Spain's Banks: Anatomy of a Coming Crisis?

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What do investors fear most about Spain?

The cancer at the core of the Spanish economy may be the structure of its banking system, according to a recent report issued by UBS.

The report comes to our attention via Tracy Alloway at the FT blog Alphaville.

Alphaville reports the context: Spanish sovereign debt-to-GDP ratios don't look appreciably worse than the rest of the pack in the eurozone. And the overall trend line for Spain doesn't seem much worse either.

So where does the problem lie?

According to the UBS report:

"Banks recapitalisation is the key event, in our view: we believe investors remain concerned about the Spanish banking sector’s asset quality and provisioning, as well as a funding structure which relies significantly on wholesale markets compared to other retail banks in Europe, albeit less than investment banks. We believe that the Spanish banking sector will have to face larger writedowns of loans and real estate and will have to re-balance its maturities structure by replacing short-term wholesale funding with more stable sources, such as time deposits and long term bonds, a process that may be under-way."

So there are really two problems with the Spanish banking system:

First, the way Spanish banks fund their own operations may be a recipe for disaster.

Relying on short term financing is not just potentially costly—but risky as well. When perceptions of credit risk rise, funding can become exorbitant.

And if things get bad enough, firms that are excessively reliant on short term financing may be virtually unable to get credit at any cost.

(Anyone ever see a Bloomberg terminal quote No Bid for a company's commercial paper? Scary stuff.)

Second, Spanish banks seem not to have set aside enough money for loan losses.

Alphaville reports: "This is in part due to Spanish accounting rules, which allow the banks to spread provisions over relatively long periods of time (think up to six years for residential mortgages)."

Loan Loss Reserve Ratios and accounting treatments for provisioning non-performing loans over time may sound like dull operational mechanics.

But the bottom line impact may be very real.

Summing up: From the UBS Report:

"We think that the current level of provisioning for Spanish banks, particularly when taking into account a broader definition of risky assets (i.e. including substandard loans and real estate re-possessed) not only leaves little room to release reserves, but suggests that banks and their regulators should be inclined to take a more conservative stance going forward. While we do stress that the lack of visibility on the size and quality of collateral may undermine the simplistic considerations (for instance, of course NPLs in residential mortgages should require a lower coverage than consumer finance), we also believe—based on our experience of the potential credit losses in troubled real estate markets (Ireland, US, etc.)—that a substantially higher coverage ratio would help funding markets to regain confidence in banks. While we have no detailed visibility on collateral, for illustrative purposes we calculate that taking coverage to 50% on all problematic loans would require €60bn additional provisions, taking coverage to 60% would require €89bn (70%: €118bn)."

Alphaville concludes on this somber note:

"The good news is that those sort of figures would only amount to about 10 per cent of Spain’s GDP, according to UBS, and would increase debt-to-GDP ratios to about 75 per cent — which is lower than the EU average of roughly 83 per cent."

"The bad news is that those recapitalisation figures are quite literally moving targets and predicated largely on stability in the wholesale funding markets."

"Something which isn’t certain at all."


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