Monday, August 6, 2012

Spain's troubled bank clean-up suffers credibility shortfall

As discussions continue over how Spain should divide the 100 billion euros it is receiving between a bad bank to hold all the troubled assets and recapitalizing the good banks, Spain is discovering that in the absence of ultra transparency this activity will not credibly clean-up its banking system.

Regular readers know that the first step in credibly cleaning up the banking system is to require the banks to disclose their current global asset, liability and off-balance sheet exposure details.

With this information, market participants can identify and value the bad assets.

As a result, the bad bank or an independent third party buys the bad assets at a price that the market thinks is credible and the banks fully absorb the losses.

Of course, it gets a lot more complicated when the goal is to protect bank book capital levels and therefore minimize the losses the banks absorb.

Just like the US government tried to do with toxic structured finance securities and the Irish government did with bad loans in its banking system, Spain is hiring third parties to value the bad assets and show that miraculously 100 billion euros is enough to a) write the bad assets down to market value and b) recapitalize the good banks.

Of course, nobody believes this is remotely possible to achieve on 100 billion euros given that Spain is facing at least 400 billion euros of bad debt.

Still, the Spanish government insists on pursuing the good bank/bad bank concept.  This raises a series of questions:

Why pay money to third parties for something the market will do for free if the banks were required to provide ultra transparency?

Why pay money for something that the market will view with distrust (after all, if there was nothing to hide, then there would be ultra transparency and no need for the third parties)?

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