1

BE AQR AND LOAN LOSS PROVISIONS

Credit Risk Management and Regulatory Provisioning in an IFRS

EnvironmentVienna, October 21 2014

Mercedes OlanoExecutive Coordinator BdE Banking Supervision

DISCLAIMER: The views expressed in this presentation are the author’s and do not necessarily reflect Banco de España’s opinion.

SECTION 1. Introduction

SECTION 2. AQR from an accounting (IAS39) perspective

SECTION 3. Conclusions

SECTION 1

Introduction

• Spanish Crisis and supervision style

• AQR 2012 and AQR 2014

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4

INDEBTEDNESS AND GDP: REAL ESTATE

The path of credit growing from 2002 to 2008 outweighs by far the GDP increases, especially in Real Estate Developers (REDs)

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NPL AND IMPAIRMENT CAME AFTER

SUPERVISORY STYLE: IMF 2012 OPINION

60. The core supervisory process at the BdE is strong and is supported by an experienced cadre of inspectors, … Regulatory capital and loan-loss provisioning requirements for real estate exposures also have been tightened and further guidance on best practices for lending in this area has been provided. The authorities have also implemented .., and adopted additional requirements on internal controls

But this was not enough

61. However, supervisory practices did not always seem to be sufficiently timely or effective for bank intervention or resolution.

Spanish supervision is based on:

• Intrusive approach (permanent examiners on site teams)

• Internal and regulatory granular information (IT specialists)

• Risk based but also strong accounting approach6

WHAT WENT WRONG? (GOVERNOR 2012)

Supervisor’s point of view on the macroeconomic effects:

1. Unexpected double dip recession

2. Overconfidence in Countercyclical provisions

3. Sluggish Savings Banks corporate reform (SIP)

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2014 CA ECB AND 2012 AQR & ST SPAIN

2012 AQR & Stress Test2014 ECB Comprehensive

Assessment

Scope • Domestic Banking Book and Real Estate

• Only credit risk taken into account

• Arrears Management Systems & Processes Assessment

• Domestic and non-domestic Banking Book and Trading Book

• Credit risk, market risk, counterparty risk taken into account

• Internal policies, processes and accounting methods etc. assessed

Portfolios • All portfolios within scope • All portfolios within scope• AQR focuses on ‘High risk’ and

material portfolios

Credit files • ~16,000 • ~17,000

Collateral valuations

• ~1.7 MM housing, ~8,000 complex assets1

• ~33,000

Methodology

• In line with national regulation • ECB methodology and thresholds

Governance and QA

• National level governance and QA

• Periodic committees held involving international authorities such as EBA, EC, ECB and IMF

• ECB and national level governance and QA (2 layers)

1. Commercial Real Estate, developments in progress and land

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SCOPE OF THE COMPREHENSIVE ASSESSMENTThe Comprehensive Assessment is the preparatory work of the transition of the ECB’s SSM to the supervision of EU18’s significant banks

Member states and number of institutions in scope

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6

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25

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16

3

13

4

5

15

6

3

7

4

3

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The AQR is one of three components within the Comprehensive Assessment in line with the provisions of the Regulation on the SSM

Supervisory Risk

Assessment(RAS)

Asset Quality Review (AQR)

ECB/EBA Stress Test

-Supervisory judgements on key risk factors, such as liquidity, leverage and funding

-Quantitative and qualitative analysis

- Assessment of data quality, asset valuations, classifications of NPE, collateral valuation and provisions

- Covering credit and market exposures, following a risk-based, targeted approach

- Forward-looking view of banks’ shock-absorption capacity under stress

AQR IS COMPRISED OF THREE PHASES

Reporting of resultsPerformance of AQRs of selected portfolios

Risk-based portfolio selection1 2 3

ObjectiveNCA proposal of relevant portfolios for each bank

ObjectiveECB-centralized challenge of proposal and selection

Process, policies and accounting review

Loan tape, data integrity validation and sampling

Credit file review and collateral valuation

Collective provisioning analysis

Risk-based

portfolio selectio

n

Bottom-up proposal

Top-down selection

Level 3 fair value exposures review

Capital ratio adjustment

February August

Quality assurance

Communication of results

Incorporation of results as part of the

comprehensive assessment (join-up)

Creation of bank level reports

Collation of results

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PHASE I. RISK-BASED PORTFOLIO SELECTION

ECB and NCAs selected portfolios based on data from June 2013 – Data for all 128 banks (16 Spanish) were submitted on schedule

to the ECB in late December– The data collection focused on material portfolios with a view to

identifying portfolios with a risk of misclassification of asset values for inclusion in the AQR

– Portfolio is defined by asset segment (e.g. Residential Real Estate, Corporate SME etc.) and country of ultimate risk of borrower

• Portfolios have been selected per bank with the relevant NCAs, subject to the minimum criteria– Selected portfolios must combine to account for at least 50% of a

bank’s credit risk-weighted assets– And represent at least half of the material portfolios

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PHASE 2. EXECUTION OF THE AQR

AQR phase 2 implies an assessment of the key balance sheet components

Collectiveprovision analysisProcesse

s, policies

and accounti

ng review(PP&A)

