Spain was lauded for its regulatory regime (by The Economist, among others) when the financial crisis first broke. Rules against off-balance sheet vehicles protected the country’s banks from America’s subprime bust. A system of “dynamic provisioning” allowed them to put money aside for expected losses before they started to be incurred. A peer review of Spain by the Financial Stability Board, published yesterday, repeats some of this praise. Yet Spain’s banks are now the source of more concern than any other country’s, given connected worries about their capital needs and the public finances.
Does this tarnishing of Spain’s regulatory reputation tell us anything (other than about journalists’ judgment)? One is simply that financial crises caused by property busts take a long time to play out. According to a study of banking crises by Carmen Reinhart of the University of Maryland and Ken Rogoff of Harvard University, house prices tend to decline for four to six years after reaching their peak. Equity prices snap back much more quickly, as we have again seen in this episode. Spain’s downturn has been particularly leisurely. House prices are down only 12% in nominal terms, thanks to low interest rates and rather conservative mortgage underwriting standards. Given the country’s oversupply of houses, they will keep falling for a while yet.
Second, Spain’s provisioning system may have smoothed the impact of the crisis but did not prevent the system from needing to be recapitalised. Countries that have had “mark-to-market” crises were forced to beef up capital more swiftly, which looks like a good thing now that sovereign-debt worries have people concerned about the potential impact of bank bail-outs on the state. When trust leaks from the system, investors want to see the market value of a bank’s assets, which is why the cajas will need to undergo lots of due diligence if they are to attract private capital now.
Third, a herd of small banks—in Spain’s case, the cajas—are as capable of causing trouble as big banks. We knew this already from America’s savings-and-loan crisis, but it bears repeating given the focus on big banks in the regulatory overhaul of finance (the Fed only today released proposals on how to define companies big enough to come under its supervisory remit).
Spain’s two big banks have by and large continued to perform passably through the crisis, in large part because they are diversified. Santander made more money in Brazil and Britain than in its home market in the fourth quarter, for instance. Smaller banks are likely to be more concentrated in the types of lending they do and the locations in which they do it. They are particularly likely to get overexposed to local developers, the real source of Spain’s banking troubles. It is a similar story in America, where smaller lenders are most vulnerable to dud commercial-property assets. Banks that are too big to fail are finance’s greatest headache; Spain’s regulators still deserve some plaudits in their handling of their largest banks. But banks that are too small to succeed are not much fun either. Read more.
