4.1. Accounting definitions

4.1.1. Definitions of non-performing assets and impaired positions

Pursuant to the provisions of the Accounting Circular, the Group classifies its debt instruments under the heading of assets impaired by credit risk, both for the risk attributable to the customer and for country risk:

Customer risk includes:

• Risks due to default: This includes those debt instruments that have amounts due on principal, interest or any other cost agreed by contract, regardless of who the holder is or the guarantee involved, with a seasoning of more than 3 months, unless they involve write-offs, as well as those debt instruments that are classified as non-performing through the accumulation of balances rated as non-performing through default for an amount exceeding 25% of the overall sums pending collection.
• For reasons other than default: This includes those debt instruments for which there is no concurrence of the circumstances required to classify them as write-offs or non-performing for reasons of default, and which generate doubt regarding their full reimbursement (principal and interest) under the terms and conditions agreed by contract.
• Country risk: The assets impaired for reasons of country risk will be the debt instruments of operations in countries with long-standing difficulties in servicing their debt, with there being doubt cast on the possibility of recovery, with the exception of those excluded from provisioning for country risk (e.g., risks attributed to a country, regardless of the currency in which they are denominated, registered in subsidiaries located in the holder’s country of residence, commercial loans with a due date not exceeding one year, etc.) and those that are to be classified as non-performing or write-offs for risk attributable to the customer.

Those operations for which there is a concurrence of reasons for classifying a transaction as credit risk, both for risk attributable to the customer and for country risk, are to be classified under the heading corresponding to risk attributable to the customer, unless it corresponds to a worse category for country risk, without prejudice to the fact that impairment losses attributable to customer risk are covered under the item of country risk when it involves a greater requirement.

Write-off risks are those debt instruments, due or otherwise, for which an individualized analysis has concluded that their recovery is deemed remote and that they should be classified as final write-offs.

4.1.2. Methods for determining value adjustments for impairment of assets and provisions

4.1.2.1. 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 collaterals 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 calculated by using statistical procedures, and they are deemed 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.

The BBVA Group uses the concept of expected loss to quantify the cost of the credit risk and include it in the calculation of the risk-adjusted return of its transactions. The parameters necessary for its calculation are also used to calculate economic capital and to calculate BIS II regulatory capital under internal models.

These models allow us to estimate the expected loss of the credit risk of each portfolio, in the one-year period after the reporting date, considering the characteristics of the counterparty and the guarantees and collateral associated with the transactions. The expected loss is calculated taking into account three factors: exposure at default, probability of default and loss given default. (See Note 4.5.1.7)

• 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. PD is measured using a time horizon of one year; i.e. it quantifies the probability of the counterparty defaulting within the coming year. Default is defined as amounts past due by 90 days or more, or cases in which there is no default but there are doubts as to the solvency of the counterparty (subjective doubtful assets).
• Loss given default (LGD) is the loss arising in the event of default. It depends mainly on the guarantees associated with the transaction.

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.

The calculation of the expected loss used to determine economic capital in our internal models includes through-the-cycle adjustments of the factors mentioned above, in particularly of the PD and LGD. These adjustments aim to establish the average level in the economic cycle of the value of the parameters used in our models. The Group considers that this makes the calculation of economic capital more stable and precise. However, the provisions for credit risk are calculated taking as a base the estimated losses incurred at the date of presentation (without any "through-the-cycle" adjustments), in accordance with IFRS criteria.

By using this method of establishing the loss provisions determined collectively, the Group aims to identify the amount of losses that it knows have been produced at the close of the year, even though they have not been identified, given historical experience and other specific information; the losses will become clear after the date the information is presented.

To calculate these unidentified incurred losses, adjustments are made to the expected loss used to calculate the economic capital under our internal models, eliminating the through the cycle loss and focusing on the loss incurred (instead of the expected loss), as required by the IFRS. These adjustments are based on the following two parameters:

• The point-in-time parameter, which is an adjustment to eliminate the through-the-cycle component of the expected loss. 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.
• The loss identification period (LIP) parameter is the period between the time at which the event occurs that generates a given loss and the time when the loss becomes known at an individual level; in other words, the time between the occurrence of the event and the date when the entity identifies it.

This adjustment is related to the fact that when the expected loss is calculated for economic capital and BIS II regulatory capital, the probability of default is measured for a time horizon of one year. Therefore, to calculate the provisions for credit risk, the expected loss at one year has to be converted into the concept of loss incurred at the year-end in accordance with IAS 39. The Group calculates the loss incurred at the year-end by adjusting the expected loss for the next 12 months according to the estimated LIPs for the different uniform portfolios.

The analysis of the LIPs is carried out on the basis of a uniform portfolio. The following methodology is used to determine the LIP interval that has taken place:

• Analysis of the frequency of regulatory and internal review: A review of the asset quality of customers allows the occurrence of losses to be identified. The more frequently the asset quality of customers is analyzed, the quicker are the losses identified and the lower the resulting LIP (the losses incurred and not reported fall, but the losses incurred and identified increase). Conversely, the lower the frequency of review of customer asset quality, the slower identification of losses, which means a higher LIP.
• Analysis of the correlation between macroeconomic factors and the probability of default: The deterioration of macroeconomic variables may be considered as a loss event if it means an increase in the credit risk of a portfolio. Analysis carried out by the Group shows the correlation between various macroeconomic variables and the probability of default, with a delay between the changes in the variables and the default rate.
• As a reference, the LIPs of our European competitors are: for corporate loans, between 3 and 12 months; and for retail loans, between 2 and 9 months.

However, the Bank of Spain requires that the allowance for losses incurred must also comply with Circular 4/2004.

4.1.2.2. 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.

Nonetheless, those letters of credit and other guarantees provided and classified as non-performing are to be covered at least by the coverage percentages specified for non-performing 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. 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, then 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 the SSPEs (Securitization Special Purpose Entities) to which Group institutions transfer their loan-books, the following control guidelines are to be considered with a view to analyzing their possible consolidation:

• The activities of SSPEs are pursued on the Group’s behalf in accordance with its specific business requirements, whereby it will obtain benefits or advantages from these activities.
• The Group retains decision-making powers in order to obtain the greater part of the benefits from the activities of SSPEs or has delegated such powers through an “auto-pilot” mechanism (SSPEs are structured in such a way that all their decisions and activities will already have been defined at the time of their creation).
• The Group is entitled to obtain the greater part of the benefits from SSPEs and is therefore exposed to the risks forthcoming from their business.
• The Group withholds the greater part of the residual benefits from SSPEs.
• The Group retains the greater part of the securitization funds’ asset risks.

If there is control based on the preceding guidelines, the SSPEs 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 of 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 coincides with 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 debt to the securitization funds that mean substantially retaining the credit losses expected from the loans transferred.

The Group only has traditional securitizations and no synthetic securitizations.