1 Loan tape

creation and Data

integrity

validation (DIV)

2

Sampling

3

Credit file

review

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7

Projection of findings of the credit file review

6

Determine

AQR-adjusted CET1%

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Level 3 fair value exposure review8

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Collateral and realestate valuation5

Revaluationof non-derivative level 3 securities

8i Core trading book processes review1

8iiLevel 3 derivative pricing model review1

8iii

Quality assurance and progress tracking (QA)10

1. For entities with material trading books only Preparatory phase

Banking book valuation

Trading book valuation

Adjust CET1% ratio

Quality assurance

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ECB templates Other

Entities’information

INFORMATION FROM DIFFERENT SOURCES HAS BEEN USED DURING THE EXERCISE

RAS templatesAQR

templates

SSM’s STRESS TEST

templates

NCA-specific restricted

reportsOther

NCA-specific templates for

QA

Advisors’ working papers

Other assets information

Historical recoveries,

sales log, etc.

Information on CFR Sample

(T4A+data room)

Loan tapes

Capital and RWA

information

EBA templates

FINREP COREP

EBA’s STRESS TEST

templates

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AQR SPAIN. QUALITY ASSURANCE PROCESS

• Phase II execution carried out by independent advisors:

• Auditors (NCA Bank teams). 3 audit firms, 600 auditors.

• Appraisers. 18 appraisal firms.

• Quality Assurance (QA) performed at two levels: NCA and ECB

• NCA

• On-site QA Teams. 60 Bank of Spain experts. Specialized teams with a deep knowledge of the entities. Activities are performed on-site next to Audit Teams (qualitative and spot-checks)

• Central QA team, 15 Bank of Spain experts and a team of 16 experts from an advisory firm, to ensure consistency of outputs across banks in the country (e.g. in the case of Banco de Central QA team, a replica of Workblock 7 Challenger Model was performed)

• ECB

• CPMO. Focused on ensuring cross-system consistency and a level playing field between systems

• Country teams. Additional QA layer carried out by ECB teams, including visits to NCA

SECTION 2

AQR from an accounting (IAS39) perspective

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ACCOUNTING LEGAL FRAMEWORK SERVES AS THE FOUNDATION FOR AQR METHODOLOGY

International rules(e.g. IAS39)

National legal framework (e.g. Circular 4/2004)

Entity’s accounting plan

AQRmethodology

ECB’s AQR encompasses the review of certain elements beyond pure accounting framework, e.g. from a prudential standpoint

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BANKING ACCOUNTING. SPANISH APPROACH TO IFRS

Financial Statement

Accounting Regulation

Individual Bank of Spain Circular 4/2004 (compliant with IFRS)

Consolidated-IFRS, if securities issued by the bank trade in a regulated market- Bank of Spain Circular 4/2004 (compliant with IFRS)

Circular 4/2004: Annex IX contains extensive requirements for banks on risk management and provisioning. Some relevant changes have been incorporated since 2004:

June 2010. Specific internal procedures and policies on credit risk (e.g. for the case of lending, the main source of repayment should be net cash generation; policies should be based on a realistic loan repayment schedule with regular due dates attuned to borrower’s primary sources of income generation and establishing a minimum frequency for reviewing collaterals, in NPE the maximum age of appraisal shall be 3 years)

June 2010. Consideration of collateral value in impairment calculation. Impairment for NPE > 90 days past due is based on 2 factors: a) months past due and b) type of collateral (e.g. impairment for a 10 months past due uncollateralized loan is 75%, while impairment for a 5 months past due RRE collateralized loan is 25% - 80% x collateral value).

June 2010. Strengthening of Foreclosed assets impairment requirements

February 2012. Real Estate Cleanup (applied both to loans and foreclosed assets)

September 2012. Specific definition for forbearance. Refinanced loan should be classified as NPE

2004

2012

2010

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(See appendix 2 for further detail)

AQR IS BASED ON INTERNATIONAL REGULATION, YET NOT BEING AN ACCOUNTING EXERCISE

As stated in AQR’s Phase 2 Manual:

• AQR complies with the main accounting principles (IAS 39, IAS 37, IFRS 13)

• AQR is a prudential exercise, so a specific methodology has been developed to provide further guidance on particular topics around how to apply the accounting principles

• Banks are not expected to incorporate into policies, processes or reporting AQR findings if they are compliant with relevant accounting principles

• For prudential purposes Banks may be required to capitalise for a shortfall relative to the ECB threshold (CET1/RWA>8%) in incremental Pillar 2 requirements

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IN PARTICULAR, THE FOLLOWING SET OF RULES IS THE GROUNDING FOR THE METHODOLOGY

Basis on international rules and standards per AQR’s workblock (non-exhaustive list)

1PP&A

2DIV

3Samplin

g

4CFR

5Collater

al

6Project.

7Collecti

ve

8Other

9Capital

Solvency regulation

Single Rule Book – (CRDIV CRR)

EBA ITS Guidelines (Simplified) NPE + Forbearance definitions

Accounting rules

IFRS13 – Fair value hierarchy

IAS24 – Related party disclosures

IAS28 – Investments in associates

IAS37 – Contingent assets / liab.

