At the presentation on Saturday of the 19 billion plan to recapitalize Bankia devised by the banks board, working with teams from the Bank of Spain, the ministry of economy and their advisers, including Goldman Sachs chairman José Ignacio Goirigolzarri had a clear answer to those asking if holders of its capital securities should take a hit: Preferred shares will not become equity.
It goes straight to the heart of a key and unique challenge around Spanish bank recapitalization. The banks have sold large quantities of subordinated debt to their depositors.
In a note published on Wednesday, UBS bank analyst Alastair Ryan points out:
With this practice essentially universal in Spain every bank we can think of has sold capital instruments on multiple occasions in recent years to its retail deposit base the decision of whether or not to impose losses on depositors is an intensely political one. If sufficient numbers of depositors are involved, then to some degree they are the same as the electorate and taxpayer.
It is partly for this reason, Ryan argues, that any scheme to pass responsibility for recapitalizing the countrys banks on to eurozone institutions, such as the European Stability Mechanism or the European Central bank (ECB), is misguided.
His tough message, no doubt shared by many policymakers in northern Europe, is that the benefits of Spanish bank balance-sheet expansion are accrued domestically and that the primary responsibility for the clean up must also be Spanish.
Spain wants to avoid further stress on its own rising sovereign bond yields and further foreign-investor flight from its government bonds arising from having to raise the cash for a large re-equitization of its banks. That is why it has floated the idea of presenting Bankia with government bonds in exchange for equity bonds that Bankia could then present to the ECB as collateral for funding. That involves passing the buck to the eurosystems shareholders: the various national governments.
Ryan says: If, for example, it were decided that the risk of deposit flight were too great to impose losses on retail capital providers and we note this as a possible consideration in the recent decision to leave the 3 billion preferred notes in BFA untouched then the provision of new capital from the euro area to such a bank would represent a transfer of non-Spanish taxpayers funds to a certain group of Spanish depositors.
That might prove tough to stomach, not just for taxpayers in Germany but also in Italy, given that Spains sovereign debt to GDP ratio of roughly 80% is well below Italys.
However, there are no easy answers in this. Spanish banks also have a funding problem, with far higher loan-to-deposit ratios than the average across the eurozone. And even if deposits stay sticky, which remains to be seen, providers of wholesale funding might yet demand the comfort of a much higher capital level to finance the Spanish banks than the 9.5% that Goirigolzarri suggests Bankia can work with after its restructuring.
UBS notes that even after dealing with legacy asset impairments, banks with high wholesale funding needs in the UK and Switzerland are now working towards Basel III core tier one ratios of 10-13%. That might set a new de facto minimum benchmark for private funding market access.
Bailing out the bailout
By requiring the Spanish state to fund such a recapitalization, could the eurozone force the country into requiring a bailout package?
The rest of Europe is on the hook. Sharply rising Target2 balances for northern Europe show that Germany, for example, faces potential bad debts of up to 640 billion if all of southern Europe is forced out of the euro.
Right now, Spanish banks are dependent on 316 billion of funding from the ECB. Ryan sees this rising rapidly as foreign investors decline to fund Spanish banks in the private markets.
We see the logical direction of Spains euro system usage as being robustly towards the 800 billion range, unless policy is changed to be more pro-active in addressing the capital and funding needs of the banking system, and improving non-resident confidence in the governments own paper, says Ryan.