Thursday, 21 June 2012

The monsters of Spain

Anyone remember Too Big To Fail?

Ever since the financial crisis of 2008, there have been cries for large banks to be broken up. The idea is that no bank should be so large that it cannot be allowed to fail because if it did it would pose a threat to the domestic or international financial system.

So far no banks have actually been broken up, apart from some that failed in 2008 - Lehman and ABN AMRO, for example. But governments and regulators around the world have been looking at ways of limiting bank size (taxing liabilities, for example), ensuring that failed banks can be resolved quickly and safely, and promoting competition in the banking sector to reduce bank power by giving customers more choice.

Except in Spain. The Bank of Spain has taken the OPPOSITE view. Over the last four years it has promoted, encouraged and facilitated the merger of the regional savings banks - the cajas - into much larger conglomerates. Its stated aim is to reduce the number of cajas from 45 to 10. That is by any standards a significant consolidation in the regional banking marketplace.

The reason is the awful exposure of the cajas to Spain's property bubble and their serious lack of capital. When it burst in 2008, many of the cajas lost huge amounts of money, leaving them seriously distressed or actually insolvent. The Bank of Spain's chosen rescue strategy for these cajas is to merge them with other banks. If the banks they chose were themselves in good shape, this wouldn't be a bad strategy. But that isn't what they are doing. Like Frankenstein, they are artificially giving life to dead bodies. And like Frankenstein, in doing this they are creating monsters.

Bankia was such a creation. In December 2010 seven cajas merged to create the monster that is Bankia. All of the seven were in financial trouble and would probably have gone bankrupt due to bad property loans if the merger had not gone ahead. But the merger alone was not sufficient to create a viable bank. The Spanish government, via its bailout fund FROB, contributed 4.5bn euros of capital to the new creation in the form of (non-voting) preference shares. Without that capital Bankia would not have been able to commence trading. It was propped up by its sovereign from the start.

In July 2011 Bankia was floated. Foreign investors wouldn't touch it, so the shares were mainly sold to Spanish companies and individuals.

It now appears that some of the cajas that merged to form Bankia were, shall we say, somewhat less than accurate in declaring the extent of their bad loans. Not surprisingly, the investors are furious. Private investors are currently pooling funds with the intention of pursuing civil action, and Spanish prosecutors are investigating whether the IPO was fraudulent.

Meanwhile, of course, Bankia has gone bust. But it is a LARGE bank - the fourth largest in Spain in terms of assets. Its operations are too extensive and too critical to the Spanish economy for it to be allowed to fail.

You see, the trouble with monsters - as anyone who has read Frankenstein would know - is that they can't be controlled by their creators. Bankia now needs bailing out, because it is Too Big To Fail. But Bankia is also too big to be bailed out by the Spanish sovereign alone. The Spanish government has had to seek help from the EU.

Nor was Bankia the only monster the Bank of Spain tried to create. It also tried to merge the solvent Cajastur (which had already absorbed the collapsed Caja Castilla La Mancha) and two smaller cajas with the desperately troubled Caja de Ahorros del Mediterraneo CAM), itself a sprawling conglomerate of twenty-seven smaller banks that it had gradually absorbed over the previous twenty years. CAM was a non-profit-making organisation with extensive ties to the regional government of Valencia: the chairman of the board was personally appointed by the then President of Valencia, who was subsequently prosecuted for bribery, fraud and corruption.

In March 2011 the attempted merger failed when the extent of CAM's bad loans became clear. The merged entity would have required capital from FROB of 2.78bn Euros, twice the original estimate. There is no doubt that had the merger proceeded the new entity would have suffered the same fate as Bankia - failure and nationalisation, putting the Spanish banking system at risk. Wisely, the management of Cajastur decided not to proceed. CAM was nationalised in July 2011 - effectively transferring the liability for its bad debts to the Spanish government - and sold to Banco Sabadell for 1 Euro. The chairman of the board was forced to resign; the Director General, together with five other directors, was dismissed and is now facing prosecution for suspected accounting fraud.