IAS39 – Financial instruments

CESR Decision EECS/1209-17 – Collective assessment for impairment loans

International Standards on Audit

ISA320 – Materiality

ISA450 – Evaluation of misstatements

ISA530 – Audit sampling

Collateral Valuation

European Standards EVS-2012 (Blue Book)

RICS

Focus of today’s presentation

Outcome of this workblock is twofold:

• From the qualitative review - A list of issues and mitigating actions

• Given the timeframe required to address such issues, execution of the remediation plan can be carried out:

• Over the course of the AQR – To be monitored by the NCA as part of the QA

• Once the AQR has been completed – To be included in the final conclusions report

• Process for the rest of Phase 2 might be tailored to the bank, where specificities and/ or issues are present and the remediation plan is considered insufficient (i.e. workarounds)

• CVA challenger model results are used in the AQR-adjusted CET1% ratio template

PROCESSES POLICIES AND ACCOUNTING REVIEW DESCRIPTION AND OUTCOMES

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• PP&A is a mainly-qualitative review of the bank’s relevant processes, policies and accounting approaches

• The review is not comprehensive (i.e. does not cover all the processes of the bank) but is focused on the elements that the rest of the AQR reviews from a quantitative angle, e.g.:

• Accounting rules applied to differentiate assets at amortised cost, held to maturity, fair-valued through P&L, AFS & trading (fair value hierarchy);

• Definition and application of the definition for identification of NPE exposures;

• Application of the definition of forbearance;

• Etc. (up to 10 elements in total)

• Workblock includes a simple CVA challenger model and analysis

Description

Outcomes

1PP&A

PROCESSES POLICIES AND ACCOUNTING REVIEW ACCOUNTING IMPLICATIONS

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1PP&A

TopicGeneral accounting

frameworkAQR Methodology

Non-Performing Exposures (NPE)

Impaired exposures according to IAS 39 paragraph 59 can be regarded as NPE although there is not a specific definition for NPE

In conjunction with EBA ITS guidelines.An NPE is defined as: -Every material exposure that is 90 days past-due even if it is not recognised as defaulted or impaired -Every exposure that is impaired-Every exposure that is in default according to CRR (past-due or identified as NPE by the entity)

Forbearance and restructuring

According to IAS 39 paragraph 59 the following is a loss event: the lender, for economic or legal reasons relating to the borrower’s financial difficulty, granting to the borrower a concession that the lender would not otherwise consider

Internal definition of the bank is valid. If possible, this should align to the IAS 39 definition.

The Credit File Review provides information about misclassification and under/ over-provisioning on sampled exposures

• Direct impact on capital from the review of the sample

• Projection of findings of the Credit File Review to the non-sampled part of the same portfolio

• AQR-adjusted collective provisioning

CREDIT FILE REVIEWDESCRIPTION AND OUTCOMES

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• The credit file review is carried out upon a sample of exposures from non-retail portfolios

• One of the parts of the CFR (Classification review) is performed also with Residential Real Estate, as an input for the parameters of the collective provisioning analysis (PI and CR)

• The Credit File Review is a three-part process covering the following:

• Credit File Review data preparation - collecting and verifying the completeness of the information for the debtors selected in the sample

• Classification review - assessing evidence of impairment or provision requirement, NPE classification, regulatory exposure class and AQR asset segment

• Review of individual impairment and provisioning levels (applies to non retail impaired debtors) – involves analysing the appropriate provision given the status of the debtor

Description

Outcomes

4CFR

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CREDIT FILE REVIEWACCOUNTING IMPLICATIONS

TopicGeneral accounting

frameworkAQR Methodology

Individual Analysis

IAS 39 paragraph 64. Individual impairment assessment of individually significant assets.

CFR covers classification review (Residential Real Estate and Non Retail portfolios) and Provisioning level review (only Non Retail portfolios)

Loss event (classification review)

IAS 39 paragraph 59 loss events such as financial difficulty, breach of contract or probability of bankruptcy are considered.

A more detailed impairment trigger list is provided (e.g. current debt service coverage ratio below 1.1 or >90 days past due on any facility). See appendix 3

Impairment loss (provisioning level review)

IAS 39 paragraph 63. Focused on present value of future cash flows (CF).

Two possible approaches to perform DCF analysis:

•Going concern: it is assumed that operating CF continue and can be used to repay debt (collateral is only considered if it does not influence operating CF).

