Circular 3/2020 of the Bank of Spain modifying Circular 4/2017 on financial information and credit risk classification

OFFICIAL STATE GAZETTE
No. 168 Tuesday, June 16, 2020 Sec. I. Page 40318
I. GENERAL PROVISIONS
BANK OF SPAIN
6187 Circular 3/2020, of June 11, of the Bank of Spain, modifying Circular 4/2017, of November 27, to credit institutions, on rules of public and reserved financial information and models of financial statements.
I
The public health emergency situation created by the spread of COVID-19 and the necessary containment measures are causing a high-intensity disruption to the Spanish economy, affecting companies and households. As a complement to the urgent extraordinary measures to address the economic and social impact of COVID-19, it is necessary for credit institutions and credit finance establishments to continue providing financial support to companies and households negatively affected by this temporary and exceptional situation. In this context, banking regulators and supervisors worldwide are recommending the proper use of the flexibility implicit in the regulatory framework, without prejudice to the adequate identification of deterioration in operations and a reasonable estimation of their coverage for credit risk. Specifically, the European Banking Authority (EBA), in its Communication of March 12, 2020, on actions to mitigate the impact of COVID-19 on the banking sector of the European Union (EU), recommends the full use of the flexibility implicit in the regulatory framework and develops this recommendation in aspects related to the accounting classification of operations by credit risk, included among others in its Communication of March 25, 2020, on the application of the regulatory framework regarding default, restructurings or refinancings, and IFRS 9 in light of COVID-19 response measures. The use of existing flexibility in the accounting framework implies, among other considerations, avoiding the automatic use of those indicators and hypotheses that, although they have proven reasonable until now, have shown not to be adequate in the context of COVID-19 or for the future. In this line, so that Spanish entities subject to Circular 4/2017, of November 27, to credit institutions, on rules of public and reserved financial information and models of financial statements, can make greater use of the flexibility provided for in the regulations, in line with the recent EBA communications of March 12 and 25, it is appropriate to modify certain aspects of said circular regarding the classification of refinancings or restructurings that serves as the basis for the estimation of their credit risk coverage. Through the modification introduced by this circular, restructured, refinanced or refinancing credit operations will not have to be classified as normal risk under special watchlist when their classification as doubtful risk does not correspond. That is, these operations may continue to be classified as normal risk on the date of refinancing or restructuring provided that the entity justifies that it has not identified a significant increase in credit risk since initial recognition. Likewise, operations of this type that are in the category of normal risk under special watchlist may be reclassified to normal risk provided that the significant increase in credit risk has been reversed. However, they must remain identified as restructured, refinanced or
refinancing until the minimum two-year probation period concludes, during which the holder must demonstrate good payment behavior. cve: BOE-A-2020-6187 Verifiable at https://www.boe.es

OFFICIAL STATE GAZETTE
No. 168 Tuesday, June 16, 2020 Sec. I. Page 40319 This modification allows entities subject to Circular 4/2017, of November 27, to make greater use of the flexibility implicit in the EBA Guidelines on credit risk management practices of credit institutions and the accounting of expected credit losses (EBA/GL/2017/06), which indicate that the restructuring or refinancing of an operation is a factor, among others, that entities will analyze to assess whether a significant increase in the credit risk of the operation has occurred or not. This same flexibility is also implicit in the European accounting framework formed by the International Financial Reporting Standards adopted in the European Union (IFRS-EU). According to IFRS-EU 9, on financial instruments, modifications of credit operations could be classified in stage 1 (equivalent to the normal risk category) if they have not experienced a significant increase in their credit risk. Within the framework of IFRS-EU 9, the change introduced by this circular consists in the fact that the existence of financial difficulties of the debtor is considered a rebuttable presumption of a significant increase in the credit risk of the modified operation, instead of automatically implying that the aforementioned increase has occurred. Therefore, the modification introduced by this circular allows maintaining compatibility with IFRS-EU 9. Finally, it should be recalled that this modification also affects credit finance establishments by virtue of the reference to the criteria of Circular 4/2017, of November 27, made in Circular 4/2019, of November 26, to credit finance establishments, on rules of public and reserved financial information and models of financial statements. II This circular consists of one provision, two transitional provisions, and one final provision. The single provision collects the modifications necessary to introduce in Annex 9, on "Analysis and coverage of credit risk", of Circular 4/2017, of November 27, so that restructured, refinanced or refinancing credit operations do not have to be necessarily classified as normal risk under special watchlist when their classification as doubtful risk does not correspond. Such operations could continue to be classified as normal risk provided that the entity justifies that it has not identified a significant increase in credit risk since initial recognition. The first transitional provision establishes that entities will adapt, when necessary, their methodologies, procedures and accounting practices to apply the modifications collected in this circular from June 30, 2020, at the latest. However, entities may opt to apply them from March 31, 2020. The modification introduced by this circular will be applied prospectively to all restructurings or refinancings, including both operations carried out prior to the date of its first application and new operations carried out after said date (in the context of COVID-19 or once this situation is overcome).
