Spanish Banks May Need up to EUR62 Bil. in Capital

The Spanish authorities commissioned two independent auditors to conduct top-down analyses to evaluate the Spanish banking sector's resilience under adverse macroeconomic developments. The contracts were awarded to external auditors, Oliver Wyman and Roland Berger, and were asked to provide estimates of the future capital requirements for the Spanish banking system as a whole under two different macroeconomic environments: one of them a baseline, considered most likely scenario, and an alternative severely stressed scenario.

The exercise covered 14 Spanish banking groups, which represent almost 90% of the Spanish financial system: Santander, BBVA & Unnim, Popular & Pastor, Sabadell & CAM, Bankinter, Caixabank & Cívica, Bankia-BFA, KutxaBank, Ibercaja & Caja3 & Liberbank, Unicaja & CEISS, B. Mare Nostrum, CatalunyaBank, NCG Bank, B. Valencia. The stress analysis went beyond examining the impact on the exposures to the real estate and construction sector, but included the rest of the loan portfolio, namely loans to households and the rest of the non-financial corporations (e.g. SMEs and retail mortgages).

With regards to modelling the baseline and adverse stress tests, the auditors mirrored the latest International Monetary Fund (IMF) Financial Sector Assessment Program (FSAP) stress exercise on the Spanish financial system, but with some important differences. First, the core capital T1 requirement is 9% under the base case, compared to 7.0% in the IMF stress analysis, and the horizon is one year longer when compared to the IMF. Core capital ratio (bank's core equity capital relative to its total risk-weighted assets) gauges the resilience of the bank from a regulator's point of view, and consists primarily of common stock and disclosed reserves (or retained earnings), but may also include non-redeemable non-cumulative preferred stock. Meanwhile, the macroeconomic conditions in the adverse scenario compiled by the auditors are more severe than the IMF assumptions. The selected hurdle rate for the Core T1 capital ratio under this adverse scenario is 6%, which is below the 7% used by the IMF in their recent stress analysis, and below the minimum state requirement of 8%.

The baseline scenario assumes that real GDP is likely to contract by 1.7% in 2012, 0.3% in 2013 before edging up by 0.3% in 2014. The unemployment rate would spike up from 21.6% in 2011 to 23.8% in 2012 before stabilising. The housing market downturn would start to slow, with the rate of decline in house prices slowing to 5.6% in 2012, 2.8% in 2013 and 1.5% in 2014. The macroeconomic assumptions underpinning the baseline scenario appear to be light on real GDP and house price falls expected in 2013, and the assumption of unemployment flat lining in 2013/14 is optimistic. Nevertheless, under this baseline scenario, the banking sector's future capital requirements would range EUR16 to 25 billion and EUR25.6 billion, according to Oliver Wyman and Roland Berger, respectively.

The adverse scenario used by the auditors is based on Spain enduring considerably sharper falls in real GDP, real estate prices and main stock market indices. Under this adverse scenario, the Spanish economy is likely to contract by 4.1% in 2012, 2.1% in 2013 and 0.3% in 2014. Not surprisingly, the unemployment rate would rise steadily to stand at 27.2% by 2014. Meanwhile, the bigger hit on the economy brings about a sharper and deepening housing market slump over the three-year horizon, with house prices projected to fall by 19.9% in 2012, 4.5% in 2013 and 2.0% in 2014. Spanish stock prices would slump by 51.3% in 2012, followed by a modest 5% fall in 2013 before stabilising in 2014. The macroeconomic assumptions underpinning the adverse scenario appear to be credible, although we would expect a sharper fall in house prices in 2013 and 2014 given the prolonged falls in real GDP and the upward trajectory in unemployment over the period. Under this adverse scenario, the bank recapitalisation estimates are aligned, with Oliver Wyman suggesting banks would need to find additional capital in the region of EUR51–62 billion, while Roland Berger puts the figure at EUR51.8 billion.

The Bank of Spain concludes that the results of the two independent results confirm the main conclusions of the recent IMF FSAP stress test exercise. The IMF 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 their adverse stress test, 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." Therefore, the Bank of Spain concludes the core of the banking system is well equipped to ride out harsh macroeconomic developments, but acknowledge problems continue to prevail to a group of institutions which are already the focus of the government assistance. Furthermore, the central bank notes that under both scenarios reported by the consultancies, the future capital requirements are below the request of emergency loans of up to EUR100 billion made by the Spanish authorities. Finally, the strategy to restructure the weakest institutions "will be decided on a case-by-case basis in conformity with requirements established by European authorities and in particular with the EU state aid rules."

Outlook and Implications

The findings of the independent auditors will allow Spain to formally request the emergency loans of up to EUR100 billion from the Euro group, and is welcome but the first of many steps to clean up the Spanish banking system. A more precise estimate of the final banking recapitalisation cost should be unveiled once four independent auditors conclude a bank-by-bank analysis in September. This will precede a period of nine months where banks have to plug any capital shortfalls, either from private funds or through an application for state assistance.

With regards to the scenarios, investors are likely to ignore the baseline scenario, which suggests that the future capital requirements will not exceed EUR25.6 billion. This is unlikely, particularly with the financial institution Bankia already requesting EUR19 billion. Clearly, the adverse case is far more credible, with its GDP profile mirroring our current baseline view. The stress scenario adopted by the consultants assumes house prices will drop by more than 60% from peak to trough, which will entail significant credit losses. According to Roland Berger, the 14 Spanish banks would endure expected credit write-downs for the three years to end-2014 at EUR119 billion in the base scenario and EUR170 billion in the adverse scenario. Meanwhile, Oliver Wyman concludes that cumulative expected losses for the existing credit portfolio in the period 2012–2014 could stand at EUR250–270 billion under the adverse scenario, consisting of EUR150–160 billion from performing loans, EUR55–60 billion from non-performing loans and EUR42–48 billion from the foreclosed asset book.

The estimates of future capital requirements in the adverse scenario from both the consultants and the IMF appear to be conservative. Indeed, real estate loans stood at around EUR1000 billion at end-2011, against a backdrop of housing market indicators heading south at a more aggressive pace, namely accelerating house price falls, plummeting residential sales and an acute mortgage lending squeeze. Furthermore, the Spanish banks' bad-loan ratio jumped to a near-decade high of 8.7% in May, and could rise appreciably in the remainder of 2012 and 2013. We are concerned that the bad loan ratio could rise exponentially should the prospect of further sharp employment losses in 2013 increasingly affect workers on permanent contracts. This would imply an increasing threat to banks' extensive mortgage portfolios, which stood at around EUR600 billion at end-2011.

A notable concern is that the stress tests conducted by the consultancies don't include the majority of banks' holding of sovereign debt. It does not assume any sovereign defaults or a Greek euro exit, and gauging the impact of such an event on bond yields and Spanish bank's holdings of sovereign bonds which are held on trading book portfolios or to maturity in the banking book. This includes Spanish banks' exposure to both Spanish debt and other troubled peripheral sovereign debt. This is a risk given that domestic banks' holdings of Spanish government debt continue to accumulate, and rose by 26% in two months to stand at EUR220 billion at the end of January 2012.