•Gone Concern: it is assumed that operating CF of debtor will cease and collateral is exercised. See appendix 3

4CFR

• The purpose of Collective Provisioning Analysis is to quantitatively assess the level of provisioning for parts of a bank’s portfolio that would typically be impaired on a collective basis

• To do so, parameters for models for all in scope portfolios are estimated, which are also used as inputs to the stress test (join-up)

COLLECTIVE PROVISIONING ANALYSISDESCRIPTION AND OUTCOMES

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• Collective Provisioning Analysis tests the provisioning level of all performing exposures and all non-performing retail exposure

• Involves creation of a simple statistical model to estimate provisioning levels (termed ‘challenger model’)

• Model is then used to analyse the gap between the bank’s reported provisioning levels and the challenger model provisioning estimate

• Where bank models are found to be out of line with accounting lines, sufficient justification of deviations has to be provided. Otherwise the challenger model will be used to determine the AQR-adjusted CET1%

Description

Outcomes

7Collective

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COLLECTIVE PROVISIONING ANALYSISACCOUNTING IMPLICATIONS

TopicGeneral accounting

frameworkAQR Methodology

Collective Analysis Non Performing Exposures

IAS 39 paragraph 64. Assets that are not individually significant can be assessed collectively

Applied to Non performing Retail Exposures. Impairment is calculated using a challenger model: -EAD x (1-CR) x LGL

Collective Analysis Performing Exposures (IBNR)

IAS 39 AG 90. On the basis of historical experience, it would be appropriate to recognise incurred but not reported (IBNR) losses.

•Historical experience considered: year 2013.•Different approaches for Corporate and Retail Exposures (challenger model):

- Corporate: PI x EAD x LGI - Retail: PI x EAD x (1-CR) x LGL

•12 month of Loss Identification Period (LIP) used to calibrate PI unless bank provides objective evidence that shorter period is appropriate

One-off adjustments

IAS 39 AG 89. It may be necessary to remove the effects of conditions in the historical period that do not exist currently

Challenger model parameters can be modified accordingly to adjustments for one-off circumstances.

7Collective

RESULTS FROM THE REVIEW OF EXPOSURES ARE ADDED UP TO CALCULATE OVERALL AQR IMPACT

• Results from Credit File Review are projected to the out-of-sample exposures portfolio by portfolio

• Sampling approach is based on a stratified selection skewed towards largest and riskiest exposures

• Hence, projection of findings is done in a consistent way, applying different projection rates to each bucket

– No projection for largest and riskiest exposures (sampling rates reach 100%)

– For smaller and less risky buckets, projection of findings may generate material impacts

• Methodology for projection of findings includes safeguards (materiality thresholds, overrides, use of common risk strata, etc.)

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Calculation of results at a Significant bank level

Calculation of results at a portfolio level

Projection of findings

• Projected credit file review findings and results from collective provisioning analysis are combined at a portfolio level

• Excess provisions from NPE can be used to compensate shortfalls in the Performing exposure

• However, compensation in the other direction is not allowed, except under very specific circumstances:

– High volume of status reclassifications

– Significant excess provisions in the performing exposures

– Previous authorisation from the ECB

• There is not compensation across portfolios: surplus from one portfolio can not be used to mitigate another’s shortfall

• Excess provisions are not reported in the disclosure templates

SECTION 3

Conclusions

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CONCLUSIONS 1/3

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Accounting standards and overseeing (supervision) are allies

• Information is key- IFRS is based on (good) information- Only information subject to quality assurance is reliable- Supervisors work with check information- Simple and comparable information is the most powerful

argument (e.g. Credit risk breakdown by portfolio and risk drivers: LTV, rating, vintage..)

- Relevant (prudential) information required implies the need for improvement in banks’ MIS (e.g. collateral information)

• Know the standards and be different if necessary- IFRS is a framework based on principles (vs rules)- Many of them are changing (e.g. from IAS39 to IFRS 9)- Countercyclical provisions are not (yet) IFRS compliant but are

useful to address a problem when the credit is growing fast: there is a lag between the origination date and the impairment

- Once the provision is in the balance sheet, it is easier to allocate it in an IFRS compliant way

• React quickly and use the accounting framework “prudentially”

- IFRS is a framework that could be used in different ways- What to do when prices (markets) disappear? E.g. Spanish land

market in the core years of the crisis. Why don't set a fallback value based on general best estimate?

- Once the impairment is recognised in the financial statements, transactions begin to appear (e.g. foreclosed assets)

CONCLUSIONS 2/3

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The AQR has shown that accounting standards are far from being uniform

• Tension prudential vs. accounting- Results from the AQR are not immediately recorded in accounts- Prudential criteria inspiring accounting rules may result being

overconservative• Relevant differences among legal frameworks

(IAS39/nGAAP/local rules)- Banks under nGAAP rules only (e.g. German domestic banks) have

had to adapt several concepts of the exercise (e.g. fair value hierarchy)

- Local regulation (e.g. Spanish) has shown to be prudent in the provisioning levels for non-performing exposures, in some cases

- However, IAS39 raises the bar on the performing exposures due to the IBNR provision requirement

- Expectation to see how well the definitions of NPE and forbearance are aligned across banks and geographies

• Devil is in the details- Under the umbrella of the accounting regulation there is a wide

range of definitions that are being interpreted by local regulators and by entities

- Methodological documents and templates have introduced definitions and standards used in this exercise for the first time

• There are big challenges ahead- Convergence required, among countries and towards IAS39 and

IFRS9- Upcoming distancing between supervisor and accounting

regulators

CONCLUSIONS 3/3

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Process has been extremely demanding for the system

• Seek and you will find (Matthew, 7-7)- Perception that without findings, the review has not been done

properly- By design, the exercise is focused on the most likely

vulnerabilities and tends to adopt a safe-side standpoint (conservatism)

• Enormous magnitude of the exercise- Up to 700 people have been involved in this exercise, among

supervisors and independent advisors (only in Spain).- Entities have allocated full-time teams up to 200 people per entity

(example of a large global bank).

