Spain Cleans Up Kitchen With Bank Tests as Bailout Looms

When Spain reveals the size of the hole in its banking system with the publication of stress test results later today, the credibility of that estimate risks being undermined by a deteriorating economic outlook.

The test conducted by Oliver Wyman on 14 banking groups is a precursor to the formation of a so-called bad bank to which troubled lenders will transfer soured real estate to bolster their balance sheets. The results will be released after the market closes in Madrid.

The independent stress test to assess the damage wrought by the property crash is a condition of Spain’s 100 billion-euro ($129 billion) banking bailout agreed in July. Spain must present convincing estimates of banks’ capital needs and realistic valuations of toxic real estate assets to spur investment and economic growth, said Ron D’Vari, chief executive officer of NewOak Capital Advisors, a New York-based financing advisory and investment banking firm.

“If people see one cockroach in the kitchen, they’re going to assume you have another 10 hiding somewhere and that is the problem Spain has had with its banks,” said D’Vari, a former head of structured finance at BlackRock Inc. “They have to be seen to be coming clean and being realistic so that the cockroaches get chased away.”

Budget Plans

Spain says it’s following a road map for recapitalizing and restructuring its banks as part of a broader effort to fix its economy.

Today’s stress test results follows last night’s announcement of Spain’s 2013 budget, which outlined the government’s plans to freeze public wages, end tax rebates on mortgages, tax lottery winnings and cut ministry spending. Spain is committed to cutting its budget deficit to 4.5 percent of economic output next year compared with a 6.3 percent goal for 2012.

The Oliver Wyman stress test follows government orders to banks in February and May to recognize 84 billion euros of losses on real estate assets and a royal decree last month that lays out a legal framework for dealing with failing lenders and setting up the bad bank. A preliminary stress test in June by Oliver Wyman and Roland Berger Strategy Consultants showed banks would need as much as 62 billion euros of additional capital in a worst-case economic scenario.

Dispelling Doubts

Economy Minister Luis de Guindos said Sept. 22 the capital needs of banks in the stress test will be about 60 billion euros, similar to the previous Oliver Wyman estimate. The state aid required by weaker banks will depend on how much capital they can generate by selling assets or transferring them to the bad bank, the economy ministry said Sept. 14.

Some analysts are skeptical today’s announcements will dispel doubts about the weakness of some lenders.

“There’s no right answer for how much capital the Spanish banks will need but they at least need to exceed people’s expectations,” said Daragh Quinn, an analyst at Nomura International in Madrid. “The real experience of the banks shows that losses just go up to the extent that the economy gets progressively worse.”

Barclays Plc predicts Spanish gross domestic product will shrink 1.8 percent in both 2012 and 2013, while Morgan Stanley expects a 2.2 percent decline this year and 1.3 percent next. The Oliver Wyman stress test published in June assumed a contraction of 4.1 percent this year, 2.1 percent in 2013 and 0.3 percent in 2014.

Credible Shortfall

While the Oliver Wyman worst-case analysis tests Spanish banks against a 6 percent core capital ratio threshold, the effective rate, including a buffer, was 9 percent in Ireland, according to Nomura’s Quinn.

The best result for Spain’s stress test would be to reveal a “credible” capital shortfall for the industry of 70 billion euros to 80 billion euros, said Simon Maughan, a financial industry strategist at Olivetree Securities in London. “If it’s any more than that, there’s a problem because there’s not much bailout money left over.”

The banking cleanup and bad bank is part of a broader effort by Spain to convince investors and European politicians that it’s serious about fixing its economy. After agreeing to seek a banking bailout in June, Prime Minister Mariano Rajoy is considering whether to seek a further aid that would allow the European Central Bank to buy Spanish bonds to bring down the country’s borrowing costs.

German Backing

German Chancellor Angela Merkel still has to seek approval from Germany’s Parliament for Spain’s bailout and Rajoy can smooth that process by showing his country is serious about mending the banking system, said Holger Schmieding, chief economist at Berenberg Bank in London.

“Whatever the number is that comes out of the stress tests, there will always be people in the markets that question it,” said Schmieding. “What really counts is that Merkel can have the arguments she needs to go before her Parliament to ask for money for Spain.”

Getting political backing for the bailout also depends on transfers of real estate to the bad bank being done at “broadly realistic” valuations, said Schmieding.

“Obviously the price at which assets get transferred is very relevant because the bad bank in Spain could become very bad,” said Edward Thomas, who helps oversee $6 billion as head of fixed income at Quantum Global Wealth Management in Zug, Switzerland. “The risk is that the Spanish government may end up recapitalizing the banking system by taking these assets off balance sheets of the banks at the wrong mark to market.”

Precautionary Measure

The stress test will categorize banks, with Group 0 being lenders that have no additional capital requirements and Group 1 those that have already been nationalized, such as the Bankia (BKIA) and Banco de Valencia. Group 2 will include other banks with capital shortfalls that need of state aid.

Group 3 will comprise lenders deemed to be capable of covering capital deficits without government help. Those with a shortfall greater than 2 percent of risk-weighted assets will have to take support from the state as a precautionary measure by issuing convertible bonds to the government’s bank rescue fund.

Banco Popular Espanol SA, a bank specializing in corporate lending, said Sept. 25 it was presenting “arguments” to Oliver Wyman over its treatment of certain asset portfolios in the stress test in the belief that it won’t need government support.

Banks in Group 2 could include Banco Mare Nostrum and Liberbank, Fitch Ratings said in Sept. 26 report. Popular (POP) could be among lenders in Group 3, according to the ratings company.

Boosting Consolidation

The process may lead to more consolidation among Spanish lenders with the best opportunities to boost market share falling to the biggest banks, including Banco Santander (SAN) SA and Banco Bilbao Vizcaya Argentaria SA (BBVA), said Quantum’s Thomas.

Santander CEO Alfredo Saenz said in a Sept. 25 presentation in London that as many as 15,000 bank branches would close in Spain in coming years and that “subscale” banks would be absorbed by stronger ones.

“Mergers in banking sectors that are in trouble is the right way to go, but the government clearly has to keep a strong handle on the process and be very clear on what the benefits of the merger are,” said Thomas.

To contact the reporter on this story: Charles Penty in Madrid at cpenty@bloomberg.net

To contact the editor responsible for this story: Frank Connelly at fconnelly@bloomberg.net

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