Why private bondholders need to share in Spain’s banking pain

IT’S under control. That seemed to be Mariano Rajoy’s message as he left for Poland to watch Spain take on Italy, hours after finalising a €100bn euro rescue deal for the country’s banks. The Spanish Prime Minister and EU finance ministers can certainly be pleased at achieving such a quick deal, but they should not rest for long.

At first, markets cheered on the €100bn funding announcement – a larger fund than many expected. That significantly strengthens the firewall around Spain should Greek voters spark panic in the markets (and among depositors) by electing an anti-austerity government. But the rally was short lived.

Whether the money comes from Europe’s temporary or permanent bailout fund, the lifeline is a loan, and as such it adds to Spain’s rapidly increasing total debt. Spain plans to use this money to inject banks with fresh capital through its own bank bailout fund, the FROB. But by sorting one problem – a lack of bank capital – Spain adds to another: its mounting national debt. Spain is effectively borrowing to invest in bank equity. Like an investor who borrows to buy stocks, Spain could face steep losses, if growth continues to decline and erodes asset values and bank capital.

What Spain really needs is a systematic reform of its banks, in addition to injecting new capital. Thus far, regulators have forced unprofitable savings banks to merge and increase their capital buffers, keeping them on life support through government funds. But the banking sector is over three times larger than Spain’s economy, and is clearly too large for the government to support in its entirety.

Spanish banks are likely to need at least €134bn of additional capital over the next three years given the likely increase in bad loans and the bigger buffers demanded by Basel III. In a deep recession scenario, Spanish banks may need as much as €180bn.

Already, if debt from regions, local authorities, social security funds and unpaid bills is added then public debt stands at a hefty 97 percent of GDP.

If all €100bn of the bailout was used, public debt would rise to over 100 per cent of GDP. That’s similar to the kind of levels Ireland endured three years ago, when public debt increased by around 20 per cent on bank bailouts, forcing the country into a prolonged spiral of austerity.

What else can Spain do? To restore sustainability in its public finances, Spain needs to rebuild a banking sector that is able to stand on its own feet. This means fewer, better capitalised and more efficient banks. It also means that the private sector should share losses with the government.

Up to now, no private bond investors have had to accept any haircuts in either Greece or Spain, where the seven largest banks have roughly €59bn of subordinated debt outstanding. Loss-sharing from the private sector and particularly from subordinated bonds would help ease some pressure on public finances.

Spain’s two national champions, Santander and BBVA, must also play their part. Like Spain’s championship-winning football team, its best strikers still need the rest of the team on the field to play. Santander and BBVA continue to pay dividends, but they are still profitable thanks in part to the government’s efforts to keep all other local banks alive. Moreover, reform should include a partial redistribution of earnings from strong to weak banks, potentially through Spain’s Deposit Guarantee Fund.

Without long-lasting structural reforms, markets will soon re-focus on more deep-seated problems. And if Spain remains frozen out of debt markets, it may ultimately need a full-blown aid package worth between €370bn and €460bn to recapitalise its banks and roll over debt obligations for the next two years.

To regain investors’ trust, Spain’s banking system needs surgery, not a never-ending anaesthetic.

Alberto Gallo is head of European macro credit research at Royal Bank of Scotland.