Nonetheless, the AQR has provided a clear starting point for both supervisor and supervisee

• AQR serves as the basis for JST and entities to start working together

- The identification of systemic trends provide an input for regulator’s agenda setting

- The activity of Supervisory Joint Teams will likely be focused on individual entities’ findings

- The process and approach of the project will naturally flow in the day-to-day interaction between SSM and Significant Banks

• The way the AQR has been steered will likely determine the roadmap for the upcoming supervisory activity

- The exercise sets the tone and the level of priority of supervisor ‘s focus on different topics

- On the significant banks’ side, some of the techniques learnt will be applied by entities to ongoing risk monitoring

APPENDICES

1. Portfolio selection

2. CBE 4/2004. Relevant changes

3. CFR. AQR Impairment triggers and Gone vs Going Concern approach

4. Parameters of the collective provisioning challenger model

5. Loss identification periods (LIPs)

6. Sampling

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PHASE I. PORTFOLIOS SELECTION

• For each institution, at least, half of the material portfolios by number should be selected. (material > 1% RWA)

• At least 50% of banking book RWA at a consolidated level should be included in-scope

• Situations in which a higher coverage would be expected:• For significant banks that represent a significantly greater risk

relative to others.• Institutions in which the data submission of phase 1 is incomplete

or inaccurate.• Institutions with a non-standard business

• Each institution has to divide its credit portfolios into domestic and non-domestic depending on the residence of the debtor.

• For non-domestic exposures, where its exposure is over than 2% of the RWA one detail per geography is required.

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1

PHASE I. PORTFOLIOS SELECTION

BOTTOM – UP SELECTION TOP – DOWN SELECTION

• Executed by NCA (supervisory teams)

• The riskiest portfolios should be selected.

• Risk is defined as the potential error in the net accounting value of the assets.

• Full flexibility (expert criteria)

• Executed by the ECB

• IT has to be used as a challenge

• The methodology:

• For each portfolio, NPE and coverage ratios should be calculated.

• Some sensitivity analysis should be applied

• A benchmark with peers should be used.

• The impact of all these mentioned above on the CET 1 Should be calculated.

• Finally, the portfolios should be organized according this impact.

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CBE 4/2004. ANNEX IX. RELEVANT CHANGES. SPECIFIC INTERNAL PROCEDURES AND POLICIES ON CREDIT RISK 1/2

The policies, methods and procedures should:

- Be based on credit standards attuned to borrowers’ ability to meet, as and when required, all their financial obligations out of income from their day-to-day business or source of revenue, without depending on guarantors, sureties or collateral, who or which should always be considered as a second, and exceptional, means of recovery when the first has failed. For the case of lending to firms and businesses in general, the main source of repayment of the loan principal plus interest and fees should be net cash flow generation, estimated from the financial statements of the business, which the entity can duly check on a regular basis. For individuals, the primary source of loan recovery shall be the income from their day-to-day work and other recurring sources of income generation.

- Be based on a realistic loan repayment schedule with regular due dates attuned to borrowers’ primary sources of income generation and, if appropriate, to the useful life of collateral (…)

- Include the credit conditions of real estate development projects. These credit conditions must be approved by the most senior governing body and contain practices which impose a precise limit (…) As a general rule, the initial financing of the cost of acquiring land for subsequent urban development shall not exceed 50% of the lower of the amount declared in the public deed and its appraised value.

- Include the circumstances and situations in which the entity would exceptionally permit loans on terms outside the approved general limits and conditions.

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CBE 4/2004. ANNEX IX. RELEVANT CHANGES. SPECIFIC INTERNAL PROCEDURES AND POLICIES ON CREDIT RISK 2/2

- Exercise extreme prudence in how appraisal values and any other external professional services are used in loans collateralised by real estate as an additional assurance to the borrower’s commitment to repay (…)

- Establish a minimum frequency for reviewing loan collateral and update the appraisals by linking them to changes in the market for the asset received as collateral or, where applicable, acquired in payment of debt. For assets assigned to loans classified as “doubtful assets”, the maximum age of the appraisal shall be three years, unless significant falls in market prices make it advisable to obtain a more recent appraisal to better reflect these situations. For real estate assets foreclosed or received in payment of debt, any appraisals required must be issued by different appraisal companies in each update. As an exception, for loans below €500,000 secured by a first mortgage on a completed house or assets acquired in payment of debt arising from such loans, the entity may use as its best estimate of their current value the lower of 80% of the latest available appraisal and the amount resulting from updating that appraisal, such updated value being less than one year of age and obtained by statistical methods by an appraisal company meeting the conditions specified above.

The Audit Committee and the Internal Audit Department shall ensure that the policies, methods and procedures are appropriate, effectively in place and regularly reviewed.

The documentation referred to in this paragraph 1 shall be at the disposal of the Banco de España and of the external auditors.”

