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Another turn of the screw for Spanish banks
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The government approves its second financial reform in just three months...
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Confidence is the basic pillar supporting the banking system. In Spain's case, this support has deteriorated over the last few months, at the same rate as the system has become increasingly dependent on Eurosystem funding. However, it was at the beginning of May, with the government's intervention in the country's fourth largest financial institution, when doubts intensified regarding the solvency of the banking system. The government's response was rapid, announcing a new financial reform that reinforces the write-down of the sector's real estate portfolio. This is the second reform in just three months. However, the financial markets did not give it an entirely warm welcome and the next few months will therefore seal the fate of Spain's financial system.
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Whereas the aim of February's reform was to raise the level of coverage for toxic real estate portfolios, May's reform forces an increase in generic provisions for non-toxic assets of the real estate development and construction sector. In December 2011, these assets totalled 123 billion euros or the equivalent of 40% of all credit to these sectors. Specifically, the new royal decree requires the average coverage for this non-toxic credit to be around 30% before the end of the year, 23 percentage points above the level established after the reform announced in February. This coverage ratio changes depending on the nature of each asset. For loans to acquire land, either backed by personal guarantees or second mortgages that are not problematic, coverage must be 52%. For developments underway and finished homes, the minimum coverage required is 29% and 14%, respectively.
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...and increases the coverage for non-toxic real estate development credit to 30%.
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The aim of these new provisions is to prepare the financial system to withstand an extremely adverse scenario and thereby dispel doubts regarding its capacity to survive. For example, according to the Ministry of Finance, even if three quarters of non-toxic development and construction credit migrated to toxic loans, the coverage rate of the latter's final stock would still be 50%. Economic activity is not expected to deteriorate to such an extent but the financial sector will be tested. The non-performing loan ratio for developers and builders rose non-stop throughout 2011 until it reached 20.9%, 7.9 percentage points above the level recorded a year earlier. The increase in the NPL ratio of all credit portfolios is lower but still significant. In the first quarter this rose by 5 tenths of a percentage point, reaching 8.37%.
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The aim of the new reform is to dispel doubts regarding the financial system's ability to resist.
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According to the Spanish government's calculations, May's reform requires additional provisions totalling approximately 28 billion euros. An amount that must be added to the almost 54 billion euros required to meet the measures adopted in February, which will help to place the coverage for development portfolios as a whole at around 45%. However, with revenue at a relative standstill, high provision requirements in just twelve months represent another turn of the screw for the income statements of financial institutions. In fact, not all of them are expected to be able to cover the new write-down with the profits made during the year. Capital gains, with the sale of holdings, or the use of surplus capital may also be employed for this purpose. Those institutions that still don't achieve the necessary coverage will have to look to the market to get capital or to the Fund for Orderly Bank Restructuring (FROB in Spanish) by issuing convertible bonds.
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The new requirements demand even greater effort.
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However, the difficulties of funding Spanish banks through traditional channels mean that this last option is gaining momentum. In fact, over the last few months, the Eurosystem has become the main source of funds for Europe's banks in general and particularly in Spain, with net Eurosystem loans to Spanish credit institutions rising by 194.2 billion euros between September 2011 and April 2012.
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Private debt continued to fall within this situation of tense finance markets and a weak economy. During the first three months of the year, this drop was most acute for households, reducing their financial liabilities by 11.5 billion euros, compared with the almost 3.0 billion euros in company deposits. The credit squeeze for the private sector largely explains this development. Specifically, in March 2012, the outstanding credit balance was 3.1% lower than the figure recorded a year ago. This trend contrasts with the increasing indebtedness of the public sector over the last few years. In the first quarter alone, the consolidated liabilities of the public sector increased by 38.1 billion euros.
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Credit falls by 3.1% year-on year in March.
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In addition to increased provisions for the healthy portfolio of development loans, May's financial reform also contains two far-reaching measures. The first establishes that those institutions not supported by FROB will have to create asset management companies to which they can transfer their foreclosed real estate assets once the relevant provisions have been made. According to the Ministry of Finance, this separation will allow credit institutions to focus on their banking business. The value at which these assets will be moved under the umbrella of real estate companies will be the result of subtracting the provisions from their book value. The government's decree also leaves the door open to private investors becoming involved and does not rule out the establishment of public support instruments, if necessary.
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Institutions must create real estate asset management companies.
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Secondly, two independent evaluations will be requested of the risk of the financial sector's whole asset portfolio. These evaluations will be supervised by the European Central Bank and the Bank of Spain. The aim is to settle doubts regarding the balance sheets of financial institutions.
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This exercise is similar to the one carried out in other countries such as Portugal and Ireland, although the outcome was very different for the two cases. While the evaluation of the credit portfolio in Portugal resulted in a minimal reclassification of assets to toxic loans, in Ireland this led to significant injections of public capital in banks. This divergence increases doubts regarding the repercussions of the external valuations of Spain's banking system, although it is very unlikely to be prescribed the tough conditions required in Ireland's case.
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The trend in the total credit portfolio could push up the capital requirements for Spain's banks.
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Another condition proposed to the financial sectors of these two European countries was the start of an orderly deleveraging process. In both cases, the ratio of loans to deposits in the system must decrease to levels close to 120% within 4 years, starting from levels above 150%. As can be seen in the previous graph, in Spain's case this ratio reached 157.5% in March 2012. Consequently, a similar requirement for our banks would intensify the credit squeeze in Spain, especially if we take into account the gradual decrease in bank deposits over the last few months.
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Deposits continue their downward slide.
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In March, the bank deposits of households and firms had fallen by 4.2% compared with the same month in 2011. There are many factors underlying this trend. On the one hand, there is the reduction in savings in an adverse macroeconomic context; on the other, greater competition with products providing a higher return, such as Treasury bills or commercial paper from banks.
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In this respect, according to the Financial Stability Report drawn up by the Bank of Spain, the outstanding balance of the commercial paper issued by financial institutions stood at more than 50 billion euros in March 2012. This figure is more than three times the one recorded half a year earlier. In fact, according to this report, the overall trend in deposits and commercial paper shows a much more moderate fall. However, the latest upswings in yields on Spain's sovereign debt over the last few months will ensure that deposits continue to be replaced by other products in the short term.
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In summary, May's new financial reform and the external evaluations will require a renewed effort from Spain's banking sector. All this within a context of marked macroeconomic weakness that will continue to damage the income statements of financial institutions. The road towards the sector's recovery will be tough but it must be taken as soon as possible. Only that way will confidence be restored in the financial system, so necessary for it to work well.
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