A heavy going blog post for a Friday afternoon, but you can digest it over the weekend (lucky you!). One of the key themes we highlighted in our recent briefing, comment pieces and general coverage on Spain is the importance of the sovereign banking loop.The idea here is that the fate of the Spanish banks and the Spanish state are becoming increasingly intertwined. The two are always connected: if a state goes down normally its banks will too, while if banks fail the state often has to bail them out to support itself (or at least that is the prevailing logic).
As the eurozone crisis has progressed numerous states (PIIGS) have had significant trouble funding themselves (selling debt). In many cases the only people willing to buy a sovereign’s debt has been their domestic banks. In turn, a situation arises where banks pile more and more risky debt while the state becomes entirely reliant on them for financing. Far from ideal.
The unlimited ECB lending and the LTRO has only exacerbated this cycle and there is a strong correlation between increased reliance on ECB funding and the sovereign-bank loop – Spanish bank borrowing from the ECB jumped by €75bn in March, an increase of 50%.
An editorial in the FT today argues that the Spanish government has done well to avoid recapitalising its banks at cost to taxpayers, especially since many of the banks could fail without bringing down the state. This is undoubtedly a positive thing - taxpayers should be kept out of the equation as much as possible as taxpayer-backed bailouts invariably create the wrong incentives (i.e. moral hazard).
But for intellectual honesty, it's also vital to account for all sides of the sovereign-banking loop.
As we noted in our recent briefing the primary aim should be to force banks to recapitalise themselves and ensure they have sufficient provisions against bad loans. However, if they get into significant trouble the chance of a self-fulfilling bond run on Spain increases significantly as the domestic banks stop buying bonds. This could push the whole country into a bailout, which the eurozone could barely (if at all) afford.
This situation is a clear side effect of the failed policies taken on by the eurozone and the ECB, which we have long argued against – failing to tackle the underlying back solvency problems, loading them up with cheap liquidity and encouraging them to fund struggling states was always going to lead us here. Unfortunately, given the state of affairs now, suggesting that Spanish banks are too small to bring down the state misses how dependent the state is on cash from domestic banks.
A Spanish banking crisis and the ensuing bond run on Spain are very real threats to the eurozone. The Spanish government needs to push banks to increase provisions against losses and a thorough stress testing would go some way to highlighting just how much they need. We are loathe to suggest any cost be transferred to taxpayers, but realistically (given the eurozone's bail out policy) this option may what the Spanish government and eurozone leaders have to go for in the end, either through the FROB (Spanish bailout fund) or the ESM (eurozone bailout fund). If so, it's of course extremely important that any funds should come with strong conditionality including giving the government preferential shares and equity warrants as well as forcing banks to produce ‘living wills’.
But whatever happens, eurozone leaders must stop seeing a bail out as an end in itself. If it comes to that, unlike the ongoing ECB and bailout operations, any injection of funds should be part of a full assessment of the viability of the institution with fair consideration given to the prospect of winding those down that don't have a sound financial footing for the long term. Banks must simply be allowed to fail. Ultimately, purging the bad practices and poor management which helped fuel the boom and bust in Spain will be vital for the long term health of the banking sector and the economy.
The link between the health of the Spanish banks and the health of the Spanish state remains very strong - unfortunately neither is looking in a good position right now.
I am wondering, having watched events in Spain from a distance for some time and noticed an apparently growing distance between the Spanish Regions actions and policies with those of the Central Government, whether Spain will provide a blueprint or game-plan for what is taking place within the EU itself, or possibly vice versa!
ReplyDeleteAre the Spanish regions going to stand-by the centre or struggle for their own sole survival when the logical end to all this arrives? Is that not the same situation with the Euro Group member states and the ECB, are not they preparing to dump their supposed obligations under EMU when the flames finally reach the fireworks box?
Interesting points but, you miss a few things.
ReplyDelete1. The bankingsector should have had a major clean up operation 2 years or so ago, which should have been finished by now. Basically get rid of the undercapitalised banks one way or another (merge them with better capitalised, better managed (especially with the Cajas that is a real problem) let them fail, taking over healthy parts by relatively healthy banks etc.)
This would have costs 50-100 Bn.
This has not been properly done.
Now leading to the situation (as there are now basically more problems as the state is involved)that a) alot of banks still need to be properly recapitalised and b) nobody with any brain left is wiling to do so and c) the state as last resort doesnot have the money and would suffer a PR disaster towards the financial markets.
So in a nutshell the banks need a recap but nobody who could do that has a penny to do that.
2. Even worse the LTRO has put more garbage on the Balance sheets of the already overexposed banks. Making it even more unlikely that third parties come up with recap funds.
3. The problem with the bankingsector in Spain is that a couple of their banks are system banks. Because the sector in their homeland is a total disaster they not only face contagion from their government but also from the rest of the Spanish bankingsector.
This problem should have been cleaned up as much as possible, however with the LTRO it has been made worse.
3. Spain has no funds to recap themselves and is running a huge deficit 'in its own right'.
4. The budget and the economic conditions are horrible. Allthough the debt itself looks as a percentage manageable. The road is clear. There is clearly no grip on the deficit. Therefor the debt will remain rising. Seen from an other angle things like 25% unemployment combined with a huge welfare state and a lot of mainly inefficient civil servants is unsustainable. With no real measures seen (only 1% solutions for 10% problems).
5. Therefor it is clear to markets that by far the most likely way is a consyantly increasing debt combined with no growth (nobody is investing in a train crash that everybody is seeing coming.
6. This is now being priced in and we are nowhere near the point that it is priced in. (Subsequently likely some EZ/ECB measures will be taken which point in the other direction but have proven to be a) costly and b) rather ineffective.
7. Also the bankloop is now being priced in. A government that most likely cannot pay it debt. As a consequence thereof rubbishes the BS of the banks. Who therefor need a recap which no privatesecor investor wants to do and the recapitalisor of last resort the state is broke (completing the circle).
So in a nutshell the debt percentage wise look ok (sort of) but it is moving fast and clearly to unsustainable levels. And this fact is priced in. Similar with the banks and the relation banks/government it becomes increasingly clear that this is totally unhealthy and is being priced in.
With pricing in things can happen in a few days and donot have to go the whole road. Therefor imho most likely a rescue via ECB/ESM and Co is not far away.
Another point why a rescue is not far away is that effectively the yields of bonds have been manipulated down by interference from especially ECB (LTRO/Bondbuying).
ReplyDeleteThe market clearly looks at it seen eg CDS prices as prices being lower than value. This can work but only when the interference is basically a certainty. Somebody keeps buying at a price higher than the value. So there is a constant natural movement towards selling. Aka lower prices and higher yields. If interference is stopped or is less effective as now (LTRO funds for the Sarko-trade are going down) prices will go down again and yields will go up.
Therefor Spain needs permanent interference to keep the yields down. In other words constant measures (buying bonds, stimulating others to buy bonds, EZ guarantees etc).
This also points clearly with yields on the rise to new measures. Which will not work longer term as said earlier Spain has 10%s problems (huge structural ones). By pumping more money in it these are not solved and the whole mechnism will start again if the effect of the infuse has faded away.