Circular 4/2016 of the Bank of Spain, of April 27, amending Circular 4/2004 on financial information standards and Circular 1/2013 on the Risk Information Central

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Circular 4/2016, of April 27, of the Bank of Spain, amending Circular 4/2004, of December 22, to credit institutions, on standards for public and reserved financial information and models for financial statements, and Circular 1/2013, of May 24, on the Risk Information Central. (BOE of May 6, 2016) (Correction of errors BOE of June 11)

The accounting regime for Spanish credit institutions is regulated by Circular 4/2004, of December 22, on standards for public and reserved financial information, and models for financial statements. Circular 4/2004 is adapted to the accounting framework established by the International Financial Reporting Standards (IFRS) adopted by European Union regulations, in accordance with Regulation 1606/2002 of the European Parliament and of the Council, of July 19, 2002, on the application of International Accounting Standards.

Annex IX of Circular 4/2004 develops the general framework for credit risk management in those aspects related to accounting. In particular, said annex addresses, among others, the policies for granting, modifying, evaluating, monitoring, and controlling operations, which include their accounting classification and the estimation of provisions for credit risk losses.

The objective of this circular is to update Circular 4/2004, primarily its Annex IX, to adapt it to the latest developments in banking regulation, maintaining its full compatibility with the accounting framework constituted by IFRS.

This update is part of the process of improving and adapting Circular 4/2004 to regulatory novelties, incorporating applicable normative changes and identified best practices, in a context of continuous evolution and refinement of credit risk accounting.

The principles that have traditionally guided the Bank of Spain as the sectoral accounting regulator remain in this circular: i) favoring sound and solid accounting; ii) minimizing the costs and uncertainties that would arise from the coexistence of multiple accounting criteria, and iii) favoring coherence in the application and deepening of international accounting principles.

More concretely, the convenience of updating Circular 4/2004 and its Annex IX derives fundamentally from the following changes in banking regulation:

− The new wording of Article 39.4 of the Commercial Code, introduced by Law 22/2015, of July 20, on Audit, which considers that all intangible assets have a defined useful life and, therefore, become amortizable. This new accounting criterion applies to individual and consolidated accounts not directly subject to IFRS.

− Royal Decree 878/2015, of October 2, which reforms the system for compensation, settlement, and registration of negotiable securities, under which the change of ownership in the sale and purchase of equity instruments will occur on the settlement date, rather than on the trade date, affecting their accounting recording.

− Commission Implementing Regulation (EU) No 680/2014, of April 16, laying down implementing technical standards with regard to reporting of information by institutions for supervisory purposes, in accordance with Regulation (EU) No 575/2013 of the European Parliament and of the Council, which includes definitions and formats for the preparation of supervisory financial information statements (known as FINREP). In particular, FINREP includes definitions of non-performing exposures and exposures with forbearance measures (restructured or refinanced), which impact the classification of operations based on their credit risk.

− The 2015 update of the Basel Committee on Banking Supervision guidelines on the management and accounting of credit risk, which provide guidelines to strengthen their robustness and coherence within the applicable accounting framework.

Taking into account the aforementioned regulatory developments, the update of Annex IX introduced by this circular seeks to deepen the coherent application of the current accounting framework by strengthening the criteria affecting: i) policies, methodologies, procedures, and criteria for credit risk management, including those related to received collateral, in aspects related to accounting; ii) the accounting classification of operations based on credit risk; and iii) individual and collective provision estimates.

It should be noted that these improvements are not of a transitional nature. Thus, even if IFRS 9 is adopted in the European Union, the criteria introduced in this circular will remain in force, aimed at strengthening credit risk management, the correct classification of operations, the solidity of provision estimates, and the adequate treatment of real collateral for accounting purposes. All this, without prejudice to a future modification of Annex IX to adapt the coverage criteria of the incurred loss model, which remains in force in the updated Annex IX, to the expected loss model, which will be introduced by IFRS 9.

On the other hand, it is necessary to modify Circular 1/2013, of May 24, on the Risk Information Central (CIR), to adapt its information requirements to the changes introduced in Circular 4/2004 by this circular.

