Did Bankia's depositors buying bonds require Spain to bailout bank?

Bloomberg carried an interesting article in which it presents the argument that Spain was on the hook for bailing out Bankia because its depositors were significant investors in its bonds.

This argument reflect one true and one fase assumption:

• True:  Spain has a moral obligation to protect investors; and

• False:  Maintaining positive book capital levels is necessary to prevent bank runs.

Spain has a moral obligation to protect investors that results from its information monopoly.  

If banks were required to provide ultra transparency and disclose on an ongoing basis their current asset, liability and off balance sheet exposure details, market participants would not be dependent on the government's assessment of the bank's solvency.  There would be no moral obligation as investors could use this disclosure and independently assess the solvency of the bank's for themselves.

However, since investors, unlike regulators, do not have access to ultra transparency, they are dependent on the the regulators to accurately assess this information and to report their findings.  This dependency creates the moral obligation.

Bank book capital is an accounting construct.  In a modern financial system with deposit guarantees and access to central bank funding, it can be positive or negative without effecting the bank's ability to operate and provide loans to the real economy.

As a result, there is no reason for governments to bailout the banks today.  The banks can simply rebuild their book capital levels through retention of future earnings.

Spain’s hands are tied with the rescue of Bankia (BKIA) because alternatives to injecting cash or government debt, such as forcing bond investors to bear the cost, risk hurting ordinary depositors.

Actually, the alternative of requiring the bank to recognize all of the losses hidden on and off its balance sheet today and provide ultra transparency does not risk hurting ordinary depositors.

Ordinary depositors are protected by deposit guarantees.  These guarantees are strengthened by the government not investing.  These guarantees are strengthened by the losses being recognized as the losses do not become a burden that crushes the real economy.

Bankia is among Spanish lenders that sold 22.4 billion euros ($28.2 billion) of preferred stock to individual investors through retail branches, according to data compiled by CNMV, the financial markets supervisor. 

In a so-called bail in, these investors would be wiped out before holders of more senior bonds, which tend to be banks and institutions.... 

“The sale of preferred stock to depositors means that almost the only option for the government now is injecting capital,” said Arturo Bris, a professor of finance at IMD business school in Laussanne, Switzerland. “A writedown of preferred shares placed with depositors would cause a social problem. It’s not really a feasible alternative.”...

The option of letting the bank rebuild its book capital level through retention of future earnings is still feasible.  It would avoid the social problem.

A taxpayer-funded bailout of Bankia would foist losses on a wider portion of society than making individual bondholders, many of them depositors, lose money....

A taxpayer-funded bailout would place the burden of the excess debt squarely on the real economy.  Everywhere this has been tried the result has been a long term economic decline.  As a result, this is not a viable option.

Fernando Herrero, the secretary general of ADICAE, a Madrid-based association of clients of financial institutions, estimated that about 1 million Spanish households bought banks’ preferred shares, some of which have been converted to common equity or subordinated convertible bonds.

“The instruments were marketed as very liquid and as safe as a deposit,” said Herrero, who described issuing the risky securities to individual investors as an “original sin.”

The bank was able to get away with this marketing because of the government's information monopoly.

If the bank had to provide ultra transparency, investors could have assessed the riskiness of the bank for themselves.  Since investors could not assess the risk of the bank, they had to trust what the government said about the bank.