GRUPO BANKINTER. Notes to the Annual Financial Statements

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1 TABLE OF CONTENTS Consolidated balance sheets as of 31 December 2005 and 2004 Consolidated profit and loss accounts for the fiscal years ending 31 December and 2005 (1) Nature, activities and composition of the Group (2) Criteria applied (3) Distribution of profits (losses) (4) Deposit Guarantee Fund (5) Accounting principles and valuation standards applied (6) Cash and deposits in central banks (7) Portfolio of traded assets and liabilities/other financial assets at reasonable value with changes on profit and loss account (8) Financial assets available for sale (9) Credit investments (10) Term investment portfolio (11) Derivatives of hedging assets and liabilities (12) Non current assets for sale (13) Stockholdings (14) Tangible assets (15) Intangible assets (16) Fiscal assets and liabilities (17) Accrued assets and liabilities (18) Other assets and liabilities (19) Financial liabilities at amortised co (20) Insurance contract liabilities (21) Allowances (22) Financial liability capital 1

2 (23) Shareholders equity (24) Valuation adjustments (net worth) (25) Contingent commitments and risks (26) Financial asset transfers (27) Order accounts financial derivatives (28) Personnel (29) Commissions received and paid (30) Interest and charges / similar earnings (31) Results of financial operations (32) Net exchange rate differences (33) Other general administration expenses (34) Other operating products and charges (35) Other profits / other losses (36) Operations and balances with related parties (37) Remuneration and balances with the Board of Directors (38) Environmental information (39) Customer service (40) Offices, centres and agents (41) Fiduciary business and investment services (42) Remuneration of auditors (43) Tax situation (44) Assets and liabilities whose value is determined using a criterion other than reasonable value (45) Risk management policies (46) Information by segments (47) Subsequent events 2

3 Directors Report Schedules I. Statement of change in consolidated net worth II. III. IV. Statement of consolidated cash flow Segmented information Operations and balances between related parties V. dividend payments VI. Balance sheets and profit and loss accounts of Bankinter, S.A. as of 31 December and

4 Consolidated Balance Sheets as of 31 December and 2005 ASSETS (*) Cash and deposits in central banks (Note 6) 539, ,916 Trading portfolio (Note 7) Debt securities 2,503,479 4,327,317 Other capital instruments 108,664 39,811 Trading derivatives 148, ,274 Pro-memoria: loaned or guaranteed 1,981,715 4,002,508 2,760,202 4,634,402 Other financial assets at reasonable value with changes to profits and losses (Note 7) Other capital instruments 24,596 23,884 Pro-memoria: loaned or guaranteed ,596 23,884 Financial assets available for sale (Note 8) Debt securities 4,251,163 3,473,735 Other capital instruments 240, ,846 Pro-memoria: loaned or guaranteed 3,804,929 3,210,431 4

5 4,491,562 3,781,581 Credit investments (Note 9) Deposits with credit institutions 5,387,117 4,205,236 Customers loans 31,653,807 26,139,388 Other financial assets 186, ,153 Pro-memoria: loaned or guaranteed ,227,707 30,484,777 Held-to-maturity portfolio (Note 10) - 448,292 Pro-memoria: loaned or guaranteed - 448,292 Adjustments to financial assets by macrohedges (Note 11) (10,217) (7,464) Hedge derivatives (Note 11) 90,065 86,028 Non-current assets for sale (Note 12) Tangible assets 3,965 3,827 Other assets - - 3,965 3,827 Stockholdings (Note 13) Associated enterprises 5,008 5,558 Multigroup enterprises 101,531 73,838 5

6 106,539 79,396 Tangible assets (Note 14) For internal use 319, ,666 Real estate investments 5,300 5,421 Other leased assets 18, Pro-memoria: acquired under financial lease , ,163 Intangible assets (Note 15) Other intangible assets 3, , Fiscal assets (Note 16) Current 45, ,564 Deferred 181, , , ,680 Accruals (Note 17) 64,406 33,277 Other assets (Note 18) Other 204, ,895 6

7 204, ,895 TOTAL ASSETS 46,075,769 40,786,010 LIABILITIES (*) Trading portfolio (Note 7) Trading derivatives 101, ,115 Short term security positions 2,462,625 3,107,171 2,564,128 3,357,286 Financial liabilities at amortised cost (Note 19) Deposits in central banks ,141 Deposits in credit institutions 6,972,252 5,712,746 Money market operations 10,000 10,000 Customer deposits 18,409,659 15,490,497 Debt securities 14,273,921 11,986,462 Subordinated liabilities 594, ,021 Other financial liabilities 349, ,337 40,609,362 34,570,204 Hedge derivatives (Note 11) ,892 7

8 Insurance liabilities (Note 20) 488, ,843 Allowances (Note 21) Pension funds and similar obligations 1, Allowances for risks and contingencies 32,040 25,271 Other allowances 131, , , ,575 Tax liabilities (Note 16) Current 66,668 26,602 Deferred 71, , , ,332 Accruals and pre-payments (Note 17) 89,390 55,733 Other liabilities (Note 18) Other 88,488 45,708 Capital of a financial liability type (Note 22) 347, ,606 TOTAL LIABILITIES 44,491,167 39,338,179 8

9 NET WORTH (*) Minority interests Valuation adjustments (Note 24) Financial assets available for sale 22,677 62,130 Gain (loss) on exchange 1, ,932 62,238 Shareholders' equity (Note 23) Capital or allowance fund Issued 117, , , ,875 Additional paid-in capital 319, ,608 Reserves Accumulated reserves (losses) 943, ,004 Reserves (losses) of enterprises carried by the ownership method Associated enterprises (1,371) 3,167 Mutligroup enterprises 37,163 12,029 35,792 15,196 9

10 979, ,200 Other capital instruments Compound financial instruments 11,695 12,384 Other ,695 12,384 Less: own securities (1,048) (33,763) Group profit (loss) 208, ,702 Less: dividends and remuneration (75,220) (68,413) 1,560,670 1,385,593 1,584,602 1,447,831 TOTAL NET ASSETS AND LIABILITIES 46,075,769 40,786,010 Pro-memoria Contingent risks (Note 25) Financial guarantees 2,482,586 2,078,119 Assets linked to third party obligations - - Other contingent risks 50,180 55,121 10

11 2,532,766 2,133,240 Contingent commitments (Note 25) Available by third parties 7,383,823 5,830,097 Other commitments 336, ,058 7,719,955 6,070,155 10,252,721 8,203,395 (*) The data as of 31 December 2005 are presented exclusively for comparison purposes. Notes 1 through 47 and Schedules I to VI are an inseparable part of the consolidated balance sheets as of

12 Consolidated Profit and Loss Account of the Bankinter Group for the fiscal years ending 31 December and (*) Interest and similar income (Note 30) 1,455,871 1,076,615 Interest and similar charges (Note 30) (998,591) (655,656) Remuneration of capital of a financial liability type (11,139) (7,255) Other 987, ,401 Income from capital instruments 16,354 9,308 Brokerage margin 473, ,267 Results of enterprises carried by the ownership method 29,623 24,645 Associated enterprises Multigroup enterprises 29,187 24,521 Fees received (Note 29) 286, ,677 Fees paid (Note 29) (69,846) (59,978) Insurance business 1,694 (75) Insurance and reinsurance premiums received 32,960 45,612 Reinsurance premiums paid (6,392) (1,119) Benefits paid and other insurance-related expenses (184,271) (185,730) Reinsurance income 2,216 1,242 Net allocations to liabilities for insurance contracts (135,737) (107,381) Financial income 101, ,149 Financial expenses (80,500) ( 69,610) Profit(loss) from financial operations (net) (Note 31) 49,776 30,684 Trading portfolio 1,903 3,367 Other financial instruments at reasonable value with changes to profit and loss 2,767 5,223 Financial assets available for sale (27,273) 42,647 Credit investments - - Other 72,379 (20,553) Gain (loss) on exchange (net) (Note 32) 47,756 36,634 Ordinary margin 819, ,854 Sales and revenues from non-financial services - - rendered Cost of sales - - Other operating products (Note 34) 24,003 18,763 Personnel (Note 28) (227,336) (192,398) Other general administration costs (Note 33) (174,940) (160,703) Depreciation (24,151) (21,031) Tangible assets (Note 14) (24,034) (21,031) Intangible assets (Note 15) (117) - 1

13 Other operating charges (Note 34) (5,532) (4,902) Operating margin 411, ,583 Losses from deteriorated assets (net) 96,898 80,143 Financial assets available for sale Credit investments (Note 9) 97,295 80,340 Held-to-maturity portfolio - - Non-current assets for sale (399) (384) Stockholdings 1 - Tangible assets - - Goodwill - - Other intangible assets - - Other assets - - Allowances (net) 5,892 7,035 Financial income from non-financial activities - - Financial expenses from non-financial activities - - Other income (Note 35) 15,231 7,214 Gains on the sale of tangible assets Gains on the sale of stockholdings Other items 14,325 6,557 Other losses (Note 35) (7,751) (6,174) Losses on the sale of tangible assets Losses on the sale of stockholdings Other items 6,741 6,015 Before-tax profit (loss) 316, ,445 Income tax (Note 43) (107,846) (77,743) Profit (loss) from ordinary activities 208, ,702 Profit (loss) from interrupted operations (net) - - Consolidated fiscal year profit (loss) 208, ,702 Minority shareholders - - Group profit (loss) (Note 23) 208, ,702 Profit per share (euros) Diluted profit per share (euros) (*) The data as of 31 December 2005 are presented exclusively for comparison purposes. Notes 1 through 47 and Schedules I to VI are an inseparable part of the consolidated balance sheets as of

