Bienvenido de vuelta to the Spanish crisis

Euromoney Skew, Sid Verma
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The Spanish banking crisis still rages with no resolution on the burden-sharing arrangement that would see the European Stability Mechanism assume legacy liabilities.

Despite Spain’s much-vaunted banking stress test – a purportedly detailed and thorough exercise – criticism of the official capital shortfall estimate of €59.3 billion has come in thick and fast. The results of the audit, conducted by Oliver Wyman, has been contested by Moody’s, which estimates banks would require between €70 billion to  €105 billion. Nomura also adds to the chorus of negativity:

“The aggregate capital shortfall identified we believe is at the low end of market expectations (essentially the same as the one already provided at the end of June). In addition, some of the criteria would seem less demanding than those used in the 2011 Irish bank stress test (which we believe is hard to justify). Using some of the criteria used in the Irish stress test, we estimate would see capital requirements for Spanish banks increase to c. €94 billion.” 

The bank stress tests are based on adverse scenarios that are less severe than the Irish tests in terms of gross credit exposures and deleveraging risks, Nomura maintains:

“From a banking perspective there is no doubting that estimating aggregate losses of €270 billion is a quite stressed scenario. And while comparisons can be odious, it is worth highlighting that these losses in Spain are equivalent to c. 17.4% of gross credit exposure, while the 2011 stress in Ireland estimated gross losses of 23.7% of gross exposure.

Looking in detail at the Oliver Wyman stress test, some of the assumptions also appear less severe than previous stress tests. The Oliver Wyman test assumes that risk weighted assets (RWAs) fall by an average of c. 19% in the adverse scenario. This benefit/reduction contrasts with some of last year’s stress tests. The EBA 2011 stress test in particular saw the banks post an increase in RWAs, with key Spanish banks seeing an average 3% increase in RWA.

It is also interesting to note the approach taken in the Irish stress test, which assumed an aggressive deleveraging of the loan book to a loan-to-deposit ratio of 122.5% from 180%. The losses incurred in reducing assets were also included in the capital needs of each bank. This meant a c. €70 billion reduction in assets, generating €13 billion of losses. Taking a similar approach to Spain, we estimate would see a reduction in loans of c. €400 billion and c. €80 billion in losses.

In this case, it would be important to clearly identify losses on the core loan book and deleveraged loan book, and therefore should not automatically be added to the aggregate losses of €270 billion identified by Oliver Wyman.

The report adds:

"Furthermore, post-shock capital needs are calculated taking a minimum core tier 1 ratio of 9% for the base-case scenario and only 6% for the stressed scenario. While the Irish stress tests were also conducted with a core tier 1 ratio of 6.0% as the reference threshold, they also prescribed an additional buffer, which in the end amounted to €5.3 billion or c. 3.0% in additional capital requirements (ie raising the effective minimum from 6.0% to c. 9.0%). The equivalent buffer for Spanish banks could see a total capital requirement of c. €66 billion. Finally, it is worth remarking that aggregate losses including Nama under the adverse scenario amounted to 23.7% of gross exposure versus only 17.4% in the Spanish case, taking the more pessimistic estimate by Oliver Wyman."

In any case, the stress tests brought no clarity as to if and when the Spanish government will request a bailout, with market players betting no request will be forthcoming until after elections in Galicia and Basque Country on October 21. It appears as if Spain has downsized the likely banking system recapitalization request to the European Stability Mechanism (ESM), relying instead on private funding sources, market players reckon. 

However, Spain's debt-sustainability challenge remains and the broader political backdrop is dispiriting: eurozone policymakers are still at odds over the burden-sharing arrangement that would resolve the Spanish crisis, after comments made by Finnish and German officials last week as to the legitimacy of the ESM bearing banking system liabilities.

Analysts at JPMorgan have the smartest take we have seen about the heart of the dispute:

"France, Italy and the Commission have been lining up behind the scenes against those parts of the core who spoke out last week, disappointed with what they see as un-collegiate policymaking. They think the core’s specific interests in limiting future ESM liabilities has been allowed to override the broader regional interest: in Spain gaining further ground and demonstrating a stable fiscal path. We saw a rebuke from Commissioner [Olli] Rehn to his home country over the weekend, with a call for Finns to reject the ‘dangers’ of a ‘hardline’ position on Europe. The perspective of Finland, Germany et al on the other hand is simple; they never agreed to pay for other country’s existing banking sector problems. In all probability, they are even less inclined to offer this kind of direct socialization to Spain, when it has the offer of OMT support on the table (and likely has sufficient headroom to take on the banking challenge itself).

These arguments reflect an ongoing failure to agree on whether burden sharing should be retroactive – applied to the existing problem – or only take place in the new world of an improved ‘steady state’ for the region. We think this argument is particularly important; a region where there is gradual socialization of all existing burdens (banking sector or sovereign) will look very different to a region where burdens remain primarily national until there is a wholly new institutional architecture in place. Half the region (the periphery) expects to move towards the former, while the other half (the core) appears to be looking ever more towards the latter. The region is moving towards the mid-October summit with a very different set of political agendas about what it hopes to achieve."

In conclusion:

"As for Spain, Germany et al have probably done nothing to dampen fears about how much a potential sovereign intervention might hurt (nor arguably should they). It is possible that they could row back on last week’s statement by suggesting that the Spanish banking programme will be excluded from their ban on the application of legacy assets. There are precedents, ESM support is supposed to be senior to other creditors rather than pari passu, but the region agreed an exemption for Spain (because the banks' programme was to be carried over from the EFSF). We think this is unlikely to happen, but it is possible – and would reflect the impacts of the political backlash against the approach taken by the core last week."