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CBE 4/2004. ANNEX IX. RELEVANT CHANGES. COLLATERAL VALUE IN IMPAIRMENT

The impairment of assets classified as doubtful due to customer arrears, except those regulated in the following paragraphs, shall be recognised by applying the percentages indicated below on the basis of the time elapsed since the date of the first missed payment that remains unpaid on any single transaction:  General treatment. The allowance percentages applicable to transactions other than those included in the risk class “negligible risk”, provided they do not have any of the collateral mentioned in b) or in the paragraph below, shall be as follows: %Up to 6 months 25Over 6 months and up to 9 50Over 9 months and up to 12 75Over 12 months 100 The foregoing scale shall be applied to transactions classified as “doubtful due to customer arrears” because of the accumulation of arrears on other transactions.

Real estate collateral. For the purpose of estimating the impairment of financial assets classified as doubtful, the value of the right in rem received as security, provided they are a first mortgage and duly constituted and registered in favour of the entity, shall be estimated, depending on the type of asset subject to the right in rem, as follows:

(i) Completed housing constituting the borrower’s principal residence. The estimated value shall, at a maximum, be 80% of the lower of the cost of the completed house and its appraised value in its current condition. (ii) Rural property in use and completed offices, commercial premises and multi-purpose industrial premises. The estimated value shall, at a maximum, be 70% of the lower of the cost of the rural property or multi-purpose building and its appraised value in its current condition(iii) Completed housing (other). The value shall, at a maximum, be 60% of the lower of the cost of the completed house and its appraised value in its current condition(iv) Land parcels, building plots and other real estate assets. The shall, at a maximum, be 50% of the lower of the cost of the land parcel or real estate asset concerned and its appraised value in its current condition.

The credit risk allowance applicable to all loans classified as “doubtful assets” referred to in this sub-paragraph shall be estimated by applying the percentages specified in (a) above to the amount of outstanding exposure in excess of the collateral value, calculated by the methodology specified above and based on the time elapsed from the due date of the first instalment or the period remaining unpaid of a given loan.

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CBE 4/2004. ANNEX IX. RELEVANT CHANGES. STRENGTHENING OF FORECLOSED IMPAIRMENT REQUIREMENTS

The value at which real estate assets foreclosed or received in payment of debt must be recognised, regardless of the legal form used, shall be the lower of: a) the carrying amount of the financial assets applied, i.e. their amortised cost, taking into account the impairment estimated using the methodology set out in Section III of this annex, and in any event a minimum of 10%, and b) the appraised market value of the asset received in its current condition less estimated costs to sell, which in no case shall be less than 10% of said value. The net amount of the two items shall be deemed to be the initial cost of the asset foreclosed or received in payment of debt. Save in rare circumstances and with clear evidence, the receipt of assets in payment of debt shall not give rise to recognition of gains or to the reversal of any allowances for the financial assets applied if these had previously been classified as “doubtful assets”. All legal expenses shall be recognised immediately in the income statement relating to the foreclosure period. Settled registration and tax charges may be added to the initially recognised value provided that as a result it does not exceed the appraised value less estimated costs to sell referred to in paragraph 32. All costs incurred between the foreclosure date and the sale date due to asset maintenance and protection, such as insurance, security services, etc., shall be recognised in the income statement for the period in which they accrued. For the purpose of determining the subsequent minimum impairment, it shall be taken into account that the time that assets foreclosed or received in payment of debt remain on the balance sheet is an unequivocal sign of impairment. Consequently, the impairment allowances shall be calculated in accordance with the methodology stipulated in paragraph 32, although the allowance percentage of 10% indicated in paragraph 32.a) above shall be replaced by that given in the following table for the pertinent time elapsed since inclusion in the balance sheet: Time since purchase %Over 12 months and up to 24 20Over 24 months and up to 36 30Over 36 months 40The treatment for assessing the value of assets acquired in payment of debt shall be applied equally to individual and consolidated financial statements. Accordingly, without prejudice to the stipulations of paragraph D) of Rule thirty-four, the allowance for impairment of financial assets of group entities, jointly-controlled entities and associates arising from delivery of real estate assets foreclosed or received in payment of debt must be equal to that which they would have had to record if those assets have remained on the balance sheet of the assignor credit institution.

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CBE 4/2004. ANNEX IX. RELEVANT CHANGES. REAL ESTATE CLEANUP 1/2

Banco de España’s Economic Bulletin April 2012:

Royal Decree-Law 2/2012 of 3 February 2012 (BOE of 4 February 2012) on balance sheet clean-up of the financial sector was published. This legislation seeks to achieve three objectives: 1) to clean up the balance sheets of credit institutions, which have been adversely affected by the impairment of their real estate-related assets; 2) to create incentives for an appropriate and efficient adjustment of excess capacity, and 3) to strengthen the governance of the institutions resulting from integration processes. By these means, it is sought to restore confidence in the Spanish financial system and to bring about a recoveryin lending.

With regard to the business in Spain of credit institutions, new provisions and additional capital requirements have been established to cover the impairment of loans and of assets foreclosed or received in payment of debts relating to development land and to real estate construction or development (hereinafter, special assets) existing at the end of 2011. This is a specific and extraordinary write-down of a specific portfolio of assets and, therefore, does not affect new loans for real estate development granted since 31 December 2011, unless these are to refinance existing loans.

