22 June 2012 Kick-off or full time?

The funding needs of Spanish banks and whats next for Spain Key Points The IMF estimates of 40bn for Spanish bank recapitalisation look too low. We estimate that the banking sector needs between 90bn and 110bn, meaning even the expected 100bn rescue package may not be enough. The amount needed could further increase if banks struggle to raise provisions against losses on top of their capital requirements. The external stress tests announced yesterday are equally too low given that they worked from current data, which may be insufficient or incorrect. We expect that this package, along with higher borrowing costs, could increase Spanish debt to 94% of GDP in 2013 and 112% in 2015 (with only slightly lower growth than expected). This package will intensify the sovereign-banking-loop in Spain as banks come under more pressure to load up on Spanish debt. Unless the far-reaching problems in the Spanish banking sector are resolved which looks unlikely further reinforcing this loop could eventually force Spain into a full bailout (as the burden becomes too much for one side to stand). This is something for which the Eurozones current bailout fund would not be equipped. Ultimately, Spains problems are not confined to its banking sector. The state faces funding costs of 548bn over the next three years, as well problems controlling regional spending and encouraging economic growth all of which, again, makes the risk of a full bailout for Spain more likely. Therefore, in order to avoid the plan being counterproductive, stabilising the countrys banking sector in longer requires the right conditions including bail-ins and bank wind downs. The ESM will not be in place to provide the funds, meaning that the EFSF will have to. This reduces questions over seniority but will lead to demands for collateral from Finland a messy issue which could itself prompt seniority concerns. We estimate that total exposure of EU countries to the Spanish economy is around 913bn, a huge amount which highlights the vital importance of ensuring that this rescue package works the first time around.

The plan Spain will access a loan from the EFSF/ESM (the eurozone bailout funds) which it will use to recapitalise its ailing banking sector. The money will be channelled through the FROB (the Spanish bank restructuring fund) but will still be a state liability as it will not go directly to the banks. However, unlike the other bailouts it will not come with fiscal conditions but only conditions for reforming the financial sector. The total level of funds needed will be decided by the Commission, IMF and the ECB in conjunction with the external stress tests conducted by Oliver Wyman and Roland Berger as will the exact reforms needed by the financial sector. 1. Is the rescue package large enough? Despite initial relief at the announcement of the Spanish rescue, markets quickly turned the pressure up as questions over the size and structure of the package took hold. In the past two weeks we have seen Spanish borrowing costs increasing across the board, with ten year bond yields staying above 7% for sustained periods.1 1.1 Are the IMF estimates too low? The most important question relating to the package is whether it will be large enough, and if so, how much is likely to be tapped. The IMF suggested the needs would be 40bn in an adverse scenario. The Berger/Wyman stress tests put the recapitalisation needs at between 16bn and 62bn. The market estimates mostly fall in the range of 60bn to 90bn. There are a number of reasons why the IMF and similar estimates should be considered too low: The Spanish government has already said that between 30bn and 50bn1 will be needed to recapitalise a few smaller savings banks between 10bn and 30bn more than the estimates the recent IMF report for these banks. The IMF assumes a fall in house prices of 24% over the next two years. However, we expect it to be closer to 35% (as seen in Ireland). Scaling the IMF estimates up based on these figures (a reasonable assumption given that most losses will stem from exposure to the bust real estate and construction sectors) suggests that, under our scenario, needs could total closer to 60bn. Furthermore, the most adverse scenario only sees banks taking a core tier one capital ratio of around 7%. This may suffice for some of the larger stronger banks, but will be too low for many of the cajas (regional banks). This proved to be the case for Bankia, while in Ireland similar problems hit the Bank of Ireland and AIB which had to increase their capital ratios to 14% and 18% respectively.2 Further extending the IMFs estimates to meet a 10% tier one capital ratio, a fair average given the 400bn exposure to the bust real estate and constructing sectors, would add another 20bn onto the recapitalisation needs.