14 EXPLANATORY NOTES TO THE FINANCIAL STATEMENTS FOR THE FISCAL YEAR ENDED 31 DECEMBER (Figures expressed in thousands of euros) (1) Nature, activities and composition of the Group The business objectives of Bankinter, S.A. (hereinafter, the Bank or the Entity) consists of banking activities which are subject to the rules and regulations governing banks operating in Spain. In addition to its direct operations, the Bank is the parent company of a group of subsidiary companies dedicated to diverse activities which, along with the Bank, make up the Bankinter Group (hereinafter, the Group or the Bankinter Group ). Consequently, in addition to its own individual financial statements, the Bank must draft the consolidated financial statements for the Group which include its participation in joint business and investments in associated entities. The Bank represents 99% of the Group s total assets as of 31 December and The Group s consolidated financial statements for fiscal year 2005 were approved by the General Meeting of Shareholders on 20 April The consolidated annual financial statements for the Group, the Bank and almost all of the member companies of the Group for the financial year are pending approval by their respective General Meetings of Shareholders. However, the Bank's Board of Directors believes that the annual financial statements will be approved without changes. Bankinter, S.A. was founded in the public deed executed in Madrid on 4 June 1965 under the name of Banco Intercontinental Español, S.A. Its name was changed to the current one on 4 May It is registered in the Special Register of Banks and Bankers under number 30. Its fiscal identification number is A and it is a member of the Deposit Guarantee Fund with code number The registered offices are located at Paseo de la Castellana number 29, in Madrid, Spain. The subsidiaries of the Bankinter Group are listed in Note 13 "Subsidiaries. The Group s consolidated annual income statements were prepared according to the accounting principles described in the section entitled Accounting Principles and Valuation Standards Used. The balance sheets of Bankinter, S.A. as of 31 December and 2005 and the Profit and Loss Accounts for the fiscal years ending on those dates are shown in Schedule VI. In financial year, the securitisation funds Bankinter 12 Mortgage Securitisation Fund, Bankinter 13 Mortgage Securitisation Fund and Bankinter 2 SME Asset Securitisation Fund were incorporated into the Group by global integration. Also in financial year, Bankinter Internacional B. V. was dissolved and Bankinter Netherlands B.V. and Prota, S.A. were sold. 3

15 (2) Criteria Applied a) Basis for presentation of the annual income statements Pursuant to (EC) Regulation 1606/2002 of 19 July of the European Parliament and Council, as of 1 January 2005, the Group is obliged to prepare its consolidated annual income statements according to the International Financial Reporting Standards adopted by the European Union (hereinafter, IFRS-EU) applicable to companies whose stock is traded on a regulated market in any member country as of the balance sheet closing date. In order to adapt the accounting system of Spanish credit institutions to the law, the Bank of Spain issued Circular 4/2004 on 22 December on the Rules for public and reserved financial information and model financial statements for credit institutions. The Group s consolidated financial statements for the financial statements were prepared by the Bank's directors (at the meeting of the Board of Directors held on 14 March 2008) pursuant to the terms of the International Financial Reporting Standards adopted by the European Union and the Bank of Spain Circular 4/2004, applying the principles of consolidation accounting policies and valuation standards described in Note 5 so as to show a faithful image of the financial situation of the Group as of 31 December and the results of its operations, the changes in its net worth (income and expenses) and consolidated cash flows in. The consolidated financial statements were prepared from the Bank's accounting records and by each one of the members of the Group and include the adjustments and restatements necessary to standardise the accounting policies and valuation criteria applied by the Group. As of the date of the formulation of these consolidated financial statements, there are different standards and interpretations adopted by the European Union which have not yet come into effect. The directors consider that the coming into effect of such standards and interpretations will not have a significant impact on the Group s consolidated financial statements. The notes to the financial statements contain additional information to that shown on the balance sheet, the profit and loss account, the statement of change in financial position (income and expenses) and the consolidated cash flows. These notes provide clear, relevant, reliable and comparable narrative descriptions and breakdowns of the financial statements. There are no significant accounting principles or standards or compulsory valuation criteria which have been overlooked in preparing them. b) Accounting principles and valuation standards In preparing the consolidated financial statements, the generally accepted accounting principles and standards used are described in the Note on Accounting Principles and Valuation Standards Used. No significant accounting principle has been overlooked in the preparation of the consolidated financial statements. Unless otherwise indicated, these consolidated accounts are stated in thousands of euros. 4

