Letter for Spanish Bankers

Spanish Banks are in a tough spot. A commercial property collapse on the tails of the financial crisis and recession of 2008-2012 has investors wondering how safe spanish bank balance sheets really are. With the recent failure and oncoming bail out of Bankia most investors have stopped wondering. The real risk to spanish banks however is a run on deposits. The Greek banking sector is already suffering from capital flights on worries of forced conversion of Euros to Drachmas. With a new election coming up in Greece and mounting fears of a Grexit, the risk for contagion of depositor fear is now quite heightened. With balance sheets already substantially weakened by the property bubble burst the spanish banking sector can ill afford to fall pray to deposit redemption ‘en masse’.

The ECB under Mario Draghi has shown some inclination to incarnate the ‘lender of last resort’ role, while the scale of these intentions have been of a large magnitude they remain modest in scope. While the extending of Long Term Refinancing Operations’ maturities and accepting collateral composed of downgraded sovereign bonds was still accepted, represented a bending of the spirit of monetary hawkishness, these actions still respect the rules imposed on the ECB by its Bundesbank roots. So the political will and the monetary structures of the Eurozone will not be available to monetize spanish debts away. The reality is that to avoid a Greek downward spiral the solutions to Spain’s problems must come from within Spain.

One way to partially bypass the ECB’s reluctance to engage more forcefully in solving the oncoming spanish banking crisis is to create a private and local version of a central bank. A bank of banks could be created and capitalized by the largest banks in Spain. A rigorous stress test could be undertaken to determine which banks have the necessary capital buffers and risk management practices to be eligible to participate in the scheme. Once fully capitalized enough and large this bank of banks could provide liquidity guarantees to the banks having passed the stress test. This would represent the mutualization of risk in the banking sector, essentially reducing un-systemic risk for the participating banks.

The remaining banks could then either be recapitalized by the federal government through the purchase of equity by the government (as was the case in the US in 09) or be closed following a bank holiday as was the case in the 30′s. While this would be costly, with a large enough proportion of banks’ liquidity needs covered by the bank of banks hopefully the cost of bailing out the insufficiently funded banks would not be fiscally crippling to the nation.

While these actions could alleviate the risk of a system wide shut down and bailout as was the case in both Ireland and Iceland, the issue of systemic risk stemming from the property bubble burst would remain.

Only a jolt of growth could sustain property prices at levels high enough to preserve bank balance sheets. Liberalizing the spanish through labour market deregulation is a good way to grow an economy in the long run, but with the global economy still teetering, a rebound in industries outside construction seems unlikely. The only option remaining to banks to preserve their balance sheets would be to take a hit on their cash flows. To prevent a further deterioration in housing prices banks will have to consider the inconsiderable. Banks must collectively agree on some form of debt forgiveness. Preferably it would take the form of mortgage extensions and interest payment sabbatical. Such a move could alleviate the pressure on spanish consumers and avoid a series of foreclosures of a magnitude from which banks could not survive. After their stress tests the banks could agree on what levels of temporary interest forgiveness could be acceptable without sparking bank bankruptcies.

This would hopefully give the Spanish economy enough time to begin restructuring towards external sectors such as manufacturing for export. While the moral hazards are numerous and the conditions for success are many, only bold actions undertaken by the banks and acceptable to them will lead to a sustainable solution. These actions would lead to a temporary crimping of banking profitability, but it might preserve their balance sheets and offer their government the respite needed to find solutions to the underlying competitiveness issues that face the nation. Their shareholders may thank them one day, and so may all the indignados.