The prospective application of the modification implies that entities will not have to review nor the classification nor the credit risk coverage of operations in financial information of reference dates prior to June 30, 2020 (or, if applicable, March 31, 2020), nor resubmit the corresponding accounting information for said dates or rework the comparative information of 2019. The second transitional provision sets the regime for the first application of this circular to public and reserved financial statements, in a manner consistent with its first application to annual accounts. Finally, in accordance with the single final provision, this circular will enter into force the day following its publication in the "Official State Gazette". cve: BOE-A-2020-6187 Verifiable at https://www.boe.es

OFFICIAL STATE GAZETTE
No. 168 Tuesday, June 16, 2020 Sec. I. Page 40320 III This circular attends to the principles of good regulation required by Article 129 of Law 39/2015, of October 1, on the common administrative procedure of Public Administrations.
Regarding the principles of necessity and efficacy stipulated in said law, this circular is limited to introducing the necessary modifications in Annex 9, on "Analysis and coverage of credit risk", of Circular 4/2017, of November 27, so that restructured, refinanced or refinancing operations do not have to be necessarily classified as normal risk under special watchlist when their classification as doubtful risk does not correspond, thus allowing entities to make greater use of the flexibility provided for in the EBA Guidelines EBA/GL/2017/06. In this way, it facilitates that entities grant new financing or change the contractual conditions of financing already granted to companies and households. As for the principle of proportionality, the modifications introduced in Circular 4/2017, of November 27, allow Spanish entities to make greater use of the flexibility provided for in the EBA Guidelines EBA/GL/2017/06, in terms similar to entities in other EU countries. These modifications relax the credit risk classification requirements for a specific type of credit operations, so that entities would not have to change their accounting practices if they do not consider it appropriate to rebut the presumption that these operations must be classified as normal risk under special watchlist. Regarding the principles of legal certainty and administrative efficiency, they are achieved by prescribing Circular 4/2017, of November 27, a stable, predictable, complete and clear accounting regulation for entities. The modifications introduced by this circular represent a greater alignment with what is established in the EBA Guidelines EBA/GL/2017/06, maintaining compatibility with IFRS-EU 9. In application of the principle of transparency, paragraphs 1 and 2 of Article 133 of Law 39/2015, of October 1, on Common Administrative Procedure, provide that prior public consultation, hearing and public information be carried out. However, paragraph 4 of said Article 133 contemplates the possibility of dispensing with these procedures when serious reasons of public interest justify it, as well as the possibility of dispensing with prior consultation when the normative proposal does not have a significant impact on economic activity, does not impose relevant obligations on recipients or regulates partial aspects of a matter. In the processing of this circular, the procedures of consultation, hearing and public information have been dispensed with, first, because there is a public interest of special gravity that justifies it. Given the public health emergency situation, and its exceptional economic effects, the immediate entry into force of the rule is necessary, to contribute as soon as possible to the maintenance of financing to the real economy, mitigating the disruptions the Spanish economy is experiencing. Second, this circular does not impose any additional obligation on entities on how to classify their credit operations. On the contrary, it relaxes the application
of the rule by allowing them now to rebut the presumption that certain credit operations must be classified as normal risk under special watchlist. In fact, entities can maintain their current accounting practices if they consider it appropriate not to rebut said presumption. Third, the modification introduced by this circular is confined to a specific aspect, providing greater flexibility, without a change in the accounting regime occurring. The Bank of Spain is authorized to establish and modify the accounting rules of credit institutions, in accordance with what is provided in the Order of the Ministry of Economy and Finance of March 31, 1989, which empowers the Bank of Spain to establish and modify the accounting rules of credit institutions. Consequently, in exercise of the powers granted, the Governing Council of the Bank of Spain, on the proposal of the Executive Commission, and in accordance with the Council of State, has approved this circular, which contains the following norms:
Single Provision. Modification of Circular 4/2017, of November 27, to credit institutions, on rules of public and reserved financial information and models of financial statements.
