Similar to those recent problems, Spain’s issues are rooted in institutions that are carrying too many nonperforming assets on their balance sheets—about twice the percentage amount as U.S. banks—that do not reflect current market values.1 The difference in Spain’s problems, however, begins with a relatively large banking industry that operates in a contracting economy with a staggering unemployment rate of more than 24%.

If and when Spanish banks update the value of the assets on their balance sheets, the losses will undoubtedly erode more of their capital bases. This occurred with Bankia, which is seeking €19 billion in government support. The difficulty with support from the Spanish government is that the country’s bank rescue fund reportedly only has €5 billion in cash. Although this fund is authorized to provide a larger amount if needed, markets may not react favorably to additional demands for Spanish credit. Spain’s borrowing costs are quickly approaching the ominous 7% mark, which has marked the threshold for bailouts for Ireland, Portugal, and Greece (see Chart 1). Spain’s economy, however, is twice as large as all three of those economies combined.

Further complicating Spain’s financial pressure is that various regions within the country, such as Catalonia, appear to be running short of money and are also seeking support from the government.

The combined factors underscore how European institutions have dragged their feet in addressing some of the problems at the core of their banking problems. For example, European banks still carry about 60% more leverage than U.S. banks, despite the demonstrated volatility that too much leverage can bring (see Chart 2). This delay has made the current attempts to address Europe’s banking problems and maintain the status quo all the more challenging amid the churning debt crisis and likely economic contraction within the eurozone. Thus, it seems like change for the continent’s banking system is eventually coming—whether by choice or by market forces.

Although the litany of summits, meetings, and nonbinding resolutions underscores the lack of a definitive plan in Europe, pressure is mounting on the Spanish banking sector to take a realistic look at their balance sheets. Indeed, in a recent release of suggestions for each European Union (EU) country, the European Commission recommended that Spain develop a “comprehensive strategy to deal effectively with the legacy assets on the banks’ balance sheets.”

In addition to placing more realistic valuations on their assets, part of this strategy could be to reduce the sizes and number of banks in Spain. And in scenes reminiscent of the financial consolidations of 2008–09, three Spanish banks said in late May 2012 that they would merge, while another large institution said it would likely sell its credit card and internet bank in order to bolster its capital levels. 

This could be another constructive step because retail and corporate banking customers are also retreating from Spanish banks, as their deposits in April were at the lowest level since the start of the European crisis. The decisions by the corporations are of particular interest because their withdrawal from the banking system, which has been the traditional source of corporate financing, may mean that they could rely more on the capital markets than the banking system. Indeed, only about 9% of corporate credit in the eurozone comes from the debt capital markets, compared to about 64% in the United States.³

The European capital markets, however, may be on hiatus while the continent works out its debt issues, so some companies may look to raise capital in the United States, where investors remain on the lookout for attractive yields.  

As market pressures continue to force the hand of European politicians and policymakers, there are multiple scenarios that have been mentioned that could emerge to support Spain. One would be the use of the European Stability Mechanism to provide support directly to banks rather than its initial intention of providing the support to national governments. Additional suggestions include jointly issued “eurobonds” that could provide governments with financing and a type of deposit insurance fund that would stem the outflow of cash from the weakest banks.

Either of these measures faces stiff opposition from Germany, which is reportedly drawing up some of its own proposals, because Germany itself would conceivably provide much of the support for those other suggestions. Other recommendations to have bond holders accept losses and become equity holders in the banks could also threaten the general public if these securities are widely held. In addition, the prospect of imposing losses on bond holders could result in a fire sale by current owners, pressuring yields on bank debt even higher.

The ongoing emergence of additional proposals points, as mentioned, to the change that is coming to the European banking system. And while the most recent blunder at a U.S. bank—J.P. Morgan’s “hedging” loss—was egregious, it pales in comparison to the developments in Europe.

This underscores that, while not perfect, the United States has benefited from moving quickly to shore up its financial institutions. And those financial institutions, unlike in Europe, are increasingly lending to U.S. companies that can benefit from GDP growth of 2% to 2.5%. Meanwhile other assets on bank balance sheets, such as those tied to real estate, continue to stabilize.

Therefore, investors wary of overseas developments may consider looking domestically for investments that may responsibly balance credit risk while delivering attractive income and/or capital appreciation that are supported by revenues that have limited exposure to the European crises.