Overhauling the weak segments of the Spanish financial sector

Supervision of Spain’s troubled banking system has now passed largely into the hands of inspectors drawn from the European Commission, the IMF, the European Central Bank (ECB) and the European Banking Authority (EBA). This follows agreement by the European authorities to provide Spanish banks directly with up to €100bn of new capital via the EFSF bailout fund.

The strict terms for bank recapitalisation are set out in a sternly-worded Memorandum of Understanding (MoU) agreed by the two sides earlier this month and seen in near-finalised draft form by Lafferty Group. The MoU is highly specific and sets out a detailed month-by-month roadmap of measures to June 2013 that aim to put the Spanish banking system back on a viable course.

More often than not, the draft reads like a series of directions. During EFSF financial assistance, the Spanish authorities are obliged to take ‘all the necessary measures’ to ensure successful implementation of the programme. They are also committed to consult with the European Commission and the ECB on adopting financial sector policies that are not included in the MoU but that could have a material impact on the achievement of programme objectives. And they must seek the IMF’s technical advice. ‘They will also provide the European Commission, the ECB and the IMF with all information required to monitor progress in programme implementation and to track the financial situation’.

Another provision in the MoU states: ‘The European Commission in liaison with the ECB and EBA will be granted the right to conduct on-site inspections in any beneficiary financial institution in order to monitor compliance with the conditions’.

The key component of the programme is an overhaul of the weak segments of the Spanish financial sector. This comprises:

• Identification of individual bank capital needs through a comprehensive asset quality review of the banking sector and a bank-by-bank stress test, based on that asset quality review;
• Recapitalisation, restructuring and/or resolution of weak banks, based on plans to address any capital shortfalls identified in the stress test; and
• Segregation of assets in those banks receiving public support in recapitalisation effort and their transfer of the impaired assets to an external Asset Management Company (AMC).

The draft MoU contains several negative references to Spanish bank accounting practices, and demands much more transparency in future. Discussing Spain’s experiment with so-called pro-cyclical provisioning, it states that the approach was not sufficient to alleviate market pressure, adding: ‘The current framework for loan-loss provisioning will be re-assessed’.

According to the draft MoU, ‘a further strengthening of the operational independence of the Banco de España is warranted’. It also asserts that 'supervisory procedures of Banco de España will be further enhanced based on a formal internal review'.

The mis-selling of subordinated bank securities, which consumers seem to have thought were similar to bank deposits, is also to be tightly controlled. ‘Consumer protection and securities legislation, and compliance monitoring by the authorities, should be strengthened, in order to limit the sale by banks of subordinate debt instruments to non-qualified retail clients and to substantially improve the process for the sale of any instruments not covered by the deposit guarantee fund to retail clients. This should include increased transparency on the characteristics of these instruments and the consequent risks in order to guarantee full awareness of the retail clients’.

Spain’s savings banks appear to be on the way out and come in for several negative comments in the MoU, which states: ‘The governance structure of former savings banks and of commercial banks controlled by them will be strengthened. The Spanish authorities will prepare by end-November 2012 legislation clarifying the role of savings banks in their capacity as shareholders of credit institutions with a view to eventually reducing their stakes to non-controlling levels. Furthermore, authorities will propose measures to strengthen fit and proper rules for the governing bodies of savings banks and to introduce incompatibility requirements regarding the governing bodies of the former savings banks and the commercial banks controlled by them. Moreover, authorities will provide by end-November 2012 a roadmap for the eventual listing of banks included in the Stress Test, which have benefited from state aid as part of the restructuring process’.

Banks receiving state aid will be subject to stringent rules, including burden-sharing by shareholders and bondholders, and curbs on pay.

‘Actions include the sale of participations and non-core assets, run-off of non-core activities, bans on dividend payments, bans on the discretionary remuneration of hybrid capital instruments and bans on non-organic growth. Banks and their shareholders will take losses before state aid measures are granted and ensure loss absorption of equity and hybrid capital instruments to the full extent possible…. The Spanish authorities commit to cap pay levels of executive and supervisory board members of all state-aided banks’.