Despite what the government says, more Spanish banks need to recognize their losses

In his Telegraph column, Alistair Osborne asks how is Spain going to cope with the 270 billion euros of losses analysts predict are in its banking system when Spain is struggling trying to figure out how to deal with Bankia.

Regular readers know that the source of capital for rebuilding bank book capital levels is retention of future earnings.  The IIF estimated that it would take less than 4 years of earnings to rebuild the bank book capital levels after recognizing losses of this order of magnitude.

By way of comparison, the financial crisis has been going for 4+ years already with no apparent end in sight.

The answer to Mr. Osborne's question is that Spain is going to deal with all the losses in its banking system by adopting the Swedish model with ultra transparency.

As a result, the losses are going to be recognized today.  The burden of excess debt is going to be removed from the real economy as debtors are going to have their loans written down to levels they can afford.

Over the next several years, Spain's banks will rebuild their capital levels through retention of their earnings and by issuing bonuses in stock.  At the same time, market participants will assess the banks using the information disclosed under ultra transparency and exert discipline on the banks so that they do not take excessive risks.

How long can Mariano Rajoy keep this up? You know, the old matador routine. Swooshing his cape and declaring: “There will be no rescue of the Spanish banks.”...

If the Spanish government adopts the Swedish model with ultra transparency, the answer is forever! 

You’d hardly expect Spain’s PM to say anything else. But no-one believes him, judging by yesterday’s trampling in the bond markets.... 

The reasons? For starters, Madrid’s botched bail-out of Bankia, that paella of seven cajas, or savings banks. In just a fortnight, Bankia has gone from requiring €4.5bn (£3.6bn) of emergency funding to €23.5bn. Go figure, as they say. 

In addition, there is the simple fact that the PM is being advised by former and current bankers.  As everyone knows, 100% of the advice offered by these individuals is self-serving.

The question the PM must ask is there any overlap between what is best for Spain and this self-serving advice.  When it comes to the government bailing out the banks by injecting funds, the answer is there is no overlap between what is best for Spain and the bankers' self-interest.

Then, there’s all Rajoy’s mixed messages, in one breath ruling out a foreign bail-out for Spain’s banks, the next backing a eurozone rescue fund for lenders that bypasses national governments. “Lots of people are in favour of that, and I certainly am,” was his take on that. 

And this is before you consider the big picture. That, on Centre of European Policy Studies figures, Spain’s banks face potential write-offs of €270bn, once they finally 'fess up to the true horrors of a property bust. That’s roughly a quarter of Spanish GDP.

In that context, the leaks over Spain’s preferred fix for Bankia were especially telling. Until now, the state-backed FROB (Fund for Orderly Bank Restructuring) had been raising money in the debt markets and transferring it to any troubled bank. 

But there are two problems now. First, that the FROB only has €5.4bn, including €1bn already committed. Second, as Rajoy admits: “With a risk premium at 500 [basis] points, it is very difficult to raise finances.” 

So, Madrid is considering injecting newly-issued bonds directly into Bankia’s parent, Banco Financiero y de Ahorros. Bankia could then use them as collateral to borrow from the ECB. 

Rajoy may see it differently but that looks uncannily like a foreign rescue by the backdoor. What choice has he got, though? 

Whatever he says, Rajoy knows Spain can’t afford to bail out its banks – not amid a double-dip recession and with the jobless rate near 25pc.

Fortunately, Spain's banks can afford to rebuild their own capital levels without the government stepping in.  They can do this by simply retaining future earnings.

Keep in mind that it does not matter whether the banks need 4 years or 10 years to rebuild their capital.  In a modern financial system with deposit guarantees and access to central bank funding, banks can continue to operate and support the real economy while they are rebuilding their capital levels.