An important step

The ongoing reform of Spain's financial sector was at the center of attention this week. On Thursday, Moody's downgraded Spain's debt rating a notch from Aa1 to Aa2, saying that the government had underestimated the cost of recapitalizing the country's savings banks, a process the ratings agency considered would now require at least 50 billion euros. Moody's had warned of such a rating downgrade, but its decision to announce the move just hours before the Bank of Spain issued a report on the recapitalization of the banking sector was nevertheless inopportune.

Meanwhile, Congress has now approved the government's decree on recapitalizing the savings banks, financial entities which have traditionally been controlled by regional governments through boards representative of political and labor organizations. The principal criticism of the measure has been that few of the savings banks are in a position to raise the 10 percent core capital ratio now required of them if they are not to seek listing on the stock market.

Moody's decision to downgrade the country's debt rating is another illustration of the confused picture being presented to investors at a time of crisis. The rating agency insists that recapitalizing the savings banks will cost 50 billion euros. But the Bank of Spain estimates the cost at 15.2 billion euros, with eight groups of savings banks and four banks unable to meet the new requirements of Basel III.

An impartial analysis based on a comparison of the quality of the agency's sources with those of the Bank of Spain, would make it immediately clear that it is the country's central bank that should be trusted. Perhaps for that reason, and also because the investment markets understand that Spain, Belgium, and Italy are not in the same situation as Greece, Portugal or Ireland, the yield spread on Spanish debt rose only slightly following Moody's announcement, and then fell gradually later.

Furthermore, as has now become clear, the ratings agencies work on a cyclical basis, in effect issuing self-fulfilling prophesies. In short, they tend to go with the flow, and reflect conventional wisdom. When the markets are bullish, they support financial adventurism, and at times of recession they punish the markets or the countries that have been hardest hit by economic downturn. An analysis such as that of Moody's favors taking short-term positions against Spanish debt, rather than offering a broader, more neutral picture.

Spain's banks and savings banks now have a clear framework within which to operate. Those that are unable to meet the new core capital requirements will have to come up with a plan to recapitalize over the next two weeks. They can either go public; a risky option given the current downturn in the capital markets, meaning they would have to meet an eight-percent core capital ration. If they cannot meet the 10-percent core capital ratio that the government is now demanding, they will be partially nationalized.

Given that such a high core capital requirement will increase solvency but make it harder to lend money, perhaps it might have been a good idea to allow other banks to take a stake in banks looking at a venture into the stock exchange. This de facto restructuring would avoid financial control of many of this country's banks falling into the hands of speculators with the result that even less money is made available for lending to businesses and home buyers.