Spain Could Solve Its Banking Crisis And Stop Dragging Down Europe

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by: Martin Lowy

Spain's troubles are indeed serious. But the recent focus on Spain's banking system is largely counterproductive. Many of Spain's smaller banks are indeed insolvent. That is well-known. Its larger banks probably are not insolvent, although it seems likely that they are undercapitalized. The larger, undercapitalized banks probably still have value, so they simply have to be forced to shrink or raise capital. That is likely to happen. Bailing out the smaller banks, however, is going to cost a great deal of money - money that the Spanish government should not be spending.

Liquidate the Insolvent Banks

The solution to the smaller banks' problems is well-known outside Europe: Declare them insolvent, transfer the 100,000 euros of insured deposits to a solvent bank, and make uninsured creditors and equity holders shoulder the loss. The deposits would be taken over by one of the large, healthier banks - or even a bank headquartered outside Spain - whichever one will offer the deposit insurance fund the best deal. Such a deposit assumption could be financed properly by the Spanish Central Bank or the ECB, secured by the good assets of the failed bank and the guarantee of the Spanish deposit insurance fund. (That has been done by the Fed in the U.S. on several occasions, and the Fed has never lost money on such a deal.) Yes, the deposit insurance fund does not have the money to do this credibly, but it would make sense for the Spanish government to guarantee the fund's obligation, since the fund could be built up over a period of time.

I do not know on whom the losses would fall - that is, I do not know who the banks' uninsured creditors are. And those losses may, themselves, cause problems, since some of the uninsured creditors may be government entities and others may be pension funds or the like. But stumbling along trying to save bankrupt banks does not work, nor does Spain have the capacity to take the losses onto its government balance sheet, which is where the current policy is headed. Let us call that the Irish Disease.

Forcing Insolvent Banks to Take Losses is a Charade

The present Spanish policy of passing laws to require provisioning by insolvent banks is a charade. The world knows it is a charade. And it brings shame on the Spanish government.

Loan Demand Will Be Satisfied

The loss of these smaller banks will not harm the Spanish economy. At the present time, there is no credible loan demand. The reason is simple: When there is no consumer demand and no export demand, solvent businesses do not want to borrow to expand. The remaining banks will be quite capable of filling whatever genuine loan demand exists.

Spain Should Focus on Its Competitiveness Problem

Getting the banking crisis behind them would permit the Spanish government to refocus on Spain's competitiveness problem, which is at the heart of Spain's economic crisis. Putting the banking crisis in the rear view mirror also would bring greater credibility to the Spanish government, which would help Spain to finance its debts while it goes through the painful process of restructuring its economy to become more competitive.

Until Spain effectively liquidates the insolvent banks, it is not likely to attract investors. Certainly, I would stay away from any involvement at all. And while Spain cycles downward, investments elsewhere in Europe are likely not to do well, either.


I am aware that many Europeans are fearful that requiring uninsured creditors to take losses will have a contagion effect on banks elsewhere on the continent. Contagion will indeed occur in that banks with weak capital are likely not to be able to get funding. But banks with strong capital will continue to be able to get funding. That is as it should be. Banks that are caught half way through the process of improving their capital positions can be assisted by central bank lending, as they have been over the last six months.

Banking crises end when banks are well capitalized-not before that time.

The Banking Crisis Is a Symptom, Not a Cause

However, ending the banking crisis in European countries will not end the economic problems of the countries involved. Those problems usually have little or nothing to do with banks. The banking weakness is a symptom, not a cause of economic stress. The cause of economic weakness and unemployment in the U.S. and much of Europe is lack of demand/over capacity, given the current state of technology and global competition and the competitiveness of a people's skills/cost structure. Such a problem is not likely to have a quick solution. Banking crises, however, get lots of ink. Therefore they get in the way of focusing on the real issues.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.