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The Globe and Mail

Worst- case scenario the most likely with Spanish banks

A man pushes a pram past a Banco de Valencia bank branch in Madrid June 25, 2012. Spain formally requested on Monday European aid of up to 100 billion euros for its banks but did not specify how much money it will seek to recapitalize ailing lenders.

Andrea Comas/REUTERS

It's going to be a long sticky summer for Spain's banks. Two independent consultancies have identified a capital shortfall of up to €62-billion ($63.5-billion) in an adverse economic scenario. That's at the lower end of market estimates, and within the €100-billion that Spain could borrow from the euro zone's bailout fund. But results are not final – the actual bill won't become clear until September.

Oliver Wyman and Roland Berger conducted two different tests. Under the benign scenario the banking system would require €16- to €25-billion of fresh capital. Given that Bankia alone has requested €19-billion, that scenario is likely to be ignored by investors. The adverse scenario looks more credible. This assumes Spanish GDP falls 6.5 per cent and house prices drop 60 per cent from their peak. In that case, banks would face losses of between €250- and €270-billion, or up to 18 per cent of their combined loan books.

However, banks have also received some concessions. First, they will be allowed to offset bad debt provisions against three years of future earnings. Given Spain's dire economic position, that seems too long. And in order to pass the test banks will have to maintain a core Tier 1 capital ratio of just six 6 per cent. That's lower than the seven 7 per cent recently used by the International Monetary Fund and below the Spanish regulatory minimum of eight 8 per cent. True, banks should be allowed to run down their capital reserves in a downturn. But investors may demand higher buffers.

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The latest audits will allow Spain to formally request euro zone bailout funds. But they are just another step in the long road towards cleaning up the banking system. The true capital bill won't be known until four independent auditors conclude a bottom-up analysis of the banks in September – though the government doesn't expect it to rise. Banks will then be given another nine months to find ways of plugging the capital hole.

In practice, nationalized lenders such as Bankia, which account for the bulk of the capital needs, will get the cash sooner. Spain's three largest banks – BBVA, Santander, and Caixabank – won't need additional capital, according to the Bank of Spain. But BBVA and Santander are already taking steps to further strengthen their buffers. Uncertainty over bank balance sheets will persist.

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