For the special assets classified as standard exposures, a one-off general provision equal to 7% of their outstanding amount as at 31 December 2011 will be set aside. The amount of this provision may only be used by institutions to create the specific provisions that may be necessary as a consequence of subsequent reclassification as doubtful or substandard assets of any such loans or of the foreclosure or receipt of assets in payment of such debts.

The Royal Decree-Law establishes provisioning requirements for all loans and foreclosed assets classified other than as standard exposure existing as at 31 December 2011, which may in no case be less than the following percentages:

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CBE 4/2004. ANNEX IX. RELEVANT CHANGES. REAL ESTATE CLEANUP 2/2

Unsecured loans for real estate construction and development classified as substandard will have a provision of at least 24%.

The Royal Decree-Law increases the provisions for real estate assets acquired in payment of debts consisting of completed real estate construction or developments, as well as houses arising from loans to households that have not been the borrowers’ principal residence, that exist as at 31 December 2011, to a minimum of 25% of the outstanding exposure, or on the basis of the time elapsed up to that date, in accordance with the followingpercentages:

The Royal Decree-Law also establishes a minimum provision, irrespective of the time on the balance sheet, of 60% for development land, and of 50% for real estate construction or developments in progress.

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CBE 4/2004. ANNEX IX. RELEVANT CHANGES. FORBEARANCE 1/2

For the purposes of this annex, the following definitions apply:

Refinancing transaction: a transaction which, irrespective of the holder or collateral/guarantees, is granted or used for economic or legal reasons relating to the holder's/s’ current or foreseeable financial difficulties, either to settle one or several loans granted by the institution itself or by others in its group to the holder/s or to one or more other companies in its/their economic group, or to bring these loans wholly or partially up to date in payment, in order to facilitate payment by the settled or refinanced loan holders of their debt (principal and interest) because they are or will foreseeably become unable to comply with the loan terms and conditions as and when required.

Refinanced transaction: a transaction which is brought wholly or partially up to date in payment as a result of a refinancing transaction carried out by the institution itself or by another in its economic group.

Restructured transaction: a transaction in which, for economic or legal reasons relating to the holder's/s’ current or foreseeable financial difficulties, the financial terms and conditions are changed in order to facilitate payment of the debt (principal and interest) because the holder is or will foreseeably become unable to comply with those terms and conditions as and when required, even if that change were envisaged in the contract. In any event, transactions are considered to be restructured when a debt reduction takes place, assets are received to reduce the debt or their terms and conditions are changed to extend their maturity, change the amortisation table to reduce instalments in the short term or reduce their frequency, or establish or extend the principal repayment and/or interest grace period, except when it can be demonstrated that the terms and conditions were changed for reasons other than the holders’ financial difficulties and are similar to those applying in the market at the date of change to loans to customers with a similar risk profile.

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CBE 4/2004. ANNEX IX. RELEVANT CHANGES. FORBEARANCE 2/2

Rollover transaction: a transaction executed to replace another previously granted by the institution itself without the borrower having any financial difficulties or foreseeably having any in the future, i.e. the transaction takes place for reasons other than refinancing.

Renegotiated transaction: a transaction whose financial terms and conditions are changed without the borrower having any financial difficulties or foreseeably having any in the future, i.e. the terms and conditions are changed for reasons other than restructuring.

In any event, to classify a transaction as rollover or renegotiated, the holders must have the capacity to obtain on the market, at the rollover or renegotiation date, loans whose amount and financial terms and conditions are similar to those applied to them by the institution and are consistent with those being granted at that date to customers with a similar risk profile

The refinancing or restructuring of transactions not current in payment does not interrupt their arrears and nor will it give rise to their reclassification to performing categories unless there is reasonable certainty that the customer can make payment on schedule, or unless new effective guarantees or collateral are provided and, in both cases, unless at least the current interest receivable, disregarding interest for late payment, is paid.

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AQR MINIMUM IMPAIRMENT TRIGGERS

External or internal rating indicating default or near default (Credit Quality Step 6 as defined in CRR)The debtor is classified as defaulted according to Article 178 of CRR5Y CDS > 1,000 bps within last12 months;Equity reduced by 50% within a reporting period due to lossesDebtor has requested emergency funding with the significant bankA material amount past due to public creditors or employeesA material decrease in the collateral value where the sale of the financed asset is required to repay the loan (e.g. CRE)A material decrease in turnover or the loss of a major customerA material decrease in estimated future cash flows

Current debt service coverage ratio is below 1.1.> 90 days past due on any facility at the debtor level (subject to materiality criteria)Covenant breach not waived by the bank;ISDA Credit Event declared.All exposures that would be defined as forborne NPE as defined in EBA/ITS/2013/03Debtor has filed bankruptcy applicationAny legal entity within the group of connected clients of the debtor (incl. subsidiaries of the debtor) has filed bankruptcy application.Bond trade (temporarily) suspended at primary exchange because of rumours or facts about financial difficultiesThe disappearance of an active market for the assets financedThe disappearance of a market for refinancing options for the debtor

