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The Spanish government has finally begun to address the key source of financial market uncertainty surrounding its banking system, the wobbly cajas savings banks . All Spanish banks must immediately apply the new Basel III core capital definition, and raise such capital to at least 8 percent (and more if the caja is unlisted) by September 2011, at which time the Bank of Spain will determine whether the capital goal has been reached. In the event that a Spanish bank fails to reach the required core capital level, it will be recapitalized through market-basis equity infusions from the state-financed Fund for Orderly Bank Restructuring (FROB) for a period of up to five years.
These developments were great news for Spain and by extension the entire eurozone. One can only hope that the new European Banking Authority (EBA) and other eurozone governments take lessons from Madrid in how to implement the next rounds of European Union banking stress tests. A minimum of 8 percent Basel III core capital, and government equity-based recapitalization in case of failure, would be a great starting framework for those stress tests!
Unfortunately the Spanish government, and in particular Finance Minister Elena Salgado, proceeded to snatch defeat from the jaws of victory by communicating badly with financial markets. Rule number one when any government tries to reestablish confidence in a banking system (which is inherently based on trust) is that a "big number" is required to change the minds of the financial market herd. You "go big" to create an overwhelming response sufficient to affect the opinions of even the most skeptical market Cassandras. The $700 billion Troubled Asset Relief Program (TARP) and the €1 trillion "EU-IMF response" in May 2010 were cases in point.
The last thing a government should do in this situation is lowball the required capital estimate (and by extension its willingness to address the issue), something financial markets will inevitably see through.
In the case of the "expected capital shortfall" in the Spanish caja sector, several market estimates had been floating around from investment banks and rating agencies. A government estimate that came in lower than the market consensus was likely to be condemned by market participants (banks and rating agencies) that have already published their own higher numbers. Sensationalist financial media and (especially) blogs—where crisis always sells better than solutions—will be eager to convey such denunciations, which will then be picked up by the many other market participants too lazy to do their own fundamentals-based analysis. And soon a superficial negative market consensus will have been established, which any government will subsequently struggle to overturn.
Why Spanish Finance Minister Elena Salgado, in presenting the new initiative, chose to state that "preliminary estimates by the Bank of Spain on the capital needs of the country's banking sector are below €20 billion," and "that doesn't mean that the FROB has to contribute €20 billion" is mystifying. It suggests a failure to understand financial markets—which is troubling at this stage in Europe's sovereign debt crisis.
The Spanish government must have known that most private sector estimates of the capital shortfall in the caja sector range from €40 billion to €90 billion,1 much higher than Salgado's figure. Why did she offer this estimate to the press? It is particularly incomprehensible because €20 billion isn't apparently even the amount the Spanish government is willing to commit to. The official press statement states:
"In the event of a failure to cover the capital needs through the market, the FROB will act as a backstop, in compliance with the EU regulation on state aid."
Since the FROB can be leveraged with a sovereign guarantee up to €99 billion (and has so far lent out only €11.6 billion), the implication is that close to €90 billion would be available for cajas' recapitalization from this source in the worst-case scenario. Financial markets—especially conservative investors in what was until recently considered risk-free government bond markets—care about the worst-case scenario, and not about government estimated losses.
It would have been better for the reception of this new and constructive Spanish banking policy initiative if Elena Salgado had kept silent about what the Spanish government thinks are the likely expected losses. Simply restating the eurozone mantra that "we will do whatever it takes to…" would have sufficed.
One can speculate that the Spanish government was fearful that too high a caja loss estimate would be perceived as a threat to the solvency of the Spanish government itself. After all, it was the reckless willingness of the Irish government to accept all the losses of its banking sector that ultimately caused Irish government finances to collapse. However, given Spain's low existing government debt and much reduced general government deficit levels in 2011, few would doubt that borrowing even the full amount of close to €90 billion in the FROB (about 8 to 9 percent of GDP) would be a serious problem. This is especially so as these extra borrowed funds would be earmarked to solving the number one outstanding financial problem in Spain.
Excessive fear of conjuring up a Spanish version of the "sovereign banking sector feedback loop" may have taken the communication off track and undermined the reception of this important new initiative. Elena Salgado cited "low expected losses to the Spanish government" and even surmised that some of the €20 billion might come from private investors, rather than the Spanish government. This would, of course, be a good thing. But her comments have allowed the superficial headline-driven financial market herd to become convinced that this new and extremely constructive initiative, which—apart from forcing much needed new transparency and new capital in the caja sector—could end up with the full or partial "privatization" of a very large segment of the Spanish retail banking market.2 That is a big, big shame.
Sadly, spin often matters more than substance in many financial markets. It's time for Europe to learn this lesson.
Notes
1. Other private sector estimates are lower at just €15 billion. See Goldman Sachs European Weekly Analyst January 20, 2011, "Spain: Sustainable."
2. I am indebted to my colleague Angel Ubide for this important long-term point and other helpful comments to this piece.