An interesting idea from Spain:Central banks study cyclical...

An interesting idea from Spain:

Central banks study cyclical provisioning model
13-NOV-2008 Intellasia | Wall Street Journal
Nov 13, 2008 - 7:05:00 AM
A layaway plan for hard times that has helped Spanish banks weather the international banking crisis is becoming a model for global policy makers seeking fresh ideas. In 2000, Spain's central bank introduced a system of so-called dynamic provisioning that forced banks to build up reserves against future, hypothetical losses.
At the time, Spanish banks resisted the regulation, fearing they would lose ground against competitors. Now the rules are credited with giving Spanish financial institutions big capital cushions that have helped them ride out the financial turmoil remarkably well, despite the collapse of the country’s housing bubble.

The Bank of England has pushed for the Spanish example to be discussed at an international level, and the Financial Stability Forum --a group of central banks and regulators that is coordinating the global response to the financial upheavals --has begun studying Spain. "We're going to be doing some work on provisioning issues," said Svein Andresen, secretary general of the Financial Stability Forum. "In that context, we're talking about the dynamic provisioning regulations that Spain has had in place" The forum also is working to improve capital adequacy at banks and to tighten control of off-balance sheet vehicles.

The Bank of Spain discouraged its banks from taking on those kinds of instruments, which helped them avoid the ‘toxic’ assets that received many others into trouble. Thanks to dynamic provisioning, Spanish banks have a US$75 billion cushion and began the year with more than 200% coverage of non-performing loans. The average coverage ratio for EU banks was 58.6% in 2006, according to the European Central Bank.

The central idea behind Spain's system is to smooth economic peaks and troughs by acting counter cyclically. During times of economic growth the system forces banks to set aside a provision for each new loan in case it goes bad The theory is that the additional cost will limit excessive growth in lending, as wells force banks to build up a cushion against future loses.

During the downturns, banks can draw on these general provisions to cover bad loans, lessening their need to cut back on lending or raise new capital. Finding ways to counteract banks' natural tendency to amplify economic cycles has emerged as a crucial issue in the debate over a new international financial framework.

Many observers believe that the seeds of the current crisis were sown by a long period of low interest rates and steady economic growth that encouraged too much risky lending by banks.

"The capacity of the financial system to exacerbate or amplify some of the trends in economic cycles is an important element that needs to be mitigated." said Jaime Caruana, director of the International Monetary Fund's monetary and capital markets department. Caruana, who helped carry out dynamic provisioning when he was governor of Spain's central bank, said the counter-cyclical principle was more important than how it was implemented.