“We find that the overall Spanish banking system under our baseline scenario is likely to withstand the consequences of the crisis, despite severe economic deterioration”. This was the judgement of the IMF, as set out in its most recent Global Financial Stability Review. The study, which was carried out in collaboration with the Bank of Spain shows that capital levels across the banking system as a whole are likely to increase for both commercial and savings banks as their projected earnings stream over the next three years should cover expected losses.

The IMF’s starting point is expected loan losses (see chart). As the IMF points out, these are not projected to rise nearly as high as they did in the recession of the early 1990s, when interest rates were much higher than now (14.3% in 1992 vs. 5.3% in 2008) and unemployment was also significantly worse (24.6% in 1994 vs. 18.8% in 2009), which suggests that banks should be able to withstand the losses generated by the current downturn. And Spanish banks’ losses on securities, which are estimated at €4bn for commercial banks and €1bn for savings banks over the period, are also relatively low.

Spain: non-performing loans as % of total loans (commercial banks only)

Source: IMF

The IMF then analyses the effects of repossessed real assets (i.e. property). Over the past two years, given the ailing state of the real estate and construction sectors, Spanish banks have increased the use of debt-for-property swaps to help them manage their credit risk and minimise losses (see chart). It is important to note that this technique only works if property prices stabilise in the medium term and banks can sell these repossessed assets at their book value. If the house price deterioration continues, banks under pressure may need to sell properties within a short period of time, resulting in substantial losses. However, the IMF thinks it unlikely that banks will recognise losses by selling these assets within the next three years. Its estimates, which are very similar to those of the Bank of Spain, suggest that commercial banks and savings banks had €22bn and €37bn respectively of repossessed assets at end-Q309. It believes that the rate of repossessions will slow in 2010, and uses the Bank of Spain’s estimates for stocks of provisions for repossessions of €6bn for commercial banks and €7bn for savings banks.

Spain: Real asset repossessions

Source: IMF

Based on the forecasted NPLs and repossessions, the table below shows that banks should see a net capital gain over the next three years under the baseline scenario. Pre-provision net earnings are expected to decline 10% per year over the period, showing that Spanish banks are still set to suffer real problems, even if system-wide insolvency is unlikely. Interest income is set to fall, medium-term funding pressures to rise and deposit growth to slow. Nonetheless, banks’ earnings stream will be sufficient to cover these losses over the period. And most reassuringly, even in the adverse-case scenario of a double-dip recession in which unemployment climbs to 24.5% and house prices fall a further 15% YoY in 2010, commercial banks would suffer no net drain on capital, while savings banks would only experience a small net drain of €2bn. The gross drain (see page 59 of the GFSR for full calculation of this) in an adverse-case scenario would be €5bn for commercial banks and €17bn for savings banks.

Spanish banks: Baseline and adverse-case scenarios (€bn)

Source: IMF.   *2010 for the baseline, 2011 for the adverse case.   **Net drain on capital = - (net pre-provision earnings - writedowns). A negative sign denotes capital surplus.

This research therefore suggests that there is enough capital in the system to cope with currently expected losses and that, even in a stressed scenario, the savings banks’ capital shortfall is manageable. While we agree with this view, we would add a couple of caveats. The first is that, going back to the first chart, it is hard to compare the current Spanish banking sector to that of the early 1990s. It has changed in scope, with two major international players (Santander and BBVA) adding to its diversity. It is also more highly regulated, with a counter-cyclical capital regime and a ban on off-balance-sheet vehicles. Furthermore, the current crisis has, despite lower loan losses, taken a greater toll on banks than the earlier recession. The second is that the future of Spanish banking remains highly unpredictable. While there may be no system-wide net capital shortfall, several individual institutions – particularly among the savings banks – are undoubtedly struggling. The Spanish authorities have set up a €99bn fund, known as the FROB, to help restructure the sector. Indeed, the FROB has already approved three restructuring plans involving eight savings banks. However, the current scheme is set to expire by June 2010. While further restructuring will almost certainly be necessary and some kind of replacement scheme is bound to be implemented, there are currently no indications as to what shape this replacement might take. Uncertainty still clouds the future of the Spanish banking sector – and, indeed, that of the wider Spanish economy. But at least the IMF’s research has shown that the system should be strong enough to survive intact.

Nick Smallwood - Credit Analyst

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