These are broad strokes, but building upon the IMF figures we would expect the needs to total between 90bn and 110bn, particularly if they are to secure the banking sector against further downturns in the Spanish economy and a potential worsening of the eurozone crisis (i.e. a Greek exit).3
Including, Bankia: 19bn; and CatalunyaCaixa, Banco de Valencia and Novagalicia: 11bn to 30bn This is not a hard and fast threshold above which debt becomes unsustainable but it does generally give a good indication that markets are becoming increasingly concerned and the prospect of a self-fulfilling bond run looks possible. 2 Cited by FT Alphaville, Bankia going GUBUbut what about the rest, 28 May 2012: http://ftalphaville.ft.com/blog/2012/05/28/1018331/bankia-going-gubu-but-what-about-the-rest/ The external stress tests do extend the core tier one capital target to 9%. 3 These estimates build on our more detailed breakdown of Spanish banking needs provided in our April 2012 report, Not so bullish now: the short term prospects for Spain inside the euro, where we estimated that the loan
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Even this could be a lower bound though. The IMF estimates do not tackle the issue of forbearance (loan repayments which have been delayed so that banks can avoid taking losses). These are the loans which are likely to default first and most quickly. There is anecdotal evidence that during the height of the crisis there was significant forbearance at play. The graph below shows that, during the financial crisis, there were a huge number of changes made to existing mortgage loans, in many cases extensions and easing of terms. As the condition of the Spanish economy continues to worsen, with low growth and high unemployment, these loans will come under more pressure and many will likely default. Ultimately, forbearance cannot continue forever ignoring the issue hides the true cost of this crisis to Spanish banks, while failing to deal with it now stores up problems for the future.

Spanish mortgages with modified conditions

Number of mortgages modified 60000 50000 40000 30000 20000 10000 0 2006M01 2006M05 2006M09 2007M01 2007M05 2007M09 2008M01 2008M05 2008M09 2009M01 2009M05 2009M09 2010M01 2010M05 2010M09 2011M01 2011M05 2011M09 2012M01

Source: INE

Additionally, the IMF estimates are based on data from the end of 2011 and so do not reflect the worsening situation in Spain this year, particularly in terms of the value of Spanish sovereign debt to which banks have a large exposure.4 In fact, the IMF procedure does not question the current value of assets at all, simply the potential impact of a deteriorating situation. As we noted back in April, the provisions against doubtful loans fall woefully short currently it stands at 83bn against 140bn in doubtful loans, with only 50bn against 80bn in doubtful loans to the bust real estate and construction sector. With our expected fall in house prices, this level could easily double. We do partly incorporate this scenario into our recapitalisation estimates above, but it also suggests that banks may need to further increase provisions against losses even with additional capital. 1.2 How will the final amount be determined? The external Berger/Wyman stress tests provided an additional assessment, with Roland Berger putting the needs at an oddly precise 51.8bn and Oliver Wyman putting them at between 51bn and 62bn both above the IMF estimate. It is worth noting though that these tests were conducted on the existing data from the Bank of Spain, while both firms ran
loss provisions for Spanish banks against real estate exposure would need to be at least doubled, see here for the full report: http://www.openeurope.org.uk/Content/Documents/Pdfs/Spain2012.pdf 4 See Gavyn Davies blog for an excellent concise run down of issues with the IMF assessments. The IMF does take into account mark to market losses for banks on Spanish sovereign debt held in trading books but not as hold to maturity. Given the severity of the situation in Spain (and our macro projections above) this is probably overly optimistic. http://blogs.ft.com/gavyndavies/2012/06/10/the-consequences-of-spains-bankrescue/#axzz1xTLGmxdV On the other hand the IMF assessment does not take account of the increased provisions mandated by the government this year which may reduce the capital needs of the banks, although since many banks are yet to fill these provisions we do not believe that will be the case.

