Memorandum of Understanding on Financial Sector Policy Conditions and Framework Agreement for Financial Assistance

OFFICIAL GAZETTE OF THE STATE
No. 296 Monday, December 10, 2012 Sec. I. Page 84550
I. GENERAL PROVISIONS
MINISTRY OF FOREIGN AFFAIRS AND COOPERATION
14946 Memorandum of Understanding on Financial Sector Policy Conditions, made in Brussels and Madrid on July 23, 2012, and Framework Agreement for Financial Assistance, made in Madrid and Luxembourg on July 24, 2012.
MEMORANDUM OF UNDERSTANDING BETWEEN THE EUROPEAN COMMISSION AND SPAIN This Memorandum of Understanding contains the following documents:
(a) A Memorandum on financial sector policy conditions.
The Memorandum of Understanding may be modified by mutual agreement of the Parties through an Update, which shall take effect from the moment of its signature.
Made in Brussels on 23/07/2012 and in Madrid on 23/07/2012, in three originals in English.
For Spain: Luis de Guindos Jurado, Minister of Economy and Competitiveness. Luis María Linde de Castro, Governor of the Bank of Spain.
For the European Commission: [signature] Olli Rehn, Vice-President of the European Commission.
20.07.2012
SPAIN
MEMORANDUM OF UNDERSTANDING ON FINANCIAL SECTOR POLICY CONDITIONS July 20, 2012 In relation to the Framework Agreement of the European Financial Stability Facility (EFSF), in particular its Article 2(1), this Memorandum of Understanding on financial sector policy conditions (MOU) details the policy conditions set out in the Council Decision [...] to be formally adopted on July 23, 2012, on specific measures to strengthen financial stability in Spain. Given the nature of the financial assistance provided to Spain, the conditionality will focus on the financial sector and will include both banking-related, in line with state aid rules, and horizontal aspects. In parallel, Spain must fully comply with its commitments and obligations arising from the Excessive Deficit Procedure (EDP), as well as the recommendations to correct macroeconomic imbalances within the framework of the European Semester. Progress in meeting these obligations in accordance with applicable EU procedures will be closely monitored and will run parallel to periodic reviews of program implementation. During the period of financial assistance by the EFSF, the Spanish authorities will adopt all necessary measures to ensure the proper implementation of the program. They also commit to consulting ex ante with the European Commission and the European Central Bank (ECB) on the adoption of any policy relating to the financial sector that, although not included in this MOU, could significantly impact the achievement of the program's objectives (the technical opinion of the International Monetary Fund-IMF will also be requested). They will also provide the European Commission, the ECB, and the IMF with all necessary information to monitor progress in program implementation and track the financial situation. Annex 1 contains a provisional list of data to be submitted.
I. Introduction

1. On June 25, 2012, the Spanish Government requested external financial assistance in the context of the ongoing process of restructuring and recapitalization of its banking sector. The request for aid falls within the terms of financial assistance for the recapitalization of financial institutions by the EFSF. Following this request, the European Commission, in coordination with the ECB, the European Banking Authority (EBA), and the IMF, proceeded to carry out an independent assessment of Spain's suitability to receive such assistance, the result of which was positive. The Heads of State and Government meeting at the Eurozone Summit held on June 29, 2012, clarified that, in the future, the ESM will be responsible for providing such assistance, once that institution is fully operational, without the loans acquiring the status of senior preferred debt. With regard to full compliance with this MOU, all other considerations contained in the declaration of the Eurozone Summit held on June 29, 2012, will be taken into account.
   II. Recent developments and prospects in the economic and financial sphere
2. The global financial and economic crisis has revealed weaknesses in the growth model of the Spanish economy. Spain experienced a long period of strong growth based, in part, on the boom in internal demand driven by credit. Low real interest rates triggered the accumulation of large internal and external imbalances, as well as the creation of a real estate bubble. The sudden correction of that boom in the context of the international financial crisis led to recession and job destruction.
3. The reversal of these economic imbalances is weighing on economic prospects. The deleveraging of the private sector entails a decrease in medium-term demand. The considerable need for external financing increases the vulnerability of the Spanish economy. A shift to a durable current account surplus will be necessary to reduce external debt to a sustainable level. Public debt is rising rapidly due to a high general deficit of public administrations since the start of the crisis, linked to the transition to a growth model with a lower tax component.
4. The challenges facing some segments of the banking sector continue to negatively affect the economy, as restrictions on credit flows persist. In particular, the large exposure to the real estate and construction sectors has eroded investor and consumer confidence. The tightening of links between the banking sector and sovereign financing has generated a vicious circle. Thus, the restructuring (including, where appropriate, orderly resolution) and recapitalization of banks is essential to mitigate these links, increase confidence, and boost economic growth.
5. With the exception of a few large credit institutions with diversified interests on an international scale, Spanish banks have lost access on favorable terms to wholesale funding markets. As a consequence, Spanish banks have come to rely heavily on refinancing by the Eurosistema. Furthermore, the borrowing capacity of Spanish banks has been severely impaired by the impact of the downgrade on the availability of collateral assets.
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OFFICIAL GAZETTE OF THE STATE
No. 296 Monday, December 10, 2012 Sec. I. Page 84551 IMF). They will also provide the European Commission, the ECB, and the IMF with all necessary information to monitor progress in program implementation and track the financial situation. Annex 1 contains a provisional list of data to be submitted.
I. Introduction

