Banking's Spanish repeat year

Spain's banking crisis is a reminder that retail bank lending has never been a low-risk activity. But this lesson, dusted off from the GFC, will keep recurring until it is learnt.

Lord knows how Spain will get Bankia, its troubled savings bank conglomerate, out of its €19 billion mess. But, for once in the crisis that has been unfolding since 2007, anyone can grasp how it happened.

Despite the enormity of Spain’s problem, this crisis is a refreshing change. It doesn’t involve wholesale deposits, collateralised debt obligations, or structured investment vehicles – or even an investment bank. It is the kind of fiasco that always brings down banks.

Bankia and the troubles of Spain’s other cajasare a repeat of the US savings and loans crisis a quarter of a century ago, which cost $100 billion. "Real estate lending became the fashion, the ‘new’ banking idea of the times,” William Seidman, who as head of the Federal Deposit Insurance Corporation tackled the S&L crisis, later recalled.

Sound familiar?

It ought to because it wasn’t so long ago and it involved a similar brew of over-leverage, a commercial property bubble, poor supervision and hubris. It was both familiar and avoidable – not wrapped up in financial alchemy or hidden in a unit of an insurance company.

There is no need to seek new lessons from this phase of the financial crisis because the old ones will do perfectly well. Do not lend excessively to property developers who will take any loan they are offered; remove the punchbowl before the party ends badly; and remember the past.

Regulators and governments have mainly focused on the unpleasantly innovative aspects of the 2008 crisis – how derivatives and deregulation permitted bad loans to cross the former divide between retail and investment banking and how Wall Street institutions such as Morgan Stanley and Goldman Sachs became too big to fail.

The repugnant way in which taxpayers suddenly found themselves on the hook for the collapse of risky institutions whose employees paid themselves very richly led both to the Tea Party and Occupy Wall Street. It is appalling yet so far we seem to be stuck with it.

The mixing of retail and investment banking at institutions such as JPMorgan Chase and UBS is just as problematic. JPMorgan’s complex trading in credit derivatives in London, on which it has lost $2 billion, has undermined its credibility in criticising the Volcker rule barring proprietary trading.

Yet the Spanish crisis, following the one in Ireland, is a useful reminder that retail banking has never been a low-risk activity. Traditionally, it has been just as effective a method of losing billions as investment banking or trading – indeed, more so.

The fact that it recurs, however, does not make it inevitable. A few interventions can make a lot of difference, as they would have done in Spain and Ireland had bankers and supervisors been warier.

The International Monetary Fund, which has had to bail out Ireland, was sanguine when it inspected both countries in 2006. It warned about credit growth but found that Spain’s banks were "highly competitive, well-capitalised and profitable... they would be able to absorb losses from large adverse shocks without systemic distress”.

Confidence that things cannot go disastrously wrong is common in credit booms. "This was a plain vanilla property bubble, compounded by exceptional concentrations of lending,” wrote Klaus Regling and Max Watson in their 2010 report on Ireland’s crisis. Any analysis by supervisors "should have sounded alarm bells loudly”.

One alarm bell for Spain was the similarity between its savings banks and the S&Ls. The latter were mutually owned local banks that were supervised under a mixture of state and federal charters and expanded rapidly into commercial property lending due to deregulation. By the mid-1980s, half of their assets were property loans.

The Spanish banks exploited a similar regulatory confusion and some were pushed by local governments to make loans. Moody’s estimates that 23 per cent of lending to the Spanish private sector last year consisted of property and construction loans. Avoiding over-concentration in property loans was the main lesson of the crisis in the early 1990s, not only in the US but also in Scandinavia and the UK. Most banks worked hard to improve risk management in order to avoid the trap again. Yet this lesson was soon forgotten.

The Bank of Spain was not a particularly lax regulator – Regling and Watson praise its refusal to let Spanish banks set up "capital-light” off-balance sheet vehicles to offload loans. Bankia’s balance sheet is in a bad way but the trouble appears to be plainly on display.

Yet the Bank of Spain, like other regulators, did not stop the bubble of the early 2000s getting out of control. Most regulators took the view of Alan Greenspan, the former chairman of the Federal Reserve, that they might warn of dangers but should not intervene.

In future they need to act like Asian bank regulators, which are unafraid to be dirigistein limiting deposit-funded lending institutions. The Hong Kong Monetary Authority, for example, adjusts the loan-to-value ratios under which local banks can make mortgage loans to mitigate property bubbles.

"The critical catalyst causing the institutional disruption around the world can be almost uniformly described by three words: real estate loans,” Seidman remarked of the 1990s crisis. Yet a decade later, supervisors became sure that banks could best judge how much to expose themselves to property.

Bankia makes clear that banks competing for business amid rising property prices are incapable of self-restraint. It will keep happening unless the lesson is learnt.

Copyright The Financial Times Limited 2012.

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