There are other caja merger disaster stories too. Caja Unnim was created in 2010 from the merger of three cajas: it went bust in 2011, was nationalised and then sold to BBVA for 1 Euro. Catalunya Caixa, Spain's fourth largest savings bank,  was created in July 2010 from the merger of Caixa Catalunya, Caixa Tarragona and Caixa Manresa: it was partially nationalised in 2011, as was Nova Galicia Caixa, created in 2010 from the merger of Caixa Galicia and Novacaixa.

The end result of this disastrous merger activity is that, according to the IMF, MORE THAN HALF of the large and medium-sized banks in Spain are now partially or wholly dependent on state support. Only the three largest banks are both fully independent and well-capitalised. All the rest are either already nationalised, about to be partially nationalised (Bankia) or are likely to require partial nationalisation as economic conditions worsen. How this can be regarded as an improvement on the previous network of smaller regional banks is beyond me. Smaller banks can be, and in my view should be, allowed to fail. But instead of allowing the smaller cajas to fail, Spain has created monsters - and now the monsters are draining the Spanish sovereign of its lifeblood.

Unlike Frankenstein's monster, though, these monsters do not seek independence. On the contrary, they have developed a symbiotic relationship with regional and national government which ensures their survival. The Spanish sovereign has become dependent on its banks for funding, just as its banks have become dependent on their sovereign for capital. George Soros described the relationship of banks and sovereigns in the Eurozone as being like "conjoined twins": nowhere is this more apparent than in Spain. To my mind this is the primary reason for Spain's insistence that even quite small banks must be bailed out or merged, not allowed to fail. If the banks fail, the sovereign bleeds to death.

So the challenge for the EU and the IMF is how to separate the banks from the sovereign without causing terminal damage to both. At present no-one has any sensible proposals for doing this, although this post from INET has some interesting ideas. The EU seems unable to think beyond the next bailout, and the IMF actually wants MORE public backstopping of banks (though without public control of banks - moral hazard, much?). But find a way, we must, even if that means painful surgery. The end of Frankenstein carries an awful warning: the death of Frankenstein leads inevitably to the death of his creation. Spain rightly fears the failure of its banks: but far more should banks fear failure of the Spanish sovereign, because if that fails they must fail too - and the rest of Europe with them.


  1. Excellent article as usual.
    Do you read or follow Bill Michell?
    One of the best economic commentaries I can find. I would be interested in reading your views on his MMT analysis.

    1. Indeed I do, and I have a lot of time for MMT. It is the only economic theory that doesn't rely on a faulty understanding of how money transmission works.

  2. Hi Frances
    Great article but I'm still a bit mystified why size in this case matters. Surely 20 little banks all failing (with corresponding loses for investors) is much the same as those 20 little banks all being merged into one big bank and failing (with similar losses for investors).

    As far as I can tell the policy hasn't been so much bad as pointless. There was a systemic problem with spanish banking which mergers were never going to work around. However the mergers didn't create the systemic problem which was always going to lead to investors losing their shirts and government having to do some sort of bailout (even if only on personal bank accounts).

    Would be grateful for your thoughts?

    1. Frances Coppola22 June 2012 at 12:34

      Size does matter. A small bank is unlikely to be critical to the national economy. In the US, hundreds of small banks failed in the 2008 crisis - but we don't hear about those, do we? That's because it wasn't their failure that caused the US economy to crash and sent shockwaves around the world. It was the failure of larger banks. The fact is that the failure of a single large bank can overwhelm the sovereign and cause major dislocation of national and international financial systems. Even twenty small regional banks wouldn't have that sort of effect.

    2. Thanks for the reply. I understand that there is empirical evidence that size matters but I am struggling to understand why 20 banks with 100million in bad debts is worse than one bank with 2billion in bad debts. Particularly if they all go under with the same event

    3. I think the real answer is that large banks tend to be economically and systemically important in a way that smaller banks aren't. They are often crucial to payments systems, for example, and to liquidity for individuals and businesses. They also frequently have external links - as we saw in the 2008 financial crisis: they are much more likely to use international sources of funding and their shares and bonds are traded on the international markets. Part of the reason for the caja consolidation and the associated change in their legal status (from mutuals to commercial banks, essentially) was to allow them to raise finance on the international capital markets. This improves their liquidity but it also increases their systemic risk.

