Spain's banks are fast joining the ranks of the most unloved in Europe just as many need to raise capital urgently, deserted by investors who believe the country is on the brink of a recession that many lenders will not survive.
The government has ruled out more state aid for a sector that comprises a motley mix of international lenders and heavily indebted local savings banks. That leaves two options: raising private capital or turning to the EU for bailout funds.
Prospects for a private sector solution are poor. Nothing on the horizon looks likely to persuade foreign fund managers to invest, such is the fear of the banks' growing bad loans, their holdings of shaky sovereign debt and the worsening economy.
Already battered by a property market crash that began four years ago and continues unabated, few Spanish banks are able to borrow funds on wholesale credit markets and the majority are instead relying on the European Central Bank.
"Most are currently on liquidity life support from the ECB but asset quality continues to deteriorate as house prices keep falling and unemployment is still rising," said Georg Grodzki, head of credit research at Legal & General Investment Management.
"Their funding remains constrained and competition for deposits intense," he told Reuters.
Economy Minister Luis De Guindos told Reuters last week that all Spanish banks had met capital requirements set by the European Banking Authority under a 115-billion-euro recapitalization plan decided by European Union leaders in December.
But fund managers remain skeptical due to the slow-burning property crash. They include Mark Glazener, head of global equities at Dutch asset manager Robeco, who sold off his exposure to Spain at the end of last year. "Given the scale of over-building over all these years, the present provisioning that the banks have made does not appear to be enough," he said.
Central and commercial bankers admit that more capital may be needed with the banks facing further defaults by businesses and mortgage holders as the economy slips into its second recession in three years and unemployment is forecast to hit 24 percent this year.
"If the Spanish economy finally recovers, what has been done will be enough," Bank of Spain Governor Miguel Angel Fernandez Ordonez said on Tuesday, insisting that no talks were underway about any possible bank bailout.
However, he added: "If the economy worsens more than expected, it will be necessary to continue increasing and improving capital as necessary in order to have solid entities."
SHOWING THE STRAINS
Markets are showing the strains. The cost of buying protection against a default on bonds issued by the two biggest banks, Banco Santander and BBVA, has risen sharply in the past month as Spain takes over from Greece as the eurozone's biggest headache.
Santander Chief Executive Alfredo Sáenz said the ECB had helped by injecting more than 1 trillion euros ($1.314 trillion) into the eurozone financial system in recent months, supporting banks as they try to cope with losses inflicted by the sovereign debt crisis.
Nevertheless, Spain still needed to speed up its banking sector restructuring and recapitalization, push ahead with auctioning two remaining nationalized savings banks and cut the number of institutions operating in the country, he said.
"Above all what we need is a more stable economic and financial market environment in the eurozone area that would allow the institutions a better access to the wholesale markets," he said. "The cheap financing provided by the ECB´s three-year liquidity funds has been a positive step. It´s a beginning but that is clearly not enough."
Market worries extend to Sáenz's own bank. It cost $418,000 a year to buy $10 million of protection against a default on Santander debt using a 5-year credit default swaps contract on April 10, up 51.7 percent since March 1, Markit prices show.
Similar protection against a BBVA default has risen faster still, by 53.8 percent to $429,000 a year over the same period.
By contrast, the cost of default insurance for financial institutions tracked by the Markit iTraxx senior financials index, has risen by just 20.2 percent.
SHAKING THE MARKETS
Spain's problems have the power to shake global markets. Investor confidence in the eurozone took a hit last week when a Spanish bond auction drew poor support, wrenching high-flying stocks and asset values down.
Spain is already being compared on markets with the three eurozone countries which have been forced to take international bailouts. European money market funds rated by Fitch already added Spanish bonds to a blacklist of unappealing creditors comprising Greek, Irish and Portuguese names in the final quarter of 2011, the ratings agency said last week.
As the conservative government sets about slashing the budget deficit, it has rejected a state-funded rescue. It also insists it will not follow the other troubled eurozone states by turning to the "troika" of the European Commission, ECB and International Monetary Fund for a bank bailout.
However, Bill O'Neill of Merrill Lynch Wealth Management said no one should assume that ECB support via the cheap loans will be limitless. Spanish banks' provisions against bad loans could fall short if, for instance, property prices were to plunge by more than 50 percent from their peak.
"If that happens, either the government will have to step in or it in turn will have to rely upon the Troika," O'Neill wrote in a note last week.
Some people believe that while the ECB's cash injections have offered immediate relief, they have also slowed down much needed deleveraging and reform of Spain's banks.
A wave of consolidation aimed at weeding out the weakest lenders will cut their number to 10 from 40 but even those expected to survive are struggling to find favor.
"People are asking questions about the way banks are raising capital, through accounting, merging and amortizing losses over two years," said one London-based bank analyst who asked to remain anonymous. "It's a kind of capital-less capital raising."
Bankia, created by a merger of seven regional banks or "cajas," has caught the eye of hedge funds which are betting on a dip in its share price in the near-term.
The volume of Bankia shares out on loan, a proxy for short-selling interest, jumped 5.1 percent in the week to April 9, with more than four-fifths of the total shares that can be borrowed already lent out, figures from Data Explorers show.
Analysts at Citigroup suggest Spanish house prices could fall a further 20-25 percent before hitting a floor. This will eat further into the value of the 300-plus billion euros' worth of property assets on banks' balance sheets — 176 billion euros of which is already classed as "troubled" by the Bank of Spain.
Typical loan-to-deposit ratios, a measure of financial strength, show Spanish banks are already lending more cash than they have on deposit and the ratio is set to widen even further as unemployed Spaniards plunder their savings.
"It is still not clear where the resources will be found to close the gap in capital and required top up in provisioning for a number of the weaker banks that form a significant part of the domestic sector," said Virna Valenti, senior credit research analyst at UniCredit subsidiary Pioneer Investments.
"Only a couple of institutions currently have access to the wholesale funding market and this will continue to be the situation for a while," Valenti said.
Paul Vrouwes, senior financials manager at ING Investment Management, said the majority of his peers would probably steer clear of buying Spanish bank shares until the country showed it could shrink its ballooning debts and generate economic growth at the same time.
"I think that Spanish banks will have to pay a lot more to investors like me to raise funds in the future. I am not so sure how they will manage when the ECB money needs to be paid back," Vrouwes said.
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