Doubtful loans at Spanish banks skyrocketing

In his Telegraph column, Mats Persson, the Director of independent think-tank Open Europe, looks at how much capital Spanish banks have and how much they actually need.

Since the start of the euro crisis, as living standards have fallen, [the] share [of “doubtful” loans, i.e. loans that are at serious risk of default, currently held by Spanish banks] has skyrocketed and now stands at 7.6% (€136bn in total or around 13% of Spanish GDP) of all loans on banks’ books.

Unsurprisingly, most of these loans are to the most vulnerable part of the Spanish economy – its real estate and construction sectors. 

One in five loans in these sectors – mostly mortgages – are now considered toxic and at serious risk of never being repaid. If this wasn’t concerning enough, two further factors are worth considering. 

First, Spanish banks only have €50bn in capital to cover against potential losses – even the simplest calculation shows this is far from enough. 

Clearly, the Spanish banking industry is insolvent as the market value of its assets is less than the book value of its liabilities.

Within the industry, there may be individual banking organizations that are solvent --- the market value of their assets exceed the book value of their liabilities.

Secondly, the Spanish housing market and construction sectors have yet to reach rock bottom. House prices have dropped rapidly over recent months but, considering the adjustment needed to compensate for the over-investment in this sector, could potentially fall by another 35%, similar to where Ireland is today following its major real estate bust.... 

If no action is taken, the insolvency problem is going to get worse.

Compounding the insolvency problem is the fact that 

Spanish banks are currently the chief buyers of Spanish government debt, meaning that if these banks suffer, it could also cause Spanish government funding to dry up. The chances of a self-fulfilling bond run on Spanish debt would thereby increase massively....

Which raises the question of what to do?

Regular readers know the choice is between the Japanese model and the Swedish model for handling a bank solvency led financial crisis.

And as today's budget shows, Spain simply doesn't have the cash for a major bank bailout operation ... if the situation is allowed to spiral ... the eurozone’s permanent bailout fund, the ESM, could be forced to step in, transferring the risk to eurozone taxpayers....  

In order to avoid prophecy becoming reality, Spanish banks should be required to at least double their provisions against souring loans... 

As ever, Spain is too big to be bailed out.

If eurozone policymakers repeat their habit of failing to take the right decisions early, the risk is that Spain and the eurozone will pay a very high price indeed.

Actually, Spain and the eurozone policymakers could choose the Swedish model.  Under the Swedish model, Spanish banks would recognize the losses on the excesses in the financial system today and would rebuild book capital through retention of future earnings.

The ESM would not fund a bank recapitalization, but would instead act as a back-stop to the deposit guarantee offered by the Spanish government.

This has numerous advantages for Spain.  For example, rather than use scarce funds to recapitalize the banking system, it could use these funds to support the various regional governments and expansionary fiscal policies.