Bank of Spain’s Circular 4/2016 on analysis and provisioning of credit risk will bring changes to the way in which banks classify and provision doubtful loans.This new standard seeks to improve transparency and comparability with the rest of European institutions.In this article, we take a look at the main changes that Spanish banks will have to face in the coming months.
The new regulation published by the Bank of Spain alings Spanish banks with the International Accounting Standards (IAS 39). Although the regulation will require banks to make substaintial changes to their systems and processes, authorities expect most banks to be capable of rolling out new standard-compliant models before year-end.One factor that will help is the decision to push the new regulation’s official implementation date from June to October.
In this article we will take a quick look at some of the most relevant changes that the circular brings, reflected in BBVA Research’s Banking Outlook report, released in June.
Circular 4/2016 defines the following types of risks:
- Normal Risk.
- Normal risk on special watch: transactions with weak points, i.e., loans that may lead to bigger losses than in the case of those classified under the normal risk category.
- Doubtful risk by reason of borrower’s being in arrears: transactions with amounts more than 90 days overdue.
- Doubtful risk by reason other than borrower’s being in arrears: transactions regarding which there are reasonable doubts as to their being repaid on the agreed terms.
- Bad debts:transactions where following individual analysis the chances of recovery are considered remote.
The main difference with previous regulations is the elimination of subprime loans (loans that, despite not being in arreras, displayed some traits that hinted at a potential non-compliance in the future). These loans are now divided into two separate categories (Normal risk on special watch and doubt and Doubtful risk by reason other than borrower’s being in arrears).
The circular seeks to drive banks to strengthen discipline in their pricing policies when granting a loan. Prices should cover, at least, the financing, structure and credit-risk costs entailed by each type of operation. The new regulation also establishes a the need to review these prices from time to time in order to cover the changes made to each operation’s cost structure and risks.
If a loan is granted at an interest rate below cost, it will need to be recognized internally at its fair value (the most objective and commonly used reference is the price that would be paid for it in an organized, transparent and deep market). In this case, the difference between the fair value and the price at which the loan is granted, should be recognized as a loss in the P&L account.This element has been positively valued by analysts, as new legistlation intends to discourage banks from granting loans at costs below reasonable levels.
Provision calculation methodology
Institutions lacking these models will need to resort to alterantive solutions, i.e., new calendards depending on the type of loan.According to these calendars, banks will have from 18 to 21 months to cover 100% of doubtful loans although, during the first monhts, they will need to provision between 20 to 60% of their value, depending on the type of loan, whereas before they were only required to provision 25% during the three initial months.
Banks are expected to increasingly adopt internal calculation methodologies in detriment of standard (calendar-based) calculation methods Obvioulsy, the most sophisticted institutions will start applying internal models earlier (some even as early as December 2016).
Still, the Bank of Spain allows banks to calculate provisions based on the incurred losses. Thus, it has decided not to move ahead of European regulation (IFRS9) which, starting in 2018, will force all European institutions to calculate provisions based on their expected loses.
Therefore, the global provision level is not expected to change significantly.What industry players do expect to see is a reassignment of coverages between insolvency provisions (which should decline) and provisions for awarded housing units (which may increase) as well as between loan portfolios.