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Spanish classification of credit

The macroeconomic situation faced by the Spanish economy has affected the existing provisioning obligations of financial entities to classify credits, strengthening their risk management and vigilance duties.

As a consequence, the existing legal regime contained in Annex IX to Circular 4/2004 issued by the Bank of Spain on risk management was recently amended in order to adapt and improve its content to new market requirements. In this sense, Royal Decree-law 2/2012 and Royal Decree-law 18/2012 introduced new rulings regarding the treatment of risks related to construction and real-estate markets. On April 30 2013 the Executive Commission of the Bank of Spain issued a new set of criteria aimed at classifying the risk of refinanced loans, focusing on the accounting policies applicable in order to manage related risks.

As a general rule, risks – with respect to the expectation of the owed amounts to be recovered – can be substantially classified as follows: (i) standard risk (riesgo normal), for such credits that will be probably repaid in full; (ii) sub-standard risk (riesgo subestándar), when instabilities or difficulties in the repayment of the debt may become visible; (iii) doubtful risk (riesgo dudoso), where the threat of default is obvious due either to non-payments or the existence of relevant circumstances concerning the debtor; and (iv) default (riesgo fallido), when the amounts due are accounted as irrecoverable and so must be covered in full.

When a credit is classified as a sub-standard or doubtful risk but no non-payment event exists, a specific provision must be provided by applying percentages ranging from 10% to 25% to the difference between the registered value of the credit/asset in the balance and the present value of the amounts expected to be recovered. If the credit is classified as a doubtful risk due to the existence of a non-payment event, the particular applicable provisions must be calculated by applying percentages in proportion to the delay in the payment, which can range from 25% if three months has passed since the first non-payment, to 100% of the credit if a year has passed.

The note issued by the Bank of Spain in April 2013 establishes (among other considerations) that the risk bearing a loan within a refinancing or restructuring transaction should automatically fall into the category of a sub-standard risk. Nonetheless, following on from some objective circumstances of the refinancing, and once it is determined whether the financial difficulty of the borrower is of a transitory or temporary nature, the credit may be re-classified as: standard, if there are no lengthy grace periods granted, the debt repayment scheme is adapted to demonstrable flow of the borrower's recurring income and/or new guarantors or new collateral are added; or, doubtful, if no new guarantees are provided, long grace periods (exceeding 30 months) are granted and/or previous refinancing or restructurings of the same credit have been performed.

Regulations on this subject are exhaustive and intricate; however it is recommended to submit any particular application to further analysis. Other factors may become involved, such as the risk related to the country of the borrower, which should be applied only in the event that the resultant provision (also calculated according to the rules contained in Annex IX), may turn out to be more demanding than the one arising up from the credit risk analysis.

Manuel Follía and Joaquín Alegre

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