So here we go again. After repeatedly failing to put a cap on the long-festering euro zone debt crisis and close gaping fiscal holes, policy makers are once again standing at the edge of the abyss. They have been driven there by a mushrooming Spanish banking crisis dramatically worsened by their own missteps.
Spain's banking woes date back well before the euro crisis first hit world headlines in 2010. Much-ballyhooed stress tests conducted that summer on 91 European banks concluded that only seven small struggling banks failed, five of them Spanish. That, it turned out, was only the tip of the iceberg.
Spain's banks, most notably its large number of regional savings banks, or cajas, took a severe pounding when the country's property bubble – like those in the U.S. and Ireland – blew up in their faces in 2008. Estimates vary on the actual balance-sheet damage and the cost of restoring the banking system to a sounder footing. The banks have written down about €100-billion ($129.2-billion) worth of property loans so far, many of them to developers. But that covers less than half their estimated potential losses.
Stabilizing the banks could take anywhere from €60-billion to €125-billion or more, based on analysts' estimates. Emilio Botin, chairman of Spain's biggest bank, Banco Santander, puts the system's additional recapitalization needs at a more modest €40-billion.
But Madrid simply can't raise that kind of money, because it has been effectively shut out of the markets from a lack of confidence in the ability of Spain and other embattled euro zone countries to meet their growing debt obligations against the backdrop of a worsening recession.
"Unfortunately, in the current jittery environment, the Spanish government is in no position to inject €125-billion into its banks without external help," BCA Research concluded in a report in May. Madrid's solution is to seek a direct bailout from the euro zone rescue fund to which it contributes. Which puts the ball back in the court of German Chancellor Angela Merkel, who has opposed such a use for the bailout money.
"It's still the euro crisis really. It's not Spain," said Nicolas Véron, a senior fellow at Bruegel in Brussels and an expert on Europe's financial landscape. "The euro crisis has gone through different phases, but it's the same crisis today. If this were just about Spain's banks, the government could just restructure the banking system and the immediate crisis would be dealt with."
But by most accounts, both the previous and current Spanish governments did their part to make a bad situation worse, with no small measure of assistance from Europe's fumbles and stumbles.
When the bubble burst, the government publicly underestimated the damage and sought to resolve the banking issue by pushing weaker banks into mergers with slightly healthier ones. One notable example was Bankia, created out of seven faltering cajas and now a ward of the state and in need of another €19-billion in fresh capital.
The mergers only compounded problems by creating larger unstable and underfunded institutions. The austerity-driven collapse of the economy under a conservative government made matters worse by further driving down property values and reducing opportunities for profitable lending. And then nervous depositors began pulling cash out the weaker banks.
European policy makers launched a bank recapitalization plan last October that was supposed to stabilize the finances of all the region's shaky banks. It made matters worse for Spain. Essentially, the bank watchdogs reassessed debt held by the banks at then low market prices and required the institutions to build up their capital cushions.
In the Spanish case, the banks could not comply because they had no access to the markets, so they relied on some accounting sleight of hand to do the trick, making their capital positions seem healthier than they actually were.
"It was a spectacular policy mistake which has exacerbated the problems," Mr. Véron said.
Spanish policy – or lack of it – also enabled a dreadful banking practice to flourish. Cash-strapped banks have packaged and sold their own junior debt to depositors as a savings product. That effectively keeps the politicians from forcing restructurings that would impose losses on ordinary depositors. Which also means no losses for holders of more senior debt in the banks. As a result, the rescue has become hugely expensive and will continue to be a costly part of any bailout.