Spain has finally grasped a nettle that should have been grabbed a long time ago. By asking the euro zone for a loan of up to €100 billion ($125 billion) to recapitalize its banks, Madrid has acknowledged what the market already knew: that Spanish bank balance sheets have been massively understating the losses arising from the country's property bust.
But can this "financial aid" for the banks be presented in a way that ring-fences the problem, enabling the government to retain access to bond markets? This is the huge gamble: if it can't, a far bigger bailout may be needed.
The tragedy for Spain is that if it had confronted its banking mess at any time over the last four years, it could probably have funded the clean-up on its own. Yet the new government of Mariano Rajoy followed the same path as its predecessor, squandering valuable time and credibility with a series of half-baked restructuring plans that failed to provide any fresh capital to the system. For much of this year, Madrid has been engaged in a futile effort to persuade the euro zone to bail out its banks directly, without channelling the loans via the government.
Perhaps the market will buy the euro zone's assurances that this is a targeted program — the exact amount will be determined following the completion of an independent audit of bank balance sheets — with only limited conditionality focused on the banks. The sums involved are not too large in the scheme of things, equivalent to around 8% of GDP. And arguably, the market has been anticipating a recapitalization of this size for weeks, so it's possible the bailout is already reflected in 10-year bond yields over 6%.
But simply by asking for external assistance, Spain has admitted it has lost market access. For many months, domestic banks and institutions have been pretty much the only buyers of its sovereign bonds. Last week's downgrades of Spanish government debt will have further hit appetite for the bonds. If the banks use the euro zone bailout cash to increase their exposure to sovereign bonds, doubts over their solvency might soon re-emerge. That would put the banking system back where it started — still reliant on the European Central Bank for funding and under pressure to deleverage.
Madrid's fear has been that the moment it seeks assistance for its banks, its own debt will be stigmatized. If this happens, a much bigger bailout will be needed to cover the government's own funding needs. That would be sure to reignite doubts about the size of the euro zone's bailout funds, capped at €750 billion. And that in turn could turn the spotlight on other vulnerable euro zone countries, not least Italy.
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