Only the EU can save Spanish banks now

We should face up to the fact that the Spanish government does not have the money to save its banks and the European taxpayer will have to bear the cost - says academic

Spain is circling the drain and on the surface the problem is that markets are worried about Spanish government debt spiralling out of control. The underlying problem, though, is the dire economic situation in the country and the lack of growth - which in turn has a lot to do with the state of the banking system. Before the crisis, banks gave more loans than they could finance with their own deposits and so turned to money markets for extra funding. In time, Spanish banks became dependent on such funding.

However, for a while now markets have been reluctant to lend to the banks because of worries that some of them are sitting on large undisclosed losses. Since the market does not know which banks are sitting on losses, it does not want to lend to any banks. The European Central Bank has stepped in as a supplier of funding to avert an immediate catastrophe, but the underlying issue has not been resolved.

The Bank of Spain has tried to tackle the problem by encouraging banks to merge. The thoughts behind this are that mergers do not produce large costs for the Spanish taxpayers, and that many banks are below optimal scale anyway. Also, it is felt that if you can coerce a healthy bank to merge with a sick bank - you hopefully get a bank out that is not too sick. But, the reality has been that when you coerce two banks of dubious quality to merge - you often just get one larger bank of dubious quality. The strategy has not worked.

The government is now trying to tackle the problem by forcing banks to increase provisions and demanding that they make repossessed assets more visible in the balance sheet - but without requiring a valuation at market prices. Although these measures do not impose direct costs on the taxpayer, they are unlikely to do much for transparency. We should face the fact that any real solution is likely to cost money. For example, the most direct solution would be an asset buyback in which Spanish banks can sell bad assets at subsidised prices to a 'bad bank' - which then winds down these assets.

The prices need to be subsidised because otherwise the banks will just hang on to the bad assets in order to avoid crystalizing losses. Since prices need to be subsidised, the scheme will cost money. On the upside, bad assets would come out into the open and would be dealt with; and transparency would be improved. The hope would be that restoring the credibility of the banking system would help Spain to return to growth, which would allow the Spanish government to balance its budget.

We should also face the fact that the Spanish government does not have the money that such a solution would require. But the European Union does. It could use the funds of the European Stability Mechanism funds to bail-out Spanish banks. Yes, this would imply more bank bail-outs on the shoulder of the European taxpayer - which is patently unfair. But what is the alternative? Palliative measures, which also cost money, followed by an eventual Spanish death spiral - and a possible collapse of the eurozone.

Dr Max Bruche is a senior finance lecturer at Cass Business School, in the United Kingdom