After the real estate bubble burst in 2008, Spain implemented a relatively unorthodox strategy to assist banks whose balance sheets were being crippled under the weight of non-performing loans. Instead of directly recapitalizing the banks, the government encouraged them to consolidate, with the idea being that they would eventually put themselves up for sale to offset some of their losses. The government's strategy required banks to write down 54 billion euros in losses from bad loans so that no additional public funds would be needed to compensate for those losses.
Bankia most exemplified this banking reform model. Comprising seven private savings banks, it raised a record 3.3 billion euros during its initial public offering in June 2011. As Spain's fourth largest bank, Bankia holds nearly 6 percent of the country 's total banking sector assets.
However, the consolidation of Bankia neglected to address an inherent problem: Its constituent banks held massive amounts of underperforming loans. In fact, it saw returns on just over half of the 35 billion euros in loans it holds in the real estate development sector.
The numbers exemplify the overall trend in the Spanish banking sector. Collectively, Spanish banks hold 300 billion euros in real estate development sector loans. Roughly 60 percent of these loans, including the 21 percent of outright non-performing assets, are deemed "troubled" by Spain's central bank. By comparison, U.S. authorities close banks when their non-performing loan ratios exceed 5 percent.
Aside from creating a financially unsound bank, the government also demanded an additional 30 billion euros worth of write-downs on loans — valuing 84 billion euros in total, when combined with the original requirement of 54 billion euros in write-downs. The combined write-down program is, however, unlikely to be sufficient to address the close to 180 billion euros in toxic assets held by Spanish banks. Furthermore, many of Spain's struggling banks will be unable to maintain the core tier-one capital ratio required by EU regulations without the government's assistance. Spanish banks will require an estimated 100 billion-250 billion euros in recapitalization later this year to reach this capital ratio target — a significant percentage of which will have to be shouldered by Madrid.
The government takeover of Bankia is a clear policy reversal for the conservative administration of Prime Minister Mariano Rajoy, who for months insisted that no additional public funds were needed for the banks. Intervening on Bankia's behalf demonstrates the failure of Spain's banking consolidation strategy.
Steps to Recovery
The potential fallout from this failure is Spain's most pressing financial problem. Despite experiencing some of the fastest debt growth in Europe, Spain's public debt until now has been lower than that of its neighbors in the eurozone periphery. However, the situation will probably change in the coming months. The failed bank consolidation strategy, coupled with the private write-down of huge amounts of bank loans, has convinced Madrid that it must intervene if it wants to save the country's banks.
The government has already signaled that it will in fact intervene. The country's banks have been aggressively buying Spanish sovereign bonds since the beginning of 2012, increasing their holdings of Spanish debt by 23 percent (roughly 230 billion euros) in four months, suggesting that the fate of the national economy depends on the fate of the banking sector.
Spain has few choices in dealing with this impending crisis. The government could force banks to sell their non-performing assets at rock-bottom prices. But such a move would ruin an already faltering real estate development sector — the origin of most of the non-performing assets — that currently accounts for nearly 7 percent of the country's total employment. In a country with an unemployment rate of over 25 percent, this would be extremely damaging politically for the Rajoy administration.
Otherwise, Spain could bail out its own banks, effectively transferring the banking debt onto the sovereign balance sheet; attendees of the May 11 Council of Ministers meeting hinted at this option. Were this to happen, Madrid would have to offset the resultant deficit. Currently, Spain has the third highest budget deficit in the eurozone at 8.5 percent, trailing only Ireland and Greece. Ordinarily, additional austerity measures such as spending cuts and tax hikes would be imposed, but these would fail to cover the astronomic costs of a bank bailout. Moreover, they would also exacerbate the already high level of social tension within Spain, where unemployment and regional budget cuts have angered the population.
Spain's last option would be a direct EU bailout, which would allay fears of losing control over the banking sector. The bailout would likely come out of the European Financial Stability Facility (EFSF) or the European Stability Mechanism (ESM). The EFSF and ESM were designed to serve as a bailout fund for sovereigns, but they do not include a provision to bail out nations' banks through an agreement between the bailout fund and the country in question. Notably, the conditions of a bank bailout would have to be negotiated because the European Union has yet to bail out a country's banking sector.
Spain would hope to avoid incurring the usual budgetary demands attached to an EU bailout, which so far have required damaging austerity measures in Greece, Ireland and Portugal. These types of measures would be extremely expensive, and difficult for the government to afford on its own. But the country's rescue would also overwhelm the current bailout funds housed in the ESM and EFSF.
Nevertheless, an EU bailout is the most likely scenario for Spain's banking sector. The Spanish government will also raise its demands for concrete EU growth plans. The demands are the only way Spain can recover economically over the next decade, but they run counter to Germany's insistence on austerity over debt-inducing growth.
However, despite rhetoric against debt-inducing growth, Berlin will prove relatively accommodating if Spain calls for a bank bailout. It will want above all to prevent the banking debt from spreading to the public balance sheet. This would disrupt markets and require a much larger sovereign bailout that Europe simply cannot afford right now. The EU has already has softened its deficit targets for Madrid, and it announced May 11 that it did not even expect Spain to reach these updated targets. French President-elect Francois Hollande likely will use the Spanish banking crisis as leverage against German Chancellor Angela Merkel, with whom he will meet May 15 to discuss softening austerity measures and cooperating on EU growth measures.
Editor's note: An earlier version of this piece misstated the functions of the European Financial Stability Facility and European Stability Mechanism. They do not include a provision to bail out nations' banks.