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AQR GOING AND GONE CONCERN AS PER AQR PHASE II MANUAL

To determine the impairment, the recoverable amount (present value of estimated future cash-flows) has to be estimated. This requires, as a first step, to determine whether a going or gone concern approach has to be used, (depending on the most likely outcome for the impaired debtor):

Under going concern, operating cash flows continue and can be used to repay the financial debt to all creditors (this is more likely when future cash-flows are material and can be reliably estimated,...). Collateral may be exercised to the extent it does not influence operating cash flows. Two options:

1. Estimate sustainable one-period cash-flow and convert to present value by using a multiple.

2. Forecast future cash-flows and discount to present value.

Under gone concern, the collateral is exercised and operating cash flows of debtor cease (this is more likely when are estimated to be low or negative,...).

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OVERVIEW CHALLENGER MODEL FRAMEWORK

PE NPE

Non-retail segments

Specific provision calculated at individual level

Retail collateralised (RRE + Other Retail collateralised)

Retail uncollateralised

𝑃𝐼 𝑥 (1−𝑐𝑢𝑟𝑒 )𝑥 𝐿𝐺𝐿𝑐𝑜𝑙𝑙𝑥 𝐸𝐴𝐷

𝑃𝐼 𝑥 (1−𝑐𝑢𝑟𝑒 )𝑥 𝐿𝐺𝐿𝑢𝑛𝑐𝑜𝑙𝑙 𝑥 𝐸𝐴𝐷

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OVERVIEW PARAMETERS REQUIRED

Parameter Description Base for calculation Source

PI Probability of impairment:Proportion of debtors/facilities that were PE in 2012 but went to NPE during 2013 in a period equivalent to LIP

• Loan tape• Portfolio exits• One-off clean-ups exclusions• Loss Identification Period

Entity (post-DIV)

• NPE misclassifications CFR + Projection

EAD Exposure at Default • Loan tape Entity (post-DIV)

LGI Loss given impairment • Post-adjustment provisions CFR + Projection

Cure Cure rate: Proportion of debtors/facilities which were NPE in 2012 and returned to PE during 2013

• Loan tape• Portfolio exits• One-off clean-ups exclusions

Entity (post-DIV)

•NPE misclassifications CFR + Projection

LGLcoll Collateralised Loss Given Loss: Expected realisation value of RE collateral backing facilities and effective recoveries from other guarantees

• Loan tape• Sales log• Sales costs• Recoveries matrices

Entity (post-DIV)

• House price indices ECB + BdE

• Appraisal haircut Credit File Review

LGLuncoll Uncollateralised Loss Given Loss: Effective cash recoveries for secured and unsecured loans

If no data is available, a 90% benchmark for secured and 60% for unsecured should be applied

• Recoveries matrices Entity (post-DIV)

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RETAIL MORTGAGES LGL FRAMEWORK4

Source: table 37 AQR phase II manual

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NPE

Specificprovision

IBNRProvision

ENTITIES HAVE HAD THE CHANCE TO PROOVE LIPS SHORTER THAN THE BY-DEFAULT 1 YEAR

“PI is calculated over a 12-month time horizon in order to provide an appropriate input for stress testing (…) when applying the challenger model for the purposes of assessing collective IBNR provisioning calibration, PI might be reduced for performing exposures to reflect a shorter than 12 months emergence period. If the bank has objective evidence that a shorter than 12-month time horizon is appropriate, then PI should be reduced by the ratio between the banks emergence period (in months) and 12 months for performing exposures differentiating, when appropriate, by segment.”

[Phase 2 Manual, Section 7.5 – Challenger model]

LIP

Loss event

Identification of the loss

event

Impairment

Diagram of Loss Identification Period (LIP)

Impairment level

Performing

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SAMPLING – EXAMPLE OF STRATIFICATION AND BASIS ON INTERNATIONAL STANDARDS

Each portfolio shall be divided into strata of exposure size and level of riskinessExample sampling rates per strata for a Large Corporate Portfolio

Basis for stratification on the International Standards on Audit 530, Appendix 1

• “Audit efficiency may be improved if the auditor stratifies (…) ”

• “The objective of stratification is to (…) allow sample size to be reduced without increasing sampling risk.”

• “(…) the population is often stratified by monetary value (…)”

• “(…) population may be stratified according to a particular characteristic that indicates a higher risk of misstatement (…).”

Riskiness Bucket 5th Pctl. Bucket 1 Bucket 2 Bucket 3 Bucket 4 Bucket 5 TOP10Default >12m 0% 3.43% 72% 86% 100% 100% 100%Default >6m 0% 8.72% 76% 86% 100% 100% 100%Default <6m 0% 5.58% 76% 83% 100% 100% 100%High risk cured 0% 5.97% 73% 100% 100% 80% 100%High risk 0% 0.27% 57% 75% 80% 100% 100%Normal cured 0% 3.49% 27% 80% 78% 100% 100%Normal 0% 0.05% 33% 86% 100% N/A 100%

Sampling rates per stratum (expressed as % of stratum population)

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