Spain should cede partial control of its troubled banking system to the ECB if it wants to receive extraordinary monetary support, Lorenzo Bini Smaghi, a former ECB board member, has said. His comments come amid fears over the solvency of Bankia, the country's fourth largest lender, after the government was reportedly forced to scrap a coercive government debt-for-equity capitalization plan.
“This plan cannot be implemented unilaterally by the Spanish government. It needs to be done according to precise limits as agreed by the ECB on a restructuring plan for Bankia [the country’s fourth-largest bank],” Smaghi told Euromoney in an exclusive wide-ranging interview.
On Sunday, Spanish government officials released details of a plan to recapitalize Bankia with Spanish government bonds, which could then be used as collateral to borrow funds at the ECB. On Monday, Spanish prime minister, Mariano Rajoy, said the government has not formally discussed its €19 billion Bankia rescue plan with the ECB but yesterday Spain backtracked, suggesting Madrid would fund the bailout in the market.
A government-guaranteed debt-for-equity plan was implemented in Ireland but “under very strict conditions in the context of a very strong IMF/EU/ECB package”, Smaghi said.
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| Lorenzo Bini Smaghi, ECB executive board |
Spanish government bond yields touched 6.5% on Monday, following the news, as markets fear the sovereign lacks the financial capacity to recapitalize the banking system, reeling from the collapse of the real estate sector. Spanish banks’ bad-loan ratio hit a record 8.16 in March, while borrowing from the ECB hit a record €263.5 billion in April, equivalent to14.5% of Spanish GDP. The government has recently called on financial institutions to make a further €30 billion of provisions to cover real-estate losses – only three months after an initial €54 billion of provisions was ring-fenced. Over the past few years, even after missed debt service payments and sharply reduced collateral values, Spanish banks have hidden losses by carrying loans at par value, complicating efforts to assess the solvency of the banking system.
One of the most worrying aspects of Bankia’s request on Saturday for a €19 billion state recapitalization was that it comes after the bank reclassified what it had previously classed as SME loans as in fact loans to the troubled property sector and also after it applied much higher provisioning charges than other Spanish banks have so far set aside against retail mortgages. That raises two questions: how bad will the mess look at other banks if they also start to come clean and how big a bailout bill can the sovereign pick up?
“The ECB can lend only to sound banks and so it needs to be reassured it is sound and solvent; to do that it can’t rely on the word of the Spanish supervisor alone,” Smaghi said.
The ex-official argued that the ECB should assume oversight of financial institutions requiring further extraordinary monetary support – overriding national vetoes – before it considers allowing banks to directly access the European Stability Mechanism (ESM).
As Euromoney has reported, market players have argued that allowing banks to access the ESM directly – or allowing the ESM access to the ECB’s repo window – would be the most effective measure to prop up the Spanish banking system.
To reduce negative sovereign-bank feedback loops, and boost the transmission of monetary policy, the eurozone’s central bank should be granted an effective veto over banks requiring extra monetary support, Smaghi said.
“If ESM was allowed to recapitalize the banks directly, it would need to have leverage over these banks. There should be a transfer of responsibility whereby banks would be under the supervision of the ESM,” he said. This would transform the ESM as into a “crisis-resolution fund, a special fund, which would recapitalize the banks and also induce them to restructure their balance sheet and manage bad assets”.
He added: “This might be a stealth move towards the creation of a eurozone-wide bank supervisory structure, which we need to have anyway, since in a single-currency bloc you can’t have 17 independent banking supervisors.”
Asked whether this move would entail a time-intensive revision in euro-wide treaties, Smaghi, currently a visiting scholar at Harvard University, said: “To some extent the ECB can do this under the current statute for banks which are under clear difficulty and require Emergency Liquidity Assistance (ELA). However, it would be preferable to generalize these powers, through a change in statutes, to give it enforceability not only in times of crises but also in a preventative way.”
However, the Italian economist stopped short of advocating ESM access to ECB repo facilities, citing debt monetization concerns, but instead called for a jump in the ESM’s capital to reflect the rise in Spain and Italy’s funding needs.
Circuit breaker
Fears are growing that a circuit breaker is needed to stem the rise in sovereign yields, without more aggressive action from the ECB. “I have a feeling deposit outflows from peripheral European banks might be the development that convinces policymakers of the seriousness of this crisis," says Andrew Stimpson, banking analyst at Keefe, Bruyette & Woods. "But the current market distress more than justifies a new, aggressive pan-EU rescue package.”
Asked whether national central banks in the eurozone should be allowed to expand the ELA programme – a liquidity facility in which national central banks set the collateral requirements and are directly liable for – he said: “More ELA programmes could take away the pressure to restructure the balance sheets of the banking system.” Asked whether the ECB should accelerate bond purchases, Smaghi widely seen as a hawk, said: “To be effective, the ECB bond purchase has to be perceived by the markets as being without limits, which would mean that the ECB is not concerned with taking the risk directly on its balance sheet.”
He argued further euro weakness would be “more helpful” than an interest rate cut.
In recent weeks, fears have grown that a Greek exit from the eurozone would exact a heavy toll on the ECB’s balance sheet, already struggling with Target2 liabilities, and the prospective reduction in the value of collateral it holds for its financing operations. Smaghi, however, struck a sanguine note: “The risk on the ECB’s balance sheet would be the last of my worries in the event of a Greek exit from the eurozone”, citing the doubling of ECB reserves in recent years, the aggregate eurosystem reserve pool at €300bn and its own internal risk management model attached to the LTRO programme
“What’s more, a counterparty would have to fail and the collateral it has posted has to be valued at a price lower than the haircut – two big events – before losses are felt on the ECB balance sheet,” he said.
Greater political integration, stronger fiscal rules, and ECB oversight over a bank resolution framework was an essential part of the crisis-fighting strategy, he concluded.
This article, originally published on Monday 28 May, has been updated to reflect Spain's reported decision to backtrack on its debt-for-equity capitalization plan.
Additional reporting by Peter Lee