16 c) Judgments and estimates used The information included in these consolidated financial statements is the responsibility of the Group s Directors. In these consolidated financial statements, estimates provided by the Group's senior management and ratified by the Directors have been used to assess the value of assets, liabilities, income, expenses and commitments. Those estimates refer to: losses from the deterioration of certain assets the useful life applied to the tangible and intangible asset items the reasonable value of certain unquoted assets the actuarial hypotheses used to calculate the liabilities and post-employment remuneration commitments the calculation of allowances made Since the estimates have been made based on the best information available as of 31 December 2005 on the items affected, it is possible that events that occur in the future could modify them in their direction in future fiscal years. Such modifications will be made prospectively, recognising the effects of the change in the estimates on the pertinent profit and loss account. d) Consolidation principles The Group has been defined in accordance with the accounting rules in force. All Dependent, Multigroup and Associated companies are partially-owned entities. Dependent Entities are those which constitute a decision-making unit for the Parent Company since the parent company has the ability to control them either directly or indirectly through other partially-owned entities. This ability to control is generally, albeit not exclusively, manifested in the holding of a direct or indirect share in one or more partially-owned entities which includes 50% or more of the voting rights in the partially-owned company. Control is understood as the ability to direct the financial and operational policies of a partially-owned entity in order to obtain profits from their activities and can be exercised even when the aforementioned percentage of ownership is not maintained. The relevant information on the shares in the partially-owned companies as of 31 December and 2005 is included in Note 13. In the consolidation process, the global information method was used for the financial statements of the dependent companies. Consequently, all significant balances and transactions between consolidated companies were eliminated in the consolidation process. Furthermore, the participation of third parties in the Group's net assets and liabilities is presented under the caption of minority interests on the consolidated balance sheet and the part of the fiscal year profits(losses) attributable to them is shown under the caption of profits(losses) attributed to minority interests on the consolidated profit and loss account. 5

17 The consolidation of the profits(losses) generated by the entities acquired by the Group during the fiscal year is performed taking into account only those relative to the period between the date of the acquisition and the end of the fiscal year. Furthermore, the consolidation of the results generated by the companies disposed of by the Group during the fiscal year is performed taking into account those relative to the period between the beginning of the fiscal year and the date of the disposal. Multigroup Entities are partially-owned entities which, while not Dependent Entities, are controlled jointly by the Group and by one or more entities not connected to the Group and their joint businesses. Joint businesses are the contractual agreements whereunder two or more entities or partially-owned entities perform operations or maintain assets so that any strategic, financial or operating decision affecting them requires the unanimous consent of all participants, although such operations or assets are not integrated in financial structures other than those of the partially-owned company. In the consolidation process, the participation method was used for the financial statements of Multigroup Entities, applying the exceptions provided for in the accounting regulations in force. The relevant information on the interests held in Multigroup Entities as of 31 December and 2005 is included in Note 13. Associated Entities are those over which the Group has significant influence. That significant influence is generally, albeit not exclusively, manifested in the holding of a direct or indirect share in one or more partially-owned entities which includes 20% or more of the voting rights in the partially-owned company. In the consolidation process, the participation method was applied to Associated Entities. Consequently, the interests held in Associated Entities are stated for the fraction represented by the Group s participation in their share capital after considering the dividends received and other write-offs. The results of the transactions with an Associated Entity are eliminated in the proportion represented by the Group s interest in the Entity. If an Associated Entity s book balance is negative as a consequence of the losses incurred, it is stated as zero on the Group s consolidated balance sheet unless the Group is under an obligation to support it financially. The relevant information on interests held in associated enterprises as of 31 December and 2005 is included in Note 13. Note 13 includes information on the most significant acquisitions and disposals, respectively, during the fiscal year in relation to participations in Dependent, Multigroup and Associated Entities. Business combinations are the operations through which two or more economic units or entities are combined into a single entity or group of companies. For business combinations carried out on or after 1 January 2004 whereunder the Group gains control of a company, it is recorded on the books as follows: The Group estimates the cost of the business combination, defined as the reasonable value of the assets received, liabilities incurred and the capital instruments issued by the acquiring entity. 6

18 The reasonable net value of the assets, liabilities and contingent liabilities of the acquired company is estimated, including the intangible assets that cannot be recorded by the acquired company, which are added to the consolidated balance sheet. The difference between the reasonable net value of the assets, liabilities and contingent liabilities of the acquired company and the cost of combining the businesses are recorded as provided for in letter m) if the difference is negative. If the difference is positive, it is recorded under the caption of Other income on the profit and loss account. e) Comparison of the information The information contained in this report which refers to the 2005 financial year is provided exclusively for comparison with the figures and therefore is not an integral part of the Group's consolidated financial statements for the financial year. f) Shareholders Equity With the publication of Law 13/1992 of 1 June and the Bank of Spain Circular 5/1993 and successive amendments, the regulation governing the fulfilment of minimum shareholders equity for credit institutions at both the individual and consolidated group level took effect. As of 31 December, the Group s shareholders' equity exceeded the minimum requirements by 511,958,000 euros (481,090,000 euros as of 31 December 2005). 7

19 (3) Distribution of fiscal year profits (losses). The proposed distribution of Bankinter, S.A. profits earned during the fiscal year ending 31 December, prepared by the Directors and pending the approval of the General Meeting of Shareholders, along with that approved for fiscal year 2005 is as follows: 2005 Distribution: Voluntary reserves 64,482 66,809 Canary Island investment reserves Active dividend 102, Total profits distributed 166, ,737 Fiscal year profit (loss) 166, ,737 The proposal for the distribution of profits for the fiscal year ending 31 December earned by the subsidiaries of Bankinter, S.A., formulated by the Directors and pending approval by the General Meeting of Shareholders, is as follows: Profit (loss) Estimated Corporate Income Tax Dividend Reserves Applications Bankinter Consultoría, Asesoramiento y Atención Telefónica, S.A Bankinter Gestión de Seguros, S.A. de Correduría de Seguros Bankinter International B.V. Bankinter Gestión de Activos, S.A., S.G.I.I.C. (antes Gesbankinter,S.A, S.G.I.I.C.) (180) (6) ,847 11,002 6,000 16,845-8

