Wednesday, June 13, 2012

Spain's Government Makes a Bad Play

Last week's glimmer of hope of a quick and orderly resolution of Spain's banking system using ECB assistance has faded away. The Spanish government should have been pleased with this tack, as it avoided the stigma of a "bailout" of the Spanish government. Instead, PM Rajoy is now dealing with his own political crisis, blaming his predecessors and suggesting that the EU use "all the instruments at its disposal" to counteract "volatility."

What's needed with Spanish banks, as with Irish banks in the past, is to take over management of the banks, write down assets to their market value, with the subsequent wiping out of shareholders and move to merge weak banks into healthier ones or to liquidate assets to pay debt holders. Now, the time frame has been moved back until auditors and consulting firms are finished with their various studies.

Meanwhile, the credit markets have spoken up and moved the Spanish sovereign 10 year bond rates to a euro era high of 6.72%, according to the Wall Street Journal.

French commentators and proxies are once again talking about banking union, fiscal union, and EU supervision of national banks. However, if leaders can't solve a simple problem like resolving a straightforward, single member traditional banking crisis in Spain, how could anyone have confidence in a system of multinational, international bank supervision by a bunch of bureaucrats who don't face popular elections?

It looks like we are right back where we've been for the past eighteen months with no "European" solution in sight. I went back to the Stern Lab Volatility Center to revisit some of the European bank systemic risk numbers. The Stern Lab uses a measure SRisk which measures for each bank the expected capital requirements at the onset of the next financial crisis, which is a market driven crisis, defined as stock market declines of 40% over six months. There's another interesting indication which is the SRisk%, the systemic risk of a given bank as as a percent of the total systemic risk in the global banking system.

Of the top ten European banks, Credit Agricole ranks number 4, despite the fact that the bank has the lowest market value of the top ten at $9.8 billion. Yet it's SRisk rank if number 4, driven primarily by its leverage ratio of 221.6, which is over twice the leverage ratio of the next highly levered bank in the ranking. Credit Argicole is reported in the Wall Street Journal as trying to shut down their Greek operations. Not surprising.

There is only one Spanish bank in the top ten risky European banks, and that is Banco Santander at number 10, with a market value of $17 billion. In the event of a crisis, it would have to raise capital in multiples of its market value, according to the Stern analysis. We know that this bank remains an institutional favorite because of its geographically diverse revenue stream, but it is still vulnerable to another global market crisis.

Globally, the Spanish banks don't appear high in the rankings, which supports the idea that the mortgage problems in their lending portfolios could have been solved through a normal resolution and workout process, much like the U.S. did during the S&L crisis and the failure of Continental Illinois. There's nothing to suggest that it would be otherwise, unless the books reveal fraud after the examination by outside auditors for Spain.

Gerald O'Dricoll formerly of the Dallas Fed makes a comment in the Wall Street Journal which supports this idea when he writes,"Many Spanish banks lent heavily to property developers and to individuals who wanted to purchase homes built by the developers. Spain's construction sector is substantially larger relative to the rest of its economy than is the construction sector in other euro-zone countries or the U.S. And bank debt to finance that sector grew much faster than elsewhere...Spanish banks have taken huge write downs on their loans, but not enough. Only the exact size of the future write downs is in doubt, not that they will be very large." Failing to fix the Spanish banking system quickly, as a demonstration of pan-European economic management, is a great opportunity lost.

French, German and British banks in the European top ten would have to raise capital in multiples of their market value in the event of another global crisis manifested as a stock market collapse. Credit Agricole seems to be a unique risk among the European top ten.

It's clear that even cleaning up Spanish banks won't end the crisis, as Italian fiscal policies and their opaque financial system would simply become the next in an unending series of problems. The European public and the politicians will eventually get issue fatigue as we roll into the fall of 2012, and the economies are already beginning to roll over. It may not be a pretty picture this Fall.

(I spent some time creating a spreadsheet with some data, only to find that if I don't use Google docs I cannot cut and paste to blogger from Excel and preserve the formatting. Therefore the need for this convoluted description, but the data are all to be seen on the site.)

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