# **Box 1. Spain’s Experience with a Dynamic Provisioning System**

The Spanish dynamic provisioning (officially referred to as statistical provisioning) was introduced in 2000 and subsequently reformed in 2004. It is a rule-based system, with a formula that has two parameters: is the average estimate of credit loss in a cycle-neutral period, and is the average through-the-cycle estimate of specific provision. The component is a general provisioning requirement on new credit ( ), while the component based on total credit ( ) represents the smoothing of specific provisioning ( ) through the cycle. That is, when specific provisions for the period are lower than through-the-cycle average, the difference is charged to profit and loss account and accumulated in a statistical provision fund, and when specific provisions for the period are higher than average, the fund can be drawn down to cover part of the losses. The and parameters vary according to six risk categories of loans, ranging from negligible to high, and the total general provision is the sum of what is required in all categories. Instead of the standard supervisory model, banks may choose to use their own internal models, although in practice most banks followed the standard model. To avoid excessive provisioning, a cap was set on the statistical provision fund at three times the latent risk.

The Spanish system was introduced in the context of loose macroeconomic conditions (due to the substantial reduction in real interest rates upon joining the European Monetary Union) and elevated credit growth in the late 1990s (see left-hand figure). It was introduced with an explicit prudential objective of covering ―latent‖ losses and improving banks‘ solvency through the cycle. The prudential buffer that the statistical provision fund provided was substantial prior to the global financial crisis (see right-hand figure), which helped improve the resilience of the Spanish banking system (although questions have emerged as to whether the buffer is enough to cover the actual losses as the crisis drags on).

<!-- Start of picture text --> Spain: Credit Growth Spain: Total Provisions/Doubtful Credit<br>30 400<br>25<br>300<br>20<br>15 200<br>10<br>100<br>5<br>0 0<br>-5<br>Source : Bank of Spain. Source : Bank of Spain.<br>Percent, year-on-year<br>Percent<br><!-- End of picture text --> However, dynamic provisioning did not appear to have any effect in terms of curtailing credit growth, although it was not the primary goal to begin with. According to the Bank of Spain (2005), annual statistical provision represented around 12 percent of net operating income on average from 2000 to 2004, which coincides with a moderate slowdown of credit growth. However, it is hard to attribute the slowdown to dynamic provisioning alone, as the period also followed the burst of dot-com bubble. In subsequent years, credit growth accelerated to levels even higher than that of the late 1990s (see left-hand figure), largely due to the housing boom, until the crisis hit.

__________________________ _Source_ : The text box draws on the discussions on the rationale, design, and effectiveness of the Spanish dynamic provisioning system in Fernández de Lis and Garcia-Herrero (2010); Poveda (2000); and Saurina (2009a, 2009b).

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