Eurozone Finance Ministers Agree to Lend Spain Up to EUR100 Bil. to Recapitalise Banks

Spain has become the fourth member of the Eurozone to request external financial assistance since the onset the region's sovereign debt crisis. The Eurozone finance ministers have accepted the request, and have agreed to lend Spain up to EUR100 billion in order to recapitalise its banking system. Spanish Economy Minister Luis de Guidos confirmed that "the Spanish government declares its intention to request European financing for the recapitalisation of the Spanish banks that need it", and he expects "the amounts needed would be manageable, and that the funds the requested would amply cover all needs." Meanwhile, a statement by Eurogroup stated that it hopes the agreed size of the loan would cover the estimated capital requirements with an additional safety margins. The final size of the loan will be known after the results of two independent audits of the Spanish banking system are published on 21 June, and will be followed by a formal request from Spain for funds. Spain has hired consulting firms Oliver Wyman and Roland Berger to conduct the independent valuation of its bank assets, which have been given access to the Bank of Spain data to run stress tests based on the methodology used in the recent Europe-wide stress tests compiled by the European Banking Authority (EBA). The two auditors are processing the data independently and will not consult each other, to improve the credibility of the results.

The triggers for the Spanish government to seek external financial assistance appeared to be Fitch's decision to downgrade Spain's long-term sovereign credit debt rating to BBB (one notch above junk status) and the International Monetary Fund (IMF) report warning of prevailing weaknesses in Spain's financial system. Fitch warned that the final cost of bank restructuring and recapitalisation is likely to be higher than previously thought, probably around EUR60 billion or 6% of GDP, which could rise to EUR100 billion or 9% of GDP in the worst-case scenario. Fitch believes Spain needs to seek external financial assistance to recapitalise its medium-sized and savings banks, which would be a significant step in restoring confidence in the sector as whole. Furthermore, the rating agency believes the offer of low cost help over a lengthy period of time from its European partners "to assist in the restructuring of the Spanish banking sector is consistent with Spain's current sovereign rating" and could be a significant step in restoring confidence in the banking sector while softening the fiscal cost to the sovereign. Meanwhile, the IMF report as part of its Financial Sector Assessment Program (FSAP) conducted new bank stress tests using detailed bank-by-bank data and concluded that the core of the banking system remains resilient but vulnerabilities remain in some segments. Indeed, under an adverse scenario, several banks would need to elevate their capital buffers by about EUR40 billion to comply with the Basel III transition schedule (core tier-one capital ratio of 7.0%). The IMF warned that the final cost of shoring up the troubled banks could be considerably larger if "they trigger major restructuring costs and reclassification of loans for instance for lender forbearance— that may be identified in the independent valuations of assets."

Prime Minister Mariano Rajoy had previously denied that Spain's banking-sector woes would trigger a request for Eurozone financial aid, but he now feels that his government will struggle to fund the higher bank recapitalisation estimates, ranging from EUR40 billion to EUR100 billion. He announced at a press conference in Madrid that "we took such measures because we believe in them, I am utterly convinced that it is like a family or a company, you cannot spend what you don't have. No administration can do this." The government has already injected EUR18.0 billion of state funds to bail out struggling savings banks. However, the decision by Rajoy to seek external aid has not been well received by many Spaniards. They have accused him of cowardice, and many believe that he was pressured by the rest of the Eurozone to seek assistance. Interestingly, the European Central Bank (ECB) has failed to resume its bond-buying programme in the secondary markets despite the mounting pressure on Spanish and Italian bond yields in recent weeks, which could have prompted Rajoy to relent. However, Rajoy continues to insist that he applied pressure on the other Eurozone leaders to get a favourable deal for Spain while trying to contain the reignited Eurozone debt crisis. Another bone of contention remains the interest to be paid on the proposed Eurozone loans to Spain, with the government providing conflicting answers. First, De Guindos claimed interest payments would affect the general government fiscal accounts and its budget deficit reduction plan, but a day later, Rajoy claimed it would not. There is considerable public hostility to the prospect of the state covering the debt servicing costs arising from requested funds to recapitalise banks.

