital requirements for both regulatory
and market-related reasons, tighter financing conditions (risk premia are higher than before
the crisis) and the increased importance of doubtful asset management.
The management of doubtful assets in the real estate sector will be particularly important. In
this respect, allow me some brief thoughts on the supervisory activity of the Banco de
España. In the last few weeks some opinions have been aired on the lack of transparency of
the Spanish banking system, as a consequence of a failure to duly record the excessive
concentration of risk in the real estate sector, particularly that in property development
companies.
Obviously both the banking sector and the Spanish economy have to digest the excesses of
the real estate cycle, which has proved to be unsustainable. However, in assessing the
position of the banking sector, the exposure to a sector and the complexities associated with
the crisis in that sector should not be confused with potential losses for banks. For an
exposure to become a loss involves there being a default and, insofar as the exposures to
this sector are secured by collateral, the ineffectiveness of that collateral in compensating for
the default and the non-recovery of the loans in question.
Furthermore, unlike what generally happens in other countries where the loss estimates used
to calculate provisions are made by auditors, here the Banco de España has established an
objective system for calculating provisions which reduces downside discretionality. Also, the
Banco de España has obliged banks to adopt pre-emptive measures in the form of a larger
pool of provisions. These can be used to cope with possible impairment of their real estate
assets by, for example, raising the provisions to be made from 10% to 20% of the value of
the properties held on their balance sheet when these assets remain in their ownership for
more than 12 months, as a precaution against sale at a lower-than-expected value.
In any event, we face an extremely complex scenario and it is essential that all Spanish
credit institutions, particularly those that have taken most risk, prepare themselves and adopt
the measures needed to ensure their profitability. For this purpose, they will have to
undertake the downsizing of the sector and, at the same time, push through measures to
raise efficiency through cost containment and through the introduction of improvements in
their risk control and management mechanisms and of ongoing innovation in product
marketing and in the implementation of technological and organisational improvements. And
the government could crown the significant financial reforms made so far with one directed at
savings banks. I am thinking of the reform needed so they can raise high-quality equity funds
that enable them to grow and continue serving Spanish society while complying with the
requirements to which they will be subject in the new international regulatory environment in
the coming years.
The financial system reforms adopted to date might suffice for the Spanish banking system
to get through the crisis and be in a position to extend credit to those needing it in the
recovery phase. But this will only happen if the reactivation of the Spanish economy comes
in a form that substantially reduces the number of unemployed, improves its competitiveness
and increases productivity. If this does not happen, obviously the restructuring task that we
would have would be much greater than that facing us at present. Thanks to the reforms
adopted, the Spanish banking system has not been an additional problem during the crisis.
But if the economy does not improve substantially due to the lack of sufficient consensus to
undertake structural reforms, credit institutions will end up being damaged and will be unable
to help in the recovery.
For this reason I wish to devote the last part of my address to the economy and, in particular,
to the other major reform required before we can start a new phase of sustained growth:
labour reform. This reform is necessary not only for the obvious reason: the need to reduce
substantially the disproportionate unemployment figures beleaguering the economy and
Spanish society. It is also necessary, as I have said earlier, so that the rising bad debts and
wholesale funding difficulties do not oblige the banking system to reduce credit more than it
will already be cut by the cyclical downturn. The labour reform is also essential so that the
ambitious budget consolidation programme proposed by the government can be successfully
carried out. If there is no labour reform and the bloated unemployment figures persist, public
finances will suffer in two ways: not only regarding expenditure, which has already reached
enormous proportions, but also on the revenue side, because the millions of people who
remain jobless barely contribute to public revenue.
The labour reform is also vital for GDP growth, for two reasons. First, because flexibility in
agreeing wages and other aspects of firms' internal organisation is indispensable for
improving competitiveness in a monetary union where devaluation is no longer an option. If,
on a firm-by-firm basis, workers and managers decide to adjust their conditions to the
changes in demand, the highest possible number of firms and jobs can be preserved.
Furthermore, by improving productivity in those firms which will perceive the favourable
change in the economic environment, the labour reform would enable workers' wages to be
improved and thus increase domestic demand without impairing the competitiveness of the
economy.
The list of necessary reforms in Spanish labour institutions is very long. But two of them are
vital in order to judge the extent of the reform finally undertaken. The one to which most
media attention is devoted is the issue of a permanent employment contract that does not
deter those businesses which wish to create jobs. Although hiring is important, at this point in
time I feel that it is particularly urgent to address the change which has to be made in
collective bargaining. At this juncture it is of paramount importance that the trade unions and
employers' associations - which in complicated situations in the past have made telling
contributions to the Spanish economy - should now let the workers and entrepreneurs of
Spanish firms decide how they can best save their businesses, preserve their jobs and even
expand their workforce. Quite another thing is that they may give guidelines or advice to
firms in the negotiation of wages and other working conditions. But it is vital that, at least in
the next two or three years, firms and workers are given the freedom and the opportunity to,
in some cases, save their business, and, in others, to achieve the increases in
competitiveness and productivity which current collective bargaining arrangements preclude.