20 Hispamarket, S.A. Intergestora, S.A. Intermobiliaria, S.A. Intergestora Nuevas Tecnologias, S.A. 32,794 7,199 25, Bankinter Capital Riesgo, SGECR, S.A. (126) (46) Bankinter Seguros de Vida, S.A. de Seguros y Reaseguros 27,272 9,548 17, Aircraft, S.A. Bankinter Netherlands BV Bankinter Sociedad de Financiación, S.A. Bankinter Emisiones, S.A. Bankinter Capital Riesgo I, Fondo Capital (2,507) (770) (5) Helena Activos Líquidos, S.L. (58) Arroyo Business Consulting Development S.L The distribution of profits for the fiscal year ending 31 December 2005 earned by the subsidiaries of Bankinter, S.A. and approved by the General Meeting of Shareholders is as follows: Profit (loss) Estimated Corporate Income Tax Dividend Reserves Applications Bankinter Consultoría, Asesoramiento y Atención Telefónica, S.A Bankinter Gestión de Seguros, S.A. de Correduría de Seguros 1, Bankinter International B.V Bankinter Gestión de Activos, S.A., S.G.I.I.C. 30,144 10,615 16,547 2,982 - Hispamarket, S.A. 2, , Intergestora, S.A. (542) (199) Intermobiliaria, S.A Intergestora Nuevas Tecnologias, S.A. 1,433 (1,884) - - 3,317 9

21 Bankinter Capital Riesgo, SGECR, S.A Bankinter Seguros de Vida, S.A. de Seguros y Reaseguros 19,581 6,840 6,294 6,447 - Aircraft, S.A. (384) (134) Bankinter Netherlands BV (18) Bankinter Sociedad de Financiación, S.A Bankinter Emisiones, S.A Bankinter Capital Riesgo I, Fondo Capital (665) (233) Helena Activos Líquidos, S.L. (6) Arroyo Business Consulting Development S.L (4) Deposit Guarantee Fund Bankinter, S.A. is a member of the Deposit Guarantee Fund. The cost during fiscal years and 2005 of the company s contributions to the Deposit Guarantee Fund was 5,532,000 and 4, euros, respectively. These costs are included under the caption of other operating charges on the profit and loss account (Note 34). (5) Accounting principles and valuation standards applied These consolidated financial statements were drafted according to the accounting principles and valuation standards currently in force. A summary of the most significant ones follows: (a) Operating company principle When preparing the consolidated financial statements, it has been considered that the management of the entities included in the Group will continue in the foreseeable future. Therefore, the application of the accounting standards is not intended to determine the consolidated net worth for the purpose of transferring part or all of it nor the resulting amount for the liquidation purposes. (b) Accrual principle The consolidated financial statements, with the exception of cash flows, have been prepared based on the real flow of goods and services regardless of the payment or receipt dates. Income and expenses are recognised on the accrual date and not on the payment or receipt date, with the exception of interest on credit investments and non-investment risks with borrowers considered as deteriorated, which are posted to results when collected. The accrual of interest on both asset and liability operations with settlement periods longer than 12 months is calculated using the financial method. For operations with shorter settlement periods, the accrual of interest is calculated using either the financial or linear method. In compliance with generally accepted financial practice, the transactions are recorded on the date on which they occur, which may be different than the value date, on the basis of which the income and financial expenses are calculated. 10

22 (c) Transactions and balances in foreign currency Balances and transfers in foreign currencies are converted to euros subject to the following conversion rules: Monetary assets and liabilities are converted to euros using the average exchanges rates on the currency market at the end of the fiscal year. Non-monetary items stated at their historical costs are converted to euros using the exchange rates on the acquisition date. Non-monetary items stated at their reasonable value are converted to euros using the exchange rates on the date when the reasonable value was determined. Income and expenses are converted to euros using the exchanges rates on the date of the operation (using the fiscal year s average exchange rates for all operations during the fiscal year). The repayments are converted to euros at the exchange rate applied to the corresponding asset. Exchange rate differences are stated on the consolidated profit and loss account with the exception of differences arising in connection with non-monetary items stated at their reasonable value, the adjustment to which reasonable value is charged to net assets. (d) Recognition, assessment and classification of financial instruments Financial assets and liabilities are recognised when the Group becomes a party to the contractual agreements pursuant to the terms of those agreements. Financial assets Purchases and sales of financial assets implemented by means of conventional agreements, these being understood as those in which the reciprocal obligations of the parties must be consummated within a particular timeframe established by law or by market conventions and may not be settled by differences, such as stock market agreements and currency purchases and sales, are stated under acquisitions as assets and are removed from sales on the balance sheet on the date when the profits, risks, rights or obligations inherent to all owners become those of the buyer which, depending on the type of asset or market involved, may be the contracting date or the settlement or delivery date. Financial debt instruments are recognised on the date on which the legal right to make or receive a cash payment arises and derivates are recognised on the contracting date. As a general rule, the Group records the removal of financial instruments from the balance sheet on the date when the benefits, risks, rights and responsibilities inherent thereto arises or when the control of same is transferred to the buyer. Financial assets are classified on the balance sheet according to the following guidelines: i) Cash and deposits in central banks corresponding to the cash balances and balances maintained with the Bank of Spain and other central banks. ii) Trading portfolio that includes the financial assets acquired with the intention of short term realisation. They are part of a portfolio of financial instruments identified and jointly managed for which recent actions have been taken to obtain short term gains or derivative instrument not designated as hedging instruments. Changes in the reasonable value of the instruments in this portfolio are recorded directly under profits and losses. 11

