DIFFERENT APPROACHES FOR CREDIT RISK CONTROL AND LOAN LOSS PROVISIONING THE SPANISH EXPERIENCE

1. DIFFERENT APPROACHES FOR CREDIT RISK CONTROL AND LOAN LOSS PROVISIONINGTHE SPANISH EXPERIENCE Javier de la Cruz Bucharest, April 2007

2. FINANCIAL INFORMATION FLOWS

3. FINANCIAL INFORMATION FLOWS PUBLIC REGISTERS LEGAL INFORM. BANKING SUPERVISORS INVESTORS SUPERVISORS SHAREHOLDERS CRAs SECURITIES SUPERVISORS FINANCIAL ANALYSTS FINANCIAL INFORMATION NATIONAL COSTUMERS TAX AUTHORITIES CCR REGIONAL. LOCAL... MANAGERS MEDIA ... CENTRAL BANK & NATIONAL FINANCIAL MARKETS STATISTICAL REQUIREMENTS MIS BUDGETS, MARKETING, ... INTERNA TIONAL PRIVATE SECTOR INTERNAL PURPOSES PUBLIC SECTOR

4. FINANCIAL INFORMATION FLOWS PUBLIC REGISTERS LEGAL INFORM. BANKING SUPERVISORS INVESTORS SUPERVISORS SHAREHOLDERS CRAs SECURITIES SUPERVISORS FINANCIAL GROUPS INTERNATIONAL ACTIVITIES FINANCIAL ANALYSTS FINANCIAL INFORMATION NATIONAL COSTUMERS TAX AUTHORITIES CCR REGIONAL. LOCAL... CONSOLIDATION DIFFERENT COUNTRIES MANAGERS MEDIA ... CENTRAL BANK & NATIONAL FINANCIAL MARKETS STATISTICAL REQUIREMENTS MIS BUDGETS, MARKETING, ... INTERNA TIONAL PRIVATE SECTOR INTERNAL PURPOSES PUBLIC SECTOR

5. FINANCIAL INFORMATION FLOWS There are many information users with different needs, so there must be different and specific information flows, regardless of convergence efforts.

6. FINANCIAL INFORMATION GENERATION

7. FINANCIAL INFORMATION GENERATION TRADITIONAL APPROACH BUSINESS OPERATIONS ACCOUNTING FINANCIAL STATEMENTS FINANCIAL INFORMATION = TRANSFORMATION ACCOUNTING IS THE BASE (THE TRUTH ?) PRIVATE SECTOR INTERNAL SECTOR PUBLIC SECTOR

8. FINANCIAL INFORMATION GENERATION MODERN APPROACH PRIVATE SECTOR I.T. INTERNAL SECTOR DATABASES APPLICATIONS PRINCIPLES & PARAMETERS BUSINESS OPERATIONS PUBLIC SECTOR FINANCIAL INFORMATION I.T. IS THE INSTRUMENT BUSINESS IS THE BASE ACCOUNTING IS JUST ONE OF THE OUTPUTS !

9. FINANCIAL INFORMATION GENERATION Information must be stored with a business perspective, IT allows to easily prepare reports in quite different ways, according to what is needed in each case.

10. CREDIT RISK

11. CREDIT RISK TRADITIONAL APPROACH RISK IS A NEGATIVE ELEMENT RISK MUST BE REDUCED OR ELIMINATED LENDING BASED ON EXPERIENCE AND COLLATERAL LOAN LOSSES ARE A NEGATIVE SURPRISE = GENERIC PROVISIONS HIDDEN RESERVES CLOSE TO CAPITAL CONSERVATIVE APPROACH LOAN LOSS PROVISIONING IS MADE CASE BY CASE EX ANTE PROVISIONS EX POST PROVISIONS SPECIFIC PROVISIONS

