El Diluvio: The Spanish Banking Crisis, 2008-2012∗ Tano Santos Columbia University and NBER July 13, 2017 Abstract This paper offers a narrative of the Spanish banking crisis between 2008 and 2012, from the early stages of the crisis to the request of financial assistance by Spain to its European partners. It centers in particular on the management of the crisis by the Spanish authori- ties. Though non performing loans were widespread, solvency concerns were concentrated in a particular segment of the Spanish banking system, the cajas sector. This sector was the anomaly of the Spanish banking system. The cajas had, one, faulty governance insti- tutions, which made them subject to capture by the powerful political regional elites, and two, unclear procedures for private recapitalization, which made access to equity markets an impossibility. Crisis management suffered from an internal contradiction. The strategy was informed by two principles. First, debt holders, independently of their seniority, would suffer no losses and, second, tax payer funds available for recapitalization would be mini- mized. Given that private capital was not forthcoming, bank debt was not to be bailed-in and tax payer funds were to be minimized the solvency crisis could never be credibly closed. Spanish authorities operated under two tight constraints. First, the cajas brought unique political economy issues to crisis resolution. Second, Spain's membership in the mone- tary union meant that Lender of Last Resort (LOLR) tools were not directly controlled by the Bank of Spain. In addition, banks and cajas depended on foreigners to refinance a substantial fraction of their liabilities, which made them subject to sudden stops. The combination of these constraints and the internal contradictions of the strategy allowed the solvency crisis to morph into a liquidity crisis, which Spain could not successfully meet given its membership in the monetary union. As a result Spain had to request a financial assistance package on June 25th, 2012. ∗I thank Jos´eLuis Peydr´oand Rafa Repullo for extensive conversations on the topic that greatly improved the paper and Mar´ıaSantos of Infobolsa for data access. Tom´asMondino provided invaluable research assistance. This paper was prepared for the third meeting if the DNB-Riksbank Macroprudential Conference Series. I thank the organizers for inviting me to write this paper and Jos´eManuel Campa of Banco Santander and Claudia M. Buch of the Deutsche Bundesbank (the discussants) for their perceptive comments. All errors and views remain, of course, my own. Contents 1 Introduction and summary 1 1.1 Spain: Banks, cajas and real estate in the early years of the euro . .1 1.2 The different phases of the Spanish banking crisis . .5 1.3 Policy response: The solvency trilemma and overconfidence . .6 1.3.1 Solvency trilemmas and credible loss discovery . .7 1.3.2 Overconfidence . .8 1.4 How was this banking crisis different from previous ones? . .9 1.4.1 The political economy of the Spanish banking crisis . .9 1.4.2 The Spanish policy response and the Eurozone . 12 1.5 A word of caution . 15 2 The Spanish banking crisis: Two factors 16 2.1 The Spanish banking system and the world financial markets . 16 2.1.1 The onset of the Eurozone banking crisis . 16 2.1.2 The world portfolio of Spanish risk . 19 2.2 Political economy: Caja Madrid: 2008-10 . 22 3 Phase I (Sept. 2008 - Apr. 2010): Initial steps 28 3.1 The banking system: Solvency reinforcement and retail banking . 28 3.2 Policy reaction: Setting up the tools to fight the banking crisis . 30 3.3 The first caja falls: Early lessons . 35 3.3.1 Caja Castilla-La Mancha . 35 3.3.2 Early lessons and policy response: The FROB . 39 4 Phase II (Apr. 2010 - Feb. 2011): Restructuring 42 4.1 Reform and restructuring of the cajas sector: The IPS (RDL 6/2010) . 43 4.2 Two failed IPS . 46 4.3 The CEBS Stress Tests of 2010 . 51 4.4 A strange tale: Cajasur . 57 5 Phase III (March 2011 - December 2011): Market tests 58 5.1 Taking stock of the restructuring process . 58 5.1.1 Restructuring and credible loss discovery . 58 i 5.1.2 Restructuring and governance . 63 5.2 The end of the cajas: The RDL 2/2011 . 66 5.3 The IPOs . 67 5.4 The collapse of Banco Base and the end of CAM . 71 5.5 The state of the recapitalization process at the end of 2011 . 72 5.6 Economic distress and the ECB . 75 6 Phase IV (December 2011-June 2012): El diluvio 80 6.1 LTROs: The ECB provides breathing space . 81 6.2 New cabinet - old measures. The end of Bankia . 83 6.3 The end . 86 7 The management of the Spanish crisis: An evaluation 86 7.1 The Spanish authorities didn't internalize the new constraints . 