Spanish Banks Face New Challenges

December 23rd, 2008

At first glance, the recent career paths of the European bankers who masterminded last year’s audacious €72bn ($98bn, £64bn) takeover and break-up of ABN Amro could hardly be more different.

With chaos sweeping through global markets, Sir Fred Goodwin resigned as chief executive of Royal Bank of Scotland and apologised to investors after his bank was rescued by the UK government. Maurice Lippens stepped down as Fortis chairman as that bank’s operations were nationalised in the Netherlands and put up for sale by the Belgian authorities.

By contrast, Emilio Botín, the 74-year-old chairman of Santander, has been firmly in place and in ebullient mood – at least until weekend revelations of the alleged $50bn (£33bn, €37bn) fraud committed by Bernard Madoff, the US asset manager.

Mr Botín was smiling because he had bolstered Santander’s capital ratios with a risky but successful €7.2bn rights issue; it ended oversubscribed. Santander, the biggest bank in the eurozone by market capitalisation, has said it is broadly on target to make a net profit of €10bn this year. This month, it was named “bank of the year” for Spain, Portugal and Latin America by The Banker magazine (part of the Financial Times Group).

BBVA, the number two Spanish bank and one that prides itself on the success of its conservative strategy under chairman Francisco González, looked similarly secure. It had increased its underlying net profit by more than 9 per cent to €4.3bn in the first nine months compared with the same period last year.

Spanish banks thus appeared to have escaped the direct effects of the global financial crisis – but they now face two serious challenges.

Santander chairman Emilio Botín (right) and José Luis Rodríguez Zapatero, Spain’s prime minister. The government has offered banks up to €250bn in loan guarantees and asset purchases.

First, they are discovering that they are not as protected as they had hoped from the indirect impacts of the crisis. In the last two days, Santander has admitted that customers of Optimal, its Swiss-based hedge funds management arm, may have lost up to €2.3bn through investments with Mr Madoff. Santander’s total direct and indirect exposure remains unclear, while BBVA disclosed on Monday that it may have lost up to €300m.

In October, Santander had already decided to compensate private banking clients who lost millions of euros from products linked to Lehman Brothers, the failed US investment bank.

The second question for Spanish banks and cajas, the unlisted savings banks, is whether they can weather the storm arising from their own, very traditional banking crisis – one caused by a continuing domestic property market collapse of spectacular proportions.

A lot of regulation and a little luck initially spared Spanish banks the worst of the international crisis that originated in the US subprime mortgage market. They were lucky – to begin with, anyway – to be so focused on the money to be made in the fast-growing Spanish economy of the time that most of them had little interest in exotic financial instruments abroad.

But Spain’s bankers agree that they were kept virtuous largely by the stern regulators at the Bank of Spain. The central bank achieved this in two ways. It made it so expensive for financial institutions to establish off-balance sheet vehicles – of the sort that subsequently sunk banks elsewhere – that few Spanish banks bothered. It also demanded in the good years that banks set aside “generic” bad loan provisions in addition to provisions for specific risks, a sensibly counter-cyclical regime that has been much remarked on abroad since the crisis began. Santander, for example, has built up more than €6bn of generic loan loss provisions.

“What they have on other countries is that the accounting and regulatory framework has been awesome,” says one senior foreign banker in Madrid.

On the face of it, Spanish bankers should therefore be brimming with confidence. Indeed, Mr Botín said as the crisis deepened that Santander was “really in a magnificent position compared to our competitors”, while José Antonio Alvarez, his chief financial officer, said in October that Santander could benefit from a “winner takes all” market “by rescuing falling banks at attractive prices”.

Five days after Mr Alvarez spoke, Santander – already the owner of Abbey, Alliance & Leicester and the branches and deposits of Bradford & Bingley in the UK, as well as of Brazil’s Banco Real – was announcing a $1.9bn deal to bail out Sovereign Bancorp in the US and buy the shares that it did not already own.

At BBVA, executives have also portrayed the crisis as an opportunity rather than a threat. Juan Asúa, the bank’s director for Spain and Portugal, boasted this month of BBVA’s prudent and rigorous risk management and said the bank saw crises as “excellent opportunities for growth and consolidation” for those with the right strategies.

For most Spanish banks, however, there is scant hope of profiting from the current financial turmoil. Even the larger, internationally diversified banks face daunting problems in the coming months, particularly if Brazil, Mexico and the UK turn out to be as vulnerable to global recession as the US and continental Europe – and if the Madoff scandal wreaks further damage on profits and reputations.

The biggest threat in the medium term is the heavy exposure of most banks and cajas to the Spanish property crash, both via their loans to overstretched developers and construction companies such as Metrovacesa and Colonial and via mortgages for home buyers.

Loan defaults are rising fast – in tandem with unemployment, which is already at 3m, or 12 per cent of the workforce – and it will not take long for the bad debt load to overwhelm even the prudent provisioning mandated by the Bank of Spain.

Willem Buiter, professor at the London School of Economics, predicted an “ugly” year ahead for the Spanish economy when he gave a talk in Madrid this month. “You’re going to have massive negative GDP growth,” he said. “The building sector has so overexpanded it’s ludicrous.”

Another weakness of the Spanish banking system in the current climate is its heavy dependence on international wholesale financing. The crisis has brought an abrupt halt to the funding of the Spanish current account deficit by German savers, who indirectly bought the covered bonds and other mortgage-backed securities sold by Spanish banks.

