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Spain's Bad Bank Needs Goodwill From Europe's Leaders

Source: Bloomberg - Mon 26th Nov 2012
Spain's Bad Bank Needs Goodwill From Europe's Leaders

Spain is trying hard to shore up its banking system, an endeavor crucial to the recovery of the euro area's 4th-largest economy. To improve the chances for success, Europe's leaders need to send a clear signal that the costs to Spain's government won't get out of control.

On Dec. 1, Spain plans to put in place a central element of its financial-sector rescue agreement with the EU : a "bad bank" designed to unburden the country's commercial lenders of some of their worst assets. The bank will spend as much as €90 billion to buy foreclosed properties and soured real-estate loans, at prices ranging from about 20 - 68% of face value. To mitigate the cost to the government, it hopes to raise several billion dollars in capital from private investors.

The move is more significant as an indicator of Spain's political will than as a salve for a troubled banking system. It addresses only a small fraction of the €1.5 trillion in assets that the government's consultant, Oliver Wyman, has identified as potentially problematic. At best, it will speed up the process of recognizing losses at banks without much changing the amount of capital they must raise to offset the losses.

Capital Needs

Even with the bad bank, Spain's financial institutions will need a lot of capital. Oliver Wyman's adverse scenario projects capital needs of about €60 billion, assuming losses of only 4.1% on some €600 billion in retail mortgage loans. If a contracting economy and rising joblessness lead mortgage borrowers to default in greater numbers, the amount of money needed to keep Spain's banking system afloat could be much larger.

The big question, then, is how much of the cost will fall on the already-strained budget of Spain's government. In principle, Spain can afford to spend €60 billion to prop up its banks, or even the full €100 billion other governments have offered to lend it for the purpose. The added borrowing would increase the country's debt burden by as much as 9% of GDP, only marginally affecting the longer-term challenge of getting its finances under control. What's more, Spain would use the money to purchase bank equity, which it might eventually sell at a profit.

The greater danger, for markets and for Spain's solvency, is that the government's bailout costs might spiral out of control as recession, banking paralysis and defaults reinforce one another. As long as that risk remains, Spain will have a hard time attracting investments and getting its economy growing again.

Here's where EU's leaders come in. They've pledged to form a banking union in which governments would take collective responsibility for overseeing banks and for recapitalizing (or liquidating) them if they fail. They've stopped short, however, of defining the point at which the new system would kick in. Germany has suggested that "legacy" assets, such as Spanish banks' toxic real-estate loans, would be the sole responsibility of national governments. This leaves the biggest issue for Spain unresolved: What will happen if performing loans - many of them fueled by the past easy-lending practices of banks in Germany and other euro-area countries - turn sour in the future ?

To restore confidence, the governments of the euro area should set a reasonable limit - say, €100 billion - to Spain's responsibility for salvaging its banks. They should also make sure the banking union is up and running in time to handle any further capital needs. Slipping beyond the Jan. 1 target date will only aggravate Europe's financial and economic ills.

A currency union consisting of such varied economies as Europe's cannot survive unless its members share risks. The predicament of Spain's banking sector offers a test of European leaders' ability and willingness to do so. If it turns out that they can't or won't, one wonders what they were thinking when they created a joint currency in the first place.

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