87 7.2 There was never a credible loss discovery strategy: Solvency trilemmas . 89 7.3 Restructuring led to more opaque balance sheets . 91 7.4 Overconfidence led to non robustness . 92 7.5 The final tally . 95 8 The Spanish banking crisis and the banking union 97 8.1 On the accumulation of risk . 97 8.1.1 Countercyclical buffers . 98 8.1.2 LTV and DTI ratios . 99 8.1.3 Corporate governance . 100 8.1.4 Restrictions on securitization . 100 8.1.5 Wholesale funding . 101 8.2 On resolution: The case of Banco Popular . 102 8.2.1 Banco Popular: Some background . 103 8.2.2 Banco Popular during the crisis . 104 8.2.3 Popular's solvency situation . 107 8.2.4 The end of Popular . 109 8.2.5 Popular's resolution: some considerations . 111 9 Conclusions 114 ii 1 Introduction and summary The Spanish banking crisis is one of the more salient chapters of the larger Eurozone crisis. Spain is the fourth largest economy of the Eurozone and home to two of Europe's largest banks. As a result an unmanaged crisis there posed a systemic risk to the entire monetary union. This paper covers the Spanish banking crisis with a particular emphasis on the policy response by the Spanish and European authorities and the implications for the future of the Eurozone. Spain's banking crisis, as the Irish and Greek crises before it, showed the limits of the monetary union and confronted policy makers with the most serious challenges in the euro's short history. The focus on this particular crisis thus goes beyond an additional entry on the large list of banking crises of interest to financial historians. The lessons that European policy makers drew from it were embedded in the new institutions of the monetary union, the single supervisory mechanism and the resolution framework. Thus a natural question is whether these new institutions would be effective in preventing future crises in light of recent experiences. The study of banking crises always veers between the common threads that link all of them, the fragility of banking, and the particulars of the case. As a result some of the smaller episodes in a banking crisis can be tedious and may lead the reader to lose perspective on the larger lessons. This long introduction and summary provides a bird's-eye view of the Spanish banking crisis and a roadmap to the rest of the paper. This paper follows a previous one, Santos (2017), on the evolution of the Spanish banking system on the early years of the euro and the reader will be referred repeatedly to that paper for background. 1.1 Spain: Banks, cajas and real estate in the early years of the euro In the early years of the euro (1999-2007) Spain's growth rate was much higher than other western countries, driven by both domestic private consumption and investment. In particular, whereas in Italy, Germany and France investment ratios remained relatively stable (around 22% of GDP), in Spain it shot up well above 30%. The culprit was to a large extent a remarkable increase in the ratio of construction investment to GDP, which went from slightly above 12% to over 16%. This increase in construction was a response to an unprecedented increase in residential and commercial real estate prices. How was it all financed? The savings rate, traditionally high, was not enough to fund domestic demand and as a result Spain became in 2007 the second largest borrower in the 1 40 35 Construction 30 25 Real estate 20 developers 15 Industry ex-constr. 10 Mortgages 5 0 1999Q1 1999Q4 2000Q3 2001Q2 2002Q1 2002Q4 2003Q3 2004Q2 2005Q1 2005Q4 2006Q3 2007Q2 2008Q1 2008Q4 2009Q3 2010Q2 2011Q1 2011Q4 2012Q3 2013Q2 2014Q1 2014Q4 2015Q3 2016Q2 Real Estate Developers Construction Mortgages Industry -Non construction Figure 1: Spain: All credit institutions: NPL ratios for four sectors: Construction companies, real estate developers, industry (except construction) and mortgages to households. In %. Quarterly: 1999Q1-2016Q4. Source: Bank of Spain - Statistics Bulletin (Tables 4.13 and 4.18) world in dollar terms, only second to the USA. All these flows were intermediated by the Spanish banking sector. There were mostly two types of credit institutions in Spain, banks and cajas. The cajas were the peculiarity of the Spanish banking crisis: private entities with defective governance institutions that made them susceptible to capture by the local Spanish political elites. They were poorly managed, funding projects of dubious economic merits, some because of political reasons. In addition to these governance problems there was another peculiar feature of the cajas sector that was to prove critical in making it difficult to address the crisis: They lacked a clear recapitalization mechanism.