The Bankia bail-out is only the tip of the iceberg in Spain

Over on City AM Forum we have an article looking at the implications of the Spanish government's decision to bail-out Bankia both for Spain and the eurozone. As we noted in our recent Spanish briefing the problems in the Spanish banking sector run deep and Bankia is therefore clearly only the start.

See below for the full piece:

Another day, another U-turn in the eurozone – although this time it may mark the Spanish government’s acceptance of the huge problems in the country’s banking system.

The Spanish government announced on Monday that it will be injecting Bankia, the country’s third largest bank, with up to €10bn in capital, using the state-backed FROB bank restructuring fund, despite previously dismissing the possibility of doing so. Given the timing of the announcement – on the same day that Greece went through political upheaval – one can’t help but think that the Spanish government harboured some hope that the declaration might fly under the radar.

Given the size of Bankia and the implications of the bail-out such hopes were deeply misplaced. Bankia has one of the largest exposures to the country’s bust real estate and construction sector at €38bn, of which €18bn is considered problematic. It was also the poster child for what now looks to be the laudable but ultimately doomed structural reform of Spanish banks which took place last year. It is the largest of the consolidated ‘cajas’ (Spanish regional banks) and the problems on its balance sheet highlight how little the banking consolidation solved.

Taxpayer-backed bank bailouts are never ideal but if Spain chooses to go down this road, getting the correct mix of support and strong conditions is vital.

The most likely form of any future intervention is the widely mooted ‘bad bank’ plan. A plan to remove the huge amount of risky assets lurking on bank balance sheets sounds great in theory but it is never that simple.

The first question, as always, is where will the money come from? Currently Spanish banks have €54bn in provisions against €136bn in doubtful loans. The latter number looks set to increase as conditions worsen, particularly with much larger falls in real estate prices expected – we predict that provisions will need to be at least doubled, while the corresponding capital need to underpin a ‘bad bank’ would be large. Bankia is likely to be only the tip of the iceberg both in terms of problems in Spanish banks and the use of public funds.

Securing private funding will be near impossible, leaving two sources of public funds: the Spanish FROB bank restructuring fund and the EFSF/ESM eurozone bailout funds. The FROB in theory has a lending capacity of €99bn, but most of the cash must be raised by issuing debt, with only €18bn directly guaranteed by the state. There are rightly questions over whether the fund could borrow cheaply if it backed a bad bank, potentially leaving the majority of the gap to be filled by eurozone bailout funds.

Given the growing political opposition to both the bailouts themselves and the austerity conditions which they come with, such a large transfer of European funds could be political dynamite in Europe.

The main concern is the huge moral hazard associated with bailing out banks – this was a trend which many in Europe hoped had been bucked, opening it up again would do significant damage to credibility in the eurozone. The aim is ultimately to encourage banks to start lending and aiding economic growth again but this is notoriously difficult – who’s to say they won’t continue hoarding funds over wider fears of a eurozone break-up. The most important part of the process will be an honest external valuation of these doubtful loans, something which Spain and the eurozone have shied away from before.

Any funds must therefore come with clear conditions. The key element to enforcing these will be allowing some banks to fail or be wound down, if too large a percentage of their assets need to be shifted to the bad bank. In the end, many of these banks have unworkable balance sheets in the aftermath of the housing bust. This will be the clearest signal to show that public funds are not being used to solely prop up banks, that only viable businesses will survive and that the Spanish government is committed to reform.

In many ways the use of public funds to help Bankia could be a turning point for the crisis in Spain. The good news is that the Spanish government finally accepts the need to tackle the wider problems with its banks, presenting an opportunity to flush out the sector once and for all. On the other hand, it significantly increases the likelihood of taxpayer-backed Spanish and eurozone funds being used to bail out banks once again. What’s clear is that, until the problems are fully addressed, the Spanish banking sector malaise will still threaten to engulf the whole economy and potentially drive the country into a full bail-out programme.