It has been a huge surprise that, according to a recent analysis (pdf) conducted by consulting firm Oliver Wyman, Spanish banks only need a relatively small public capital injection between €40 and €55 billion to cope with the crisis in the case of an adverse scenario.
Government officials have quickly sold these results as indisputable proof of the solvency of Spain’s financial system, while many national and foreign analysts are starting to wonder whether there is something wrong with these estimates, particularly given the banks’ massive exposure to the recent property bubble. The truth is that one should carefully examine the analysis in order to reach an adequate picture of the real condition of Spanish banks.
To begin with, the appraisal of the consolidated losses of the Spanish banking system between 2012 and 2014 amounts to €270 billion, i.e. 15 per cent of all their assets. The first line of defence for these red numbers is current provisions, which total €110 billion and which therefore reduce uncovered losses to €160 billion. This is one of the crucial figures that everyone should be considering right now: at the end of 2011, Spanish banks needed €160 billion to absorb losses.
Up to this point, the results are quite consistent; in fact, many analysts, including myself, have been claiming for months that banks needed an extra capital in the range of €150 and €200 billion (under the increasingly unrealistic assumption of no sovereign defaults). The problems start precisely when the analysis explains how these losses will be assimilated by Spanish banks.
The analysis divides this €160 billion into three groups: €35 billion from excess capital buffer, €60 billion from future pre-provision profits and €10 billion from Asset Protection Schemes and deferred tax assets. In that case, the capital deficit amounts to just €55 billion, as we recalled initially. How is this possible?
Firstly, Spanish banks only enjoy this capital buffer under the assumption that Core Tier 1 can be reduced to 6%. However, after the subscription of the Memorandum of Understanding (MoU) with Brussels, this is no longer possible. The article 23 of the MoU establishes that ‘Spanish credit institutions will be required, as of 31 December 2012, to meet until at least end-2014 a Common Equity Tier (CET) 1 ratio of at least 9%’. Therefore, excess capital buffer disappears as a loss-absorption element and the banks’ capital deficit goes back to €90 billion.
Secondly, Asset Protection Schemes of €8 billion must be fully considered as a public capital injection, since they are a governmental promise to cover the losses emerging from a given asset portfolio. In this way, the capital deficit goes up to almost €100 billion, the full amount of the EFSF loan to Spain.
Finally, one needs to wonder whether such a weakened banking system can delay its complete recapitalisation by two more years. 2013 and 2014 are supposed to provide Spanish banks with some €35 billion in pre-provision profits. But future profits are just an uncertain expectation, not currently available capital. Given the depressed economic scenario and increasing concerns about the quality of Spain’s public debt, recapitalisation seems unavoidable in the near future. Spanish banks hold more than €400 billion in credits against the general government and the budget deficit seems to be out of control: up until June, it amounted to 8.5 per cent of first semester GDP. Despite this, the central government has just approved a 2013 budget that increases expenditures by six per cent. This is clearly not the best moment to postpone the achievement of some acceptable level of capitalisation for the banking system.
However, it would be an error to think that the over-indebted Spanish government can inject at least €150 billion into the banks, especially after the joint opposition of Germany, Netherlands and Finland to a direct recapitalisation by the ESM. There is a much fairer and more efficient alternative called bail-in, by which banks’ creditors suffer the losses without directly liquidating the institutions. The MoU imposes partial losses to hybrid capital and subordinated debt holders, but this is clearly not enough: with a 100% conversion of these two financial securities and a 40% conversion of unsecured senior debt into equity, Spanish banks’ capital would be increased by €150 billion – just what the above analysis estimates they actually need.