Spanish banks run with the bears

The latest attempt by Spain to shore up its banking system, its fourth in four years, underscores how Europe botched its response to the financial crisis and made its current position far more fragile and vulnerable in the process.

On Friday the Spanish Government, having already partially privatised its fourth largest bank, Bankia, announced its banks would have to add €30 billion ($A39 billion) in provisioning against their property loans. Only in February the Spanish banks were forced to add €54 billion ($70 billion) in provisioning against those exposures.

Despite the latest attempt to stabilise a banking system undermined by its exposures to a property bubble that has burst, the Spanish long-term bond rate spiked and its sharemarket fell. The 30 per cent coverage of the banks' property exposures the new provisioning would create wasn't deemed sufficient.

Ever since the global financial crisis erupted it has been apparent that the Europeans were reluctant to bite the bullet on their banks' problem exposures, preferring to try to avoid the need for massive recapitalisations and to buy time in the hope that would reduce the scale of the task for governments that were themselves in parlous financial positions.

Even after several rounds of stress-testing the European banking system remains under-capitalised in the eyes of the rest of the world. That situation has been worsened by the way the European Central Bank's trillion-euro injection of effectively costless funding into the banks has been deployed by the banks, which have been buying their countries' sovereign debt to reduce their governments' borrowing costs. Weak public and private balance sheets have become inextricably entwined.

The contrast is with the UK and US, where the governments took the hard decisions early and used tough and realistic assessment of the condition of their financial institutions as their guide. The cost to taxpayers and shareholders was massive but the banks were recapitalised and stabilised and, in the US, have rebounded. In those economies the challenge is to manage public sector debt and deficit levels, rather than combined sovereign debt and banking crises.

The Spaniards, while insisting their banks make larger provisions against their property loans, have confined their direct intervention to Bankia, although the Spanish government has said that it is prepared to make available five-year loans convertible into equity for banks unable to raise new funds to cover the impact on their capital bases of the extra provisioning. None of the banks has yet explained how they will raise new capital.

Apart from the obvious need to stabilise the banks against a backdrop of a shrinking economy and an unemployment rate that is already amongst the highest in Europe, the Spanish and European authorities would be acutely conscious that the outcome of the Greek elections poses a very real threat to Spain.

With the parties that committed Greece to an austerity regime in return for eurozone funding unable to form government and the radical left and, it appears, the population at large revolting against the austerity program there is a dangerous period of brinkmanship looming that poses a real threat to the other ailing southern European economies, particularly Portugal, Spain and Italy.

The Greeks appear to want the funding without the austerity and appear to believe the rest of Europe will fold rather than risk the chaos of a formal Greek default and/or exit from the eurozone.

If it appeared probable that Greece would exit and revert to the drachma, there would almost inevitably be a pre-emptive run, not just on Greece's banks, which would be destroyed, but probably also on the banks of the other weak economies in case the eurozone did implode.

Those countries do need to shore up confidence, and the capital bases, within their banking systems without significantly worsening their already weak public sector financial positions in the process.

The belated action in Spain, while a step in the right direction, may not be enough and may have come too late if the unstable politics within Greece can't be resolved and trigger a chain reaction within the most vulnerable eurozone economies.

Europe's procrastination and its unwillingness to take the kind of harsh medicine that the US and UK swallowed so painfully and controversially in 2008 and 2009 bought it time but has compounded and complicated its problems and its risks.

If all the eurozone economies had, three years ago, done even what Spain announced last week they'd still have a sovereign debt crisis to manage but it wouldn't be enmeshed with a badly under-capitalised banking system as well.