broadly the same test. This is of concern since the problem may well be at the source of the data, given that many banks could be adjusting their figures or providing incomplete data. These tests would therefore fail to get to the heart of the problem. More extensive tests conducted on a bank-by-bank basis are expected later in the summer, although they have already been delayed once until September. However, this piecemeal approach could result in a continually increasing estimate of potential losses a situation seen during the Irish crisis (at least initially) as well as with Franco-Belgian bank Dexia and Spains Bankia. In all those cases this approach added to the uncertainty and furthered market concerns. 2. How much benefit will the rescue package offer? It is clear that the banking sector in Spain is in need of substantial recapitalisation, so any additional capital will likely provide some benefit even if it falls short of the total amount needed. An important consideration is the duration of the loans. Reports suggest the loans could last for 15 years, with an interest rate of 3% - 4% and a five year grace period on any payments.5 This represents a decent benefit compared to the 6.5%+ which Spain would pay on the market to borrow for the same duration. However, if the loans are any shorter, it would likely not provide much difference to the borrowing costs which Spain faces on the market reducing the benefit of the rescue package.6 Below we cover a few more issues which will determine the effectiveness of the rescue package. 2.1 Will adequate conditions be applied to the funds? This is a point of vital importance if the right conditions are not applied then the benefits of the package will be limited, while the negative impacts could grow. Firstly, we would strongly encourage the use of bail-ins and bank wind-downs to ensure that there is adequate cost and conditionality applied to the funds. In particular, Spanish bank bondholders are yet to take significant losses, potentially creating significant moral hazard and further heaping bank losses onto taxpayers without even trying to force the sector to stomach any of the burden. There is some hope though, in the EFSF guidelines on lending money for bank recapitalisations. Under eligibility conditions the guidelines state7: The following pecking-order in the financing of the recapitalisation should be respected. First, before considering a public intervention, the primacy of private sector contributions should be reasserted. Recapitalisation of a financial institution should be first and foremost financed by its shareholders, as the owners and those ultimately responsible for past business decisions.8 On the conditionality of funds the guidelines go further stating: Where appropriate, additional conditionality could draw from the future EU bank crisis resolution frameworkIn particular, such a conditionality could include requirements to enhance the supervisory toolbox in the three crucial phases of crisis management identified (preparation, early intervention and resolution) such as

El Mundo, Espaa atrasa la devolucin del eurocrdito a 2017, 13 June 2012, http://elmundo.orbyt.es/2012/06/12/elmundo_en_orbyt/1339530841.html 6 The obvious consideration here is that Spains borrowing costs would shoot up even further if it was suddenly to try and issue 100bn in debt, meaning the consistently low rate of the whole package is more beneficial than first appears. 7 See here for the full EFSF guidelines on recapitalisation of financial institutions: http://www.efsf.europa.eu/attachments/efsf_guideline_on_recapitalisation_of_financial_institutions.pdf 8 A footnote adds: In the future, special crisis management and resolution intervention powers for national supervisors could expand the possibilities for the private contributions via mechanisms such as bailing-in bondholders.

recovery and resolution plans, early intervention tools for supervisory authorities, asset separation tools, bail-in tools.9 In combination these guidelines do provide some faint hope that conditions relating to losses being imposed on bondholders may be incorporated and could be drawn from the Commissions latest proposals released on 6 June.10 That said, this is an issue which has been little discussed by eurozone leaders and unfortunately does not seem to be at the forefront of their thinking. However, the need for conditions in Spain goes further than just ensuring the correct use of taxpayer backed funds, if more of an incentive were needed. Despite some progress, the Spanish banking sector still needs to be substantially reformed particularly in terms of banks shedding their massive exposure to the bust real estate and construction sectors and reducing the size of the mortgage loans on their balance sheets. Banks also need to rebalance and adjust their focus away from the real estate, construction and mortgage sector this will take time but will take even longer if they are allowed to delay taking the full losses on their current exposures. Simply merging banks will not solve this problem, meaning some will need to be wound down and there will likely be the need for a series of bad banks (a proposal which has already been put forward).11 Until this is done questions will remain over the health of the sector and in turn the state which underpins it. Importantly, this will require the FROB and the Bank of Spain to play a more active role in enforcement and alter their current modus operandi of merging and consolidating struggling banks. In recent days it has become clear that the troika (mostly the Commission and the ECB) will also play an active part, suggesting that the previous failings of Spanish regulators may not be repeated although given the troika enforcement record in Greece this is far from guaranteed. 2.2 What cost will banks pay for this assistance? This is linked to the point above, but difficult to determine since the money will not be provided to banks in the form of loans per se, but as injections of equity or convertible shares.12 EU Competition Commissioner Joaqun Almunia has suggested the cost will amount to an interest rate of 8.5%.13 This is said to be down to the state aid requirements, which stipulate that any hybrid capital must carry this minimum interest rate. The cost must meet the legal requirements but we would encourage the focus to be on the conditions of the loan rather than the cost, ultimately these are struggling firms; applying punitive interest rates could do more harm than good.

