Spain's banking rescue should become example for Europe

A Bloomberg editorial correctly points out that Spain's banking rescue should become the example for not just Europe, but globally.

Unfortunately, the editorial recommends injecting capital into the banks.

As regular readers know, injecting capital is not needed in a modern banking system with deposit guarantees and access to central bank funding.  With these in place, a bank can operate and support the real economy for years with negative book capital levels.  As a result, the banks are capable of rebuilding their book level capital through retention of future earnings.

Perhaps no country better illustrates the mutually reinforcing links among the euro area’s banking, sovereign-debt and economic crises than Spain. 

Its banks are largely paralyzed amid concerns about heavy losses on real estate loans that, by various estimates, could require as much as 120 billion euros ($150 billion) in fresh capital to offset. 

Tight bank credit has in turn deepened the country’s economic slump, increasing banks’ potential losses and fueling fears that bailout costs will overwhelm the Spanish government’s already stretched finances. 

The longer the situation lasts, the worse it gets: Nervous investors pushed Spain’s 10-year borrowing rate as high as 6.7 percent Wednesday, up from less than 5 percent in early March.

This analysis is flawed because it omits the critical fact that EU financial regulators have set a 9% Tier I capital requirement for the end of June 2012.

It is this capital requirement that has triggered the credit crunch in Spain and the rest of Europe.  It is not the losses hidden on and off the Spanish banks' balance sheets.

As demonstrated by the US Savings & Loans during their solvency crisis, being insolvent or having negative book capital levels does not stop a bank from making loans.

What stops a bank from making loans is a regulatory requirement that says they must shrink their balance sheet!

Spain’s response has been far from adequate. 

Government- induced bank mergers haven’t reduced the system’s capital needs. Last week, the country’s third-largest bank, Bankia SA, said it would require 19 billion euros in fresh capital to cover losses -- far more than the resources available in the country’s bailout fund. 

A bank run of sorts has already begun: Central- bank data suggest that, in the first four months of this year, more than 100 billion euros in private money has fled Spain for other euro-area countries, an amount roughly equal to a 10th of the country’s annual economic output. A European Central Bank measure of deposits in Spain’s banks declined by 31.5 billion euros in April.

The trigger for the bank run is the growing perception that Spain will not be able to honor its deposit guarantee.

This is very important as depositors don't care about bank book capital levels.

This blog has offered numerous example proving this point including:  a child asking how they can know the bank will give them back their money and a parent answer it is insured by the government; and how many economists/policymakers/financial regulators know what the book equity level was at the end of last quarter for the bank where they have their checking account.

Restoring confidence to prevent bank runs is not a matter of injecting capital into the banks, but rather a matter of backstopping the deposit guarantee.

It’s imperative that Europe step in to break Spain’s fall, lest the country’s problems topple the euro area’s banking system. 

Europe’s banks have about 672 billion euros in claims on Spain’s banks, government and companies, according to the Bank for International Settlements.  Germany’s claims alone add up to about 186 billion euros, or nearly half of German banks’ aggregate capital. 

How, then, can Europe draw the line at Spain? 

Dire as the country’s predicament may seem, it offers an opportunity to create a model for bank recapitalizations throughout the euro area....

The Bloomberg editorial goes on to recommend injecting equity into the banks.  As stated above, in a modern banking system, this is unnecessary.

Spain should be a model for bank recapitalizations in a modern banking system.  It should be a model of letting the banks rebuild their book capital levels through retention of future earnings.

According to an IIF study on the Spanish banking system, it will take less than 4 years for Spanish banks to rebuild their book capital levels.

Let’s say Spain’s banks need 120 billion euros in new equity -- or capital -- to cover losses and restore confidence.

Injecting new equity into the banks does not restore confidence.  Confidence for depositors is a function of confidence in the deposit guarantee.

As discussed in previous posts, one of the unintended consequences of threatening to kick Greece out of the EU is redenomination risk.  Suddenly, depositors are looking at the potential for having their funds forcibly converted into a weaker currency.

This too is also not addressed by injecting new equity into the banks.  In fact, an argument can be made that injecting new equity into the banks increases redenomination risk as it unnecessarily uses up sovereign borrowing capacity.

The first place to look for the money would be the banks’ own subordinated creditors, whose claims aren’t secured against any of the institutions’ assets. These investors, who received a higher return to compensate for their low position in the pecking order of creditors, have often been made whole in bank bailouts....

Until banks are required to provide ultra transparency, governments have a moral obligation to bailout the subordinated creditors.

This moral obligation is the direct result of the governments conducting stress tests and publicly announcing that the banks have passed.  If the government, which has a monopoly on all the useful, relevant information about the banks says they are solvent, then it is up to the government to bailout investors who relied on this representation should the banks not be solvent.

Ultimately, the place to look for capital to rebuild a bank's book equity levels is retained earnings.  Earnings that are subject to ultra transparency so that market participants can see that the bank has recognized all the losses on and off its balance sheet and exert discipline on the level of risk taken by the bank to achieve those earnings.