Spain: Financial Sector Reform—Fourth Progress Report

EXECUTIVE SUMMARYImplementation of Spain's financial sector program remains on track. Essentiallyall measures specified in the program have now been implemented, as envisaged under itsfront-loaded timetable. Of note, capital-augmentation measures arising from last year's stresstest are now complete, SAREB has almost concluded its organizational development and isnow accelerating the liquidation of its assets, and key reforms of Spain's financial sectorframework have been adopted or put in train.Macro-financial developments since the last progress report have been broadlypositive. Output and unemployment have stabilized, with strong export growth. The clean-upof banks' balance sheets under the financial sector program has significantly bolstered thesystem's capital and liquidity, with all banks now having a core tier 1 capital ratio in excess of9 percent, except for one relatively small bank that is in the process of being taken over by astronger bank. Profits in the first half of 2013 also exceeded assumptions in the stress test'sbase case. On the other hand, profitability was boosted at least in part by temporary factors,and nonperforming loans, which tend to lag changes in economic growth, are still increasing.Against this background of mixed but broadly positive developments, Spain's financial marketsrose briskly in recent months.Despite recent improvements, important risks remain, including those associatedwith the ongoing macroeconomic adjustment. The correction of Spain's large external,fiscal, and financial imbalances is well underway, with policy actions at both the European andSpanish levels helping to ease market pressures over the last year. Nonetheless, significantfurther adjustment remains. Deleveraging by households and businesses, as well as plannedfiscal adjustment over the next several years, will continue to weigh on domestic demand, suchthat the pace of recovery is likely to be restrained, with concomitant challenges for bankprofitability that could in turn slow the recovery of credit conditions, reinforcing headwinds togrowth and downside risks. There is also upside potential, especially in the medium term, in ascenario of strong policies and reforms by both Spain and Europe.