Why didn’t Europe bail out Spain’s banks directly?

By Felix Salmon
June 10, 2012
The FT has the best explanation of the way that Europe has this weekend agreed to bail out Spain's banks.

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The FT has the best explanation of the way that Europe has this weekend agreed to bail out Spain’s banks. Impressively, the whole deal was done on Saturday, in good time to let all the Spanish negotiators spend Sunday preparing for and watching Spain’s big opening match against Italy in the European Cup. (Portugal lost today; Greece had a draw on Friday; and Ireland isn’t in the tournament plays Croatia tomorrow. According to the odds, Spain has the highest chance of winning both the PIIGS subset and the tournament as a whole.)

The big question, going into this weekend, was whether Europe would be willing to recapitalize Spain’s banks directly, or whether it would simply help Spain bail out its banks. And the answer seems to be somewhere in the middle. Europe is going to lend money to Frob, which is basically the Spanish Tarp; Frob, in turn, will use that money to recapitalize the banks.

So really there are two bailouts here. The Spanish government is getting debt finance from Europe, and the Spanish banks are getting equity finance from the Spanish government. Because the money is ultimately going to the banks, the Europeans and the Spaniards have an excuse for not imposing tough austerity conditions on Spain. And that’s good: Spain has never been fiscally profligate in the way that Greece was, and there’s no reason why it would ever benefit from some kind of Germanic nanny double-checking and second-guessing every check it writes.

On the other hand, all the money for bailing out Spain’s banks is immediately going to become Spanish sovereign debt. And that’s not good, for anyone worried about the Spanish fiscal situation. What’s more, it’s unclear how much of the money is going to come from the ESM rather than the EFSF. That might seem like a niggardly distinction, but it’s an important one: the ESM has preferred-creditor status, which means that it’s senior to anybody buying Spanish sovereign bonds. And as a result, at the margin, the more ESM debt that Spain has, the higher the spread on Spanish government bonds, since every euro of ESM debt effectively subordinates every euro owed by the Spanish government to bondholders.

The way to avoid all this would have been for Europe to recapitalize the Spanish banks directly, rather than doing so by lending money to Frob. The IMF couldn’t participate in such a plan, since it can only lend to governments, not to banks — but the IMF isn’t participating in this plan, either. And by taking equity in the Spanish banks, Europe would actually have a chance of turning a substantial profit on the whole operation, instead of just lending money to Spain at concessionary rates. As it is, if the equity that Spain takes in the Spanish banks ends up rising in value, all that rise in value will accrue to the government of Spain, rather than to the Europeans who provided the money.

But clearly Europe hasn’t yet reached the point at which it’s willing to directly help out the financial sectors of member countries, no matter how necessary or potentially profitable that might be. Taking equity stakes in Spanish banks — or any other private-sector institution, for that matter — is clearly something which Europe wants to leave to individual countries, and I can understand that, at least in theory. In practice, however, I suspect that Spain and the markets would have been much happier if the flow of money had been direct, rather than being intermediated by the Spanish government.

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