4.1.1. Definitions of non-performing assets and impaired positions
The classification of financial assets impaired for reasons of customer default is done in an objective way and on an individual basis according to the following criterion:
- The total amount of debt instruments, irrespective of the holder and the guarantee involved, with an amount past due for more than ninety days for principal, interest or contractually agreed expenses, unless they should be classified directly as write-offs.
- Contingent liabilities in which the guaranteed party has incurred default. Debt instruments classified as impaired through the accumulation of balances in default for an amount exceeding 25% of the overall amounts pending collection.
Classification of financial assets impaired for reasons other than customer default is done individually for all risks whose individual amount is significant and for which there is a reasonable doubt about their total reimbursement under the terms and conditions agreed by contract, since they show objective evidence of impairment that negatively affects the cash flows expected from a financial instrument. Objective evidence of impairment of a financial asset or group of financial assets includes observable data about the following aspects:
- Significant financial difficulties on the part of the obligor.
- Continued delays in payment of interest or principal.
- Refinancing for the counterparty’s lending conditions.
- Bankruptcy and other types of reorganization/winding-up is likely.
- Disappearance of a financial asset from an active market due to financial difficulties.
- Observable data that suggest a reduction in future flows since the initial recognition, such as:
a. Adverse changes in the counterparty’s payment status (delays in payments, drawdowns on credit cards up to the limit, etc.).
b. Domestic or local economic conditions correlated with default (unemployment, fall in property prices, etc.).
Write-off risks are those debt instruments whose recovery is deemed remote and should be classified as final write-offs.
4.1.2. Methods for determining value adjustments for impairment of assets and provisions
Methods used for determining value adjustments for impairment of assets
The impairment on financial assets is calculated by type of instrument and other circumstances that may affect it, taking into account the guarantees received by the holders of the instruments to assure (fully or partially) the performance of the transactions. The BBVA Group recognizes impairment charges directly against the impaired asset when the likelihood of recovery is deemed remote, and uses an offsetting or allowance account when it records provisions made to cover estimated losses on their full value.
The amount of the deterioration of debt instruments valued at their amortized cost is calculated by whether the impairment losses are determined individually or collectively.
Impairment losses determined individually
The amount of impairment losses recorded by these instruments coincides with the positive difference between their respective book values and the present values of future cash flows. These cash flows are discounted at the instrument’s original effective interest rate. If a financial instrument has a variable interest rate, the discount rate for measuring any impairment loss is the current effective rate determined under the contract.
As an exception to the rule described above, the market value of quoted debt instruments is deemed to be a fair estimate of the present value of their future cash flows. The estimation of future cash flows for debt instruments considers the following:
- All sums expected to be recovered during the remaining life of the instrument including those that may arise from collateral and credit enhancements, if any (once deduction has been made of the costs required for their foreclosure and subsequent sale). Impairment losses include an estimate of the possibility of collecting of the accrued, past-due and uncollected interest.
- The various types of risk to which each instrument is subject.
- The circumstances under which the collections will foreseeably take place.
With respect to impairment losses resulting from the materialization of insolvency risk of the obligors (credit risk), a debt instrument is impaired when:
- There is evidence of a reduction in the obligor’s capacity to pay, whether manifestly by default or for other reasons; and/or
- Country-risk materializes, understood as the common risk among debtors who are resident in a particular country as a result of factors other than normal commercial risk, such as sovereign risk, transfer risk or risks derived from international financial activity.
The BBVA Group has developed policies, methods and procedures to calculate the losses that it may incur as a result of its credit risks, whether attributable to the insolvency of counterparties or to country risk. These policies, methods and procedures are applied to the arrangement, study and documentation of debt instruments, risks and contingent commitments, as well as the detection of their deterioration and in the calculation of the amounts needed to cover their credit risk.
Impairment losses determined collectively
The collectively determined losses are deemed to be equivalent to the portion of losses incurred on the date that the accompanying consolidated financial statements are prepared that has yet to be allocated to specific transactions.
Through statistical procedures using its historical experience and other specific information, the Group calculates the losses that, having occurred on the date of preparation of the accompanying consolidated financial statements, will become clear individually after the date the information is presented.
Quantification of losses incurred takes into account three basic factors: exposure at default, probability of default and loss given default.
- Exposure at default (EAD) is the amount of risk exposure at the date of default by the counterparty.
- Probability of default (PD) is the probability of the counterparty failing to meet its principal and/or interest payment obligations. The probability of default is associated with the rating/scoring of each counterparty/transaction. There are two additional parameters implicit in the calculation of PD:
a. The point in time parameter converts the through-the-cycle probability of default (defined as the average probability of default in a complete economic cycle) into the probability of default at a given point in time.
b. The loss identification period (LIP) parameter is the period between the time at which the event that generates a given loss occurs and the time when the loss becomes known at an individual level. The analysis of the LIPs is carried out on the basis of uniform risk portfolios.
