Circular 4/2017 of the bank of Spain, on the financial information of credit institutions

Àlex Plana Paluzie, M&A Lawyer. AGM Abogados

In the past BOE of December 6^th, was published Circular 4/2017, of November 27^th, from the Bank of Spain to credit institutions, on rules of public and reserved financial information, and financial statement models (the “Circular”).

The Circular regulates accounting standards of credit institutions, highlighting the following matters of Title I: content of the annual accounts (chapter 1), recognition and valuation criteria, where the rules on impairment of values ​​/ provisions stand out (chapter 2), business combination and consolidation (chapter 3) and content of the financial statements (chapter 4). In addition, Title II regulates certain aspects of the reserved financial information (corresponding to the information to be sent for supervisory purposes), Title III the internal accounting development and Title IV the presentation of information to the Bank of Spain.

The Circular adapts the Spanish regulations to the International Financial Reporting Standards (IFRS), specifically to IFRS 9, on financial instruments and IFRS 15, on ordinary income. These changes will apply as of January 1^st, 2018, repealing Circular 4/2004, of December 22^nd.

Although the Circular comes into force on January 1^st, 2018, the financial statements of the corresponding credit entities will continue to be regulated till December 31^st, 2017 by the rules, formats and terms contemplated in Circular 4/2004.
Among the matters affected, we highlight the following two:

The most important impact that this Circular will cause is the deterioration of financial assets (provisions). As the same expository of the Circular indicates, this will mean that this type of impairment will no longer be based on the loss incurred to be based on the expected loss. Consequently, entities should:

1. Analyze their financial assets again.
2. Increase the deterioration of its financial assets.

Among the elements most affected by the new impairment standards are credit portfolios, while credit risk must have an accounting reflex prior to that which would be applied with Circular 4/2004, as well as exposures in refinancing or debt restructuring.

In relation to the classification system of debt instruments, entities should review it, based on the contractual characteristics and business model of the entity with respect to them. By business model is meant: “the way in which the entity manages its financial assets to generate cash flows. In particular, the business model may consist in maintaining the financial assets to receive their contractual cash flows, in the sale of these assets or in a combination of both objectives. “
Regarding the classification of financial instruments for valuation purposes, new criteria are introduced, with the following 6 types of asset portfolios:

1. Financial assets at amortized cost. Debt instruments whose contractual conditions give rise to cash flows on specified dates, with payments of principal and interest, and with willingness to maintain by the entity to receive such flows.
2. Financial assets at fair value with changes in other comprehensive income. Debt instruments with the same characteristics as before, but with the will of the entity, also, to collect the flows with the sale of the instruments.
3. Financial assets obligatorily at fair value with changes in results (i) held for trading, or (ii) not intended for trading, necessarily valued at fair value through profit or loss. Financial assets not included in the two previous types and those that the entity holds for trading, including derivatives other than hedging.
4. Financial assets designated at fair value with changes in results. Any type of financial asset designated as such initially and irrevocably.
5. Derivatives-hedge accounting. All types of derivatives that serve as hedging instruments (with a favorable position for the entity).
6. Investments in dependents, joint ventures and associates. Investments in equity instruments of related entities.

With respect to financial liabilities, the following 4 types of portfolios are identified:

1. 1. Financial liabilities at amortized cost. As a general rule, financial liabilities will be included in this portfolio.
   2. Financial liabilities held for trading. Any financial liability that:
   3. They have issued to repurchase them in the near future.
   4. Be short positions of values.
   5. They are part of a portfolio of joint instruments in which there is evidence of recent actions to obtain short-term profits.
   6. There are derivatives that do not meet the definition of a financial guarantee contract and have not been designated as hedging instruments.
   7. Financial liabilities designated at fair value with changes in results. Any type of financial liability designated as such initially and irrevocably.
   8. Derivatives-hedge accounting. All types of derivatives that serve as hedging instruments (with an unfavorable position for the entity).

Finally, we can highlight some of the consequences of this Circular that can be derived in terms of distress M & A and commercialization of bank debt.

• • First, the sale of credits owned by credit institutions to third parties could be achieved under better conditions. This effect may occur in the sense that, due to the accounting for impairment due to expected loss, entities may make provisions before their credits and do so in greater amounts. Faced with this situation, the commercialization, either at book value or below it (with assumption of additional losses), by credit institutions, could be carried out in better conditions for the purchaser.
  • Second, in relation to access to credit and the refinancing or restructuring of debt by companies, a bidirectional effect can be given. On the one hand, companies with business plans in which the entity foresees high compliance possibilities, could obtain better conditions. In contrast, companies with business plans of doubtful compliance would see the conditions of the entity harden.
  • Third, the effects discussed in the previous paragraph regarding access to credit, refinancing and restructuring of debt with credit institutions opens up a broader range of possibilities for the funds and entities dedicated to distress M & A, as these investors may have different opinions on the risk analysis of credit institutions, betting on the viability of business plans that credit institutions have not considered sufficiently viable.

In conclusion, in the banking field companies can receive more disparate deals, due to the criterion of expected loss, with a limitation in the number of companies that access the credit, generating more business opportunities for funds and entities dedicated to distress M&A .