Cited by FT Alphaville, No bail-in, Spain, 10 June 2012: http://ftalphaville.ft.com/blog/2012/06/10/1035781/no-bail-in-spain/ 10 See here for the Commissions full proposals, which include bondholder bail-ins and a mechanism for winding down banks, although these do not come into force for some time: http://europa.eu/rapid/pressReleasesAction.do?reference=MEMO/12/416& 11 There are some valid concerns over the reform plans for the Spanish banking sector as they stand, particularly the proposal to transfer assets to the bad banks at a reasonable book value. The idea behind the bad banks is to allow the banks to realise their losses and shed bad assets. Transferring them at optimistic values leaves them open to future write downs, a burden which will fall on the state further worsening its position. It the assets are overvalued they will also continue to delay the broader realignment of prices in the real estate sector, something Spain urgently needs if it is to rid itself of the hangover of oversupply in housing. Ireland faced this problem with NAMA. 12 The use of convertible shares is attractive but will only prove sufficient if the circumstances under which they are converted are clearly defined and are set at reasonable level allowing for the buffer to come into place before it is too late. 13 Cited by Reuters, Spain to charge at least 8.5% for loans to banks, 12 June 2012: http://www.reuters.com/article/2012/06/12/spain-banks-loans-idUSL5E8HCKCM20120612

2.3 Spains fiscal autonomy will be further limited by this programme The Spanish government initially argued that the rescue money came with no fiscal conditions, although it has cooled on this line of argument recently. But even though there will be no direct fiscal consolidation plan as in the other bailouts the room for fiscal adjustment is similarly limited. Since the bailouts of Greece, Ireland and Portugal, creditor countries and Germany in particular have put a strong emphasis on ensuring widespread fiscal consolidation and that all eurozone countries have a balanced budget within a few years this culminated in the so-called fiscal treaty. Although these adjustment programmes are not as strict as those under the bailouts, the principles are the same. Combine this with the increased monitoring under the Spanish rescue package and the reduction in scope for political negotiation, with an increasingly frustrated group of eurozone leaders, and it becomes clear that Spain will in reality have little more room for fiscal adjustment than the likes of Ireland and Portugal.14 This is all driven home by our macroeconomic projections for Spain shown below:

Spain Macroeconomic Projections

160 140 Debt as % of GDP 120 100 80 60 40 20 0 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Current IMF OE adjusted

Importantly, the rescue funds will not go directly to banks and will remain a state liability, meaning they will be incorporated into the Spanish debt levels. This could result in around a 10% jump in Spanish debt to GDP ratio. We incorporate this into our projections above, along with higher Spanish borrowing costs (6.5% over 10 years) as well as slightly lower growth and primary surplus projections (although not far off the IMFs most recent estimates).15 This is an adverse scenario but worth considering since it shows with a large uptake of these funds, as well as continually deteriorating conditions in Spain, the state could face an unsustainable debt load in the near future highlighting the limited room for manoeuvre which Spain has. 2.4 EFSF vs. ESM does it matter how the funds are provided? Differing seniority of debt from each fund means that it is important where the funds are dispersed from. It is very unlikely, however, that the ESM will be in place in time to provide the loan. As the table below shows, the treaty is yet to be ratified by numerous countries and has faced many delays, so at least initially the money will come from the EFSF.

Cited by Zerohedge, The Spanish Bank Bailout: A complete walkthrough from Deutsche Bank, 10 June 2012: http://www.zerohedge.com/news/spanish-bank-bailout-complete-walk-thru-deutsche-bank 15 Here we assume the full 100bn is tapped this year. We assume borrowing costs stay around 6.5% and that growth averages 0.8% over the next 5 years, while the primary surplus averages -1.3% over the same period, in line with the IMF estimates.