In the specific case of non-performing assets, the PD assigned is 100%. An asset is considered to be “non-performing” when there are amounts past due by 90 days or more, and in those cases in which there is no default but there are doubts as to the solvency of the counterparty (subjective non-performing assets).
- Loss given default (LGD) is the estimate of the loss arising in the event of default. It depends mainly on the characteristics of the counterparty and the valuation of the guarantees or collateral associated with the operation.
To calculate the LGD at each date in the balance sheet, the cash flows from the sale of collateral are estimated by calculating its sale price (in the case of real-estate collateral, the reduction it may have suffered in value is taken into account) and its cost. In the event of default, the property right is acquired contractually at the end of the foreclosure process or when the assets of borrowers in difficulty are purchased, and this right is recognized in the financial statements. After the initial recognition, these assets classified as “Non-current assets held for sale” or “Inventory” (see Notes 2.2.4 and 2.2.6 to the Group’s Annual Consolidated Financial Statements) are valued by the fair value corrected for the estimated cost of their sale or their book value, whichever is lower.
As of December 31, 2013, the results of estimated losses incurred for credit risk yielded by the Group’s internal models do not differ materially from the provisions determined in accordance with Bank of Spain requirements.
Methods used for provisioning for contingent exposures and commitments
Non-performing contingent exposures and commitments, except for letters of credit and other guarantees, are to be provisioned for an amount equal to the estimation of the sums expected to be disbursed that are deemed to be non-recoverable, applying criteria of valuation prudence. When calculating the provisions, criteria similar to those established for non-performing assets for reasons other than customer default are applied.
In any event, letters of credit and other guarantees provided which are classified as non-performing will be covered by applying similar criteria to those set out in the preceding section on value adjustments for impairment of assets.
Likewise, the inherent loss associated with letters of credit and other guarantees provided that are in force and not impaired is covered by applying similar criteria to those set out in the preceding section on impairment losses determined collectively.
4.1.3. Criteria for removing or maintaining assets subject to securitization on the balance sheet
The accounting procedure for the transfer of financial assets depends on the manner in which the risks and benefits associated with securitized assets are transferred to third parties.
Financial assets are only removed from the consolidated balance sheet when the cash flows they generate have dried up or when their implicit risks and benefits have been substantially transferred out to third parties.
Group is considered to substantially transfer the risks and benefits when these account for the majority of the overall risks and benefits of the securitized assets.
When the risks and benefits of transferred assets are substantially conveyed to third parties, the financial asset transferred is removed from the consolidated balance sheet, and any right or obligation retained or created as a result of the transfer is simultaneously recognized.
In many situations, it is clear whether the entity has substantially transferred all the risks and benefits associated with the transfer of an asset or not. However, when it is not sufficiently clear if the transfer took place or not, the entity evaluates its exposure before and after the transfer by comparing the variation in the amounts and the calendar of the net cash flows of the transferred asset. Therefore, if the exposure to the variation in the current value of the net cash flows of the financial asset does not significantly change as a result of the transfer, it is understood that the entity has not substantially transferred all the risks and benefits associated with the ownership of the asset.
When the risks and/or benefits associated with the financial asset transferred are substantially retained, the asset transferred is not removed from the consolidated balance sheet and continues to be valued according to the same criteria applied prior to the transfer.
In the specific case of securitization funds to which Group institutions transfer their loan-books, existing contractual rights other than voting rights are to be considered with a view to analyzing their possible consolidation. It is also necessary to consider the design and purpose of each fund, as well as the following factors, among others:
- Evidence of the practical ability to direct the relevant activities of the funds according to the specific needs of the business (including the decisions that may arise in particular circumstances only).
- Possible existence of special relationships with the funds.
- The Group’s implicit or explicit commitments to back the funds.
- Whether the Group has the capacity to use its power over the funds to influence the amount of the returns to which it is exposed.
Thus, there are cases where the Group is highly exposed to the existing variable returns and retains decision-making powers over the institution, either directly or through an agent. In these cases, the securitization funds are consolidated with the Group.
4.1.4. Criteria for the recognition of earnings in the event of the removal of assets from the balance sheet
In order for the Group to recognize the result generated on the sale of financial instruments, the sale has to involve the corresponding removal from the accounts, which requires the fulfillment of the requirements governing the substantial transfer of risks and benefits as described in the preceding point. The result will be reflected on the income statement, and calculated as the difference between the book value and the net value received, including any new additional assets obtained minus any liabilities assumed.
When the amount of the financial asset transferred matches the total amount of the original financial asset, the new financial assets, financial liabilities and liabilities for the provision of services, as appropriate, that are generated as a result of the transfer will be recorded according to their fair value.
4.1.5. Key hypothesis for valuing risks and benefits retained on securitized assets
The Group considers that a substantial withholding is made of the risks and benefits of securitizations when the subordinated bonds of issues are kept and/or it grants subordinated finance to the securitization funds that mean substantially retaining the credit losses expected from the loans transferred.
The Group currently has traditional securitizations only, and no synthetic securitizations.