Circular 3/2010 of the Bank of Spain modifying Circular 4/2004 on financial information standards and financial statement models for credit institutions

Skip to main content.

VIEWING THE REGULATION

Index

Full Regulation

Regulation at a Date

Current Regulation

Circular 3/2010, of June 29, from the Bank of Spain, to credit institutions, modifying Circular 4/2004, of December 22, on public and reserved financial information standards, and models of financial statements. (BOE of July 13)

Circular 4/2004 represented a profound change, insofar as it incorporated international financial information standards adopted by the European Union into the basic accounting regulation applicable to credit institutions. This change, however, did not alter the philosophy of offering entities guidelines on good practices regarding credit risk coverage, which would guide them on the minimum levels thereof and ensure the coverage of any estimated loss associated with doubtful loans. These presumptions, collected in Annex IX, are those currently applied by entities, and recognize in the estimation of impairment -albeit indirectly and partially- the effect of the existence of certain guarantees for some categories of loans.

The experience accumulated with the application of said Annex IX in an environment as complex as the current one in recent years has guided a reflection on some aspects that may be subject to improvements.

First, the indirect recognition of guarantees on real estate assets, through different schedules, resulted in partial coverage and gave rise to incongruent situations that implied both the lack of coverage of potential losses over long periods of time (essentially due to the effect of the six-year long schedule) and the obligation to provision loans at 100% despite the existence of guarantees that would reduce the loss.

Second, this indirect treatment of guarantees, through different schedules, meant that potential losses on different loans were provisioned in different proportions and with varying timeframes depending on their nature. Furthermore, these timeframes were very broad, ranging from 24 to 72 months, when the potential amount of the loss associated with the impaired loan could be inferred in much shorter timeframes.

Third, the recommendations and presumptions associated with Annex IX focused on the ex post problems of damage in the loan portfolio, without there being recommendations that, ex ante, would help prevent the emergence of problems in credit portfolios.

Fourth and finally, the acquisition of assets in payment of debts, absent from Annex IX, constitutes a legitimate option to mitigate problems derived from impaired loans. However, their high volume in circumstances of delinquency tension advises establishing some basic principles for the estimation of their impairment.

The proposed modifications introduce improvements in these aspects. First, real estate guarantees are recognized, provided they are first charge, starting from the lower value between the book or proven cost of the real estate asset or its appraised value, but applying cuts that reflect both the heterogeneity of the guarantees and the different possibilities of mobilizing them in the short term. These cuts range from 20% for finished homes that are the borrower's primary residence to 50% for plots and developable urban land. Second, the different schedules are unified into a single one, which guarantees the total coverage of credit risk (either from the loan amount or doubtful credit, or from the same after deducting the adjusted value of the guarantees) once 12 months have passed; that is, the time period for provisioning loans is substantially reduced. Third, ex-ante risk management principles are established, which focus on aspects such as the correct evaluation of the borrower's cash flow generation, the role that guarantees should play in the analysis of granting and managing credit operations, as well as the conditions that must be introduced in the case of financial restructurings. Finally, certain presumptions are established regarding provisions for assets acquired in payment of debts, which incentivize the search for management solutions relative to this type of asset that allow releasing the resources invested in them promptly for the benefit of the typical activity of credit institutions.

Consequently, in exercise of the powers granted, the Governing Council of the Bank of Spain, upon proposal of the Executive Committee, has approved this Circular, which shall be governed by the following rules:

FIRST RULE

The following modifications are introduced in Annex IX of Circular 4/2004, of December 22, to credit institutions, on public and reserved financial information standards, and models of financial statements [ 1 ] :

1. The following paragraph is added to section 27 of the thirty-fourth rule:

"In the estimation of losses by impairment of adjudicated assets presented in the balance sheet as 'non-current assets held for sale', entities shall apply the methods and criteria of Annex IX of this Circular."

