Words About Spain and Banks and Stuff

While everyone’s focusing on Cyprus’s bailout, Spain’s been attempting some progress. And while some feared Cyprus would be the “blueprint” for all bailouts going forward, that doesn’t seem to be the case.

Not that it’s been smooth sailing in Spain. Spain remains mired in recession in part because credit markets are shrinking, thanks to a banking sector long in need of an overhaul. Tactics to recapitalize banks have run the gamut (bank mergers, bailout funds, creating good banks/bad banks, more mergers and toughing it out). But it looks like a plan is near, and in fact, Spain has sought outside, private sector help in managing the banks’ assets longer term.

Unfortunately, it looks like Spanish bank investors will bear the brunt—for now. The plan entails somewhat of a reverse stock-split with its largest nationalized bank (which is still publicly traded). Investors will be subject to losses of up to 61% (30% for junior bondholders) and will see preferred shares converted to ordinary, likewise with subordinated debt, in exchange for €10.7 billion from the Fund for Orderly Bank Restructuring. (A better fare than investors in one of Spain’s smaller banks, subject to losses up to 90%.) At the non-publicly traded, smaller nationalized banks (the majority of Spanish banks are in fact not publicly traded), investors will also see preferred shares turned ordinary, but with the option to sell them to Spain’s deposit guarantee fund.

Let’s be clear, no one wants to see heavy losses to private investors. However, they’re mandated by the EU in order for the state to aid businesses. And in that sense, this is just free market discipline—harsh as it can be at times. And, this is far preferable to the Cyprus model—dinging large depositors. And worlds better than the now-abandoned Cyprus model—punishing secured depositors.

What will be more interesting to watch is how Spain’s banking sector evolves once they get past the recapitalization. The periphery’s weak banking sectors have all experienced varying levels of strife, for differing reasons. Cypriot banks are in trouble because they failed to diversify and made big investments in (hindsight is 20/20) Greek debt. Whereas Spanish banks were hit hard by Spain’s huge housing bubble, and because its cajas were run as national non-profits.

It’s an odd choice for a bank. When a business is allowed to make a profit, it’s more incentivized to use its resources efficiently (more production at lower costs), which not only helps the business grow, but helps lower costs and encourage innovation for the benefit of its customers. We often tout the private sector more efficiently allocates wealth into the correct areas thanks to the invisible, guiding hand of capitalism—there are myriad examples, like solar power versus fracking—and the concept most certainly applies to the banking sector, as well.

But non-profit Spanish banks were often bogged down with bureaucracy and narrow interests and lacked the incentive profit motive provides. Simply put, a profitable bank is immensely less likely in need of a state bailout.

Which highlights another issue. World leaders seem stuck on the idea there’s a cross-border, silver-bullet solution to make banking safer—and prevent future banking crises. But Spain isn’t Cyprus isn’t Ireland isn’t Italy. Basel III standards wouldn’t have absolutely prevented Cyprus’s—or Spain’s—banking ills. That said, there is a sort of silver bullet for banks—make prudent decisions that allow increasing profitability. Hopefully Spain gets some of this private sector schooling on the merits of profit motive.