How to tackle Spain's banking issues is anyone's guess

The new Spanish government has said that having the banks clean up their balance sheets is its first priority.  A Wall Street Journal article asks how are they going to do this?

Regular readers know that this requires two steps.

• First, the banks must be required to write the assets down to where an independent third party would be willing to buy them in an arm's length transaction.

• Second, the banks must be required to disclose on an on-going basis their current asset, liability and off-balance sheet exposure detail.  

Ultra transparency is needed so that market participants can assess whether the banks have really recognized all their losses.  This is needed so that market participants can assess the on-going risk of the banks as they gradually rebuild their capital base through retained earnings and, if possible, equity sales.

September was another month of slim pickings for Spanish bankers. 

Data out today from the central bank indicated that lending to households, companies and the governments fell at the sharpest annual rate on record. 

And bad loans ticked higher for a sixth straight month, to a new crisis-high of €128.1 billion, or 7.16% of the total, as more of the country’s ailing real estate developers went out of business. 

Popular Party chief Mariano Rajoy... has made cleaning up the balance sheets of Spain’s banks one of his priorities... 

But he has not said how he wants to tackle the problem, leaving analysts to dream up solutions. 

Some expect the new government to create a state-owned bad bank where lenders can dump their toxic real estate. But such a scheme would require considerable government fundraising upfront, something that looks challenging at a time when the very existence of the euro zone is under question. 

Other analysts expect Spain to increase the provision requirements on their most toxic assets: some €175 billion in problem assets tied to real estate. Banks have set aside just over 30% to cover losses from these assets at the moment. 

Analysts at Credit Suisse reckon the new government may decide to increase the provisioning levels to 45%-50%, which in turn would generate a capital shortfall of between €40 billion and €60 billion. In this market, it’s not clear where the money will come from to foot such a large bill.

The money is not needed immediately.  Spain's banking industry can retain sufficient earnings over time to cover this capital shortfall.

Spanish banks have been kicking the can for years on their real estate problems. A clean-up, while painful, is necessary.