Outlook and Implications

The Spanish government is stressing that any European financial rescue is purely to prop up its banking sector, and will continue to access the sovereign credit markets, unlike the other recipients of Greece, Ireland and Portugal. Clearly, this is a preferred option, hoping to avoid the situation where the Eurozone rescue funds would struggle to cover Spain's gross financing needs for the next three years. At this stage, it appears the rescue package will not be accompanied by strict conditions that were attached to the other bailout recipients, namely ramping up pressure on Spain to accelerate both the pace of its fiscal tightening and structural reforms (except for banking-sector reforms). De Guidos insists "since the funds being asked for are to attend to financial sector needs, the conditionality, as agreed in the Eurogroup meeting, will be specifically for the financial sector," More likely, the fiscal pressures on Spain are likely to ease, with both the European Commission and Germany agreeing in principle to allow Spain an additional year to cut its general government budget deficit to 3.0% from the currently agreed 2013. The Spanish government's sensitivity to limit the already considerable damage to national pride arising from the request for financial aid was highlighted by the initial disagreement amongst the finance ministers about the role of the IMF in any future rescue package. Spain has insisted that the IMF's role be kept to a minimum, with the organisation not asked to provide any money. Finally, it was agreed that the IMF would help monitor the Spanish banking-sector reforms, while the EU institutions would ensure Spain remains committed to its broader economic commitments. However, IMF Managing Director Christine Lagarde welcomed the general aims of the rescue package, believing it to be consistent with the IMF's estimates of the Spain's banking recapitalisation and would help to alleviate some of the financial pressures on Spain.

The main goal of the timing and the size of the banking sector rescue package being compiled for Spain is to remove some uncertainty of its final sovereign financing requirement in 2012 and 2013, and help to alleviate any concerns of the impact of any unexpectedly large requests for state assistance from struggling banks after the partly nationalised financial institution Bankia requested EUR19 billion to provide adequate provisioning for future real-estate losses. Critically, Spain needs continued access to the sovereign debt markets, and plans to hold regular debt auctions as normal. The central government faces a busy debt issuance schedule in the second half of 2012, needing to roll over sovereign debt redemptions totalling EUR80.7 billion from June to the end of 2012, plus financing a general government budget deficit of EUR56.7 billion (5.3% of GDP). With regards to spikes in maturing central government debt in 2012, the toughest months are July (EUR17.9 billion), and October (EUR26.8 billion). In addition, it will need to issue new bonds to provide some additional financial assistance to the 17 autonomous regions which face a tough debt redemption schedule, facing a further EUR15.7 billion of debt maturing in the second half of 2012.

The biggest risk attached to the sooner-than-expected request for external financial assistance from Spain is that the final cost of cleaning up the Spanish banking system could exceed EUR100 billion. At this stage, the size of the bank recapitalisation requirements remains a moving target, given that housing market indicators continue to head south. Recently, the Bank of Spain estimated that that Spanish banks' troubled real estate assets (loan portfolio and repossessed properties and land) stand at EUR184 billion, which provides an indication of the potential real estate losses. Furthermore, we continue to argue the financial risks to Spain are even more acute in 2013—with Spain facing another tough financing year. According to the IMF, Spain's gross financing requirement for 2013 is estimated at 21.5% of GDP (around EUR230 billion), not surprising given the accumulating public debt and still marked general government budget shortfall.

International investors will be increasingly uneasy about the rising Spanish public debt, which is now expected to climb well above 90% when the pledged EUR100 billion (around 9% of GDP) is included. The sharp rise in Spain's public debt ratio is a concern since its previously lower ratio when compared with the other troubled economies provided some welcome protection from circling international investors and sceptical rating agencies during the Eurozone sovereign debt crisis. Worryingly, Spain will be increasingly vulnerable to any major external shocks, given its heavier future financing requirements.