Institutions, very frequently due to the pressure exerted by the market, often decide to distribute these profits to shareholders through generous dividends, which in turn has a negative impact on the institution’s capital. When the downswing arrives and the risk assumed in the past turns into bad debts, the income statement is not capable of withstanding the losses. These losses may erode a very significant part or even all of the institution's capital. Recapitalising banks during downswings is not easy, as recent events have so starkly shown. By the way, I should note here that the current recapitalisation with public funds raises significant challenges in terms of management incentives at the recipient institutions and of competition policy for the entire banking system in question. However, this is neither the time nor the place to go into this in more details. BIS Review 149/2008  3  Accordingly, from the prudential standpoint, there are more than enough arguments to justify the development of regulatory policy instruments that enable credit institutions to recognise during upswings the higher level of credit risk accumulating in their balance sheets. The dynamic provisioning is a way to achieve this recognition. The idea, an extremely simple one, is that banks should set aside provisions for loan losses when the risk is assumed. They will then be able to use these provisions during the downswing, when the risk materialises.
It was also Rojo who, in the final stage of his mandate as governor of the Bank of Spain, designed and put into practice the prudential regulatory mechanism of dynamic provisioning. This has contributed to reinforcing the stability of the Spanish banking system and today commands wide recognition; but, when initially launched, it aroused understandable rejection by Spanish banks and was met with indifference on the part of the international community of banking regulators and supervisors. Let me give you the background to this prudential and countercyclical regulatory mechanism. The origins of Spanish dynamic provisioning must be sought in credit developments in the late 1990s. Having emerged from the 1993 recession, the worst for 40 years in Spain, the economy, and much more intensely so bank lending, began to expand at an increasingly brisk pace. The Bank of Spain was led to introduce dynamic provisioning, which came into force in mid2000, by a combination of factors. These included most notably: the mix of strong credit growth, with the dangers this entailed for the stability of the financial system; heightened competition, which acted to exacerbate these risks given that credit institutions applied increasingly lower risk premia to maintain their market share; the deterioration in the level of loan loss provisions and their extremely high correlation with current default rates; and, finally, the Bank of Spain’s past supervisory experience.