12. CREDIT RISK MODERN APPROACH INTERNAL MODELS PD & LGD & EL & UL RISK IS PART OF THE BUSINESS RISK MUST BE CONTROLLED AND MANAGED CREDITS GRANTED ON CREDIT RISK EVALUATION LOAN LOSSES ARE INCORPORATED TO INTEREST RATES PRICING = SPECIFIC PROVISIONS GENERIC PROVISIONS STATISTICAL PROVIONS “ANTICYCLICAL PROVISIONS” EL LGD EX POST ESTIMATION CAPITAL EX ANTE ESTIMATION LOAN LOSS PROVISIONING REAL LOSS STATISTICAL PROVISIONS SPECIFIC PROVISIONS = = & UL SOLVENCY CAPITAL REQUIREMENTS GENERIC PROVISIONS UNEXPECTED LOSS = = = CONFIRMED LOSS UNEXPECTED LOSS EXPECTED LOSS

13. CREDIT RISK Credit Risk Control and Management has significantly improved and this must be recognised from all the relevant perspectives.

14. ACCOUNTING AND SUPERVISORYAPPROACHES

15. ACCOUNTING AND SUPERVISORY APPROACHES ACCOUNTING APPROACH EFFECTIVE INT. RATES LOAN LOSS PROVISIONING REAL LOSSES CASE BY CASE ESTIMATIONS PORTFOLIO ESTIMATIONS PRESENT LOSSES + = = POLICY EFFECTS STANDARDS SETTER? ACCOUNTING IAS CONVERGENCE = UNDERSTANDING INTERNATIONAL STANDARDS SUPERVISION BASEL SUPERVISORY APPROACH FORWARD LOOKING CAPITAL LOAN LOSS PROVISIONING EXPECTED LOSSES PD LGD AVERAGE LOSSES * = =

16. ACCOUNTING AND SUPERVISORYAPPROACHES Accounting and supervisory approaches are evolving and converging on an international basis in a parallel way, although there is still a clear need for mutual understanding, ON AN INTERNATIONAL BASIS AND UNDER MODERN RISK CONTROL AND MANAGEMENT FRAMEWORKS.

17. TAXATIONAPPROACH

18. TAXATION APPROACH TRADITIONAL APPROACH FINANCIAL STATEMENTS TAX FORMS TAXES ARE A % OF PROFITS = SUPERVISORY PROVISIONS PROVISION CAPS TAX PROVISIONS FINANCIAL INFORMATION IS AN INSTRUMENT, NOT THE TARGET HIGHER PROVISIONS = LOWER TAXES BALANCE OF POWER TAX AUTHORITIES FISCAL POLICIES INCENTIVES FOR LOWER PROVISIONS TAXES = INCENTIVES FOR HIGHER PROVISIONS TAXES = INCENTIVES FOR HIGHER PROVISIONS BANKING SUPERVISORS BANKS SOLVENCY = INCENTIVES FOR HIGHER PROVISIONS IMAGE = INCENTIVES FOR LOWER PROVISIONS

19. TAXATION APPROACH MODERN APPROACH FINANCIAL STATEMENTS PROFIT AND LOSS TAXES BALANCE OF POWER BANKING SUPERVISORS + ACCOUNTING STANDARDS SETTERS FISCAL POLICIES DEFERRED & ANTICIPATED TAXES TECHNICAL CRITERIA ADJUSTMENTS TO TAXES, NOT TO PROFITS FINANCIAL INFORMATION

20. TAXATIONAPPROACH Tax issues should no longer directly influence financial information. Taxation should begin where profits and losses are technically determined.

