Brussels warns of risks Spanish banking sector faces from ongoing recession

The European Commission on Wednesday said the adjustment program imposed on Spain in exchange for the bailout to clean up its banking sector remains on track but warned of a number of potential risks that could derail the situation.

In its third report on Spain’s compliance with the terms of the rescue package of up to 100 billion euros to recapitalize banks in problems, the so-called troika - the Commission, the European Central Bank and the IMF - highlighted the risks deriving from the banking business in itself, uncertainties generated by new regulations, and the impact of a prolonged and deep recession. “The challenges are significant,” the report said.

The troika’s admonitions put something of a damper on the increasingly upbeat mood of the government regarding the arrival of a much-awaited economic recovery. They also come on the heels of updated forecasts released Tuesday by the IMF predicting that the economy would not recover until 2015, a year later than previously expected.

The Commission warned that the ongoing depressed state of economic activity accompanied by rampant unemployment could further push up non-performing loans. It painted a scenario of a vicious circle under which banks further tighten the tap on lending in order to meet capital needs, thereby delaying the recovery further. If the economy remains in the doldrums, this could lead to further deterioration in the quality of the banks’ assets and further need to top up capital.

“A prolongation of the negative trend for unemployment, disposable income and the solvency of companies raises the risks, especially for weaker banks,” the report said.

Although the banks have seen a pick-up in their earnings in the first quarter of this year, the troika sees further potential pressure on their balance sheets as coming from a ruling by the Supreme Court calling for so-called floor clauses in interest payments included in home mortgages, which could undermine their net interest income.

Measures introduced by the Andalusian regional government limiting evictions from the family home was highlighted as another potential drag on the banks. The Bank of Spain has also tightened provisions banks must make for loans that have been restructured or refinanced, which could put a further strain on capital.

The weakest lenders are the nationalized banks, which have received by far the bulk of the 41.5 billion euros Spain has drawn from the 100 billion euros made available by the European Stability Mechanism (ESM) to clean up the balance sheets of lenders ravaged by their over-exposure to the ailing real estate sector.

Despite improved access to the wholesale funding markets, lending by Spanish banks remains tight as a result of weak demand because of the anemic state of the economy and deleveraging undertaken by banks and households. Loans to the domestic sector in the four months to April declined by 8 percent from a year earlier, while lending to companies was down 19.5 percent.

While Spain has largely met the commitments accompanying the bailout, the troika pointed to a delay in the approval of the regulations governing the operations of the Sareb asset management corporate, the so-called bad bank set up to absorb lenders’ toxic real estate assets. Those norms are expected to be approved shortly.

Despite the provisos, the troika considers that Spain will not need to draw further on the loan from the ESM, although it insisted on the wisdom of extending the maturity of the bailout beyond January of next year as a safeguard. The ECB is due to carry out an in-depth analysis of European banks’ capital requirements needs in the middle of next year.

The official stance of Economy Minister Luis de Guindos and the conservative Popular Party government of Prime Minister Mariano Rajoy is that the expiry of the loan does not need to be extended, although an official decision on this is not expected to be taken before the fall. However, according to EU sources, there are certain members of the government who look more favorably on extending the loan as a safety net.