Hidden pins in Spain's bank cushion

Spain's banking solution to the GFC has been toasted and emulated by policymakers around the world. Now it looks rather less convincing.


Spain’s turmoil spells trouble for the eurozone, but it also poses a tough question for the wider world. After the 2008 crisis, Spain’s banking regulation was held up as a model. Its central innovation – that banks should squirrel away extra reserves in boom times – was eagerly incorporated into the Basel rules on bank capital. But now that Spain’s banks are a disaster, the Spanish solution to the problem of unstable credit booms looks rather less convincing. It is time to think afresh about financial bubbles – and face up to a harsh lesson for deficit-addicted governments in the rich world.

Spain’s policy became the toast of central bankers because it filled a gap. In most advanced economies, central banks use interest rates to target inflation and therefore cannot simultaneously use them to prevent bank lending from getting out of hand. Meanwhile, supervisors focus on banks’ capital-to-asset ratios, ignoring the fact that a normally adequate capital buffer may be woefully inadequate if credit is expanding furiously, signalling a likely bust. The Spanish innovation – that buffers should vary across the economic cycle – seemed simple and elegant. During the bubbly phase of a credit boom, higher reserve requirements promised to restrain reckless lending. Then, during the downturn, the buffer would allow lenders to survive without a bailout.

To be fair, the Spanish approach worked up to a point. Starting in 2000, Spain’s banks put aside extra provisions with the result that, after Lehman’s collapse, they were strong enough to keep on lending, avoiding a credit crunch. But Spain’s extra cushion has proved utterly inadequate amid the eurozone crisis.

Why did Spain undermine its innovation by implementing it so timidly? The question is important because today’s revamped Basel rules require banks to build up counter-cyclical buffers of the same size that Spain had. The comforting answer – that the euro crisis is exceptional – is unfortunately the wrong one; history is littered with banking crises that would swamp a buffer of the size Basel now targets. Rather, Spain’s implementation fell short because of factors that stand as a caution to regulators everywhere.

These start with lobbying. After a few years of expensive provisioning, Spain’s banks complained. They were helped by the international accounting profession, which claimed that the accumulation of loan-loss provisions was a dark plot to smooth earnings; and reportedly by US officials, who suggested that Spanish banks might have to be de-listed from US stock markets because time-varying provisioning made their books hard to understand. In 2005, the Spanish authorities responded to this pressure by easing the rules.

Could the authorities have stood their ground? Enter the second factor in Spain’s story: it is hard to face down lobbyists when the cost of prudence is certain and the benefits are unclear. In a new International Monetary Fund paper, Giovanni Dell’Ariccia and co-authors drive this home. They consider credit booms in 170 countries and find that, while more than half led to a painful hangover, two in five actually boosted long-term growth. In fact, countries that spent more than five years in a boom since 1970 outperformed their more sober rivals.

Since the inflation of the 1970s, central bankers have built up the independence necessary to raise interest rates. But there is no equivalent deference to regulators who seek to choke off credit booms. What’s true for Spain’s counter-cyclical provisioning may be even truer for other regulatory measures; Israel’s central bank has restrained frothy property lending with rules on loan-to-value ratios, only to be met with sob stories of struggling young couples desperate to buy homes. Because regulatory interventions create obvious losers, they will always face political resistance – and will seldom be pursued vigorously enough to avert a bubble.

If the Spanish solution is not a silver bullet, where does that leave policy? Spain’s story underlines the need to battle banking’s externalities with several weapons – resolution mechanisms that make it easier to inflict losses on creditors, rules that insist on extra permanent capital as well as extra cyclical capital, measures to drive risk out of too-big-to-fail behemoths into small-enough-to-fail hedge funds. But the ultimate guarantor of banking solvency will always be the long-suffering taxpayer. As soon as global growth is re-established, governments will have to cut their deficits and force down their public debt ratios – all in grim preparation for the next banking bust.

Sebastian Mallaby, an FT contributing editor, is a senior fellow at the Council on Foreign Relations. Copyright The Financial Times Limited 2012.

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