This circular has the following structure: a first rule introducing modifications in several rules of the body of Circular 4/2004; a second rule with modifications in Annexes I, III, IV, V, and IX of said Circular 4/2004; a third rule modifying the body of Circular 1/2013; a fourth rule to modify Annexes 1 and 2 of this latter circular; two transitional provisions, regarding the first application of the new accounting criteria and the submission of reserved individual statements until December 31, 2016, respectively; and a final provision on its entry into force. Additionally, this circular has three annexes: Annex 1, with the text of the updated Annex IX, which replaces the previous one; Annex 2, with the new indexes of public and reserved individual statements, as well as the formats of the new reserved individual and consolidated statements incorporated by this circular; and Annex 3, with the modifications in the data module on real collateral of the CIR.

Rule 1 updates the following rules of Circular 4/2004:

− Rules eighth, sixty-sixth, seventy-second, and the additional provision second, to reflect changes in the organizational chart of the Bank of Spain carried out during 2015.

− Rule twenty-second, to adapt it to the modification in the change of ownership in the sale and purchase of equity instruments, which now takes place on the settlement date rather than on the trade date, pursuant to Royal Decree 878/2015, of October 2.

− Rules twenty-eighth, thirtieth, and forty-third, to refer to the new accounting criterion on the amortization of intangible assets, introduced by the latest modification of the Commercial Code through Law 22/2015, of July 20, on Audit, applicable from January 1, 2016, to individual accounts and consolidated accounts not directly subject to the IFRS framework.

− Rules sixtieth, sixty-fourth, and sixty-seventh, to adapt them to the new structure of Annex IX and the new operation classification criteria incorporated into said annex.

− Rules sixty-seventh and sixty-ninth, to adapt the reserved statements to the changes derived from this circular.

Rule 2 introduces:

− Annex 1, whose content replaces that of Annex IX of Circular 4/2004.

− Modifications in the following statements of Circular 4/2004 to adapt them to the content of Annex 1: the public individual statements of Annex I, the public consolidated statements of Annex III, the reserved individual statements of Annex IV, and the reserved consolidated statements of Annex V.

− Annex 2, which contains the formats of the new reserved individual and consolidated statements added in Annexes IV and V of Circular 4/2004, for supervisory monitoring of the improvements introduced by Annex 1, as well as the new indexes of public and reserved individual statements.

Rule 3 modifies Rule 2 of Circular 1/2013 to adapt it to the new accounting classification criteria for operations by credit risk of the updated Annex IX.

Rule 4 introduces Annex 3, which modifies the content of the data module on real collateral of the CIR in Annex 1 of Circular 1/2013, and the instructions for elaborating it in Annex 2 of said circular, to adapt them to the improvements introduced by Annex 1 of this circular.

Below is a summary of the content of Annex 1, highlighting the main changes introduced in each of its five sections, after the introduction.

Introduction

It contains the objectives and scope of application. While the scope of application of the accounting classification criteria by credit risk is the total activity of the entity, the scope of application of the alternative solutions for coverage estimation, as well as the references for the valuation of foreclosed real estate assets, is limited to business in Spain. The formulation of consolidated accounts will be carried out by applying to foreign dependent entities estimation methodologies for coverage similar to those contemplated in this annex, although adapted to the particularities of the country in which such dependents operate.

General framework for credit risk management

This section on policies, methodologies, procedures, and criteria for credit risk management has been updated, taking into account supervisory experience and international best practices, under the auspices of the Bank of Spain's powers to issue the necessary provisions regarding credit and counterparty risk attributed to it by Article 46 and the final sixth provision of Royal Decree 84/2015, of February 13, which develops Law 10/2014, on the ordering, supervision, and solvency of credit institutions. This is without prejudice to decisions, recommendations, and orientations that the European Central Bank may adopt in the future regarding the management and supervision of credit risk.

This first section is structured in four sections: i) granting of operations; ii) modification of conditions; iii) evaluation, monitoring, and control of credit risk; and iv) collateral and valuations.

In the first section, on "granting of operations," emphasis is placed on the pricing policy of entities; in particular, on the accounting repercussions of the confrontation between the price of operations and their cost at the time of granting.

