Fact du jour — Spanish debt-to-GDP ratios aren’t actually (relatively) that bad.
In terms of eurozone contagion then, what tends to spook investors is really the possibility of a banking crisis swiftly feeding into Spain’s public finances — especially given that Spanish banks are still quite reliant on short-term wholesale funding.
It’s a point made with some force by a host of UBS analysts on Friday:
Banks recapitalisation is the key event, in our view: we believe investors remain concerned about the Spanish banking sector’s asset quality and provisioning, as well as a funding structure which relies significantly on wholesale markets compared to other retail banks in Europe, albeit less than investment banks. We believe that the Spanish banking sector will have to face larger writedowns of loans and real estate and will have to re-balance its maturities structure by replacing short-term wholesale funding with more stable sources, such as time deposits and long term bonds, a process that may be under-way.
Indeed as UBS note, Spain’s banks still look like they’re at the start of a loan loss provisioning cycle (provisions = the stuff banks set aside to cover soured loans) even though the financial crisis is now more than two years old.
This is in part due to Spanish accounting rules, which allow the banks to spread provisions over relatively long periods of time (think up to six years for residential mortgages). These rules are now changing, but perhaps not soon enough.
UBS writes:
As a result, while under several metrics Spain has been among the countries worst hit by the financial crisis, Spanish banks have shown among the lowest cost of credit in Europe (on average 60-80bp for the past two years) while their reported [non-performing loan] NPL coverage has been falling from well above 200% before the crisis to approximately 62% currently, including the generic provisions. We see the new provisioning rules implemented from Q3-10 as a positive step towards strengthening the provisioning system and making it more comparable to European peers.
As for those actual NPL coverage ratios — officially reported at 62 per cent according to UBS — they may in reality end up being much lower. The Swiss bank reckons the real number amounts to just 30 per cent. That includes UBS’ estimates for substandard loans and foreclosed-upon real estate on the banks’ balance sheets.
So what would be needed to boost market’s confidence in Spanish banks?
How about €60bn, or even €89bn? Says UBS:
We think that the current level of provisioning for Spanish banks, particularly when taking into account a broader definition of risky assets (i.e. including substandard loans and real estate re-possessed) not only leaves little room to release reserves, but suggests that banks and their regulators should be inclined to take a more conservative stance going forward. While we do stress that the lack of visibility on the size and quality of collateral may undermine the simplistic considerations (for instance, of course NPLs in residential mortgages should require a lower coverage than consumer finance), we also believe – based on our experience of the potential credit losses in troubled real estate markets (Ireland, US, etc.) – that a substantially higher coverage ratio would help funding markets to regain confidence in banks. While we have no detailed visibility on collateral, for illustrative purposes we calculate that taking coverage to 50% on all problematic loans would require €60bn additional provisions, taking coverage to 60% would require €89bn (70%: €118bn).
The good news is that those sort of figures would only amount to about 10 per cent of Spain’s GDP, according to UBS, and would increase debt-to-GDP ratios to about 75 per cent — which is lower than the EU average of roughly 83 per cent.
The bad news is that those recapitalisation figures are quite literally moving targets and predicated largely on stability in the wholesale funding markets.
Something which isn’t certain at all.
Related links:
Spanish banking negativity – FT Alphaville
The Spanish (asset) Elimination - FT Alphaville
Contagion fears over ‘too big to bail’ Spain – FT