The following changes are introduced in Annex 9, on "Analysis and coverage of credit risk", of Circular 4/2017, of November 27:
a) Point 24 is modified, which reads as follows:
"24. Refinancing and restructuring policies must ensure that the entity has in its internal information system mechanisms that allow adequate identification and monitoring of refinancing, refinanced and restructured operations, as well as their adequate accounting classification based on their credit risk. The decisions adopted will be reviewed periodically, in order to check the adequate compliance with refinancing and restructuring policies. An operation will cease to be identified as refinancing, refinanced or restructured when the requirements of point 100 are met. However, in accordance with the traceability principle stated in point 45, the entity's internal information system must retain information on the modification made, necessary to ensure at all times the adequate monitoring, evaluation and control of the operation." b) Point 58 is modified, which reads as follows:
"58. The coverage of all operations for which an individualized estimation is not required will be subject to collective estimation. Therefore, the coverage of the following operations will be subject to collective estimation:
a) Those classified as doubtful due to delinquency (distinct from those that were identified as with low credit risk) that are not considered significant, including those classified as doubtful risk due to delinquency due to accumulation of overdue amounts in other operations with the same holder. b) Operations classified as doubtful for reasons other than delinquency (distinct from those that were identified as with low credit risk) considering exclusively automatic classification factors, as in the cases of:
i. Refinancing, refinanced or restructured operations that do not have overdue amounts older than ninety days but remain classified as doubtful risk because the remaining requirements for their reclassification outside this category are not verified, according to what is established in point 120.
ii. Refinancing, refinanced or restructured operations in probation period reclassified to doubtful risk due to being subject to the second or subsequent refinancings or restructurings, or due to having overdue amounts with an age greater than thirty days, according to what is established in point 102.