This reform is particularly important in a setting where there is a need to change our
country's pattern of production. The so-called productive model is ultimately the result of the
structural and institutional features of each economy. Spain has a model which is
inseparable from its current institutions and, if we wish to move towards a situation in which
the most productive sectors play a leading role, we have to change the current labour
framework to provide for and promote the reallocation of economic and human resources
towards the sectors best endowed to add the most value. The required sectoral redistribution
of labour is unlikely to take place if region- and industry-wide collective bargaining
agreements continue to prevent each firm's wages from being linked more closely to
productivity.
With the labour reform, Spaniards should adopt the same attitude shown by other countries
in the reform of their financial system. Those countries which had serious problems with their
banks have acknowledged their failure and have set to work to reform regulations that failed.
They are thus examining what has been done in other countries, including Spain, so that
those banking problems do not return. Together with the Secretary of State for Economic
Affairs, I am participating in Financial Security Board (FSB) discussions to radically reform
the financial systems of all countries. Both of us have had the privilege to witness how
Spanish banking regulation and supervision is being carefully appraised and, insofar as is
possible, it is intended to take advantage of the good work done in the past in Spain.
We in Spain should take this same attitude to learning. We should recognise that we have
failed in labour regulation since, for the third time in recent decades, unemployment has
approached the unacceptable figure of 20%. We should therefore find out what other
countries are doing with their labour institutions and try to incorporate into Spanish legislation
whatever seems most reasonable to achieve their low unemployment rates and their high
labour productivity levels.
Unfortunately, we are at a historic crossroads. If we do not undertake ambitious labour
reform, the Spanish economy will enter a tough and complicated period, in which not only will
growth be lower than it would be with extensive reform, but, moreover, its impact on public
finances will be extremely negative, making it difficult to achieve the targets set in the
Stability Plan. The same can be said of the banking system, since if we undertake sufficiently
extensive reform, we will be able to reasonably negotiate the current crisis; otherwise, banks
would have to ultimately focus on the battle against bad debts and on the difficulties in
obtaining external funding, and the authorities would have to focus on restructuring the banks
that have deteriorated to the point of being clearly inviable.
However, if we take advantage of this historic moment and carry out far-reaching labour
reform, we will face a more positive scenario in which Spanish firms could promptly raise
their competitiveness in the difficult (for these purposes) environment of a monetary union.
Spain would enter a scenario in which increased productivity would provide a significant
boost to its best firms. This would be particularly positive for SMEs, which find it most difficult
to take advantage of the flexibility mechanisms offered by the current institutional framework,
and they would benefit enormously from the implementation of a more flexible and simpler
system. Meanwhile, budgetary consolidation could be achieved without swingeing cuts in
expenditure and the banking system would be in a position to support this new growth phase.
It would thus be a mistake to opt for small-scale labour reform, as if we could even afford to
tackle this reform slowly, in various phases over various years. This would have been
possible 5 or 10 or 15 years ago, when the last expansion phase started and the need for
labour reform was not pressing. Indeed, there was so little urgency that, unfortunately, in the
last 15 years there has not been a single labour reform capable of preventing our rigid labour
markets from suffering, for the third time, an adjustment along the old familiar lines of leaving
millions of Spanish workers jobless.
Voices are sometimes heard casting doubt on whether labour reform is urgent, arguing that
the labour market is not at the root of this crisis. This is quite true, but it is an argument which
does not constitute grounds for ignoring the prime importance of this reform. If you allow me
the metaphor, our labour market has shown itself to be a fragile ship which, each time there
is a storm, springs leaks which are enormously costly to seal. Obviously the storm is not the
fault of the ship's captain, but he can make repairs before it is sunk by the storm. But, what is
more, our labour ship also functions poorly when there are no storms. In the periods of
highest growth of the world economy, we continue to have the highest unemployment rate
and our labour productivity growth is mediocre, limiting the scope for wage increases. The
ship does not sink but it sails - in terms of productivity and of reducing unemployment - at a
poor speed in comparison with the rest.
Lastly, it is true that, even if a reform is approved which assimilates our labour institutions to
those in the more developed countries, this does not ensure the immediate resolution of our
problems of growth, public finances or banking system health. More measures have to be
adopted and, among them, as I have said, budgetary consolidation is key. But let there be no
mistake: while labour reform is not a sufficient condition, it is nevertheless an absolutely
necessary and essential one without which the other measures or reforms adopted will have
a much diminished effect on the competitiveness of our economy.
Thank you.