2. The title of Annex IX is modified, which will become "Analysis and coverage of risks".

3. Section 1 is given a new wording, which reads as follows:

"1. Entities shall establish the policies, methods, and procedures that they will apply in the granting, study, and documentation of their debt instruments, contingent risks, and contingent commitments (hereinafter, operations), as well as in the identification of their impairment and the calculation of the amounts necessary to cover their credit risk, both for insolvency attributable to the client and for country risk, for all entities in the group, Spanish and foreign.

The policies, methods, and procedures must:

a) Be approved by the Board of Directors, or equivalent body of the entity, and ratified by the parent entity in the case of entities dependent on Spanish groups.

b) Be adequately justified and documented. Among the necessary documentation, proposals and opinions from the corresponding internal departments of the entity must be included.

c) Be supported by granting criteria linked to the borrower's ability to pay, in time and form, the total financial obligations assumed from income derived from their business, or source of income, habitual, without depending on guarantors, sureties, or assets delivered as collateral, which must always be considered as a second -and exceptional- recovery path when the first has failed. In the case of financing for companies and businesses in general, the main source for returning the capital lent, plus interest and commissions, must be the generation of estimated net cash flows from the business's financial statements, which the entity can contrast duly and periodically. In the case of individuals, the primary source of recovery will be income from their habitual work and other recurrent sources of generation thereof.

d) Be based on a realistic payment plan regarding the financing granted, with periodic maturities related to the primary sources of income generation of the borrower and, if applicable, to the useful life of the guarantee. In the case of financing to individuals, amortization plans must observe a maximum ratio between the service of their debts, including all recurrent payments to attend to their credits at the entity and for other debts, and the borrower's available recurrent income that the entity can evidence as coming from their most recurrent income generation source. Under no circumstances will the resulting available income after attending to the service of their debts imply a notable limitation to cover the borrower's family living expenses.

e) Include financing conditions for real estate projects, approved by the highest governing body, containing practices that impose a precise limit regarding the percentage of financing of the cost to acquire the land and its subsequent development, including its urban development and subsequent construction. Costs will be estimated from the amount declared in public deeds, or from its appraised value if this is lower, plus, based on the amount of the material execution budget of the project duly signed off, partial work certifications carried out by duly accredited technicians, including in each phase the necessary expenses and accrued taxes. As a general rule, the initial financing of the cost of acquiring land for subsequent urban development will not exceed 50% of the lower amount between that declared in the public deed and its appraised value.

f) Include the circumstances and situations in which the entity would exceptionally allow credit operations under conditions outside the approved general limits and conditions.

g) Have a debt renegotiation policy approved by the highest governing body, which considers, to access the renegotiation of initially agreed conditions, at least the following requirements: a) a minimum experience with the borrower; b) a track record of borrower compliance over a sufficiently long period, or an amortization amount of the lent principal that is equivalent, and c) a limit on the frequency of renegotiation over a sufficiently large number of years.

h) Exercise extreme prudence in the use of appraised values, and any other type of work by external professionals, in credit operations that have real estate assets as additional collateral to the borrower's personal guarantee. In exercising this prudence, entities will use their own professional judgment, evaluating the degree of potential mobilization of real estate assets and considering that, frequently, their value tends to decline when they are most needed to protect the entity against the impairment of the credits they serve to protect. Appraisal requirements to estimate the value of real rights serving as collateral in operations classified as 'doubtful assets', as well as those received in payment of debts, will be carried out by independent appraisal companies and, for assets located in Spain, in accordance with OM ECO/805/2003, of March 27, carried out by companies registered in the Official Register of Appraisal Companies of the Bank of Spain. For real estate assets located in other countries, entities must have a written procedure, approved by the highest governing body, emphasizing the need to obtain prudent estimates, carried out with generally accepted written standards and conducted by independent external professionals to the entity with recognized competence in the country where the asset is located. In the case of real estate located in another country belonging to the European Union, the equivalence criteria established in Article 6 of Royal Decree 716/2009, of April 24, by which certain aspects of Law 2/1981, of March 25, on the regulation of the mortgage market and other norms of the mortgage and financial system are developed, will be used.