  3. Very nice article !

    One thing of note, France has been spared on the real estate front. But there's a huge bubble there. From 2000 to 2012 prices have gone up by 140%. People have gotten indebted for 25-30 years to buy a home, just like in Spain.

    Right now, there is still no sign of a reversal, but the french banks are still ill prepared for this.

  4. Very interesting article.

    It turned out this moment - the ECB is going to accept any kind of asset backed security, consumer loans too (cars,...), for the repos (repurchase agreement).

  5. The Oncoming Storm22 June 2012 at 20:12

    Good article, there's worrying parallels with Ireland here in that the senior bosses of Anglo Irish and Irish Nationwide had very close links with Fianna Fail and that may have been a reason behind the disastrous blanket garuantee that eventually led to the bail out. It could well be that there's more shocks to come out of Bankia and the other cajas and that could be the proverbial straw :(

  6. I think that puts it all together. This one is up there with the cold hard truth post, all the better without graphs! I suppose you econ/finance jobbers cant do without :-)

    How will it end? badly, 2 thoughts.

    Spain (like Italy) is a large country with a large economy, history and culture, they wont be push around and in the end they will act in their own national interest, as Italy is showing signs!

    And as said the EUro is an ideological tool and its believers will sell their children first before abandoning it.

    Am I right in saying Target2 only comes into play on a break up of the banking system?

    1. There are huge misunderstandings about Target2. Target2 would be an issue if the Euro itself broke up, because it depends fundamentally on the ECB. Individual country exit could be managed, I think. In theory Target2 could survive a collapse of the banking system, since it operates through central banks. But as a banking system collapse would almost certainly bring down the Euro itself it is a bit of an academic question.

  7. Target 2 does have 2 dimensions
    a) From the real world economy perspective
    Allowing to sum up account deficits, gave the North Euro Region the opportunity to export and lend money, lend, lend (especially in case of Greece). Target2 allows to/does export inflation (sums up in the top node - so the average inflation did fit) ... finally export promotion beyond the 'customers' solvency. On a long term Target2 could create inflation in the countries exporting - minor issue.

    b) In case of the the so called 'printed money', in this special case a central controlled by those who need the money, allowed the banks to transfer liquidity/solvency to Luxembourg, Germany, Finland and The Netherlands. (German Language but you can look at the charts, nothing more to say)

    Current state - Target2 discussion Germany. The Deutsche Bundesbank is currently liable to it's own banking system (something new and rare... afik). Germany's foreign assets 1 Bio. The corresponding claim is held against ECB and collateralized with the government bonds exchanged by the ECB (write-off very likely). Link to the original asset backing is broken. The so called break down of the EURO, which is simply not a valid option in practice, would fore the write offs.

    Germany's target 2 balance consists of 2 kinds of claims/debts
    a) Underlying transaction is a real world business (purchasing assets in the North Euro region) - fraction.
    b) Simple transfers we have seen during the last (1 billion that moved to North Euro Region) - majority

    In case of a) the money is lost in every case (partial breakup - for Example Grexit). In case of b) the discussions are hot. The North Euro Region simply transferred their assets to the North Euro Region into a save heaven, still the majority.

    In some special cases the goods originally shipped will not be payed, because the money created (to cover those invoices too) has been used by others to transfer the assets and purchase realities in Germany for example. (Greece and Spain). - Not a huge amount. Think if all this would continue ...

    From the banking systems perspective Target2 is not a big issue except the EURO does disappear, but it does not help the employee in Germany if it's employer goes broke, because of bills not payed by working/profitable business in South Euro, only suffering from money shortage and finally crash because of missing solvency in Greece or Spain - not unlikely. The economy and the companies work - the problem is the money supply.

    All these arguments are mixed up in Target2 discussions.

    1. That's probably the best explanation of the Target2 confusion I have ever read. Kudos.