Spain: Deposit Guarantee Fund Asset Management

During the 1960s and early 1970s, Spain experienced strong economic growth. Annual GDP growth averaged 7% from 1961 to 1974.^FNSee Appendix A: Macroeconomic indicators (1970-89) for data on GDP growth, inflation, and the exchange rate. However, in the mid-1970s, developments emerged that ultimately brought this period of rapid economic expansion to a halt. The global increase in oil prices in 1973 and 1974 contributed to double-digit inflation in Spain. The death of Francisco Franco in 1975 accelerated the political transformation from dictatorship to democracy. Additionally, reforms in 1971 and 1974 paved the way for a swift financial liberalization in the Spanish banking system. These reforms facilitated the opening of new branches and deregulated deposit interest rates and multiple lending rates (De Juan 2019; Sheng 1996).

Between 1973 and 1983, the number of bank offices more than tripled, with significant growth in small and medium-sized institutions. Employment in the banking sector increased from 150,000 in 1975 to more than 180,000 in 1980. This expansion came alongside regulation and supervision that were considered inadequate. And while the banking sector became more innovative and complex, a number of the new entrants lacked banking experience, and in some cases, ethical standards (Sheng 1996).

In 1977, problems in the Spanish banking system—composed of 110 banks—became apparent. A number of insolvent banks characterized their problems as temporary liquidity problems. The Bank of Spain, as lender of last resort, dealt with liquidity problems using its rediscount facility but identified that in many cases, these liquidity problems masked solvency issues. Failed banks had typically breached limits on exposure to related parties or single entities (De Juan 2019; Sheng 1996).

The Bank of Spain lacked experience in dealing with banks in crisis, which made it difficult to identify bank losses accurately. The small group of examiners performed supervision primarily on regulatory compliance (De Juan 2019). At the same time, the Bank of Spain had no ability to sanction wrongdoers, and had no means, nor the legal powers to prevent a bank failure (Sheng 1996).

In November of 1977, as a first response to the escalating problems in the banking sector, the Spanish legislature created the Deposit Guarantee Fund (Fund), administered as an account within the Bank of Spain.^FNSee Appendix B for the timeline of legislation during the Spanish Banking crisis (1977-85). It provided deposit insurance for up to 500,000 pesetas (approximately $10,000).^FNBased on an average exchange rate of 1997 approximately Spanish pesetas 50 = $1 USD (Sheng 1996). Its ongoing operations were funded equally by the Bank of Spain and banks, which each contributed 0.1% of all bank deposits (Deposit Guarantee Fund 1981). These funds, however, could only be used to return funds to depositors after a bank was closed (Sheng 1996). In January 1978, Spain passed legislation that allowed the Fund, for reasons of public interest and with a three-fourths approval from the Fund’s advisory committee, to use the funds when a distressed bank was in danger of insolvency, rather than wait for the bank’s liquidation (Spain 1978).

In March 1978, the Bank of Spain created a public-private management company called the Banking Corporation (Corporación Bancaria S.A.) to complement the deposit insurance scheme of the Fund. The Corporation would be a resolution authority: it would take over, clean up, and sell banks in crisis (Sheng 1996). The Corporation started with a fund of 500 million pesetas, which came from equal contributions by the Bank of Spain and the banking industry (Malo de Molina and Martín-Aceña 2011). If the existing shareholders were unwilling or unable to recapitalize a bank, the Corporation gained ownership and, eventually, management rights of the bank by buying a controlling interest of shares for one peseta—a symbolic price—per share (Sheng 1996). It would then seek a buyer for the bank. The Bank of Spain required this intervention as a condition for accessing its newly created liquidity facility (De Juan 2019). The first bank intervention by the Corporation occurred in March 1978 (Seminario 1984).

However, the Corporation lacked the legal authority to recapitalize insolvent institutions and struggled to sell “rehabilitated” banks. The Corporation did not close until many years later due to legal battles. In 1980, the Spanish government reconstituted the Deposit Guarantee Fund as a separate legal entity and granted it legal powers to intervene and “rehabilitate” banks in a crisis. Unlike the Corporation, the government gave the Fund the power to inject capital and to purchase and manage non-performing assets (Sheng 1996; Malo de Molina and Martín-Aceña 2011).