i) Establish a minimum frequency to review real guarantees taken as coverage for granted loans and update appraisals linking them to changes experienced by the market of the asset received as collateral or, if applicable, acquired in payment of debt. In the case of assets affected by credit operations classified as 'doubtful assets', the maximum age of the appraisal will be three years, unless significant drops in market prices advise a more recent appraisal to better reflect these situations. In the case of real estate assets adjudicated or received in payment of debts, appraisals must be issued, if applicable, by different appraisal companies in each update. As an exception, for operations under 500,000 euros with first charge guarantee on finished housing, or assets acquired in payment of debts resulting from this type of operation, the entity may use as the best estimate of their current value the lower amount between 80% of the last available appraisal, and that resulting from the update of that appraisal, with an age of less than one year, obtained through statistical methods by an appraisal company meeting the conditions indicated in section h).

j) Set financing conditions and terms for affiliated entities, similar to those granted to other entities of similar credit risk but with which there is no affiliation. These conditions will also be observed in operations granted to other partners to finance their participation in the capital of that type of entities.

k) Detail, among other issues:

i) The criteria for granting operations, which will include issues such as the markets, products, type of clientele, etc., in which to operate, as well as the global limits of the risks to be assumed for each of them, and the requirements that clients and guarantees must meet to be granted operations.

ii) The need to identify in each operation the sources of ordinary income generation of each borrower, and their quantification, which will serve as the first and fundamental path for the recovery of granted credit operations. The Bank of Spain expects entities to have this type of information, not only at the moment of granting credit operations, but with the frequency that best adapts to the risk profile of the borrowers. Among those aspects that entities must avoid in the evaluation of credit risk is the use of old or unreliable financial information of the borrower, as well as excessive dependence on assets delivered as collateral as a path for recovering the lent amount.

iii) The pricing policy to be applied, which, at least, must be oriented to cover the financing, structure, and inherent credit risk costs of each class of credit operations offered. The periodic review of the pricing policy must adjust in response to changes in the cost structure, competitive factors, and the change in risks of each type of credit operation offered by the entity.

iv) The responsibilities and delegated powers of the different bodies and persons in charge of granting, formalizing, monitoring, valuing, and controlling operations.

v) The requirements that studies and analyses of operations to be carried out before their granting and during their validity must meet.

vi) The minimum documentation that different types of operations must have for their granting and during their validity.

vii) The definition of criteria to classify operations based on their credit risk and the way to quantify individual and collective estimates of impairment losses, including in the latter case the parameters to be used in the estimation.

The Audit Committee and the Internal Audit Department will ensure that policies, methods, and procedures are adequate, effectively implemented, and regularly reviewed.

The documentation referred to in this section will be available to the Bank of Spain and external auditors."

4. Letter d) of section 13 is suppressed, whose letters e) and f) become the new d) and e).

5. Sections 17 and 18 are given a new wording, which reads as follows:

"17. Assets classified as doubtful due to client delinquency, except those regulated in the following sections, will be covered applying the percentages indicated below, depending on the time elapsed since the due date of the first installment or term that remains unpaid from the same operation:

a) General treatment.– The coverage percentages applicable to operations other than those listed among the risk classes as 'no appreciable risk', provided they do not have any of the guarantees mentioned in letter b) nor in the following section 18, will be those indicated below:

The above scale will be applied to operations classified as doubtful due to client delinquency due to accumulation of overdue amounts in other operations. For these purposes, the date for calculating the coverage percentage of these operations will be that of the oldest overdue amount that remains unpaid, or the date of the classification of assets as doubtful if it is earlier.

b) Operations with real estate guarantee.– For the purpose of estimating the impairment of financial assets classified as doubtful, the value of real rights received as collateral, provided they are first charge and are duly constituted and registered in favor of the entity, will be estimated, according to the type of asset on which the real right falls, with the following criteria:

(i) Finished home, primary residence of the borrower.– Includes homes with a valid habitability or occupancy certificate issued by the corresponding administrative authority, where the borrower lives habitually and has the strongest personal ties. The estimation of the value of the rights received as collateral will be at most the lower amount, weighted by 80%, between the cost of the finished home and the appraised value in its current state. For these purposes, the cost will be represented by the purchase price declared by the borrower in the public deed. In the case of a notable age of the deed, the cost may be obtained by adjusting the original with an indicator that adequately reflects the average evolution of the second-hand housing market between the date of the deed and the date of estimation.