23 iii) iv) Other financial assets stated at reasonable value with changes in profits and losses, including (1) financial assets which, while not part of the trading portfolio, are considered hybrid financial assets and are stated entirely at their reasonable value and (2) those managed jointly with liabilities by insurance contracts stated at their reasonable value, or with financial derivatives whose object is to significantly reduce their exposure to variation in their reasonable value, or which are managed jointly with financial liabilities and derivatives in order to significantly reduce global exposure to interest rate risk. Financial assets available for sale which refer to debt-representing securities not classified as investments, other financial assets stated as reasonable value with changes in profits and losses, credit investments or trading portfolio and the capital instruments of entities which are not dependent, associated or multigroup entities and which are not included in the categories of trading portfolio or other assets at reasonable value with changes in profits and losses. The changes in reasonable value of instruments in this portfolio are stated directly in the entity s net worth until they are removed from the financial asset balance sheet. v) Credit investments, including the financial assets which, while not traded on an active market and not required to be stated at their reasonable value, their cash flows are of a determined or determinable amount and in connection with which the Group s entire disbursement will be recovered, excluding the reasons attributable to the debtor s solvency. This includes both the investments from typical credit activity, such as the cash amounts drawn and pending repayment by clients and deposits loaned to other entities, regardless of how they are legally implemented, and the securities representing non-traded debt, and the debt assumed by the buyers of goods or the users of services, all of which are part of the Group s business. vi) vii) viii) ix) Term investment portfolio which corresponds to the fixed-term debt securities and cash flows which the Group has decided to maintain through redemption, basically because of the financial capability to do so or because of linked financing. The Bank may not classify any financial asset as a term investment if during the financial year in progress or the two previous financial years it has sold or reclassified assets included in this portfolio for more than an insignificant amount in relation to the total amount of the assets included in this category. Adjustments to financial assets by macro-hedges that correspond to the balancing entry of the amounts posted to the profit and loss account originating in the valuation of the portfolio of financial instruments which are effectively covered against interest rate risks by means of reasonable value hedge derivatives. Hedging derivatives which include the financial derivatives acquired or issued by the Group that qualify to be considered as accounting hedges. Interests which include capital instruments in multigroup or associated entities. Generally speaking, the financial assets are recorded at cost. At year-end, their value is assessed on the basis of the following criteria: i) The financial assets are stated at their reasonable value, with the exception of credit investments, the term investment portfolio, capital instruments whose reasonable value cannot be determined with sufficient objectivity, interests held in dependent, multigroup and associated entities, and financial derivatives for which such capital instruments serve as the underlying assets and which are settled by delivery of same. ii) The reasonable value of a financial asset on any given date is understood as the amount for which it could be delivered between duly informed interested parties in a transaction carried 12

24 out under conditions of mutual independence. The best evidence of reasonable value is the quoted market price of an asset on an organisation, transparent market. When there is no market price for a certain financial asset, recent transactions of analogous instruments are used to estimate the reasonable value, or, in the absence of such transaction, sufficiently verified valuation models are used. The specific peculiarities of the asset in question are taken into account, particularly the different types of risks inherent to the financial asset involved.. iii) The reasonable value of the financial derivatives with a quoted value on an active market is the daily trading price. If, under exceptional circumstances, there is no trading price for a particular date, then methods similar to those used to estimate the value of OTC financial derivates are used. The reasonable value of OTC financial derivatives is the sum of future cash flows originating from the instrument and discounted as of the valuation date using methods recognised by the financial markets. iv) The credit investment and term investment portfolio are stated at their amortised costs, using the effective interest rate method to determine this. Amortised cost is understood as the acquisition cost of a financial asset corrected by the repayment of principal and the part charged to the profit and loss account by using the effective interest rate model, of the difference between the initial cost and the repayment value at expiry and less any reduction in value due to deterioration recognised directly as a decrease in the amount of the asset or by means of a correcting account. If they are covered in reasonable value hedging operations, the variations to the reasonable value related to the risk or the risks covered in said hedging operation are recorded. The effective interest rate is the rate which is exactly equal to the value of the financial instrument with the estimated cash flows throughout the expected life of the instrument, based on the contractual conditions, such as early repayment options, but without considering losses due to future credit risks. For fixed interest financial instruments, the effective interest rate is the contractual interest rate established at the time of acquisition plus any applicable commissions. For adjustable interest financial instruments, the effective interest rate coincides with the yield rate in force for all items up to the date of the first adjustment of the interest rate of reference. v) Interests held in the capital of other entities whose reasonable value cannot be determined in a sufficiently objective manner and financial derivatives whose underlying assets are such instruments and which are settled by delivering the assets are stated at cost, corrected where applicable by the losses due to deterioration which they have experienced. Variations in the book value of financial assets are generally stated, with a balancing entry to the profit and loss account, differentiating between those originating from the accrual of interest and similar, which are recorded under the caption "Interest and similar yields" and those with other origins, the net amount of which is recorded under the caption Profit/loss from financial operations on the profit and loss account. However, variations in the book value of the instruments included under the caption Financial assets available for sale are temporarily recorded under the caption Adjustments to net worth value except when they are due to exchange rate differences. The amounts included under the caption Valuation adjustments continue to be part of the 13

