Experts wrong in saying 'not if, but when' for Spanish bank bailout

If Spain adopts the Swedish model for handling a bank solvency led financial crisis, the experts are wrong when they say it is 'not if, but when' for Spain asking for a bailout for its banks.

Regular readers know that under the Swedish model, banks absorb all the losses hiding on and off their balance sheets today -- and provide ultra transparency to prove the fact.  Then, banks rebuild their book capital levels through retained earnings and banker bonuses in the form of newly issued equity.

By adopting the Swedish model, the Spanish government is explicitly recognizing that its resources are limited and better utilized elsewhere.  It is also explicitly recognizing the banking system has access to unlimited resources to fill the hole left by the bad assets.

Why does the banking system have access to unlimited resources to rebuild bank book capital levels?

Because the banks do not have to rebuild their capital today.  They can retain earnings for the next several years (decades?) until such time as they have rebuilt their book capital level.

In a modern banking system, by design, banks can absorb the losses today and rebuild their capital over time.  Remember, banks can continue to operate and support the real economy so long as their deposits are guaranteed and the central bank is willing to provide them with access to liquidity (it is the run on funding that forces financial firms to close ... they can remain open while insolvent if the regulators allow it).

According to a Reuter's article,

Economic experts watching Spain don't know how much money will be needed or precisely when, but some are near certain that Madrid will eventually seek a multi-billion euro bailout for its banks, and perhaps even for the state itself.

Prime Minister Mariano Rajoy has repeatedly said Spain doesn't need or want an international bailout, and the European Union, which along with the IMF has already rescued Greece, Ireland and Portugal, also dismisses such talk.

Does Mr. Rajoy understand that a bailout is not necessary under the Swedish model for handling a bank solvency led financial crisis?

But economists believe that Spanish banks will have to turn to the euro zone's rescue fund, the European Financial Stability Facility (EFSF), for help in covering losses caused by a property market crash which has yet to end....

Actually, Spain would be better off turning to the EFSF and its successor, the European Stability Mechanism (ESM) as a backstop to its deposit guarantees.

"They're going to need EFSF money to recapitalize the banking sector," said Carsten Brzeski, a senior economist at ING in Brussels. "I think we'll only see a real end to the Spanish misery if the real estate market stabilizes."...

Let the banks recapitalize the banking sector through retention of future earnings.

Meanwhile, by adopting the Swedish model, force the banks to recognize their losses.  By requiring ultra transparency where banks disclose on an on-going basis their current asset, liability and off-balance sheet exposure details, market participants can confirm this.

By disclosing the losses, the real estate market can adjust and stabilize.

One of the critical "unknowables' for Spain is just how bad a situation its banks are in.

There is absolutely no reason that just how bad a situation Spain's banks are in should not be known.

It could be easily determined by the market if the banks were required to provide ultra transparency.

The Spanish housing market, once a driver of the economy, has been in turmoil for more than four years, but prices still haven't fallen as much as economists think is needed to squeeze the air out of the bubble.

Only when prices have bottomed will assessors be able to calculate how just much bad mortgage debt is sitting on the banks' balance sheets, and therefore how much extra capital the sector requires to return it to health. 

"Prices have dropped by about 15-20 percent from peak to now and they will probably have to drop another 15-20 percent before they reach bottom," said Brzeski. He estimates Spanish banks may need as much as 80 billion euros of extra capital once all bad mortgage debt is accounted for....

As a result, economists expect Spain's banking sector will have no choice but to recapitalize.

Where is the capital going to come from?

The government is unlikely to fund such an operation while it is trying to slash the budget deficit, and private investors are reluctant to invest in such a troubled sector. 

That leaves the European Financial Stability Facility as the most likely option for the banks - and possibly also for the government eventually.

It also leaves future bank earnings.  Better to use the future bank earnings which are unlimited.