Spain’s decision to apply for eurozone assistance to recapitalise its banking system removes one of the key structural weaknesses which has undermined confidence in the euro for many months. Until now, successive Spanish governments have repeatedly claimed that there was no need for eurozone assistance for their banking sector. However, these claims have not carried much credibility since the economy dropped back into recession last year, taking the real estate sector down with it. (See earlier blogs here and here.) The failure of Bankia was the final moment of truth.
Since then, it has been apparent that Spain would face a large bill to recapitalise its banks, but it has not been clear exactly how large the bill might be, or where the money would come from. This uncertainty has worried both domestic deposit holders in Spanish banks, and providers of liquidity to the banking sector. It has been one of the two proximate causes of the recent worsening in the euro crisis (the other, of course, being the Greek elections).
This weekend’s bail-out removes much of the uncertainty both about the overall cost of the bank rescue, and about the source of its funding. It is therefore a large step forward. However, it does not solve Spain’s other structural problem, which is how to stabilise its government debt ratio. If anything, it makes that problem worse, and places an increased focus on the European summit on 28/29 June to address the issue.
First, the details of the bank rescue. The IMF brought forward to last Friday the publication of its eagerly awaited study on the likely cost of this operation. It is important mainly because it comes with the authority of an international agency, and because it is based on economic stress tests which genuinely represent “worst case” economic scenarios. Here are numbers used in the study:
The relevant figures are in the right hand columns, which are the IMF’s downside case. (The Bank of Spain’s adverse case is shown in the middle of the table.) In the IMF downside scenario, GDP falls by 5.7 per cent cumulatively in 2012-13, compared to 2.0 per cent in the baseline case, and the cumulative decline in house prices is 24 per cent, compared to 9 per cent in the baseline. Anything worse than this really would represent Armageddon.
Based on these assumptions, the IMF presents the additional capital needs of the Spanish banking sector as follows:
The relevant figures in this table are on the far right, which represent the total needs of the entire banking sector on various assumptions about capital ratios. (G1 banks are the large internationally active banks; G2 are former savings banks which have not received state support; G3 are savings banks which have received state support; G4 are small private banks; and FROB are those currently administered by the government work-out entity.)
The €37 billion figure which the IMF says is the minimum capital injection required today assumes that the banks should meet the full Basel III targets, which officially do not take effect until 2018. This is a tough requirement, tougher than recently in use in US stress tests, for example. Three quarters of this extra capital requirement is absorbed by the former savings banks (G3 plus FROB) which have already received state support. The large international banks are completely unaffected.
Although the economic and capital requirements assumed in this €37 billion estimate represent a realistic downside case, there are three other reasons for arguing that the eventual needs could be higher than this central IMF estimate:
First, the figures apply to the end of 2011, since when the baseline capital positions of the banks may have deteriorated considerably.
Second, the figures do not include any allowance for losses in that portion of bank loans which are already classified under “lender forbearance”, which means that likely future defaults on that part of the loan book are being understated.
Third, the IMF estimates do not allow for all of the future write-downs which the banks may need to take on their holdings of Spanish government bonds. Losses on bonds held by trading books are included, but those on held-to-maturity books are not.
Overall, despite the pessimistic economic assumptions, the IMF’s €37 billion estimate may prove to be too low; and in any event it only covers the period to the end of 2013. Therefore both the IMF and the eurozone want Spain to accept a bail-out of much more than €37 billion, with figures of €80-€100 billion being mentioned.
This injection would come either from the EFSF or the ESM. It would not go directly to the banks, but would be siphoned via the FROB, and would therefore add to government debt. A bail-out of €80 billion, which should impress the markets, would therefore solve the problem of the Spanish banks at the cost of adding around 11 percentage points to the government debt ratio, taking it to over 100 per cent of GDP in 2015.
If the injection comes from the ESM, rather than the EFSF, then the debt incurred would be senior to other Spanish government bonds. This could damage spreads on remaining government bonds since these would henceforward stand behind the official sector loans.
Can Spain’s public sector balance sheet cope with this? It is already facing huge difficulty in hitting the targets required in the fiscal pact. The following table shows the IMF’s most recent estimates of the outlook for the public accounts, based on the main economic case, not the downside scenario:
If Spain had tried to finance the bank recapitalisation from the private bond market, its bond issuance would have roughly doubled this year, which clearly would have been untenable. In that sense, the eurozone-funded money is a get-out-of-jail card for Spain, especially since policy conditions are expected to be lenient outside the banking sector.
But if Spain’s banks need to be recapitalised to cope with a downside scenario, what does this say about the Spanish sovereign? If the IMF were to plug its downside scenario into its forecast for the public finances, the budget deficit would be 2 percentage points of GDP worse in 2013 and thereafter. This will be the next big worry for the markets.
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