Spain fails to take the banking crisis by the horns

In his Wall Street Journal Heard on the Street column, Simon Nixon observes

Four years into the crisis, Spain's failure to deal with the weaknesses in its banking system has become a threat to global financial stability. 

There is no great secret over what is required: Madrid only had to look to the experience of the U.S., U.K. and Ireland, among others, to see this crisis wouldn't end until Spanish banks were forced to write down toxic real-estate exposures to realistic levels and plug any capital shortfalls with equity. 

Please re-read the highlighted text as it is exactly what your humble blogger has been recommending.

Yet for the second time in a little over two months, Madrid has produced a plan that looks short of the mark.

First, the new provisions banks are being required to make look inadequate..... Provisions will now cover about 45% of the full €325 billion of problematic real-estate loans in the system. Analysts say this isn't enough; UBS, for example, reckons provision coverage needs to reach 60%, which would imply €80 billion of extra write-downs. 

Second, no new equity is being provided. Instead, the state-backed Fund for Orderly Bank Restructuring will bail out any bank with a capital hole with convertible bonds that charge an interest rate of 10%. Much depends on the terms of the bonds, but markets are unlikely to be convinced. Madrid appears to be making the same mistake that the U.K. made in October 2008, when it tried to recapitalize banks with preference shares before being forced to back down just weeks later and provide equity. 

The one glimmer of hope in Friday's proposals is a commitment by the government to hire outside advisers to review bank balance sheets. But this won't be a full deep-dive asset-by-asset valuation of the sort undertaken in the U.K. and Ireland but a "stress test" based on current valuations. 

Meanwhile, the government's other major proposal—to require banks to spin off their real-estate loans into separately capitalized vehicles—will likely come to nothing unless investors trust valuations.... 

Investors will not trust either the outside advisers valuations or the valuations the banks put on the assets spun off.

If the banks are properly reserved, then they should have nothing to hide and should simply be required to provide ultra transparency to prove the point.

Madrid's continued failure to do what is needed to regain market confidence is baffling.... But this piecemeal approach is deeply corrosive to Madrid's credibility. Madrid may struggle to hold this latest line for long: The new package is unlikely to be the last.

Please note that in a modern banking system with deposit guarantees and access to central bank funding, banks do not need to come up with the equity today.  Rather, the banks can rebuild their book capital levels through retention of future retained earnings.  This relieves Spain having to bailout its banks.