1. WHAT IS HAIRCUT AND WHY FOR LIQUIDITY

When a Spanish bank goes to ECB or Banco de España for liquidity (regular MRO/LTRO or Emergency Liquidity Assistance ELA), it pledges assets.

The commercial bank receives central bank liquidity, and in return it provides one or more financial assets as collateral, to which the central bank applies a haircut. This ensures that amount of liquidity bank receives is less than collateral's worth, creating buffer against potential price declines.

Formula: Liquidity = Market Value - Haircut

Example: €100M Spanish Government Bond with 5.5% haircut = Bank gets €94.5M liquidity.

Haircut protects central bank if collateral value falls before it can sell it.

2. REGULATORY FRAMEWORK IN SPAIN

A) ECB General Framework - Applicable to all Spanish banks:

ECB carries out daily valuation of collateral and imposes margin calls at trigger point. Furthermore, valuation haircuts are imposed, whereby size of haircut depends on liquidity classification of asset and its maturity.

Categories under ECB:

Spanish specific add-on:
Spain is rated low triple-B sovereign, which requires ECB to apply 5.5% haircut to Spanish treasury bills posted by banks, in keeping with valuation-haircut framework. If all three rating agencies move Spain to BBB+ or below then under ECB's current framework it moves into Step 3 collateral bucket, which requires additional 5% haircut across maturities.

ECB uses highest rating, not lowest - crucial for Spain.

B) Banco de España Implementation:

Banco de España Law 13/1994 + Circular CBE 3/2008 implement ECB rules + add national discretions:

• Banks must test on regular basis, and at least annually, ability to use its source of collateral in repo operations, to ensure capability of using securities to obtain required liquidity, if needed, and assess market appetite for particular security, including related haircut applied
• Deduction of any haircut - percentage established by Banco de España according to expected volatility
• Under Circular 2/2016, covered bonds must meet 80% LTV residential, 60% commercial to be eligible - see below

C) LCR / NSFR - Liquidity Regulation:

LSIs in Spain are subject to Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) as applied in EU legislation. LCR came into force Jan 2018, NSFR June 2021.

• LCR: Must hold High Quality Liquid Assets > 100% of 30-day net outflows
• Level 2 assets are subject to 15% haircut and cannot exceed 40% of total HQLA
• NSFR: Stable funding > Required stable funding over 1 year
• Spanish LSIs report LCR monthly, NSFR quarterly - and enjoy comfortable liquidity levels per IMF FSAP 2024.

3. COVID TEMPORARY HAIRCUT REDUCTION - KEY FOR SPAIN

ECB Decision 7 April 2020, effective 20 April 2020 - Documentos Ocasionales 2128:

Dual reduction of collateral haircuts:
(i) Permanent reduction (20% on average) of haircuts on credit claims as result of regular review of ECB's risk control framework
(ii) Temporary reduction of haircuts for all collateral assets (marketable and non-marketable alike) by fixed factor of 20%, to support provision of credit while effects of pandemic persist

This allowed Spanish banks to pledge same ICO-guaranteed loans and get 20% more liquidity - critical for Spanish SMEs.

Expired in 2023, but permanent credit claims reduction remains.

4. SPANISH COVERED BONDS - HAIRCUT BY LAW

Spain has unique covered bond regime - Cédulas Hipotecarias - now under Royal Decree Law 24/2021 + Law 6/2023 aligning with EU Covered Bond Directive.

Old Law 2/1981: CBs issuance cannot exceed 75% of whole mortgage portfolio, against which bondholders are priority claimants over private creditors in event of bank insolvency - strong overcollateralization.

New Law:

• Value of mortgage loans at time of incorporation into cover pool cannot exceed 60% of appraised value for commercial, rising to 80% if residential property
• New minimum pool overcollateralization requirement is prescribed (2% or 5%, depending on pool assets) per Art 129 CRR

This statutory haircut (20% residential, 40% commercial) is why ECB gives lower haircut to Spanish cédulas vs ABS - because law forces overcollateralization.