25 net worth until the asset which gave rise to them is removed from the balance sheet, at which time the entry is cancelled from the profit and loss account. For financial assets designated as hedged items and hedging or reasonable value, the differences in the value of both the hedging elements and the hedged elements, inasmuch as the type of risk being covered, are recorded directly on the profit and loss account. In hedging operations to cover the reasonable value of the interest risk on a portfolio of financial instruments, the gains or losses arising on the hedging instrument are recorded directly on the profit and loss account, while the gains or losses due to variations in the reasonable value of the hedged amount, inasmuch as the hedged risk is concerted, is recorded on the profit and loss account with a balancing entry under the caption "Adjustments to financial assets due to macrohedges. Financial Liabilities Liabilities are classified on the balance sheet as follows: i) Trading portfolio that includes the financial liabilities acquired with the intention of short term realisation. They are part of a portfolio of financial instruments identified and jointly managed for which recent actions have been taken to obtain short term gains or derivative instruments not designated as hedging instruments or arising from the sale of financial assets acquired temporarily or received on loan. ii) iii) iv) Financial liabilities at amortised costs that refer to financial liabilities not recorded under any other caption on the balance sheet and which are part of the habitual funding activities of financial institutions, regardless of how they are implemented or their maturity dates. Hedging derivatives including the financial derivatives acquired or issued by the Bank which qualify to be considered book hedging. Capital in the form of financial liability that includes the amount of the financial instruments issued by the institution that, with the legal status of capital, do not meet the requirements to be considered net assets and that consist mainly of the shares issued that do not contain political rights, with profitability set according to whether interest rates are fixed or floating. They are valued as financial liabilities at amortized cost unless the institution has designated them as financial liabilities at fair value if they meet the conditions for it. Financial liabilities are recorded at their amortized cost, as defined for financial assets, except in the following cases: i) Financial liabilities in the item trading book are valued at their fair value, as defined for financial assets. Financial liabilities covered in fair value coverage are adjusted, with changes recorded in fair value in relation to the risk covered in the coverage transaction. ii) Financial derivatives that have an underlying of capital instruments whose fair value cannot be determined in a sufficiently objective manner and which are liquidated in their delivery, are valued at cost. Variations in value in books of financial liability are recorded, generally, with a offset in the profit and loss account, with a distinction between those originating in the accrual of interest and similar items, which are recorded in the item Interests and related charges, and those 14

26 due to other causes, which are recorded at their net amount in the item Results of financial transactions in the profit and loss account. As regards financial liabilities designated as covered items and accounting coverage, the differences in valuation are recorded on the basis of the criteria indicated for financial assets. (e) Acknowledgment of income and expenses Income and expense of interest and related items are recorded generally according to the period of accrual and by application of the effective interest method. Dividends received from other entities are recorded as income at the moment the right to receive them arises. Commissions paid or collected for financial services, regardless of their denomination in contractual terms, are classified in the following categories, thereby determining their assignment in the profit and loss account: i) Financial commissions which are an integral part of the yield or effective cost of a financial transaction, and which are assigned in the profit and loss account throughout the expected lifetime of the transaction as an adjustment to the cost or effective yield. These include the commitment fee and commissions for the study of assets products, commissions for excess credits and overdraft commissions in liability accounts. ii) Non-financial commissions are those that derive from the provisions of services and that might arise in the execution of a service provide during a period of time and in the provision of a service that is executed in a single act. Income and expenses for commissions and related fees are recorded in the profit and loss account generally in accordance with the following criteria: i) Those related to financial assets and liabilities valued at a fair value with changes in losses and profits are recorded at the moment of collection. ii) Those related to transactions or services that are provided over a period of time are recorded during the period of said transactions or services. iii) Those related to a transaction or service provided in a single act are recorded when said act is performed. Non-financial income and expenses are recorded in accounting on an accrual basis. Collections and payments deferred for more than a year are recorded as the amount resulting from the financial updating of expected cash flows at market rates. (f) Impairment in the value of financial assets The book value of financial assets is generally corrected as a charge against the profit and loss account when there is objective evidence that a loss has occurred owing to impairment, which occurs in the following cases: i) In cases of debt instruments, which are understood as loans and values representing debt; when, after their initial recognition there is an event or combined effect of several events that has a negative impact on future cash flows. ii) In the case of capital instruments, when after recognition there is an event or combined effect of several events that its book value will not be recovered. 15