c) Those classified as normal risk under special watchlist that are not considered significant. d) Those classified as normal risk under special watchlist as a result of an individual analysis of the operation in which exclusively automatic factors were considered or in which no factor other than automatic ones had a decisive influence. This is the case, among others, of operations classified in this category because the holder has overdue amounts with more than thirty days of age, according to what is established in point 95. e) Those classified as normal risk under special watchlist due to their belonging to a group of operations with similar credit risk characteristics ('homogeneous risk group'). This is the case, among others, of groups of operations classified in this category due to the holder belonging to collectives (such as geographic areas or economic activity sectors) in which weaknesses are observed. f) Those classified as normal risk." c) In point 99, the first paragraph is modified, which reads as follows, and the fourth paragraph is suppressed:
"99. Operations classified in this category may be reclassified to normal risk if the causes that motivated their classification as normal risk under special watchlist disappear. Generally speaking, the reclassification criteria from special watchlist to normal upon a favorable evolution of credit risk must be consistent with those that determine the inverse reclassification upon an unfavorable evolution. However, this consistency must be applied only to the extent that the criterion analyzed represents a reversal of the significant increase in credit risk." d) Section II.B.2, titled "Refinancing, refinanced or restructured operations classified as normal risk under special watchlist", is renamed "Refinancing, refinanced or restructured operations other than those classified as doubtful risk". e) Point 100 is modified, which reads as follows:
"100. Refinancing, refinanced or restructured operations for which their classification as doubtful is not appropriate on the date of refinancing or restructuring, according to what is established in points 115 and 116, or having been reclassified from the doubtful risk category, upon meeting what is established in point 120 for their reclassification, will remain identified as such, during a probation period, until all the following requirements are met:
a) That it has been concluded, after an exhaustive review of the holder's asset and financial situation, that it is not foreseeable that they may have financial difficulties. b) That a minimum period of two years has elapsed since the date of formalization of the refinancing or restructuring operation, or, if later, since the date of reclassification from the doubtful risk category. c) That the holder has paid the accrued principal and interest installments since the date on which the refinancing or restructuring operation was formalized, or, if later, since the date of reclassification from the doubtful category. Additionally, it will be necessary:
i. That the holder has satisfied through regular payments an amount equivalent to all amounts (principal and interest) that were overdue on the date of the refinancing or restructuring operation, or that were written off as a consequence of it, or
ii. That other objective criteria have been verified that demonstrate the holder's payment capacity, when it is more appropriate considering the characteristics of the operations.
cve: BOE-A-2020-6187
Verifiable at https://www.boe.es

OFFICIAL STATE GAZETTE
No. 168 Tuesday, June 16, 2020 Sec. I. Page 40323 Therefore, the existence of contractual clauses that delay repayment, such as grace periods for principal, will imply that the operation remains identified as refinancing, refinanced or restructured until the criteria described in this letter are met. d) That the holder does not have any other operation with overdue amounts more than thirty days at the end of the probation period.
Therefore, when all the previous requirements are met, the operations will cease to be identified in the financial statements as refinancing, refinanced or restructured operations, without prejudice to the information on the modifications made in the operations being duly recorded in the entity's databases, as stated in point 24, in application of the traceability principle, and declared to the Risk Information Central.
While they remain identified as such, refinancing, refinanced or restructured operations that do not require classification as doubtful risk will be included in the normal risk under special watchlist category, unless the entity justifies that it has not identified a significant increase in their credit risk since initial recognition, in which case the operation will be classified as normal risk." f) Point 117 is modified, which reads as follows:
"117. When the refinancing or restructuring of an operation that was previously classified as normal risk or normal risk under special watchlist occurs, the entity must perform the analysis described in points 115 and 116 to determine whether the reclassification to doubtful risk of the operation is appropriate or not:
a) When this analysis results in that the reclassification to doubtful risk of the operation is not appropriate, the entity will not derecognize the existing financial asset in its entirety from the balance sheet, as no substantial modification in the amounts it expects to recover before and after the refinancing or restructuring has been manifested; only the partial derecognition of amounts on which it has ceased to have rights or of failed amounts will proceed, if applicable. The existing financial asset will be classified according to what is established in point 99. b) When the analysis results in that the reclassification to doubtful risk of the operation is appropriate, the entity will determine whether the derecognition of the existing financial asset in its entirety from the balance sheet is appropriate following the policies established for this purpose. When derecognition is appropriate, the new recognized asset will be a purchased or originated financial asset with credit impairment. When derecognition is not appropriate, the entity will classify the existing financial asset as doubtful risk and proceed, if applicable, to the partial derecognition of amounts on which it has ceased to have rights or of failed amounts." g) Point 120 is modified, which reads as follows:
"120. To proceed with reclassification outside the doubtful risk category, it will be necessary that all criteria that, generally speaking, determine the reclassification of operations outside this category, and the specific criteria collected below, are verified:
a) That it has been concluded, after an exhaustive review of the holder's asset and financial situation, that it is not foreseeable that they may have financial difficulties. b) That a minimum period of one year has elapsed since the date of refinancing or r