Don’t be fooled by the optimism overflowing from the stress test of Spain’s banking system released on Friday. American Consultancy Oliver Wyman, which performed the test under the steering committee tasked with assessing Spain’s bank recapitalization, uses two disingenuous assumptions to drastically underestimate banks’ financial needs by up to a whopping 60 billion euro. Cries of relief that Spain will not have to request rescue funding in excess of the 100 billion euro in already granted European aid are suspect at best.
The Wyman report offers two different scenarios spanning the course of 2012-2014 — one baseline and one adverse. Media focus has centered upon the adverse case, which is the projected upper bound of a potential bailout’s size. That figure is 53.75 billion euro. Unfortunately, this calculation is victim to the same two major errors contained within Wyman’s June 2012 report, which Colin Lokey at Seeking Alpha pointed out upon its release.
The first problem with such a modest number is that the report uses a 6-percent tier 1 capital adequacy requirement for the banks under the adverse scenario while it uses a 9-percent requirement for the baseline case. Although 6 percent is a more reasonable ratio than 9 percent in the banking world, changing the capital adequacy requirement between simulations creates incomparable results. When assessing banking system health under two different macroeconomic conditions, no assumptions of the model, besides the economic ones, should change.
The switch from 9 percent to 6 percent is unlikely to happen in reality. The European Banking Authority (EBA) requires banks within the Euro Area to hold 9-percent tier 1 capital against risk-weighted assets. And given that plans are on the way for a Eurozone banking union, it seems dubious that Spanish banks will be able to escape from the 9 percent requirement even during an “adverse” situation.
Recalculating Spain’s capital shortfall under the 9 percent requirement in the adverse scenario reveals that the Wyman report underestimated needed tier 1 capital by 12.66 billion euro. This increases the bailout figure to 66.4 billion euro.
The Wyman report’s capital adequacy switcheroo hides yet more problems. The report overestimates total tier-1 capital adequacy within the Spanish banking system by a sizeable 45.3 billion euro — this includes those banks not needing bailout (but taking heavy losses) as well as those in need of rescue. That’s not all. The number of individual banks in need of bailout funding increases from seven to 10 after adjusting to the more realistic tier-1 capital requirement of 9 percent.
The second flaw within Wyman’s analysis is that it is extraordinarily overgenerous in estimating the ability of Spain’s banks to generate profits — 59 billion euro during 2012-2014 to be exact. In 2011, total profit generation by Spanish banking groups was 11.43 billion euro. That’s an almost 50 percent decline from the previous year’s figure of 20.3 billion. If this trend continues through 2014, which seems likely given Spain’s growing financial problems, total profit generation will amount to a mere 12.09 billion euro. That’s a 46.91 billion euro discrepancy with Wyman’s numbers.
After recalculating losses in excess of loss absorption capacity (i.e. how much Spain needs in rescue funds) using a comparable and politically realistic capital adequacy requirement as well as a reasonable assessment of generated profits, the new bailout figure comes to 113.31 billion euro.
That’s more than the 100 billion euro Spain currently has available through the European Financial Security Facility (EFSF). Over the period 2012-2014, Spain will likely apply to the European Stability Mechanism (ESM)—Europe’s permanent bailout fund — for more funding and also to the European Central Bank (ECB) for purchases of Spanish sovereign debt through the new Outright Monetary Transactions (OMT) program announced in early September. Spanish Prime Minister Mariano Rajoy and ECB President Mario Draghi will continue fighting over bailout conditions, as part of their ongoing high-stakes game of chicken.
The most optimistic scenario seems to be one in which generated profits are higher. During 2008-2011, profits decreased on average by roughly 16 percent each year. Forecasting this trend through 2014 entails generated profits of 24.46 billion euro and a total bailout need of 90.86 billion. However, the first bailout scenario of 113.13 billion seems the more plausible of the two because Spain has come under severe financial heat more recently, thereby making the 44 percent drop in annual profits from 2010-2011 more representative of future developments.
The Wyman report is a gross underestimation of Spain’s financial needs. As political leaders rejoice and neglect to question the flawed assumptions underlying the report’s predictions, their cognitive dissonance towards the bust Spanish banking system will become increasingly apparent.