June 15 (Bloomberg) — Only a few years ago, Spain’s banks were seen in some policy-making circles as a model for the rest of the world. This may be hard to fathom now, considering that Spain is seeking $125 billion to bail out its ailing lenders.
But back in 2008 and early 2009, Spanish regulators were riding high after their country’s banks seemed to have dodged the financial crisis with minimal losses. A big reason for their success, the regulators said, was an accounting technique called dynamic provisioning.
By this, they meant that Spain’s banks had set aside rainy- day loan-loss reserves on their books during boom years. The purpose, they said, was to build up a buffer in good times for use in bad times.
This isn’t the way accounting standards usually work. Normally the rules say companies can record losses, or provisions, only when bad loans are specifically identified. Spanish regulators said they were trying to be countercyclical, so that any declines in lending and the broader economy would be less severe.
What’s now obvious is that Spain’s banks weren’t reporting all of their losses when they should have, dynamically or otherwise. One of the catalysts for last weekend’s bailout request was the decision last month by the Bankia group, Spain’s third-largest lender, to restate its 2011 results to show a 3.3 billion-euro ($4.2 billion) loss rather than a 40.9 million-euro profit. Looking back, we probably should have known Spain’s banks would end up this way, and that their reported financial results bore no relation to reality.
Dynamic provisioning is a euphemism for an old balance- sheet trick called cookie-jar accounting. The point of the technique is to understate past profits and shift them into later periods, so that companies can mask volatility and bury future losses. Spain’s banks began using the method in 2000 because their regulator, the Bank of Spain, required them to.
“Dynamic loan loss provisions can help deal with procyclicality in banking,” Bank of Spain’s director of financial stability, Jesus Saurina, wrote in a July 2009 paper published by the World Bank. “Their anticyclical nature enhances the resilience of both individual banks and the banking system as a whole. While there is no guarantee that they will be enough to cope with all the credit losses of a downturn, dynamic provisions have proved useful in Spain during the current financial crisis.”
The danger with the technique is it can make companies look healthy when they are actually quite ill, sometimes for years, until they finally deplete their excess reserves and crash. The practice also clashed with International Financial Reporting Standards, which Spain adopted several years ago along with the rest of Europe. European Union officials knew this and let Spain proceed with its own brand of accounting anyway.