The crisis in Spain’s financial system has moved into a new and important stage. In early May, the government of Mariano Rajoy decided to nationalize Banco Financiero y de Ahorros (BFA), a bank that has been 100% owned since 2010 by the seven “cajas” (Spanish-style savings banks) that compose Bankia. It will be the eighth institution taken over by the government since the financial crisis broke out in 2008, and it is the most important to date. Bankia has 10 million customers in Spain, and its assets are valued at 340 billion euros or US$427.85 billion.

The nationalization of Bankia will take place through the conversion into shares of the 4.465 billion euro loan granted by the government to BFA-Bankia in 2009 through FROB (The Fund for Orderly Bank Restructuring), created that year to manage the restructuring of the Spanish financial system. Spain’s minister of economics explained in a public announcement on May 9 that the decision has been taken in order to “guarantee solvency, the tranquility of depositors, and to dispel doubts in the markets about the institution’s capital needs.”

Joaquin Maudos, professor of economic analysis at the University of Valencia in Spain believes that nationalization “is the only solution that can resolve the institution’s solvency problems.” According to Maudos, auditors at Deloitte have estimated that the firm recorded a deficit of US$4.4 billion at the end of 2011, which happens to be the same amount as its net assets, “so the restructuring of this deficit means reducing the institution’s asset value to zero.” Given the situation, he explains, the only way to resolve the problem was to convert the loans from FROB into ordinary shares, which means the nationalization of BFA-Bankia.

Santiago Carbó, professor of economic theory and history at the University of Granada, also considers nationalization inevitable. He adds, “Now the first and foremost mission for the institution and its new administrator is to undertake an important effort at transparency, and establish various mechanisms for obtaining the resources needed for guaranteeing the viability of this financial institution.”  Jose Ignacio Goirigolzarri, a Spanish banking executive, has assumed the presidency of Bankia in place of politician Rodrigo Rato.

Luis de Guindos, minister of economics and competitiveness, told the Congress on May 23 that the government would contribute all of the funds necessary for restoring confidence to the Spanish financial system but that the government intends to get back that money. Although he said that Bankia would need 9 billion euros of public funding, he revised that figure to 19 billion euros on May 25. As of today, the cost of rescuing the institution is an estimated 23 billion euros — the original 19 billion euro figure plus the 4.465 billion euros that Bankia has already received. In dollar terms, the total sum is US$28.9 billion, making it the most expensive bank rescue in the history of Spain.

The government will immediately contribute 4.46 billion euros that will be converted into shares in order to take over Bankia. The bank has pending regulatory needs for 7.1 billion in provisions, plus a buffer or cushion of capital that the minister estimated at 1.9 billion euros. That way, the government’s exposure to the institution will rise to more than 13.46 billion euros (US$16.9 billion).

The leading question now is what the Spanish government plans to do for the institution. Citing anonymous sources close to Mariano Rajoy, Reuters noted in a May 17 article that the prime minister plans to restructure, downsize and sell the bank over the next three years — the maximum legal period during which the government can maintain control of the institution. The article asserted that other big Spanish banks such as Santander, BBVA and La Caixa could view BFA-Bankia as a tempting target for gaining more market share or for directly acquiring areas of business activity that BFA-Bankia might be able to sell off.

Nevertheless, Carbó notes that Bankia “is an institution that is too big and too important to be easily divided up and sold off; as they say in English, it is ‘too big to fail’ and unwind.” He adds that “the government has put capital into BFA-Bankia, and it will surely be there for several years, until the various options become totally clear. If BFA-Bankia carries out a successful plan, the institution could re-purchase part — or in the best case scenario, all — of the capital invested in it by the government.”

Maudos predicts that “once the financing is injected, Bankia will have to complete its restructuring process — reducing its network of banks and its head count to cut its costs — and must get rid of some ownership positions where it has amassed capital gains … in order to improve its solvency.” He believes that it will not be easy for Bankia, at least over the short term, to wind up in the hands of other institutions, given its size and the fact that the bank will need more money to cover the new provisions established by the government. He asserts that “the best thing will be if the government has enough time to re-launch the institution and, once it is restructured, look for possible buyers or even divide up the institution.”

Just the Tip of the Iceberg?

Bankia’s difficult position is the clearest example of the delicate situation that the Spanish financial system is in at this point. Spain’s banking sector has been severely damaged by the bursting of the real estate bubble that, along with the international crisis, sent Spain into a recession from which it has still yet to recover.

According to the Bank of Spain, the country’s banking system had an exposure to the real estate sector of US$387.5 billion at the end of 2011. Of this total, some US$231.4 billion represented either toxic or problematic assets. In the real estate construction and development sector, the rate of arrears was 20.9% at that time. Bankia is one of the institutions most exposed to real estate, with some US$47.18 billion in that sector. Of that total, 84.7% of the loans are considered problematic, according to the CMV, the commission that regulates Spain’s national stock exchange.