5. CASE LAWS

CASE 1: Banco Popular Español S.A. - Failing or Likely to Fail - 6 June 2017 - The Defining Spanish Liquidity Case

ECB, acting within SSM, pursuant to Article 18(1) of Regulation 806/2014, ruled that Banco Popular Español was failing as result of serious difficulties it was facing. ECB had decided bank was "failing or likely to fail" on 6 June 2017 and notified SRB. SRB and Spanish FROB sold bank to Banco Santander for €1, wiping out shareholders and AT1/AT2.

Collateral Haircut Issue:
Popular posted EUR 40 billion in collateral, which under ELA rules should have entitled it to EUR 10 billion in ELA, though Popular received only EUR 3.6bn. ECB approved full request, but Spanish regulators did not. Bank had also unrealistically low haircuts: valuations assigned to bonds on collateral list were unrealistically high - haircut on Popular bonds as low as 1% in some cases.

Judgment: General Court Case T-523/17 - Popular creditors v SRB/ECB
Court observed valuation 1 aimed at determining whether bank was failing became obsolete following assessment carried out by ECB on 6 June 2017. Upheld resolution was in public interest as it protects all depositors and ensures financial stability.

Principle: Haircut is not technical - it determines survival. Even with €40bn collateral, if haircuts are 75% under ELA (non-marketable loans) you get €10bn, but if Banco de España doubts quality, it can refuse ELA even if ECB approves. Liquidity = Collateral x (1-haircut) x Trust.

CASE 2: ECB Spanish Sovereign Downgrade Threat - 2012

When S&P, Moody's, Fitch threatened to downgrade Spain to BBB+, Euromoney reported:

It's quite amazing how one relatively small rating agency in Canada has power to increase ECB repo haircut requirements by 5% for whole Spanish banking system.

Spanish banks held ~€250bn Spanish bonds. 5% extra haircut = €12.5bn less liquidity overnight. Forced Spanish banks to pledge more collateral, creating doom loop. Led to ECB's OMT announcement.

CASE 3: The State of the Netherlands v. Deutsche Bank AG EWCA Civ 771 - Negative Interest on Collateral[2019]

Though UK case, applied to Spanish banks posting cash collateral under 1995 CSA.

Court of Appeal held negative (as opposed to positive) interest not payable on cash collateral posted under 1995 Credit Support Annex to ISDA.

When ECB deposit rate went -0.5%, Spanish banks posting €1bn cash collateral to Deutsche Bank argued Deutsche should pay them negative interest? Court said No - where parties have not otherwise agreed how to address negative interest rates, no obligation in CSA on party transferring eligible collateral in form of cash to pay negative interest.

Spanish banks had to amend all CSAs with 2014 Negative Interest Protocol.

CASE 4: IMF FSAP Spain 2024 - Less Significant Institutions

IMF Technical Note 2024 found LSIs enjoy comfortable liquidity levels in general but must test collateral regularly. Banco de España now requires monthly LCR and quarterly NSFR, plus annual collateral usability test - failure to test = Pillar 2 liquidity add-on.

6. CURRENT HAIRCUT SCHEDULE FOR SPANISH BANK (2026)

If you are Banco Santander / BBVA / CaixaBank pledging to Banco de España today:

• Spanish Bonos 0-3Y: 0.5% haircut
• Bonos 10Y+: 5.5%
• Self-issued Cédulas (retained): ECB accepts self-issued covered bonds as collateral, but not self-issued senior unsecured - haircut 8-12%
• Credit Claims (ICO loans to SMEs): Haircut 20-42% depending on rating + additional 10% if no rating
• ABS with two ratings at least single A: subject to valuation haircut of 10%

ELA haircuts are higher: 40-60% - because collateral is lower quality (non-performing loans).