Open Europe Blog

A heavy going blog post for a Friday afternoon, but you can digest it over the weekend (lucky you!). One of the key themes we highlighted in our recent briefing, comment pieces and general coverage on Spain is the importance of the sovereign banking loop.

The idea here is that the fate of the Spanish banks and the Spanish state are becoming increasingly intertwined. The two are always connected: if a state goes down normally its banks will too, while if banks fail the state often has to bail them out to support itself (or at least that is the prevailing logic).

As the eurozone crisis has progressed numerous states (PIIGS) have had significant trouble funding themselves (selling debt). In many cases the only people willing to buy a sovereign’s debt has been their domestic banks. In turn, a situation arises where banks pile more and more risky debt while the state becomes entirely reliant on them for financing. Far from ideal.

The unlimited ECB lending and the LTRO has only exacerbated this cycle and there is a strong correlation between increased reliance on ECB funding and the sovereign-bank loop – Spanish bank borrowing from the ECB jumped by €75bn in March, an increase of 50%.

An editorial in the FT today argues that the Spanish government has done well to avoid recapitalising its banks at cost to taxpayers, especially since many of the banks could fail without bringing down the state. This is undoubtedly a positive thing – taxpayers should be kept out of the equation as much as possible as taxpayer-backed bailouts invariably create the wrong incentives (i.e. moral hazard).

But for intellectual honesty, it’s also vital to account for all sides of the sovereign-banking loop.

As we noted in our recent briefing the primary aim should be to force banks to recapitalise themselves and ensure they have sufficient provisions against bad loans. However, if they get into significant trouble the chance of a self-fulfilling bond run on Spain increases significantly as the domestic banks stop buying bonds. This could push the whole country into a bailout, which the eurozone could barely (if at all) afford.

This situation is a clear side effect of the failed policies taken on by the eurozone and the ECB, which we have long argued against – failing to tackle the underlying back solvency problems, loading them up with cheap liquidity and encouraging them to fund struggling states was always going to lead us here. Unfortunately, given the state of affairs now, suggesting that Spanish banks are too small to bring down the state misses how dependent the state is on cash from domestic banks.

A Spanish banking crisis and the ensuing bond run on Spain are very real threats to the eurozone. The Spanish government needs to push banks to increase provisions against losses and a thorough stress testing would go some way to highlighting just how much they need. We are loathe to suggest any cost be transferred to taxpayers, but realistically (given the eurozone’s bail out policy) this option may what the Spanish government and eurozone leaders have to go for in the end, either through the FROB (Spanish bailout fund) or the ESM (eurozone bailout fund). If so, it’s of course extremely important that any funds should come with strong conditionality including giving the government preferential shares and equity warrants as well as forcing banks to produce ‘living wills’.

But whatever happens, eurozone leaders must stop seeing a bail out as an end in itself. If it comes to that, unlike the ongoing ECB and bailout operations, any injection of funds should be part of a full assessment of the viability of the institution with fair consideration given to the prospect of winding those down that don’t have a sound financial footing for the long term. Banks must simply be allowed to fail. Ultimately, purging the bad practices and poor management which helped fuel the boom and bust in Spain will be vital for the long term health of the banking sector and the economy.

The link between the health of the Spanish banks and the health of the Spanish state remains very strong – unfortunately neither is looking in a good position right now.

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