These figures have caused international investors to lose confidence in the Spanish financial system and, as a result, in the solvency of the government, since those investors believe that the government could be forced to invest more public funding in order to help the sector.  Doing that could make it impossible for Spain to comply with its goals for reducing the government deficit, while also increasing its debt. As a result, financing costs in Spain have risen considerably since the beginning of the crisis, to the point where people are discussing the possibility that the country might have to ask the European Union for financial assistance.

Mauro Guillen, professor of management and director of the Lauder Institute at Wharton, notes, “so long as the economy does not recover, one bank after another will have problems” because “a financial system cannot withstand a recession that goes on for years.” In his opinion, to the extent that banks are experiencing such problems, they will have to be rescued, “but Greece and Spain and the peripheral countries do not have enough resources to rescue banks indefinitely.”

Michele Boldrin, professor of economics at Washington University in St. Louis, believes that the nationalization of Bankia and other financial institutions should have been undertaken two years ago. “A series of Spanish banks and [Spanish-style] savings banks [known as “cajas”] are bankrupt because of the managerial incompetence of politicians, and they are paralyzing the Spanish financial system and the country,” he says. Boldrin adds that what is happening in Spain is similar to what happened in the United States in 2009, “but the difference is that the clean-up of the financial system took place [in the U.S.] very quickly, and here the process has already taken two years, and they have not managed to solve the problem.” Boldrin believes that appropriate measures won’t be taken in Spain because “that would mean that political power would lose control over the financial system, which is something it is resisting.”

The Second Time Around

In an effort to dispel such doubts, the government approved new measures for the banking system on May 11. Now known as the “second phase” in the reform of the financial sector – following the first phase, which was carried out in February – the reforms will raise the requirements for the provisions that banks need in order to cover their possible losses in problematic real estate assets. This means that institutions will have to make provisions for US$68 billion of bad debt.

This time around, Spain’s executive branch has decided to increase the generic provisions for banks by 7% to 30% in order to cover deteriorating mortgages on non-problematic assets, estimated to be US$155 billion. In practice, this means that they will need provisions covering US$38 billion. These new capital requirements will be charged to their financial results.  Those institutions that don’t have enough capital after this restructuring will have to capitalize themselves in the marketplace or, if they are unable to do so, they will be able to apply for assistance from the government, which will grant them public-sector loans at a 10% interest rate.

In addition, by the end of 2012, banks will have to put their toxic assets that are tied to real estate into separate, independent institutions. That is to say, they will have to create what people are calling “bad banks.” Finally, the entire portfolio of assets owned by Spanish banks will be evaluated by independent experts appointed by the Ministry of Economics.

“These measures go in the correct direction, including the still pending valuations,” believes Carbó. However, in his view, their success will depend in part on how the various measures are carried out and, to an important degree, how clearly they specify where they are going to get the resources for financing the possible needs for restructuring and recapitalization that emerge during this process. “This requires specifying not only what kind of assistance may be possible today but also what may be needed as the macroeconomic deterioration worsens. This is about support — establishing a guarantee or backstop that is fundamental for calming markets and that is still not entirely clear,” says Carbó.

According to Maudos, it is not so clear that these government measures are going to dispel doubts about Spain’s financial system. The two last phases of the reform have focused on cleaning up exposure to the real estate sector, which is the most problematic area and generates the most doubts in the markets. He warns that commercial real estate loans represent only 20% of the entire credit portfolio, and that there is another 80% of the portfolio that includes mortgage loans for housing (valued at more than US$754 billion); loans to small and midsize companies; loans to large corporations, and so forth. These kinds of loans will also have to be addressed carefully. “If the macro situation shows negative GDP growth rates in 2012 and 2013, and the quality of all these assets deteriorates, this is where investors believe that current provisions are not sufficient,” he notes.

“We’ll have to wait and see the results of the assessments of the two independent appraisers and the three later audits [which will be done for the Spanish financial system] in order to find out about any possible shortfalls in provisions. If the figure is reasonable, it will be addressed through FROB [which will issue debt to help these institutions], but if it is very high there will be no other remedy but to ask for external aid,” he argues.

As for the total amount of funding required, Carbó believes that it is hard to determine. “It could be more than the nearly 15 billion euros that the government has estimated, but I believe that the total cost to the government of assisting its financial sector will continue to be lower in Spain — relative to the country’s GDP — than it was in neighboring countries,” he says.

According to Michele Boldrin, the government has to directly attack the bad things about the Spanish system, and root them out. “They have to restructure those institutions that have problems and recapitalize them. In the current economic context, only the government can do that.” However, financial aid from the EU will be needed because the government will not be able to issue enough debt to raise the capital needed to carry out this process. Boldrin supports the idea of “Europeanizing the Spanish financial system,” so that Spain “reaches an agreement with Europe to change the incompetent administrators of the institutions that are taken over and, finally, after structuring them, to sell them on the market.”

Boldrin believes that it would be useful for banks to purchase foreign institutions that have been restructured in order to create a more open and competitive market. “If, at the end of the process, only four big Spanish banks were left [standing], and they had a lot of power, then that would create an oligopoly that is very bad for the financial system and the economy of the country, which would depend too much on them.” Even if these banking giants are created, there should be a great deal of international diversification in Spain, so that Spanish banks only have about 10% of the market in their country, she adds.