Andrés Iniesta took his opportunity in the World Cup final, but will Spain take advantage of the chance offered by stress tests to restore market confidence in its financial system and economy?
It’s a question that Jacques Cailloux, chief European economist at RBS, has been debating with his colleagues, and his conclusion is that Spain will fluff the chance to restore international investors’ confidence in the medium term solvency of its banking sector (emphasis ours throughout):
We estimate that the Spanish banking sector needs additional capital of between €50bn (central case stress with 5% sovereign debt haircut) and €90bn (with 30% sovereign debt haircut) to rebuild confidence in its solvency. This means recapitalising the banking sector to worst case “what if” asset quality stresses, as we see negative sentiment receding only if weak financial institutions are overcapitalised and de-risked. These recapitalised institutions would then have the option to repay capital should the out-turn be more benign.
We, however, expect the BoS/CEBS to publish much lower capital shortfalls for its weak banks, as suggested by loss assumptions agreed with the Caja Madrid SIP in its recent FROB recapitalisation. If the total banking sector recapitalisation is <€20bn as we expect, then we believe the Spanish banking sector will continue to be weak with falling profitability trends, as wholesale funding costs remain high and credit supply is reduced.
But let’s imagine for the moment that the Spanish don’t fluff their big chance. How would a €50bn recapitalisation be funded? Cailloux says the obvious answer is the European Financial Stability Facility, providing its mandate could be adjusted.
How that stress test is funded will likely depend on the severity of the test. A relatively mild stress, which involves a relatively small capital injection, could probably be managed domestically. A more severe test would have in our view to be partially or entirely funded overseas. There is already a structure in place – the European Financial Stability Facility (EFSF) – which could be used to deliver the funds. The EFSF enjoys government guarantees which will allow it to raise funds cheaply in the market. It was put in place to support sovereigns that were under stress in the bond market, and it is not immediately obvious that its’ mandate can be adjusted overnight. But given the alternative – ratifying a new structure – the EFSF still looks like the best show in town.
We believe that the authorities must implement a demanding stress test. Our own analysis suggests a figure of around Eur50bn for the total capital injection. This is a price worth paying to win back the confidence of the market. Once the banks are recapitalised, they are better placed to regain access to funding markets on their own feet, and therefore to support their existing asset portfolios and the new lending that is required to put the economy back on the road to recovery.
As a warning to Spain, Cailloux concludes his note by looking at what would happen to Spain and the eurozone in the event of a “credit event” that would lead to a 30 per cent haircut on Spanish sovereign debt.
Those of a nervous disposition should look away now.
Our analysis suggests that a sovereign credit event of that magnitude would lead to huge financial losses – around Eur400bn for Spain and Eur1.3tr for the rest of the euro area, equivalent to 40% and 15% of Spanish and euro area GDP respectively. On top of these financial shocks the real output losses following the default based on historical precedents would be of 10ppts for Spain and of 1ppts for the rest of the euro area. The risks of such outcome materialising must be avoided at all costs making the case for a comprehensive policy intervention overwhelming. A credible stress test is one part of that package. But the Spanish government may need to draw on support if it comes under attack in the bond market. The solution has to be a no-additional-strings attached backstop facility.
If that’s a reason not to fudge the stress tests, we don’t know what is.
Related link:
When is a stress test not a stress test? – FT Alphaville