Spain Plans to Accelerate Banking Reform Under Bailout Umbrella

The recent meeting of Eurozone finance ministers has confirmed a maximum of EUR100 billion to the emergency loans will be made available to Spain to recapitalise its banking sector, which will able to receive aid over the next 18 months. A final loan agreement is expected to be signed on or around 30 July, with an unconfirmed report suggesting the average maturity of the loan will be 12.5 years at an interest rate of 3–4%. Furthermore, the ministers have agreed to make some EUR30 billion available by the end of July if requested by Spain. Economy Minister Luis de Guindos hopes the umbrella of the bailout will allow Spain "to clean up its financial system that I think is going to go very deep" and "to make the maximum use of the next eighteen months to do this clean up... and bring down debt levels in the Spanish economy".

The Eurozone finance ministers also rubber-stamped the decision to allow the ESM to recapitalise Spanish banks directly once a single European banking supervisor is in place from next year, implying that a state guarantee will not be required. This aims to break the unsustainable cycle of weak banks and indebted sovereigns lending to each other. De Guindos welcomed the agreement as "very, very positive", overcoming some initial opposition from some member countries. The next step is for the Spanish government to group its banks into four main categories. The first group is the large listed banks not needing aid, the second includes nationalised banks such as Bankia which need immediate assistance, the third will represent mid-tier banks that can raise their own capital and the final group will contain the remaining mid-tier banks which could struggle to meet new capital requirements identified in the bank-by-bank independent audit to be completed by September.

According to Reuters, the terms of the bank bailout's draft memorandum of understanding (MoU) to be signed by Spain will ensure that its 14 banking groups (around 90% of the banking system) will be stress tested again by independent consultants to gauge their recapitalisation needs by the second half of September 2012. Furthermore, Spanish banks will need to increase their core capital ratios to at least 9% by the end of 2012 and maintain them at this level until the end of 2014. This stiffens the current requirement where credit institutions need to keep their core capital ratio (a bank's core equity capital relative to its total risk-weighted assets) to a minimum 8%. The required ratio jumps to 10% for those credit institutions that have a wholesale funding ratio of over 20% and have not placed securities representing at least 20% of their share capital or voting rights with third parties. Core capital ratio 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. Furthermore, the government will review the provision requirements to cover any future losses on currently performing real estate assets. In May 2012, banks were asked to increase their provisioning for currently performing real-estate loans from 7% to 30%, implying they have to find an additional EUR30 billion to beef up their buffer against expected losses from real-estate loans. This reinforces an earlier move in early February 2012 when banks were asked to put aside EUR53.8 billion as a buffer against the prolonged property market downturn.

The impending reforms will also deepen the focus on savings banks, with the government planning to implement a new law to reduce the stakes that savings banks (cajas) have in commercial lenders to non-controlling levels. Furthermore, the cajas which are receiving state aid will become listed companies. The MoU document also states that holders of hybrid capital and subordinated debt in state-rescued banks will have to take a haircut on their investments to lessen the cost of restructuring to the taxpayers. This is likely to have an impact on hundreds of thousands of small shareholders who brought instruments such as preference shares are likely to be affected.

Outlook and Implications

The Spanish financial system is still struggling to shake off the burden of a heavy real-estate loan portfolio and deflating repossessed assets and land, the main factor behind the unease of sovereign debt lenders. Indeed, according to the Bank of Spain, the stock of "problematic" real-estate assets (either loans or foreclosed property) now stands at EUR184 billion. The latest phase of the reform drive to clean up the banking sector at an accelerated pace is to be welcomed. The pledge to raise the core capital ratio to 9.0% will help to improve the resilience the banking sector facing punishing heading headwinds, namely a recession that is expected to linger throughout the remainder of 2012 and 2013 and still tumbling house prices that could fall by 50% from peak to trough. Indeed, Spanish banks have reported that bad loans (including retail credit cards) ratio climbed to 8.7% in April, its highest level since early 1994. Furthermore, the promise to review the current provision requirements to cover any future losses on currently performing real estate assets is a prudent move given that housing market indicators continue to head south. This is critical given that existing bank loans to the construction sector and property services stood at a staggering EUR396.8 billion, or 37.0% nominal GDP at end-2011. Clearly, doubtful loans could climb appreciably in 2012/13 with construction companies and property developers facing accelerating house price falls alongside a stock of around one million unsold new properties, not surprising given the double-digit drop in residential sales and an acute mortgage lending squeeze.

The MoU document did not mention explicitly the creation of a single "bad bank" to hold the damaged real estate assets from its banking sector. Spain had appeared to agree to the establishment of a "bad bank", which would allow more transparent monitoring of distressed real estate loans while helping the banking sector to resume normal lending activities. One option would be to replicate the Irish bad bank template, which involved the creation of a state-run National Asset Management Agency (NAMA), which took ownership of EUR77 billion of property loans. The "haircut" applied to Irish property loans was 30%, implying it cost the government some EUR54 billion to take control of the loans. The Spanish government and its domestic banks would need to agree on the size of the haircut applied to the troubled real estate loans transferred to the state run 'bad bank', but we would expect it could be at least 50% given that house prices are now expected to halve from peak to trough alongside a stock of around million unsold new properties. Therefore, to be sure of avoiding losing taxpayers' money, a more aggressive haircut than the Irish figure would need to be applied with any near-term recovery in Spanish property prices likely to be laboured.