Knowing that much depends on confidence on the side of the markets, the Bank of Spain took a much protracted measure on February and lifted a bit the veil that covers the assets of Spain’s financial system. Some details were given related to the saving banks.
The results of the exercise are depicted in the cartoon above in a loosely accurate manner. There has been no panic and the markets, although not quite asleep yet, still lay on their bed crying a bare minimum. So, what’s to fear?
Saving banks are basically publicly owned banks with private management coming from the ranks of regional governments. If it sounds like a recipe for corruption, unreliable accounting, valuation problems and lack of profitability… well, that’s what they seem to be.
Through their stock holdings and direct employment in their oversized physical networks, they have a considerable clout in employment. This and an ages-honed practice of (illegal) political party financing through their welfare foundations, makes them respected power brokers.
The funniest part is that they have no owner. There are no shares and no direct control by the government, but regional governments have a big say in the appointment of their boards, shared with syndicates and a motley crew of minor entities.
In the saving banks report, BOS gives a much coveted breakdown of real estate assets sitting at the saving banks. Unfortunately, no similar breakdown is given for the banks proper.
Notwithstanding vigorous protests of supervisory authorities claiming a much better situation for the banks, I think we can safely project the same holdings structure to the banks balance sheets for a grand estimate of risk to the Spanish financial sector.
Assets of saving banks are 1.326 bn, while those of banks amount 1.822 bn. The credit structure by sectors is similar for both groups. This table breaks down credit risk to developers and construction companies (which I will refer collectively to as “real estate sector”) at the saving banks:
I have added two columns to BOS data, one with what I believe to be a very conservative estimate of expected defaults, based on actual default rates increased for more troubled categories, the other with a reasonable discount for liquidation value of defaulted credits, considering the nature of their underlying guaranty and the situation of the markets. I think these are all very conservative values since they don’t take account of the fact that the financial sector is by far the biggest owner of real estate and almost the only acquiring party these years.
The result is pretty unsettling. It appears that saving banks alone will be needing to cover near 70 bn losses in the next years, only from the real estate sector。Even considering that 38 bn reserves have already been created, the resulting amount is not small. The balance sheet of the banks is bigger but their standing loans to the real estate sector amount to roughly same than the saving banks. If we assume a similar balance structure for both kinds of banks, which we have no reason whatsoever not to, aggregate expected losses directly related to real estate for the financial sector reach about 140 bn, or 14% of GDP.
If we consider together credits for acquisition of houses and credits to the real estate sector companies, it turns out that credit somehow backed up by real estate takes up 1.100 bn (60% of credit to families and companies, 100% of the GDP) – sorry for the emphasis, but this has stunned me…
So are Spanish banks doomed to bankruptcy? Not necessarily, of course. If assets are hold to maturity and a bank is allowed to operate, ordinary profits will mop up practically any amount of losses over time. See this article of James Kostohryz for a great explanation of bank’s solvency.
However, Spanish banks are faced with a situation which makes gradual absorption of debts more difficult:
- Heavy reliance on external wholesale funding. The national deposit base is too small compared with outstanding credit, which forces recourse to foreign banks or, since the crisis started, to ECB. Foreign creditors tend to be more easily scared and shutting off of credit can be catastrophic for the country’s financial sector.
- Fiscal weakness of the government: Although Spanish public debt is not too high, the explosion of fiscal deficits, on par with that of the US, UK, Ireland, etc., coupled with slow to no growth prospects and lack of external competitiveness, have put Spain on tight bond vigilante surveillance. The government can’t just go ahead and assume the bank’s losses.
- Size of the financial sector, which is overblown, not least because of the redundant presence of the saving banks. There is a huge excess capacity both of credit and physical infrastructure and the balance sheet of the sector is too big, especially considering the price adjustments still needed in real estate. Excessive competition and costs will limit the ability of the sector to generate profits.
- Reliance of the economy on the real estate sector. In the last two decades, Spain’s inefficient economy has relied on external credit to blow a construction and property bubble, which was the only reason behind economic growth. It is going to be very difficult to absorb the excess workers in other sectors.
- Scarcity of credit. Non-performing assets kept in the balance limit the ability of the banks to finance new productive sectors. Savings are being used to shrink the balance sheet of companies and families and deleverage.
- Europe is entering a monetary tightening cycle, responding to the needs of its more advanced economies. Unfortunately, this is the opposite of what is needed in the periphery, where inflation and low interest rates would allow banks to wipe up the real size of credit, mop up losses and access easier financing.
So to the question, are Spanish banks going to fail? there is only one sure answer: not as long as they keep access to funding. A situation like the one described could prolong itself on time until all bad credits were absorbed. At the same time, any sound bank can go belly up if cut off from credit. Much more so the Spanish banks, who depend on external credit and are in a less than desirable position. It will all depend on the mood of the markets.
What’s sure is that the reform of the saving banks has been one more lost opportunity. Real consolidation, removal of the (obviously inept and corrupt) management and real privatisation (and you know it is real when a foreign bank takes them up in a tender) would have served many purposes, among which, downsizing of the sector, alleviation of public finances, increase of competition, release of financial resources, etc.
Faced with this situation, the response of BOS can, at the risk of enraging some bureaucrats there with our lack of understanding of valuable nuances, be summarized as follows:
- Increase transparency: scant as they are, data on saving banks are a welcome world-wide novelty. If BOS produced it grudgingly and after much delay. Data for the whole financial sector where scheduled for January. The savings banks’ report was issued by the end of February and promises of information on commercial banks are carefully forgotten.
- Improvement of solvency ratios (stricter valuation rules for real estate to apply gradually this year, higher capital requirements)
- Limited fusions-of-sorts (rather accounting consolidations of saving banks from different regions with the explicit goal to maintain the physical network intact)
- Some very weak limitations on the number of board directors and their provenance, very unlikely to have effects on managerial control of the institutions.
- Mandatory transformation in commercial banks of the more troubled saving banks, unlikely to affect managerial control.
One can conclude that the reform made is lipstick on a PIIG (sorry, it was so tempting…) The management is still there, well in control. The size of the industry and that of the balance sheet remains unchanged, and so is risk. Balance sheets keep filled to the rim of overvalued bad assets.
Capital requirements are a non-issue, since these are meant to protect an entity from normal losses risks. On Thursday, the Bank of Spain will present, with great fanfare, the results of yet another stress test. I am willing to bet a cent against any fearless soul out there that this will distract the attention of the public from the more relevant asset composition issue (remember full disclosure was promised for January?)
Given the present situation, capital will be insufficient, even at the increased ratios, since they don’t even cover losses incurred this far. The real issue is asset valuation.