In the second section, on "modification of conditions" of operations, concepts applicable to restructured or refinanced operations are aligned with FINREP, and their accounting classification by credit risk is simplified.

The third section, on "evaluation, monitoring, and control of credit risk," contains the general principles for coverage estimates, which refer to governance, integration in management, effectiveness, simplicity, documentation, and traceability. It should be noted that, in application of the principle of effectiveness, entities must carry out periodic checks through retrospective tests (backtesting) between estimated losses and actually experienced ones, benchmarking exercises using the alternative solutions offered in the updated Annex IX and comparative information published by the Bank of Spain, as well as sensitivity analysis; furthermore, the entity must ensure coherence between the accounting classification of operations based on credit risk and its coverage level.

Credit risk coverage may be "generic," to cover incurred but not yet realized losses in a group of operations with similar risk characteristics, or "specific," to cover incurred losses in a specific operation. Generic provisions for normal risks will be estimated collectively; specific provisions for doubtful risks may be estimated individually or collectively.

The aforementioned general principles should guide the development of both proprietary methodologies for making individual estimates of specific provisions and internal methodologies for collective estimates of specific and generic provisions. This section also provides specific requirements for individual estimates and, separately, for collective estimates. Entities must internally validate compliance with these principles and requirements both before the first use of said methodologies and periodically during their application.

Additionally, this section includes criteria to identify operations whose coverage will be subject to individual estimation and those whose coverage will be subject to collective estimation.

In the fourth and final section, on "collateral and valuations," effective real and personal guarantees are developed, along with the requirements to determine the reference valuation of real collateral; all of this, for the purposes of coverage estimation, where effective collateral plays a fundamental role. These requirements are tightened as the accounting classification of the risk worsens, increasing the required frequency for their update and the requirements on the valuation procedures used.

Classification of operations based on credit risk due to insolvency

This section includes the definition and characteristics of the categories in which operations are classified accounting-wise based on the insolvency risk of the holder or the operation, which are: normal, doubtful, and defaulted.

The main novelties are the disappearance of the "substandard" category and the inclusion of a new category of risks identified as "under special surveillance" within normal risks. This category includes operations that present weaknesses in their solvency, but without raising doubts about their total repayment; among others, restructured or refinanced operations identified in FINREP as "in probation period."

The distinction between doubtful risks and normal risks in the updated Annex IX is aligned with the distinction between exposures with and without default (non-performing and performing) of FINREP. Likewise, the classification as doubtful risks of operations of a holder due to the accumulation of delinquent operations (known as "drag effect") is aligned with FINREP.

The classification of operations as defaulted risks, considering their recovery remote, takes into account the time elapsed since their qualification as doubtful and since the portion not covered by real collateral was fully provisioned.

Coverage of loss due to credit risk of insolvency

This section establishes the criteria for the estimation of coverage, for whose calculation:

− The existence of effective collateral will be taken into account when establishing the levels of both specific and generic provisions. The calculation of coverage will be made on the amount of risk exceeding the amount recoverable from effective real collateral. In case of effective personal collateral, the effect of substituting the direct holder by the guarantor may be considered.

− The amount recoverable from real collateral will be estimated by applying to its reference value, determined as established in the section on "collateral and valuations" of the first section, the necessary adjustments to adequately incorporate the uncertainty of the estimation and its reflection in potential value drops of the real collateral until its execution and subsequent sale, as well as execution, maintenance, and sale costs.

In application of the principle of proportionality, this section offers alternative solutions, calculated based on sectoral information and the accumulated experience of the Bank of Spain, for the estimation of specific coverage of doubtful risks and generic coverage of normal risks by those entities that have not developed internal methodologies for these estimates.

In these alternative solutions, the same risk segmentation is used for generic and specific coverage, based on FINREP concepts. The alternative solutions for estimating generic coverage are simplified, consisting of a percentage, which depends on the risk segment, to be applied to the gross book value of the operation not covered by effective collateral.

The Bank of Spain will keep the alternative solutions updated, taking into account the accumulated experience at each moment on the Spanish banking sector. Furthermore, the Bank of Spain plans to periodically carry out benchmarking exercises of provision levels in the Spanish banking sector and publish its results at an aggregate scale.

