Spain banking crisis looks like it might be spiraling out of control

As predicted by your humble blogger, by pursuing strategies that did not credibly address the bad loans in its banking system, the Spanish government finds itself with a banking crisis that looks like it might be spiraling out of control.

As reported by Ambrose Evans-Pritchard in the Telegraph,

The country’s finances are unravelling on every front, with internal rescues for Catalonia, Valencia, Murcia, and Andalucia fast depleting the €18bn fund set aside for the regions. 

It emerged today that Spain’s social security system has raided a rainy-day fund to cover state pensions for the first time as deepening recession erodes contributions. 

Tomas Burgos, social security minster, said the government had drained €4.4bn from the Fondo de Prevencion – financed from workers’ illness insurance – to the meet the shortfall in July, reducing the account to just €400m. 

Mr Burgos said Madrid may have to use “all mechanisms at our disposal” to meet payments, revealing that the next step may be a raid on the pension system’s €67bn Reserve Fund. The pension system has been losing contributors as unemployment soars to 25pc. It shed a further 137,000 jobs in August. 

Meanwhile, official data shows that the toxic property loans of Spain’s four nationalised banks have reached €75bn and are rising faster than feared. Bankia’s “potentially problematic” loans are €42bn. The biggest surprise is a 50pc surge in bad debts to €9bn at Cataluyna Caixa since January. Non-payments on mortgages have doubled. 

Nomura’s Jens Nordvig said Spain’s crisis has entered a “more dangerous phase”, resembling the sort of currency dramas once confined to emerging markets. 

Capital flight has been running at an annual rate of 50pc of GDP, more than twice the rate in Indonesia during the Asian meltdown in the 1990s. 

Foreigners have sold Spanish securities worth 19pc of GDP over the past quarter. Spanish residents have shipped funds worth 16.7pc of GDP into foreign bank accounts. 

Net claims on Spain through the ECB’s Target 2 payments system have reached 39pc of GDP. 

“The build-up in central bank liabilities is explosive,” said Mr Nordvik.

With its finances unraveling and its banks sitting on an unknown pile of losses, it is no surprise that depositors are racing to withdraw their money and move it to other banking systems that are perceived to be safer.

Given the threat to kick Greece out of the EU, the depositors have every reason to be concerned with having their savings converted into pesetas that are far less valuable.

As reported by the Wall Street Journal, Spain is looking to the ECB to fill the funding void left by the deposits being transferred out of the Spanish banking system.

Nearly three months after Spain requested a €100 billion ($126 billion) European bailout for its banks, the problems facing the country's frail banking system are deepening, putting pressure on the European Central Bank to take action this week....

But the very storm that drove investors away from Spain—the deterioration of its banking system—appears to be gathering force. The latest trouble is the inability of Spanish banks to finance themselves through usual means. 

Capital markets remain largely shut because investors refuse to buy bank bonds at affordable prices. And customers, nervous about the banks' health, are increasingly yanking their deposits. 

The reason that Spain's banks cannot tap the capital markets is because they are opaque black boxes and no one can figure out what losses are hidden on and off their balance sheets.  If investors cannot figure out the risk of investing, they demand a sizable risk premium to be compensated for the unknown risk.

The banks appear to be exhausting their capacities to wring cash out of the European Central Bank, the lender of last resort for much of Southern Europe's battered financial system.

The banks are exhausting their capacity because they are running out of collateral to pledge.

The problems have been building since last fall. But the recent intensification has sent Spanish officials scrambling to prevent their banking system's liquidity problems from escalating into an acute financial crisis....

It is the liquidity crisis spawned by the run on the banks that historically causes the banking system to collapse.

In one sign of the mounting pressures, the Bank of Spain appears to have started providing emergency loans to some of the country's banks, according to central-bank data and industry officials.

Ireland also provided emergency liquidity assistance.  This occurs when the banks have effectively run out of good collateral to pledge to the ECB and are left pledging assets that the ECB is unwilling to accept as collateral.

Under the emergency liquidity assistance program, the Spanish government is using its guarantee to get money from the EC.

The Spanish government offered another relief measure last week by scrapping a regulation that essentially put a ceiling on the interest rates banks can dangle in front of depositors—a rule introduced last summer to defuse an escalating and potentially destabilizing price war among banks. 

The banks quickly responded by jacking interest rates above 4% in a bid to woo skittish customers. 

They are trying to slow a parade of customers pulling money out of bank accounts. 

Deposits dropped 4.7% in July to €1.51 trillion, according to ECB data. The nearly €75 billion monthly decline was the sharpest in Spain since the ECB started tracking such information in 1997....

This raises the question of how large the deposit withdrawal were in August and in the first part of September.

"You have a liquidity crisis now," said Philippe Bodereau, head of European credit research at giant bond investor Pimco. "A bank 'jog' is happening in Spain. The private sector is leaving the banking system." 

Propelling the exodus are fears about the industry's health. 

Even after the Spanish government sought to erase the concerns in June by seeking a €100 billion loan to recapitalize the sector, customers and investors remain wary of losses lurking on the banks' books and the prospect that Spain eventually might leave the euro zone. 

It is the risk of having the deposits converted to less valuable pesetas that is the primary driver in the run on the Spanish banks.

Spain's banks have filled the void left by departing customers by turning to the ECB and Spain's central bank. 

At the end of July, the industry had borrowed a total of €410 billion from the ECB. The biggest borrowers range from relatively healthy institutions like Banco Santander SA to wards of the state such as Bankia SA. Four of the five biggest ECB borrowers hail from Spain, according to UBS analysts....