In March of 1980, the passage of Royal Decree-Law 4/1980 reconstituted the Fund as a public body governed by the rules of private law (Spain 1980). The enhanced Fund combined the deposit guarantee scheme with the management activities previously performed by the Corporation, but now with increased legal powers. Initially, it was independent from the Corporation, but later the Fund acquired the Corporation’s working teams (Malo de Molina and Martín-Aceña 2011). More specifically, beyond deposit insurance, the Fund was now empowered “… to carry out any such actions as it considers necessary to reinforce the solvency and proper functioning of the banks, in the [defense] of their interests of their depositors and the Fund itself” (Spain 1980). The Fund became known as the “Bank Hospital” (De Juan 2019).

The new powers enabled the Fund to recapitalize a distressed bank, make it viable, and sell it to another bank within a year. The Fund could gain bank ownership, extend credit to banks at any rate or in any form, acquire all types of assets (shares, loans, real estate, etc.) at book value, provide guarantees to acquiring banks, absorb losses to restore solvency, and recapitalize banks and nonbanks. While the Bank of Spain continued to provide emergency liquidity as lender of last resort, it was through the Fund that insolvency problems were addressed (De Juan 2019).

The Board of Directors of the newly constituted Fund followed the model adopted by the Corporation, with eight members—half from the Bank of Spain and half from the banking industry. The Deputy Governor of the Bank of Spain served as the chair and would cast the decisive vote in the event of a tie (De Juan 2019). The Secretary General of the Fund acted as the executive director and managed a staff of 120 employees at its peak (Klingebiel 2000).

Contributions to the Fund remained equally distributed between the Bank of Spain and the banking industry. Banks’ contributions ranged from 0.1% to 0.3% of deposits. Legislation also authorized the Bank of Spain to make long-term loans to the Fund at the rediscount rate, and with no limit (De Juan 2019). The Fund’s total debt was 506 billion pesetas at the end of 1986 (Deposit Guarantee Fund 1987). The Fund closely coordinated its operations with the Bank of Spain. In providing initial liquidity support to troubled banks, the Bank of Spain would evaluate their viability. Those banks identified as needing additional capital would be asked to have their shareholders provide capital. Banks whose shareholders were unwilling or unable to provide that capital were then forced to transfer control of the banks to the Fund at a nominal price; otherwise, they faced the loss of liquidity support from the Bank of Spain and possible suspension of their banking charter (Sheng 1996).

Once the Fund gained majority ownership via this mechanism, new management would come in and clean up the bank. The Fund would force the banks’ directors to resign. If they refused to resign, the Fund fired them directly after gaining control of the bank. In all cases, the Fund recruited new executives from the market, appointed a new Board, and restructured management (De Juan 2019). The newly appointed management would introduce administrative reforms and enhance operational efficiency. The Fund’s interventions rested on the assumption that banks would remain viable even after the Fund concluded its support (Sheng 1996). The Fund would then implement a financial package to attract a buyer.

The main measure that the Fund took to attract buyers was to acquire a bank’s non-performing assets at face value. In doing so, the Fund absorbed substantial losses that typically exceeded the bank’s capital (De Juan 2019). The Fund purchased the non-performing assets of the insolvent banks at face value because Spanish authorities considered it impossible to agree on a market price (De Juan 2019). The Fund would end up purchasing a large portion of non-performing assets, which it could sell even after the Fund released control of the bank (Sheng 1996).

After a bank was “rehabilitated,” the Fund prepared to sell it to a “healthy” bank that could meet the qualifications and solvency requirements. By law, the offer had to be publicized and occur within a year after the Fund gained control of the bank (De Juan 2019). If a suitable buyer appeared right away, the Fund would try to sell the bank immediately with the intention to avert any further loss of confidence in the bank and depletion of its capital base. In some cases, an external accounting firm would conduct a comprehensive audit and identify potential buyers (Sheng 1996).

The Fund, together with the Bank of Spain, arranged a prospectus for the sale of a troubled bank with a deadline for bids. The prospectus would be sent to selected domestic and foreign banks and included the maximum value of and specific conditions in which bad assets could be carved out by the Fund. This turned out to be a key issue in negotiations between the Fund and potential buyers. The offer also outlined the specifics on the support to be provided by the Fund and the Bank of Spain (e.g. subsidized interest rates, regulatory forbearance, guarantees against “hidden liabilities,” etc.). Potential buyers could make counterproposals, which the Fund’s Board of Directors would review. Buyers were required to renounce any future claims or legal actions against the Fund that would result from differences between expected and realized asset returns. Lastly, the Board would communicate to the Ministry of Finance the offer chosen. Then, the Ministry had fifteen days to exercise its option to purchase the shares when the national interest was a concern. This two-stage mechanism provided checks and balances to the restructuring efforts (Sheng 1996).