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Status of the ESM treaty Ratified To be ratified this month To be ratified next month Ratification date unknown

Country France, Greece, Slovenia, Portugal, Finland, Slovakia, Belgium 16 Netherlands, Spain, Cyprus, Luxembourg, Italy, Malta 17 Germany, Austria, Ireland 18 Estonia

Head of the Eurogroup, Jean-Claude Juncker, said after the Eurogroup meeting on the 21 June that the loans would be made by the EFSF and then transferred to the ESM when it becomes operational. ESM loans are senior to other types of Spanish debt while EFSF loans are not. This may make things easier to start with, however, once the loans are transferred to the ESM it is not clear whether they will then become senior, although eurozone leaders have hinted that they will not. However, the ESM treaty suggests that the rules on seniority will apply once the treaty is signed not just once it has been fully ratified. This means that if the programs existed before the treaty was signed, they will stay as pari passu (not senior), i.e. the existing Greek, Irish and Portuguese bailouts. However, if the programmes began after the treaty was signed (as in this case) then the loans will be senior. In any case, given the lack of losses on official loans in Greece we already know that they will de facto be senior. Germany has made it clear it wants the loans to come with the ESM level of protection and seniority, although the significant market jitters which have arisen from this issue mean it could still go the other way.19 Regardless, this could prove a source of uncertainty and force Spanish borrowing costs to rise further.20 There is also a question relating to Spanish guarantees/contributions under the EFSF and ESM. Under the EFSF it would usually step out of its guarantees if it received a full bailout sparing it the contingent liabilities but decreasing the size of the fund. However, under this recapitalisation plan this is not the case (since it focuses only on funding for the banking sector), meaning Spain is essentially still underwriting 12% of this rescue. Additionally, no matter its bailout status it will still need to pay in capital to the ESM once it is up and running and offer its share of the guarantees/callable capital. 2.5 Ireland and Finland flies in the ointment? Building on the point above, if the EFSF is used the Finnish government is obliged to ask for 'collateral' as it did with Greece the noises coming out of Finland suggest it will, especially

All these countries have suggested or are heavily rumoured to be voting on the package ahead of the 1 July deadline. Italy is expected to ratify it by the end of June. Luxembourg applies only to the lower house. 17 The German parliament is expected to ratify the treaty on the 29 June, however the German President is not expected to give final approval until the Constitutional Court has finished its own assessment which may not be completed until the middle of July. Ireland is expected to ratify the treaty in early July. Austria is also expected to vote in the first week of July although there are still negotiations going between the government and the opposition, which is demanding an FTT in exchange for supporting the treaty. 18 Estonia has attempted to delay the issue many times, mostly due to constitutional questions which the Estonian supreme court has said it will rule on by 12 July. Additionally some of the non-eurozone countries, the UK in particular, are yet to approve the treaty change underpinning the ESM which could yet cause problems for its implementation. 19 Cited by Bloomberg, Schaeuble wants Spain aid to come from ESM, 11 June 2012: http://www.bloomberg.com/news/2012-06-11/schaeuble-wants-spain-aid-to-come-from-esm-handelsblattsays.html 20 Cited by FT Alphaville, An ESM subordination save?, 11 June 2012: http://ftalphaville.ft.com/blog/2012/06/11/1037371/an-esm-subordination-save/