1. On June 25, 2012, the Spanish Government requested external financial assistance in the context of the ongoing process of restructuring and recapitalization of its banking sector. The request for aid falls within the terms of financial assistance for the recapitalization of financial institutions by the EFSF. Following this request, the European Commission, in coordination with the ECB, the European Banking Authority (EBA), and the IMF, proceeded to carry out an independent assessment of Spain's suitability to receive such assistance, the result of which was positive. The Heads of State and Government meeting at the Eurozone Summit held on June 29, 2012, clarified that, in the future, the ESM will be responsible for providing such assistance, once that institution is fully operational, without the loans acquiring the status of senior preferred debt. With regard to full compliance with this MOU, all other considerations contained in the declaration of the Eurozone Summit held on June 29, 2012, will be taken into account.
   II. Recent developments and prospects in the economic and financial sphere
2. The global financial and economic crisis has revealed weaknesses in the growth model of the Spanish economy. Spain experienced a long period of strong growth based, in part, on the boom in internal demand driven by credit. Low real interest rates triggered the accumulation of large internal and external imbalances, as well as the creation of a real estate bubble. The sudden correction of that boom in the context of the international financial crisis led to recession and job destruction.
3. The reversal of these economic imbalances is weighing on economic prospects. The deleveraging of the private sector entails a decrease in medium-term demand. The considerable need for external financing increases the vulnerability of the Spanish economy. A shift to a durable current account surplus will be necessary to reduce external debt to a sustainable level. Public debt is rising rapidly due to a high general deficit of public administrations since the start of the crisis, linked to the transition to a growth model with a lower tax component.
4. The challenges facing some segments of the banking sector continue to negatively affect the economy, as restrictions on credit flows persist. In particular, the large exposure to the real estate and construction sectors has eroded investor and consumer confidence. The tightening of links between the banking sector and sovereign financing has generated a vicious circle. Thus, the restructuring (including, where appropriate, orderly resolution) and recapitalization of banks is essential to mitigate these links, increase confidence, and boost economic growth.
5. With the exception of a few large credit institutions with diversified interests on an international scale, Spanish banks have lost access on favorable terms to wholesale funding markets. As a consequence, Spanish banks have come to rely heavily on refinancing by the Eurosistema. Furthermore, the borrowing capacity of Spanish banks has been severely impaired by the impact of the downgrade on the availability of collateral assets.
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OFFICIAL GAZETTE OF THE STATE
No. 296 Monday, December 10, 2012 Sec. I. Page 84552
III. Main Objectives
6. The Spanish banking sector has been harmed by the bursting of the real estate and construction bubble, and the consequent economic recession. As a result, several Spanish banks have accumulated large reserves of problematic assets. Concerns about the viability of some of these banks have contributed to market volatility.
7. The Spanish authorities have adopted a series of important measures to try to correct these problems affecting the banking sector. These include the cleaning up of bank balance sheets, increasing minimum capital requirements, restructuring the savings bank sector, and significantly increasing provisioning requirements for loans intended for real estate developments and foreclosed mortgage assets. These measures, however, have not been sufficient to ease market pressure.
8. The main objective of the program for the Spanish financial sector is to increase the long-term flexibility of the entire banking sector, thereby restoring its access to the market.

• As part of the general strategy, it is fundamental to provide an effective response to inherited assets, proceeding to a clear segregation of non-performing assets. This will dispel any remaining doubts about the quality of bank balance sheets, allowing these entities to perform their financial intermediation role more effectively.
• By thus improving the transparency of bank balance sheets, the program aims to facilitate an orderly reduction of banks' exposure to the real estate sector, restore market-based financing, and reduce banks' dependence on central bank support to ensure their liquidity.
• Furthermore, it is essential to refine risk identification and crisis management mechanisms, in order to reduce the probability and severity of future financial crises.
  IV. Restoring and strengthening the solidity of Spanish banks:
  Bank-focused conditionality

9. The key component of the program is a review of the vulnerable segments of the Spanish financial sector; it consists of the following three elements:

• determination of the capital needs of each bank, through a general analysis of the quality of assets in the banking sector and a bank-by-bank stress test, starting from the aforementioned analysis;
• recapitalization, restructuring and/or resolution of weak banks, based on plans addressing the capital deficits detected in the stress test; and
• segregation of assets from banks receiving public support for their recapitalization, and transfer of their non-performing assets to an external asset management entity.
  Roadmap.