(ii) Exploited rural estates, and finished offices, premises, and multi-purpose warehouses.– Includes land not declared as developable where construction is not authorized for uses other than its agricultural, forestry, or livestock nature; as well as multi-purpose use buildings, linked or not to an economic exploitation, that do not incorporate characteristics or constructive or regulatory elements that limit or hinder their multi-purpose use and therefore their easy realization in cash. The estimation of the value of the rights received as collateral will be, at most, the lower amount, weighted by 70%, between the cost of the estate or multi-purpose building and the appraised value in its current state. For these purposes, the cost will be formed by the purchase price declared in the public deed; in the case of construction at the expense of the borrower, the cost will be formed by the price of acquisition of the land declared in the public deed plus the amounts of work certifications, including other necessary expenses and accrued taxes, excluding financial and commercial expenses.

(iii) Finished homes (remainder).– Includes finished homes that, on the date to which the financial statements refer, have the corresponding valid habitability or occupancy certificate issued by the corresponding administrative authority, but which are not qualified for consideration in section i) above. The value of the rights received as collateral will be, at most, the lower amount, weighted by 60%, between the cost of the finished home and the appraised value in its current state. The cost will be represented by the purchase price declared by the borrower in the public deed. In the case of financing to real estate developers, the cost, in addition to the amount declared in the deed for the acquisition of the land, will include the necessary and actually incurred expenses for its development, excluding commercial and financial ones, plus the sum of the construction costs evidenced by partial work certifications, including the one corresponding to the end of work, carried out by technicians with sufficient professional qualification. In the case of groups of homes that are part of promotions partially sold to third parties, the cost will be that which can rationally be attributed to the homes constituting the guarantee.

(iv) Plots, lots, and remainder of real estate assets.– The value of the rights received as collateral will be, at most, the lower amount, weighted by 50%, between the cost of the plot or affected real estate asset and the appraised value in its current state. For these purposes, the cost will be formed by the declared purchase amount in the public deed, plus the necessary and actually incurred expenses by the borrower for the consideration of the plots or lots as consolidated urban land, as well as those indicated in the preceding section iii).

The credit risk coverage applicable to all operations classified as 'doubtful assets' referred to in this section b) will be estimated by applying to the amount of the outstanding risk exceeding the value of the guarantee, calculated according to the methodology of the letters above, and depending on the time elapsed since the due date of the first installment or term that remains unpaid from the same operation, the percentages indicated in letter a) of this section.

Under no circumstances will the coverage be lower than the amount resulting from the generic coverage based on the corresponding risk class, calculated on 100% of the parameter α corresponding among those provided in section 29.b).

18. Operations in the name of clients other than those referred to in the following section that have any of the pledge guarantees indicated below will be covered applying the following criteria:

a) Operations that have partial monetary guarantees will be covered by applying to the difference between the amount at which they are registered in the asset and the current value of the deposits the coverage percentages indicated in the general treatment established in the previous section 17.

b) Operations that have partial pledge guarantees on participations in monetary financial institutions or debt securities issued by Public Administrations or credit institutions mentioned in the risk classes as 'no appreciable risk', or other financial instruments traded in active markets, will be covered by applying to the difference between the amount at which they are registered in the asset and 90% of the fair value of said financial instruments the coverage percentages indicated in the general treatment established in the previous section 17."

6. Section 20 is given a new wording, which reads as follows:

"20. In financial leasing operations, unpaid installments up to the moment of materially recovering possession or use of the leased goods will follow the coverage treatment provided for in the remaining operations in the previous section 17, applying to financial leases on assets"