(Bloomberg) -- Spanish banks should limit cash dividends for another year and take advantage of a jump in share prices to raise capital, the International Monetary Fund said.

The government should consider strengthening the power of the Bank of Spain, which has recommended banks restrict cash dividends this year, so it can force them to cap payouts, the IMF said today in its fourth review of Spain’s progress in meeting the terms of its European banking bailout.

It should also consider attaching conditions to its plan to offer banks guarantees that will allow them to keep counting some deferred tax assets as capital. Legislation could force them to issue more equity or stop paying cash dividends for as long as three years in return for the help, the Washington-based IMF said.

Mounting losses at former savings banks including Bankia group led Spain to seek 41.3 billion euros ($55.8 billion) in European aid last year as the cost of cleaning up soured real estate assets risked undermining government finances. While Spain “remains on track” in meeting its bailout terms, bank profits could remain under pressure as households and companies scale back borrowing and the government continues to cut spending, the IMF said.

Buoyant Markets

“To avoid exacerbating already-tight credit conditions, supervisory actions to strengthen solvency and reduce risks should prioritize measures that boost banks’ nominal capital,” it said. “Such actions include encouraging banks to take advantage of buoyant equity markets to increase share issuance.”

Shares in Banco Popular Espanol SA, a Spanish lender forced to sell shares last year after stress tests uncovered a capital shortfall, have jumped almost 80 percent since the end of June.

In June, the Bank of Spain told banks to limit cash dividends to 25 percent of profits. Those guidelines were welcome and could “usefully be extended” into 2014, the IMF said.

Spain is in the process of determining how to change the accounting treatment of about 59 billion euros of deferred tax assets to soften the impact of new rules known as Basel III, which will require banks to deduct them from capital over time.

While it’s a welcome step to amend the rules so that some deferred tax assets become transferable claims on the government, and therefore no longer deductible under Basel III, the change “should not be provided as a windfall,” it said. “For example, DTA legislation could be combined with legislation requiring banks to either issue more equity or refrain from cash dividends for a given period” such as three years, the IMF said.

Asset Sales

Lenders continue to face an “impaired” ability to generate income from their core banking activity as lending shrinks and asset yields diminish, the IMF said. “Much uncertainty remains regarding the eventual extent of credit quality deterioration, which is likely to continue for some time,” it said.

Spanish banks need to keep selling assets to free up space on their balance sheets for new lending to the areas of the economy that are growing, the IMF said. Supervisors will have to make sure that banks “adequately provision for loan losses so that banks do not delay asset disposal simply to avoid recognizing losses,” the report said.

European finance ministers said last week they supported Spain’s decision not to request more bank aid after the program ends in January. The IMF, which is monitoring Spain’s banking program along with the European Union, will publish its fifth and final progress report in early 2014 as the program ends on Jan. 23.

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