Oh what tangled webs regulators weave when first they let banks to deceive

With apologies to the Bard, Spain is providing a classic case study of what happens when financial regulators adopt policies, like regulatory forbearance, that bless banks not reporting their true condition.

The Wall Street Journal carried an interesting article on how deceptive reporting by banks did not fool institutional investors, but may have influenced the investment decision of individual investors.

Facing international skepticism from big investors, Spanish banks are increasingly leaning on individual, or retail, clients to buy their debt and equity. That has boosted the banks' funding and capital buffers but also raised concerns that they are playing down their problems to avoid scaring away small investors.

Spanish banks have raised €23 billion in equity since 2010, around 70% of which was purchased by retail investors, according to estimates from analysts at UBS AG....

The sales of shares and bonds to individuals and households—usually after a marketing blitz—have provided key support to Spain's banking sector as it grapples with heavy real-estate losses and efforts to meet Spanish and European Union regulators' rules for more capital.

The regulator blessed deception.

But some observers say the banks' reliance on such retail investors has conversely played a role in exacerbating the problems in the banking sector by keeping it from fully recognizing its losses. 

The reason: As Spanish citizens have increasingly become stakeholders in their country's banks, regulators and banks fear that large losses would be a blow to confidence and cause such mom-and-pop investors to flee, according to analysts, economists and people familiar with the regulators' thinking. 

This argument is entirely self serving for the bankers.  It supports their continuing to pay themselves large bonuses because cutting back on bonuses would be a signal that something was wrong.

Because of this, banks "want to show the public there are no major losses," said José Garcia Montalvo, a professor of economics and business at the University of Pompeu Fabra in Barcelona. "They've tried to gain time through mergers or recognizing only some" losses. 

These examples are consistent with regulators having adopted the Japanese model for handling a bank solvency led financial crisis and its policy of protecting bank capital levels.  They give an indication of just how complicated the web of deception is.

Compounding the problems, banks aren't allowed to pay interest or dividends on debt or equity products if they post a loss, which could further alienate small investors who tend to be more fickle than large, long-term investors such as pension funds. 

Nor do such products have the guarantees of plain-vanilla deposits, which could further undermine the confidence of smaller investors if they were to lose their investments. 

Do you think that bankers were aware of these facts prior to selling the securities to individuals?

For their part, banks have encouraged investors to convert types of debt into either common stock or mandatory convertible notes, which pay a high initial yield before later converting into stock.  

Banco Santander SA and Bankinter SA issued mandatory convertibles to depositors early in the financial crisis. Most of Banco Sabadell SA's recent rights issue went to retail investors. 

"Retail investors look more at the investment as income, and getting regular dividends are much more important," Andrea Filtri, an analyst at Mediobanca in London.

 Nothing like cementing the status quo of covering up the losses and paying big bonuses!

He and other analysts note that amid Spain's economic woes and sharp real-estate downturn, no major Spanish bank has posted an annual loss since the start of the financial crisis in 2008.... 

A spokesman for the Bank of Spain rejected the idea that bank regulators have allowed banks to disguise or delay possible losses....

Completely unbelievable ... but consistent with the tangled web.

On Friday, the government will outline further plans to shore up the sector, including allowing banks to unload toxic real-estate assets into off-balance-sheet vehicles.

The government also plans to introduce another big change in banking regulation that will force banks to set aside an extra €20 billion to €40 billion in generic provisions, according to people familiar with the matter. The fresh provisioning comes on top of the €54 billion that Spain forced banks to set aside in February. 

While the provisioning effort announced in February was meant to cover losses on problematic real-estate assets, the extra provisioning set to be announced Friday will cover potential future losses on outstanding loans to property developers that are still performing, this person said.... 

Is this remotely enough to handle the bad debt problem in the Spanish banking sector?

Why should investors believe that it is given that the Spanish regulators were clearly blessing deceptive financial reports by the banks?

Since Bankia's initial public offering in July, it has posted a profit each quarter. 

Bankia said in March that its 2011 profit reached €309 million. Its parent company, Banco Financiero y de Ahorros SA, reported full year profit last week of €40.9 million. 

The government plans to inject €7 billion to €10 billion into the Madrid bank and Banco Financiero y de Ahorros, according to a person familiar with the matter.... 

"The acceleration of the resolution of Bankia caught everyone by surprise," said Antonio Garcia Pascual, Barclays Capital's chief economist for Southern Europe.

Bankia effectively destroys the credibility of the Spanish government and regulators when it comes to any assurances they might give as to whether the problems in the banking sector have been addressed.

The fact that the government is thinking of injecting 10 million euros tells everyone that the government has blessed misleading financial statements from Bankia.  There simply is no way the losses requiring this bailout were discovered last week.