Will Spain suffer an Irish bust?

Fears have increased over the financial health of Spain's Bankia

The big question for Spain and for the eurozone is whether it is a giant version of the Republic of Ireland.

To put this another way, will the cost of rehabilitating its banking system be greater than Spanish taxpayers can afford?

And if the price is unbearably large, would it make sense for Spain to request a bailout from the International Monetary Fund or the eurozone's European Financial Stability Facility (EFSF) or both?

According to a senior banker, we will get some of the answers on Friday, when the Spanish government is expected to decide what level of losses Spanish banks should be obliged to recognise on their reckless property and construction loans, on top of 50bn euros of provisions they have already been forced to make to cover potential losses.

This banker expects just a handful of savings banks - of which the biggest and most important is Bankia - to be instructed to set aside 25bn to 30bn euros to cover the additional costs of loans going bad.

This is expected to lead to the partial nationalisation of Bankia, which is Spain's biggest retail bank with around 15% of domestic banking assets.

The partial nationalisation will be a controversial operation, because it will lead to huge losses for many thousands of Spanish investors, who bought shares in Bankia and provided it with loan capital when it was listed on the stock market last year.

There are fears that if the value of Bankia's shares were wiped out in the rescue, this could prompt such anxiety among savers that they could withdraw their savings from Bankia, further weakening the bank.

So why are Spain's savings banks in such a mess?

Well, the central bank, the Bank of Spain, has estimated - in its last Financial Stability Report - that Spanish banks are sitting on what it calls "troubled" property and construction loans of 184bn euros, equivalent to more than 17% of Spanish GDP.

Those loans are the poisonous legacy of a housing and construction boom that saw 5 million new homes built between 1997 and 2007, twice the increase in new Spanish households. Whole ghost towns were built.

Such is the dire quality of these loans that the banks are assuming they will ultimately get back only half or less of what they lent.

So it is possible that the banks are getting close to having properly recognised the scale of pain they face on this category of their lending.

However, they may not yet have made proper provision for likely losses on other categories of loan, notably residential mortgages, loans to small companies, and loans to highly indebted big companies.

That is why bankers, regulators and analysts increasingly fear that the capital banks will need as a protection against these losses may exceed what can be raised from conventional investors and Spanish taxpayers.

That said, there are substantial costs and risks for Spain in borrowing the money from the eurozone's bailout fund, the EFSF, quite apart from the humiliation of being seen to have its economic policy dictated by Germany.

One potential pitfall of taking a rescue loan from the eurozone is that it would probably have the effect of subordinating Spain's existing sovereign debt.

To put it another way, the implicit value of the Spanish government's existing debts would be reduced. And that would then force even greater losses, perhaps calamitous losses, on the banks, which have lent well over 260bn euros to the Spanish public sector.

So some bankers argue that Spain might be better off asking the IMF for emergency funds that could go directly to the banks, rather than counting as a loan to the government.

How long can the Spanish government prevaricate and fail to make sure the banks have all the capital they need?

Well probably not that long, because Spanish banks are reining in their lending, and thus damaging the Spanish economy, in response to their capital deficiency.

Based on the recently published results of Spain's seven publicly listed banks, the investment bank Morgan Stanley calculates that lending in Spain is contracting at a damaging annual rate of around 8%.

A credit crunch is exacerbating Spain's recession.

If all this sounds familiar, that is because it is - to a great extent - a re-run of the collapse of Ireland's banks.

Just like Spain, Ireland for months insisted it had the resources to sort out its banks on its own. But in the autumn of 2010, it capitulated in the face of horrific market reality, and went cap in hand to the eurozone and IMF.

The other lesson of Ireland, many would say, is that the longer a government fails to face up to the true weakness of its banks, the bigger the eventual costs of the remedy.

UPDATE

One part of the Spanish government's plan to strengthen the banks has happened tonight.

Spain's banking bailout fund, the FROB, will convert a 4.47bn-euro loan to Bankia into shares in the troubled bank.

This amounts to a partial nationalisation of the bank, because state fund will emerge with a stake in the bank of 45%.

Whether that will be the last injection of taxpayers' money into Bankia, we shall have to wait and see.

The Bank of Spain, the Spanish central bank, said tonight:

"The new management of Bankia will have to submit, as soon as possible, a fortified clean-up plan that will place it in a position to address its future with every guarantee of success."

The central bank added: "Bankia is a solvent institution that continues to operate on an absolutely normal footing. Its customers and depositors have no cause for concern."

UPDATE 12:30 BST

I may have committed a solecism in my note yesterday on the impact of a possible bailout of Spain's banks.

In theory, loans from the European Financial Stability Facility do not have preferred creditor status, whereas loans from the IMF and from the EFSF's successor, the European Stability Mechanism, do have preferred status.

So if Spain wants to avoid the danger of its existing sovereign debt acquiring second class status in any bailout, it would probably be better off nipping in fast and asking for EFSF help - rather than hanging about and taking the risk that ultimately it will need succour from the ESM or IMF.

Or to put it another way, in respect of the impact on Spain's overall borrowing costs, the EFSF might well be the cheapest option.