27 As a general principle, correction of the book value of financial instruments owing to impairment is made against the profit and loss account of the period in which the impairment is manifested; and the recovery of the losses owing to previously recorded losses from impairment, if any, is recognized in the profit and loss account in the period in which the impairment is eliminated or reduced. In the event that recovery of an amount owing to recorded impairment is considered remote, the impairment is eliminated from the balance sheet, though the institution may perform the actions necessary to achieve collection until final expiration of rights owing to prescription, cancellation or other causes. In the case of debt instruments valued at their amortized cost, the amount of losses owing to impairment incurred is equal to the negative difference between its book value and the present value of estimated future cash flows. For listed debt instruments, use can be made, as a substitute for the present value of future cash flows, of market value provided that it is sufficiently reliable to be considered representative of the value that the Group may recover. Estimated future cash flows of a debt instrument are all the sums, both principal and interest, that the Group estimates that it will be obtained during the lifetime of the instrument. Said estimate considers all the relevant information available as of the date of preparation of the financial statements that provide data on the possible future collection of future contractual cash flows. Similarly, the estimate of future cash flows of instruments that have real guarantees, the flows that would be obtained from their realization are taken into account, menus the costs necessary for their collection and subsequent sale, independently of the probability of execution of the guarantee. Calculation of the present value of estimated future cash flows is used as a type of update of the original effective interest rate of the instrument, if its contractual rate is fixed, or the effective interest rate in the date referred to in the financial statements as determined in accordance with contractual conditions when variable. Portfolios of debt instruments, contingent risks and contingent commitments, whatever the bearer, instrumentation or guarantee may be, are analyzed to determine the credit risk to which the Group is exposed, and estimate the coverage needs for value impairment. For the preparation of financial statements, the Group classifies its transactions according to the credit risk, with a separate analysis of the insolvency risk imputable to the client and the country risk to which they are exposed, if any. Objective evidence of impairment shall be determined individually for all debt instruments that are significant and individually and collectively for groups of debt instruments that are not individually significant. When a specific instrument cannot be included in any asset group with similar risk characteristics, it will be analyzed in an exclusively individual manner to determine if it has impaired and, if necessary, estimate the loss from impairment. Collective evaluation of a group of financial assets to estimate losses from impairment is performed as follows: i) Debt instruments are included in groups that have similar credit risk characteristics that indicate the capacity of debtors to pay all sums, principal and interest, as per contractual conditions. The characteristics of credit risk used to group assets are, among others, the instrument type, the industry of the debtor, the geographic area of the activity, the type of guarantee, the age of the due amounts and any other factor that may be relevant to estimate future cash flows. 16

28 ii) Future cash flows in each group of debt instruments are estimated for instruments with credit risk characteristics that are similar to that of the respective group, following the adjustments necessary to adapt historical data to present market conditions. iii) Losses from impairment in each group are the difference between the book value of all the debt instruments in the group and the present value of estimated future cash flows. Debt instruments not valued at their fair value with changes in the profit and loss account, contingent risks and contingent commitments are classified, according to the insolvency risk imputable to the client or transaction, into the following categories: normal risk, substandard risk, doubtful risk owing to client slowness in paying and failed risk. For debt instruments not classified as normal risk, estimates are made of the specific coverage necessary for impairment on the basis of the age of the unpaid amounts, the guarantees provided and the economic situation of the client and, if relevant, of the guarantors. This estimate is generally made on the basis of arrears calendars. In addition to the specific coverage for impairment indicated above, the entity covers inherent losses incurred in debt instruments no valued at their fair value with changes in the profit and loss account and contingent risks classified as a normal risk through collective coverage. In this regard, the Bank of Spain determines the parameters, methods and amounts to be used in coverage of losses from inherent impairment that occur in debt instruments and contingent risks that have been classified as normal risk. The method of calculation, as provided in Annex IX of Circular 4/2004 of the Bank of Spain, is divided into two phases. In the first phase, balances are divided into six types of risk as per the regulation. These types are as follows: no appreciable risk, low risk, medium-low risk, medium risk, mediumhigh risk and high risk. The impaired amount will be the sum of the following: a) The result of multiplying the value of the variation in the balance period of each of the risk types by the relevant regulatory parameter, plus b) The result of multiplying the total balance of transactions included in each of the risk types at the end of the period by the relevant regulatory parameter, minus c) The amount of the net reserve for specific global coverage made during the period. The global balance of generic coverage must, at all times, be between 33% and 125% of the amount resulting from adding the product of multiplying the amount of each type of risk by its relevant regulatory parameter. For the Group, the balance as of 31 December 2004 and 2005 is the maximum value. 17