As for the loans that the Fund could not sell to the new investors of a bank, sale of mortgage loans and real estate were most successful (Klingebiel 2000). In every instance, the Fund tried to minimize losses by maximizing recovery of assets acquired at face value, and by repossessing any guarantees collected as collateral for nonperforming loans (Sheng 1996).

The Spanish banking crisis of 1977-85 affected 52 of the country’s 110 banks—most of them of small- and medium-size—that comprised over 20% of bank deposits (De Juan 2019). Of all the banks affected by the crisis, 90% were established between 1973 and 1978. None of the banks established during the financial liberalization of the 1970s survived as an independent bank. By 1985, 85% of total deposits were held by eight banking groups. The seven largest Spanish banks were minimally affected by the crisis and together with the Spanish Bankers’ Association, established in 1977, assisted in resolving almost all of the small failed banks, although under considerable pressure from the government (Sheng 1996).

Three small banks were liquidated. The Fund intervened in 29 banks with assets amounting to 1% of the financial system. Spain dealt with 20 banks related to the “politically sensitive” Rumasa industrial conglomerate outside of the Fund, through a special nationalization and reprivatization program in 1983 (Klingebiel 2000; Sheng 1996).^FNIn 1983, the Rumasa group of more than 200 industrial companies and 20 banks of small and medium size was nationalized instead of being rehabilitated via the Fund. The case was politically sensitive, in part because the Rumasa group employed over 50,000 people. The financial resources required to rescue Rumasa would have greatly exceeded the Fund’s capacity: the companies were highly leveraged, and the banks exhibited negative capital of 21 billion pesetas ($146 million). Spanish authorities viewed intervening in Rumasa’s banks via the Fund as likely to trigger the failure of its industrial companies. However, they rejected any Fund assistance for Rumasa’s non-bank companies as inappropriate to the Fund’s mission (Sheng 1996).

By law, the Fund had to release control of a bank within a year of takeover, encouraging quick resolution and resale. By 1985, 22 banks were sold to domestic banks and five to foreign banks (Sheng 1996). Banks restructured by the Fund were sold after an average of 13 months, including the 20 banks of the Rumasa group. Many cases were resolved within six months (Sheng 1996; De Juan 2019). Initially, Spanish domestic banks were not interested in acquiring the “rehabilitated” banks. However, after the Fund sold two banks to foreign institutions, Spanish banks—in light of foreign competition—were incentivized to buy banks from the Fund, even by absorbing short-term losses in some cases (Sheng 1996; Klingebiel 2000). None of the banks sold by the Fund suffered a relapse (De Juan 2019).

In all instances, bank shareholders took the first losses by losing their equity. Depositors only experienced losses when the three small banks were liquidated. Losses absorbed by the Fund after taking control of banks were split equally among the Bank of Spain and the banking industry. Contributions from the banks totaled 0.12% of liabilities per year (10% of annual profits). By the end of 1984, these contributions reached only $0.5 billion, significantly less than the total losses incurred by the Fund. Therefore, the Bank of Spain had to lend an additional $2.9 billion to the Fund through long-term loans at a 7.25% annual interest rate (Sheng 1996).

The Fund would restructure the banks with the objective to sell them. To clean up the banks, the Fund acquired 373 billion pesetas in total assets: 270 billion in loans, 31 billion in real estate, and 73 billion in shareholdings. The Fund continued with the asset purchases through 1985, and in line with the rapid-asset-disposition objective, disposed of more than 50% of them within five years. By 1986, it registered losses of 25.7 billion pesetas for cleaning up the banks and a cumulative 90 billion pesetas of overall losses. By 2000, the Fund only held a small fraction of the assets it had acquired (Klingebiel 2000).

The Fund’s estimates suggested it would be able to repay the Bank of Spain’s loans completely by the end of the 1990s, based on its reserves (Sheng 1996). However, it is not clear from public sources whether the Bank of Spain or Spanish taxpayers ultimately bore losses on these loans to the Fund. The Fund’s debt was 506 billion pesetas at the end of 1986 and 349 billion pesetas at the end of 1989 (El Pais 1990; Deposit Guarantee Fund 1987).