10. The recapitalization and restructuring of banks will develop according to the following schedule:

• In July 2012, the program will be launched with the provision of a first tranche. In particular, until the full recapitalization of banks has been completed, some of them may face a risky situation. In a context of persistent difficulties in sovereign financing and extremely limited access of certain banks to external financing, the financial situation of the latter will remain complex. Under these circumstances, the immediate availability of a reliable support mechanism that can be mobilized in urgent cases to cover the costs of unexpected interventions contributes to restoring confidence. The first tranche will have a volume of 30,000 million euros, which the EFSF will pre-finance and keep in reserve. To use these funds before the European Commission adopts the relevant decisions on restructuring, a reasoned and quantified request from the Bank of Spain will be required, subject to the approval of the European Commission and the Eurogroup Working Group, in coordination with the ECB.
• Before the second half of September 2012, an external consultant will have completed a bank-by-bank stress test regarding the 14 banking groups that make up 90% of the Spanish banking system. The stress test, based on the results of a general study published on June 21, 2012, will estimate the capital deficits of each specific bank and open a process of recapitalization and restructuring of banking groups, as reflected in Figure 1.
• Based on the results of the stress test and the recapitalization plans, banks will be classified. Group 0 will be formed by banks where no capital deficit is detected and which do not require the adoption of further measures. Group 1 has already been predefined as banks that are already owned by the Orderly Banking Restructuring Fund (FROB) (BFA/Bankia, Catalunya Caixa, NCG Banco, and Banco de Valencia). Banks with capital deficits, according to the stress test, and which cannot cover said deficit privately and without state aid, will belong to Group 2. Finally, Group 3 will be composed of banks with capital deficits, according to the stress test, but which have reliable recapitalization plans and can cover said deficit without resorting to State aid. The distribution of banks among Groups 0, 2, and 3 will be carried out in October, based on the results of the stress test and an assessment of the recapitalization plans.
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No. 296 Monday, December 10, 2012 Sec. I. Page 84553 Figure 1. Restructuring of the Spanish Banking Sector: Schedule cve: BOE-A-2012-14946

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• In early October, banks from Groups 1, 2, and 3 will present recapitalization plans establishing the planned ways to end the detected deficit. Capital can be obtained, fundamentally, through internal measures, asset divestment, liability management practices, and also by increasing equity or resorting to state aid.
• The Spanish authorities and the European Commission will assess the viability of banks based on the results of the stress test and restructuring plans. Banks considered non-viable will be resolved in an orderly manner.
• Regarding banks in Group 1, the Spanish authorities will begin preparing restructuring or resolution plans, in conjunction with the European Commission, starting from July 2012. These plans will be completed in light of the results of the stress test and presented in time for the European Commission to approve them in November 2012. On this basis, state aid will be granted and the planned plans can be implemented immediately. Before the end of the year, the transfer of non-performing assets to an external asset management entity will have been completed.
• Regarding banks in Group 2, the Spanish authorities must present a restructuring or resolution plan to the European Commission, by October 2012 at the latest. Given the need to incorporate the results of the stress test, the approval process is expected to extend until the end of December, at which point these banks will be recapitalized or resolved in an orderly manner. All banks in Group 2 must include in their restructuring or resolution plan the necessary steps to segregate their non-performing assets to an external asset management entity.
• Regarding banks in Groups 1 and 2, no assistance will be provided until the approval of a final restructuring or resolution plan by the European Commission, except in the case that it is necessary to use the funds from the first tranche.
• For banks in Group 3 that project a significant capital increase equivalent to more than 2% of risk-weighted assets, they will be required, as a precautionary measure, to issue convertible bonds according to the recapitalization plan to meet their capital needs by December 2012 at the latest. The FROB, using program resources, will subscribe to these bonds, which can be redeemed until June 30, 2013 if the banks manage to obtain the necessary capital from private sources. Otherwise, they will be recapitalized through the total or partial conversion of the bonds into ordinary shares. Banks must present restructuring plans.
• Banks in Group 3 that plan a more limited capital increase, equivalent to less than 2% of risk-weighted assets, will have until June 30, 2013. If they fail to achieve their goal, they will be recapitalized through state aid and must present restructuring plans.
• Banks in Group 3 that, as of June 30, 2013, continue to benefit from public support under this program, must include in their restructuring plans the transfer of their non-performing assets to the asset management entity, unless it can be demonstrated, in the case of banks requiring less than 2% of risk-weighted assets in state aid, that other means to achieve full off-balance sheet segregation are less costly.
  Diagnosis.