Credit risk due to country risk

The accounting classification criteria and coverage of losses due to credit risk due to country risk have not changed in relation to those of the replaced Annex IX.

Foreclosed or received-in-payment real estate assets

This section includes criteria for the valuation of assets foreclosed or received in payment of debts, including the estimation of their impairment. The release of coverage in applied financial assets and the reversal of accumulated impairment since the initial recognition of foreclosed or received-in-payment assets are allowed when the estimation of the fair value of the latter is corroborated by the entity's ability to realize the assets, taking into account the entity's sales experience and inventory turnover, as well as the time the asset remains on the balance sheet.

In sum, the Bank of Spain, through this circular, continues the process of adaptation and improvement of Circular 4/2004, particularly its Annex IX, with the objective of favoring sound and solid accounting in the application and deepening of the accounting framework represented by IFRS.

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 contains the following rules:

Rule 1.

Modifications in the wording of the rules of Circular 4/2004.

The following modifications are introduced in the rules of Circular 4/2004 [ 1 ] :

a) In rule eighth, on "Accounting Criteria," the first paragraph of section 4 is replaced by the following text:

"4. Consultations on the application of accounting criteria not contemplated in the circular shall be addressed to the Bank of Spain (General Directorate of Supervision) and shall include, along with the proposed accounting treatment, an exhaustive description of the transaction or event to be accounted for, indicating, when feasible, its possible quantitative impact on the financial statements, and the reasons that, in the opinion of the board of directors or equivalent body, justify the proposed treatment. The Bank of Spain, if it does not consider said treatment adequate, will indicate the accounting criterion that should be applied, which, in any case, will be coherent and compatible with the criteria regulated in this title, current Spanish accounting standards, and International Financial Reporting Standards approved by European Commission regulations for other transactions and events with which they have similarity. If the Bank of Spain considers such criteria of interest for other credit institutions, it will proceed to their public dissemination."

b) In rule twenty-second, on "Recognition, classification, and valuation of financial instruments," the last paragraph of section 2 is modified, which reads as follows:

"In particular, operations carried out in the foreign exchange market and financial assets traded in the secondary Spanish securities markets, whether they are equity instruments or debt-representing securities, shall be recognized on the settlement date."

c) In rule twenty-eighth, on "Intangible Assets," the following modifications are made:

i) Section 5 is replaced by the following text:

"5. In individual annual accounts and in consolidated accounts not subject to the framework of International Financial Reporting Standards adopted in the European Union, intangible assets shall be assets with a defined useful life.

The useful life of intangible assets shall not exceed the period during which the entity has the right to use the asset; if the right to use is for a limited period that may be renewed, the useful life shall include the renewal period only when there is evidence that the renewal will be carried out without significant cost.

When the useful life of intangible assets cannot be estimated reliably, they shall be amortized over a period of ten years. It shall be presumed, unless proven otherwise, that the useful life of goodwill is ten years.

Intangible assets shall be amortized in accordance with the criteria established for tangible assets in paragraph B.2) of rule twenty-sixth.

The entity shall review, at least at the end of each fiscal year, the period and method of amortization of each of its intangible assets and, if it considers them not adequate, the impact shall be treated as a change in accounting estimates, in accordance with rule nineteenth.

Whenever there are indications of impairment of intangible assets, including goodwill, the entity shall proceed to analyze whether there is impairment of value, in accordance with the procedure established in rule thirtieth."

ii) A new section 5 bis is added, with the following text:

"5 bis. In consolidated accounts other than those referred to in section 5 above, the entity shall assess whether the useful life of intangible assets other than goodwill is defined or indefinite. Assets with defined useful life shall be amortized, while those with indefinite useful life shall not be amortized; in no case shall the amount recognized for goodwill be subject to amortization.

An intangible asset shall have an indefinite useful life when, based on analyses performed of all relevant factors, there is no foreseeable limit to the period during which it is expected that the asset will generate net cash inflows to the entity.

Intangible assets with indefinite useful life shall not be amortized, although the entity shall review their useful life in each fiscal year and, if as a result"