21 June 2012

Chapter from Banker’s Cookbook: Cooking Banking Books in Spanish Way*

Even though Spanish banks may have appeared relatively stronger and less leveraged in the IMF’s April 2012 Global Financial Stability Report when compared to several of their European peers, they now are ahead of the others when it comes to the need of bailout money. Somehow Spanish households and non-financial companies have got much more over indebted. (See the Figure 1 below.) So, what’s the recipe of cooking the banking books in Spanish way?


Some observers have referred to the practice of the dynamic loan loss provisioning, i.e. setting aside rainy-day loan-loss reserves that allows displaying better results in “bad times”, a practice that had been implemented only in a few countries. Although there definitely were and are problems with the correct provisioning rates (for example, there is no such thing as “cyclically neutral year”; in reality, past excesses have almost always been “cured” with creating even bigger bubbles, thus provisioning rates for a “cyclically neutral year” sound quite like a nonsense), I don’t think that this is the first thing to look at. The others believe that the problem was cheap money flowing into the country as a result of the eurozone membership. Yes, that’s part of the below described pyramid-like scheme.

Basically, we are talking about a by definition not working business model that only generates profits until the actual cost of doing business is (either knowledgeably or unintentionally, although the market participants could be assumed to know it) underestimated, misreported and postponed for paying sometime in the unknown future. One of the key components is underestimating risk cost in credit pricing. To illustrate this for Spanish case, consider for example Figure 2 that summarises banks’ lending margins on typical residential mortgage loans back in 2005, and the estimated expected losses in a “cyclically neutral year” that are/were reflected in the (regulatory) provisioning rates as of 2009, i.e. after having gained some downturn experience. It is obvious that the risk margins even did not cover the expected losses over long term, leave alone the other costs.  


Back in 2006, everyone seemed to think that high provisioning rates could compensate for excessive risks in Spanish housing market even though already back in 2004-2005 it was estimated that home prices might be overvalued by 20-60%. See for example the conclusions of the IMF’s Financial Sector Assessment Program about Spanish housing market back in 2006: “The Spanish financial system seems to be resilient to a downturn in the housing market. [...] The resilience of credit institutions is underpinned by (a) prudent LTV ratios on the outstanding loan portfolio; (b) a moderate DTI ratio for the average household; (c) a low proportion of households with DTI ratios above 50 percent; (d) good level of capitalization; and (e) very high provisioning.”

What a misconception and illusionary security! Clearly, the following recipe from the “banker’s cookbook” cannot be anything else than a major accounting trick.


Increasing Profits and Improving Profitability while Postponing the Costs of Doing Business into the Unknown Future

Use explicit and/or implicit guarantees (such as public sector deposit guarantee – no matter that the funds there are insufficient for dealing with larger bank failures, people usually do not know it  –, or benefitting from the eurozone membership) in order to attract more money cheaper.

Lend more money than would be feasible otherwise; this can be done by boosting demand for credit as a result of lowering lending margins below the true risk cost (whatever the later is).

Now, of course, in order to retain profitability, loan losses in the income statement have to be shown lower as well. Whoops, the dynamic provisioning applied by the Bank of Spain seems to be a bit of a limiting factor: they have some pre-defined alpha and beta factors.

But anyway, be still kind with the borrowers who may get into trouble with repaying their debts; apply flexible credit terms, refinance and restructure old loans etc. For one thing, this allows you to record interest revenues even if nothing is really being paid by the borrower (these revenues come from the increased loan principal amounts). Secondly, you’d be most probably loved by the government for “being friendly and acting responsibly”. Thirdly, as historic loan loss figures are now lower, there is a fairly good chance that provisioning rates will be lowered over time (as the ratio of provisions to non-performing loans seems to be fairly high). At that point, no one really cares that the debt burden of households and companies is increasing; historic losses are low, and that’s basically it what everyone sees.

Higher profits (thanks to the ballooned revenue figures and artificially reduced losses) allow you to present a fairly strong capitalisation and create a sense of security. What you now need, is even more business. That’s how you do it: you issue covered bonds (cédulas hipotecarias or CH, as these are being called in Spain) or fund your activities using other forms of structured products (such as mortgage-backed securities). Of course, the volume of CHs is limited to 90 percent of the issuer’s collateral pool and there are some other constraints such as LTV (the Loan-to-Value ratio) capped at 80 (70) percent for residential (commercial) mortgages. But, as you lend more on more flexible terms, mortgage prices will rise nicely, and so does the value of your collateral pool. Let’s not even mention that as a result, the LTV ratios on the outstanding loan portfolio will now seem even more prudent, households even wealthier etc...


That was basically the recipe applied by the Spanish banks for many years, the mechanics for building a bubble. But then the “unknown future” arrived because things got bad first with the U.S. “NINJA loans” which was followed by the fall or nearly a fall of the other dominos. Everyone started to pay attention to the issues such as external imbalances, and the indebtedness of public and private sectors. Naturally, even a bit more scrutiny broke the illusion of security. As the logic of the business model was to postpone paying the real cost of doing business, it could not and cannot end with anything else than in one or another way injecting new money into the banking system when the total collapse is to be avoided. Considering the above, I also think that the IMF’s recent conclusion (IMF, Spain: Financial Stability Assessment (Washington, June 2012)) as if the core of the Spanish banking system appeared resilient, is not valid. 


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* The fact that I’m discussing Spain and Spanish banks in this article does not automatically mean that the banking sectors in other (European) countries are healthier.

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