11. The Spanish authorities will estimate the economic and accounting value of the credit portfolios and foreclosed mortgage assets of the 14 banking groups. The estimation will be carried out by an external consultant, who will rely on data provided by four independent auditors, and will develop as follows:

• Starting from a predetermined sample of operations, the accounting review will include the following: i) analysis of data quality, including the correct identification of restructured/refinanced loans; ii) verification of the cve: BOE-A-2012-14946

OFFICIAL GAZETTE OF THE STATE
No. 296 Monday, December 10, 2012 Sec. I. Page 84556 adequate classification of operations; iii) review of the calculation of asset impairment losses; and iv) assessment of the impact of new provisioning requirements on both receivable and non-receivable credits in the real estate and construction sectors.

• The expanded mandate of the auditors' due diligence procedure will also provide for the collection of data necessary for an estimation of the economic value of assets. This will include a broader sample, necessary to assess mechanisms and suitability in loan generation and classification, as well as the management of corresponding arrears, in order to check and adapt current classification and risk parameters. The information obtained by the auditors will be combined with data from each bank that, at the request of the advisor, the authorities or the banks themselves will provide directly, where appropriate. Furthermore, a rigorous estimation of the value of collateral and foreclosed mortgage assets will be carried out, which will inform the external consultant's general analysis of asset quality.

12. The analysis of asset quality will be the basis for the bank-by-bank stress test to be carried out by the external consultant. It will also be the basis for any future assessment of Spanish banks' assets (see paragraph 21). This stress test will be based on the hypotheses developed for the general study and will utilize detailed information and asset quality analysis by independent entities, through data verification and validation, and will take into account the capacity to absorb losses. All necessary information for the stress tests, including the results of the asset quality analysis, must be provided to the consultants by mid-August at the latest. The results of the stress test will be made public during the second half of September 2012. The Bank of Spain and the European Commission, in consultation with the European Banking Authority (EBA), and in coordination with the ECB, will determine the specific capital needs of each participating bank (where applicable).
13. In accordance with the adequate governance structure established in the Mandate regarding this procedure, a Strategic Coordination Committee, which will include, along with the Spanish authorities, the European Commission, the ECB, the EBA, the IMF, and a Committee of Expert Coordination, will closely supervise the work of independent entities. The latter will provide updated information to the Strategic Coordination Committee every fifteen days.
    Recapitalization, restructuring and/or resolution.
14. The approach applied to bank restructuring and resolution is based on the principles of viability, burden-sharing, and limitation of competition distortions, in a way that promotes financial stability and contributes to the flexibility of the banking sector. Recapitalization plans involving the use of public funds will give rise to a restructuring process. Restructuring plans for banks requiring public funds must demonstrate that it is possible to guarantee the long-term viability of the entity without resorting to continued state aid. Such plans must focus on the bank's ability to generate value for shareholders, given its risk profile and business model, as well as the costs associated with the necessary restructuring. The degree of restructuring necessary will depend on the relative magnitude of the public support provided.
15. Restructuring plans will address the bank's ability to generate profitable and sustainable commercial activity in the future, and its financing needs. Restructuring plans must be based on a significant cutback of unprofitable activities, proceeding to their divestment where feasible, in risk reduction through the segregation of the most problematic assets, in the rebalancing of the financing structure, including reduced dependence on the central bank for liquidity, in the improvement of corporate governance, and in functional restructuring through the rationalization of branch networks and staff. All of this should culminate in a sustainable improvement in the operating ratio of the banks concerned. Non-listed entities must also present a reasonable timeline for their entry into the stock market.

• Restructuring plans for viable banks requiring public support will detail measures to minimize the burden on taxpayers. Banks receiving state aid will contribute with their own resources, to the greatest extent possible, to the cost of restructuring. Possible measures include the sale of participations and secondary assets, the elimination of secondary activities, the prohibition of dividend payments, the prohibition of discretionary remuneration of hybrid capital instruments, and the prohibition of non-organic growth. Banks and their shareholders must suffer losses before state aid measures are approved, and guarantee the absorption of losses from capital instruments and hybrid capital instruments, to the greatest extent possible.
• In the case of non-viable banks requiring public funds, the Spanish authorities must present an orderly resolution plan. These plans must be compatible with the objectives of preserving financial stability, in particular, protecting customer deposits, minimizing the burden of resolution on the taxpayer, and allowing sound banks to acquire assets and credits within the framework of a process comp