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given its objection to 'small' countries bailing out 'larger' ones.21 This issue will get messy, as it did in Greece. It will add another complex layer to negotiations, while politically it will boost the popularity of the (True) Finns, who are already in the midst of launching a campaign against further bailouts. It could also lead to legal challenges based on the triggering of 'negative pledge' clauses on Spanish bonds given that they essentially become subordinated to Finland's claim on Spain (similar to the concerns over the seniority of the ESM mentioned above). Using the EFSF may therefore avoid one area of confusion but could potentially create another at the same time. It has also been suggested that if Spain is able to avoid fiscal conditions on its bank bailout then Ireland could request similar treatment (i.e. a loosening of 'austerity').22 This line is being denied by the government but pushed strongly by the opposition and its hard to deny that they have a case. Ultimately, Irelands fiscal troubles stemmed from bailing out its banks, something Spain is now able to dodge thanks to external help. Ireland already feels that it is paying a huge price for protecting the European banking system this will only add to this ill feeling. Given Ireland's perceived 'success', especially in Germany, some flexibility may be forthcoming but we doubt enough to assuage Irish anger.23 2.6 Will this tackle the sovereign-banking-loop in Spain? The link between the banks and the state in Spain has been steadily increasing as the banks rely ever more on their implicit guarantee from the state to remain solvent, while the state relies on strong domestic bank demand to be able to sell its debt at reasonable interest rates. Add into the mix that Spanish banks are now reliant on liquidity from the ECB (passed through the Banco de Espana) and the loop looks even stronger.24 Unfortunately, this package is only likely to intensify the loop rather than break it. Spanish banks will now be seen as totally reliant on their guarantees from the state and the eurozone at least in the short term. At the same time, concerns over the solvency of the Spanish state are increasing, meaning the Spanish banks (newly flush with capital) will be under even more pressure to purchase their governments debt, not only as an exchange but because they are the only ones willing to do so. In a worst case scenario, boosting the sovereign-bank-loop without tackling the real problems in the Spanish banking sector sets the scene for a worse and more painful crisis, likely pushing Spain into a full bailout. 3. Will this package alleviate Spanish funding pressures? The aim of this package is to help reduce the pressure on the Spanish state and prompt the market to return its borrowing costs to a more adequate level. However, looking at the Spanish states funding needs over the next few years, even with the recapitalisation of the banks taken care of, it faces a huge level of debt refinancing. Up to mid-2015 Spain faces funding needs of 547.5bn, over half its GDP and a large majority of its debt. Spanish debt maturing

Cited Reuters, Finland demands Spain collateral if EFSF used, 9 June 2012: http://www.reuters.com/article/2012/06/09/us-finland-finmin-spain-idUSBRE8580F120120609 22 Cited by AFP, Ireland wants rescue deal negotiated to match Spains, 9 June 2012: http://www.france24.com/en/20120609-ireland-wants-rescue-deal-negotiated-match-spains 23 Italy is another potential source of ill feeling here, since it might be guaranteeing 18% of the loans to Spain, which at an interest rate of 3% - 4% while Italy still faces borrowing costs of up to 6% for similar length loans. 24 For a full discussion of this issue, see Open Europe blog, Spanish sovereign-banking-loop, 13 April 2012: http://openeuropeblog.blogspot.co.uk/2012/04/spanish-sovereign-banking-loop.html

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The Spanish central government will need to rollover 209bn in bonds and 75bn in bills, equal to almost 30% of GDP and close to half of its official debt.25 This will become increasingly difficult if Spanish borrowing costs remain at elevated levels.

Spanish debt maturing

100,000 80,000 millions 60,000 Bonds 40,000 20,000 0 2012 2013 2014 2015 Bills

Spanish deficit From mid-2012 to mid-2015 Spain will have to finance a deficit worth 179bn that is assuming it manages to stick to the IMF projections and its deficit cutting plans. Unpaid bills Spain also faces large stocks of unpaid bills at all levels of government, totalling around 105bn. These are due to be wound down over the next year or two despite having been at elevated levels for some time. Ultimately these funds are mostly owed to domestic creditors meaning withholding the money for longer will be counterproductive for the Spanish economy.

Spanish government arrears

120,000 100,000 millions 80,000 60,000 40,000 20,000 0

Central Govt.

Regional Govt.

Local Govt.

There is some relief, in that Spain has pre-funded much of its expenditure for the rest of the year, reducing this burden somewhat. However, the amount to be rolled over in the next year
25

Spain has done a good job of pre-funding much of the remaining debt which needs to be rolled over this year. However, even if this protects Spain from high yields for longer than expected, ultimately the country still has a significant amount of debt to refinance in the coming years and will not be able to do so at 7%+ rates.