21. THE SPANISH EXPERIENCE

22. THE SPANISH EXPERIENCE OBJECTIVE EVENTS (TIME) NON-PERFORMING LOANS EARLY 1980´s DEFAULT EVENTS SUBJECTIVE EVENTS (FINANCIAL CONDITION) NON-PERFORMING DEBTORS ASSETS CLASSES TYPE OF LENDING SPECIFIC PROVISIONS AS % OF LOANS COLLATERAL & GUARANTEES ELAPSED TIME SHORT AND LONG TABLES

23. OBJECTIVE APPROACH PAST DUE DEFAULTED DEBT WRITE-OFF t MATURITY MINIMUM ... ... ... MAXIMUM TECHNICAL DELAY SIGNIFICANT DELAY OBJECTIVE DETERIORATION CRITICAL SITUATION HIGH RECOVERY DECREASING RECOVERY MARGINAL RECOVERY NO PROVISIONS INCREASING PROVISIONS (FROM 25% TO 100%) WRITE-OFF ??? NON-ACCRUAL BASIS RECOVERIES = EXTR. ITEMS

24. SUBJECTIVE APPROACH DOUBTFUL PAST DUE/DOUBTFUL WRITE-OFF t MATURITY MINIMUM ... ... MAXIMUM SERIOUS CONCERN ABOUT REGULAR PAYMENT EVALUATION OF TIME & FINANCIAL CONDITION CRITICAL SITUATION SIGNIFICANT LOSS DECREASING RECOVERY MARGINAL RECOVERY MINIMUM PROVISIONS (10% - 25%) INCREASING PROVISIONS (FROM 25% TO 100%) WRITE-ÓFF NON-ACCRUAL BASIS RECOVERIES = EXTR. ITEMS

25. THE SPANISH EXPERIENCE EARLY 1980´s SPECIFIC PROVISIONS STOCK LATE 1980´s HIGH PROFITS CYCLE CONCERNS HIDDEN RESERVES FOR EXTREME LOSSES GENERIC PROVISIONS CREDIT RISK CONTROL MORE ACCURATE EVALUATION HISTORICAL PROJECTIONS QUALITATIVE ASPECTS LATE 1990´s STATISTICAL PROVISIONS + CREDIT RISK NTERNAL MODELS RISK CONTROL INCENTIVES FLOW

26. CONVERGENCE AND CHALLENGES INTERNATIONAL CONVERGENCE EUROPEAN UNION IAS “PUBLIC” COMPANIES APPROACH LOAN LOSS PROVISIONING FOR “PUBLIC” COMPANIES NATIONAL STANDARDS SETTER? GENERIC & SPECIFIC PROVISIONS EARLY 2000´s BIS MEMBER INTERNATIONAL CONVERGENCE EUROPEAN UNION BASEL BANKING APPROACH CAPITAL UNEXPECTED LOSS INTERNAL MODELS EXPECTED LOSS

27. LOAN LOSS PROVISIONING SUBSTANDARD INDIVIDUAL ANALYSIS SPECIFIC PROVSSIONS PAST DUE 5 CALENDARS COLLECTIVE ANALYSIS DOUBTFUL LOAN LOSS PROVISIONS INTERNAL MODELS a “OLD GENERIC” STOCK UL GENERIC PROVSIONS b “OLD STATISTICAL” FLOW EL

28. GENERIC PROVISIONS a b NO SIGNIFICANT RISK 0,0% 0,00% LOW RISK 0,6% 0,15% MEDIUM - LOW RISK 1,5% 0,60% NORMAL RISK MEDIUM RISK 1,8% 0,,90% MEDIUM - HIGH RISK 2,0% 1,50% HIGH RISK 2,5% 2,25%

29. GENERIC PROVISIONS EVERY YEAR, FOR EACH KIND OF RISK a “OLD GENERIC” VOLUME VARIATION a * b “OLD STATISTICAL VOLUME b * GENERIC PROVISIONS S S a “OLD GENERIC” b “OLD STATISTICAL + SPECIFIC LOAN LOSS PROVSIONING - GENERIC LOAN LOSS PROVISIONING =

30. THE SPANISH EXPERIENCE The Spanish experience shows that priorities have to be set to strike a balance and address the challenges that arise around the credit risk control and management modernisation processes, where international convergence trends from different perspectives still need mutual understanding and further coordination.