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November 21, 2018

IMF published its staff report and selected issues report under the 2018 Article IV consultation with Spain. Directors welcomed further strengthening of the banking system. They stressed the importance for banks to continue raising high-quality capital as a shield against shocks, including from potential spillovers related to market volatility. Directors underscored the need for rigorous management of liquidity and interest rate risks, particularly ahead of the eventual gradual normalization of the accommodative policies of ECB. They welcomed the authorities’ plan to create a macro-prudential authority to better address potential financial stability risks and to swiftly expand the macro-prudential toolkit of the Bank of Spain.

The staff report notes that health of the banking system continues to steadily strengthen. Asset quality improved as nonperforming loans (NPLs) on a consolidated basis dropped to 4.5% of total loans in the first quarter of 2018, just below the euro area average. Implementation of the NPL guidance of ECB is critical to keep reducing impaired assets. Since August 2017, several major banks have announced plans to dispose of NPLs. However, some banks still need to lower their elevated levels of NPLs and foreclosed assets.  The common equity tier 1 (CET1) ratio inched up by 0.3 percentage points to 13.4% at the end of 2017. CET1 capital on a fully loaded basis remains lower than that of many European peers, even though they are generally less leveraged. Similarly, by some estimates, the Spanish banking system may be among those in Europe facing relatively large shortfalls to comply with the upcoming minimum requirements for own funds and eligible liabilities (MREL) targets. The resolution of Banco Popular, via the purchase by the largest bank in Spain, and the merger of the two state-owned banks have consolidated the banking sector further, with a potential to improve the system efficiency. 

The report shows that banks continued to build capital buffers, but progress has been slow and uneven. Continuing the buildup of capital buffers and keeping on track the buildup of “bail in-able” debt in the largest banks would help to shield against shocks, especially related to interest rate and sovereign risks, where exposure of the Spanish banking system is relatively high. Larger capital buffers would also help protect banks from potential spillovers related to volatility in emerging markets, as any significant increase in asset impairment at Spanish banks’ large subsidiaries would impact group-wide profitability. The report highlights that while gradually rising interest rates might support profitability, stress tests performed during the 2018 Euro Area Financial Sector Assessment Program (FSAP) and the 2017 Spain FSAP suggest that sharp interest rate increases could erode margins via higher funding costs, and that some banks are vulnerable to interest rate and government bond yield shocks through valuation effects and trading losses, given their significant exposures to long-duration sovereign bonds.

The report further notes that the 2017 FSAP identified four priority areas where momentum must endure. These include accelerated cleanup of legacy bank assets, further improvement in bank profitability and capitalization, rigorous management of interest and liquidity risks, and reform of the institutional framework for financial oversight. Actions taken to address FSAP recommendations so far have been limited in some areas. FSAP called for a tough stance on the implementation of the ECB NPL guidance, including promoting banks’ disclosure of NPL reduction targets and progress. FSAP also proposed to establish a Systemic Risk Council—chaired by the Bank of Spain and comprising the Treasury and other financial oversight agencies—to bolster systemic risk surveillance and promote inter-agency coordination. The Spanish authorities are moving in this direction, as they are drafting a proposal for a national macro-prudential authority.

Additionally, the focus for institutional upgrades has been on creating an independent insurance and pensions supervisor, a financial consumer protection authority, and enhancing the transparency of the appointment process for senior positions at financial oversight agencies. The urgency to enhance the macro-prudential toolkit has risen. Even though there is no clear evidence, so far, of a generalized house price overvaluation, it is critical that the Bank of Spain has a comprehensive toolkit at its disposal to enable it to act promptly if misalignments emerge. This means that a legal basis should be established for the use of macro-prudential tools. The authorities have three near-term priority financial sector projects, including setting up of a national macro-prudential authority, transposing the EU mortgage directive into national law, and launching a sandbox for facilitating innovation in financial activities within a controlled framework.

 

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Keywords: Europe, Spain, Banking, Insurance, Securities, Macro-prudential Framework, NPL, FSAP, Stress Testing, Systemic Risk, Article IV, IMF

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