Monday, May 21, 2012

Spain Introduces New Reforms to Clean Up Its Banking Sector

On Friday May 11, 2012, the Spanish government introduced new reforms to clean up its banking sector. The Spanish government has struggled to correct its banking crisis, which occurred in 2008 with a property bubble burst—rapid increases in the value of real estate properties to the point of unsustainable levels and ultimately lead to a drastic drop in value. These new reforms mark Spain’s fourth attempt to correct its banking crisis in the past three years and come only a few days after the government part-nationalized the country’s fourth largest bank, Bankia, by claiming a 45% stake. The country’s past reform attempts were likely unsuccessful because Spain’s approach of making gradual changes to its banking sector was not enough to offset the receding economy and falling property values.

The Spanish government imposed two main reforms. First, banks must set aside an additional 30 billion in provisions to cover potential bad loans—provisions, also known as loan loss reserves, require banks to increase their capital. Banks must meet certain capital/asset ratios (also known as capital requirements). For instance, if a bank needs to write-off unpaid loans (assets), then the bank must increase its capital in order to meet the specified capital requirements. Thus, Spain increased the bank's capital requirements to ensure that the banks would have sufficient capital in the event of loan write-offs.

Spain’s provisions cover 45% of a bank’s real estate assets when added to the 54 billion provision increase mandated this past February. The Spanish government decided to allow banks one month to develop a plan to meet the extra provisions. The government also decided to offer five-year loans with a 10% interest rate to those banks struggling to find capital. If a bank fails to pay back these five-year loans, then the loan converts into shares. Therefore, if the bank fails to pay, the government becomes a part owner of the bank.

The second reform is to hire two independent auditors to value the banking sector’s assets. The Spanish government agreed to hire independent auditors after its recent takeover of Bankia. This is because past auditors refused to sign off on Bankia’s accounts when they discovered discrepancies over the value of foreclosed properties and the value of junk loans—loans with a high risk of default. Thus, Spain likely hired independent auditors in hopes that their outside perspective will reveal other discrepancies similar to those discovered in Bankia’s accounts. While the auditors have not yet been identified, Spain’s Economy Minister Luis de Guindos ensured that the auditors have “maximum international prestige.” The hiring of independent auditors with such “international prestige” ensures credibility and confidence in Spain’s banking reform efforts.

Although the International Monetary Fund (IMF) managing director Christine Lagarde welcomed and praised these reforms, others remain skeptical. Many economists, including Columbia University’s Xavier Sala-i-Martín, believe that the 30 billion increase is not enough. Instead, some economists propose that an increase of  50 billion is necessary.  Other economists worry that the reforms and the nationalization of banks like Bankia will leave Spain with greater debt in the future. This is because the five-year loans Spain offered to banks to finance the required provisions as well as Spain’s nationalization of Bankia could leave the country without reimbursement of its loans to banks and with a large ownership share in failing banks that have little hope of turning a profit. Even investors are skeptical as shares in Spain’s top three banks, which include Banco Santander, BBVA, and Banco Popular, all fell in response to the announcement of the new reforms.

The European Commission recently forecasted that Spain would fail to meet its imposed budget deficit target next year, which is 5.3% of its gross domestic product (GDP). Instead, the European Commission projects Spain’s budget deficit to be 6.4% of its GDP. This suggests that Spain’s austerity measures—policies of drastic cuts on government spending and/or increases in taxes—are not as effective as originally thought. However, these projections do not account for Spain’s newly introduced banking reforms. The Spanish government views the banking sector as a key component to the country’s overall economic recovery and is hopeful that these reforms will help the country meet its future targets as well as restore the banking sector that has continued to struggle since 2008.

No comments: