Tuesday, December 4, 2012

A rough estimate of Spanish recapitalization needs (ls)

I aim to provide a rough estimate of future losses of the Spanish banking system, therey pinning down its potential need for recapitaliziation out of ESM funds.  Data mainly comes from the Bank of Spain. I do not claim to obtain estimates accounting for endogenous feedback loops, it is rather a rule-of-thumb exercise which nevertheless sheds some light on the sufficiency of current rescue packages.

Total assets of Spanish financial institutions equal some €5.2 Trillion. The stock of aggregate credit is €2.0 Trillion. Securitiy Holdings amount to €1.2 Trillion. Roughly €400 bn of government debt is held by residents and probably €300 bn from financial instutions. 

How about losses from the stock of credit? The ratio of non-performing loans currently stands at about 10%, implying that €200 billion of credit are underwater. A commonly used benchmark for recovery rates is 40 percent, however, it is reasonable to assume an inverse relation between NPL-ratios and recovery rate since a large number of NPLs implies lots of liquidations which depresses collateral prices and hence recovery rates. I therefore assume a recovery rate of 30%. Additionally, one has to account for losses which banks yet have accounted for with the help of (dynamic) provisioning. I heroically assume that 33% of future losses are covered yet.

Thus, expected losses from the credit stock are: €200 bn x 30% x 67% = 40.2€ Billion

How about losses from securitiy holdings? By assumption, about 300€ bn of securities carry exposure against the government. Spains Debt-to GDP Level is projected to rise to 90% in 2013. Returning to the Maastricht criteria would call for a 33% haircut. Admittedly, this is an unrealistic worst-case scenario but useful for illustration. In this case, losses amount 100€bn.

Note that I abstract from potential losses out of interbank exposures. I do so because I assume that removing NPL-risk and haircut risk essentially removes the two main drivers of aggegate Spanish bank risk and stabilizes the system such that no interbank defults occur.  

Hence, total projected losses add up to 140€ bn. The financial system's aggregate equity position is about €400bn. So 35% are likely to be siphoned off in the next years, leaving the system with roughly €250 bn equity in relation to total assets of five trillion Euros, i..e the system would operate with a prohibitively high leverage ratio of 19:1. In order to avoid such unfavourable outcomes, European leaders agreed to inject €100 bn into the shaken Spanish banking system.

My rule-of-thumb calculation indicates this is very likely to turn out as insufficient. Clearly, my government debt scenario is very pessimistic. But note in contrast the exterme vulnerability of expected losses from credit against worsening recovery rates and worsening NPLs. It seems as we need an additional rescue package...