or two is still particularly large. With uncertainty continuing from the bailout and market pressure already returning only a few days after it was announced, raising this money is unlikely to come easily or cheaply to Spain. This will further increase the pressure on the banks to load up on Spanish sovereign debt, with potentially huge consequences if this loop ever breaks down. If the problems in the banking sector are not resolved their ability to continue funding the state will at some point come under huge pressure, if this falls apart Spain may find itself without any willing creditors. 4. What is the exposure of EU countries to the Spanish economy? Open Europe estimates that EU countries have a total exposure of 913bn to the Spanish economy. This comes through various sources including: the potential 100bn rescue package, central bank lending and exposure of these countries banking sectors to Spain.26 Interestingly, the huge exposure of the northern eurozone countries banking sectors to Spain serves as reminder of the role which these countries played in allowing Spanish banks to become overleveraged and unwieldy in particularly by providing large amounts of cheap credit. Overall the figures highlight the importance of finding a lasting solution to the problems in Spain and the significant avenues for contagion which exist.
Non-Eurozone: Bulgaria Czech Republic Denmark Latvia Lithuania Hungary Poland Romania Sweden United Kingdom N/A N/A N/A N/A N/A N/A N/A N/A 2.91 83.13 913.24

Eurozone:

Exposure to Spain bn Austria 16.46 Belgium 28.11 Cyprus 0.85 Estonia 1.10 Finland 7.74 France 202.59 Germany 263.13 Greece 9.42 Ireland 10.10 Italy 104.95 Luxembourg 1.08 Malta 0.39 Netherlands 92.41 Portugal 31.25 Slovakia 3.72 Slovenia 2.59 Spain 51.32

Total

Source: BIS, ECB, EU National Central Banks, European Commission and Open Europe calculations

We have not included the ECB Securities Markets Programme purchases of Spanish debt since the figures are not readily available. Total SMP purchases from Spain and Italy total around 135bn, if done proportionately Spain would account for 54bn of this, however, due to lack of transparency we cannot be sure. We have also not included the Target 2 imbalance in this instance since Spains position in the eurozone is not under question, this is the only instance in which we see this imbalance representing a direct exposure for these countries, until then it is seen as part of the eurozone architecture. Some non-eurozone countries have exposure down as N/A since the Bank for International Settlements does not provide figures for their banking sector exposure, in most cases exposure will be negligible.

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5. What do the eased ECB collateral rules mean for Spain? The ECB announced on 22 June that it would be easing the rating requirements on certain types of collateral which it accepts in exchange for its liquidity provision, in particular on asset-backed-securities (ABS) and other types of consumer finance. Rightly, this has been seen as an attempt to ease the pressure on Spanish banks the Spanish banking sector holds a huge amount of these instruments following the credit boom and since the bust they have become unsellable and often have plummeted in value and rating. This raises huge questions over the ECBs independence (did it face pressure from eurozone leaders to do this as Spanish banks continued to struggle) and its impartiality (why did it institute a measure so heavily focused on aiding a specific countrys banking sector). These questions aside, what does it mean for Spanish banks? Ultimately, it should help the banks access more liquidity, especially given the increasing rumours that they were running low on assets to use to gain loans from the ECB. This may provide an additional buffer in the very short term but will ultimately make little difference for a few key reasons: As this report shows Spanish bank problems extend far beyond liquidity needs, the whole sector needs substantial overhaul and reform some additional loans will make little difference to their overall situation. The loans that can be accessed will only be short term, unless another long term refinancing operation (LTRO) is announced, meaning they will have little impact on the banks longer term lending decisions. Given that house prices are expected to fall much further and more homeowners expected to default the value of many of these ABSs could decrease significantly in this instance the banks would face margin calls and be forced to put up more assets as collateral against their loans. This would create additional strains and may catch some banks unawares, creating further problems. Most of this money is unlikely to find its way into the real economy and probably wont boost bank lending. This is not just because the factors above, but also because its not clear that the necessary demand is present in the Spanish economy, or at least not with a low enough level of risk to make sure it is not counterproductive for the banks.

The target of this move is to boost lending in the Spanish economy but that is unlikely to happen. The economy is rebalancing and the banking sector is in dire straits, expecting lending to be growing at this stage may be too much to ask. In reality, until the wider banking problems are sorted out and confidence returns to the Spanish and eurozone economies, banks are likely to continue hoarding money simply easing some collateral requirements will not make a substantial difference.

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