That is why the Spanish state – although it has not so far needed to rescue insolvent banks – has been generous with liquidity support: the government of José Luis Rodríguez Zapatero, the Socialist prime minister, has offered the banks a total of up to €250bn in loan guarantees and asset purchases until the end of 2009 in order to maintain the flow of credit to borrowers. Two weeks ago, the finance ministry said that 90 per cent of eligible banks had applied for the government debt guarantees.

Last, the emergency nationalisations of US, UK and other European institutions – accompanied by capital injections – have had the perverse effect of making healthy Spanish banks appear short of capital when lists are drawn up and capital ratios compared by analysts. “What’s happening in Europe is that the shittiest banks got saved first,” says the foreign banker.

It was for this reason that Santander, despite having said it had no urgent need of new capital, launched its surprise rights issue. Others are under pressure to do the same, albeit for lesser amounts – BBVA has just announced an issue of preference shares to raise up to €1bn. But attracting cash will not be easy: although Santander’s rights issue was at a deep discount, there were tense moments at the bank and its underwriters when the shares slid close to the offer price the week before it closed.

Spanish bankers have been voicing loud objections about the injustices arising from foreign bank bail-outs. They have pointed out that their accumulated generic provisions are equivalent to core capital, even though not technically counted as such. “We have seen unfair competition as a result of assistance to foreign banks that has absolutely distorted markets,” Roberto Higuera, chief executive of Banco Popular, said last month.

They have even discussed the possibility of seeking redress on competition grounds from the European Union, although at present, as one senior Spanish banking representative puts it, “the priority is to save the system, not to complain”.

Bankers are meanwhile drawing in their horns on acquisitions – even Santander says it has no further purchases in mind right now – and are appalled by what they see as a further retreat of continental European banking into fragmented national fiefdoms as a result of the crisis.

In spite of their sharply lower share prices and the need to go cap in hand to the government for liquidity support, Spain’s bank bosses have so far been spared the need to offer the humiliating apologies made by some of their US and European peers. By next year, if the property market slides further and the fallout from the Madoff affair proves harsh, even Spanish bankers might have to say sorry.

Even in today’s strange new world of state-capitalised private sector banks, the Spanish caja de ahorros, or savings bank, is an unusual creature, writes Mark Mulligan. Owned by no one but controlled by society, they are more akin to charitable foundations than co-operatives or mutual societies.

However you define them, though, the 45 regional cajas are facing one of the most difficult periods in their 173-year history, as bad loans eat into profits and core capital.

The legal framework for the modern-day caja was created in 1835, when liberal ideals and industrialisation were taking root in Spain. Aimed at encouraging thrift and enterprise among the working classes, they grew from the foundations of the Catholic church’s “Montes de Piedad”, early microlending institutions that extended small sums to the poor.

There is still a charitable element, as the cajas are foundations that must, by law, dedicate some of their profits to social works. However, in the past 30 years they have come to resemble more closely their listed competitors, financing the excesses of Spain’s property-fuelled boom. With roughly half the assets and savings of the financial system, they are now as important to the country’s well-being as commercial banks. Sector leaders such as La Caixa, with its portfolio of equity in some of Spain’s biggest listed companies, are also important corporate power brokers.

However, the cajas do not have the international diversity that has allowed large listed institutions such as BBVA and Santander to be picky about whom they lend to in Spain. Instead, the intensely regional cajas have scooped up “all the rubbish” as they seized market share at the top of the property cycle, in the words of a senior investment banker in Madrid.

As Spanish property developers collapse, the savings banks’ exposure to the sector – and to overstretched home buyers – is taking its toll. Less than 1 per cent a year ago but more than 3 per cent now, their collective non-performing loan rate is higher than that of the listed banks and climbing with alarming speed.

Credit rating agencies have made a series of downward revisions and bankers fear that the smallest and most overexposed lenders could eventually fail. “If a bank goes over 10 per cent on NPLs, it’s difficult to come back, and I think a lot of them are going to go over,” says the investment banker.

Although banking officials and politicians are loath to subscribe publicly to such a nightmare scenario, there is consensus that reform and consolidation in the savings bank system are unavoidable. This could take several forms, with the most drastic involving the aggregation of some of the worst affected into larger entities, which would then be recapitalised and sent back to work.

Another would be a series of takeovers, with strong cajas such as La Caixa, the Catalan powerhouse, or the capital’s Caja Madrid mopping up weaklings in “sunbelt” regions along the Mediterranean coast. But political will for such change might be lacking.

With regional politicians and local councillors distributed through the three tiers of corporate governance, the institutions have become, to varying degrees, platforms for pork barrel politics, regional power games and partisan bickering. The attempt to merge three cajas in the Basque country, for example, has become a long-running soap opera as political differences threaten the deal.

Tie-ups across borders in Spain’s proudly autonomous regions have also proved all but impossible in the past, mainly because of legal complexities. As it is, a caja simply wanting to advertise in all of Spain’s 17 regions needs 18 permits – one from each regional government and one from the centre.

Those who are eager to reform the cajas say it is up to legislators to facilitate a shake-out. They argue that reducing the limit on political representation on the banks’ boards, supervisory commissions and general assemblies from 50 per cent now to 25 per cent would be a good start.

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