June 7, 2012 / WSJ

Pressure for a European Union plan to recapitalize Spanish banks intensified Thursday after the Fitch Ratings agency lowered its investment-grade rating on Spain by three notches, saying European policy missteps have aggravated the country's economic and financial challenges.

Spanish Prime Minister Mariano Rajoy said his government would wait for the completion of assessments of the country's banking sector before disclosing an estimate of potential capital needs.

Meantime, key European leaders huddled in bilateral meetings Thursday as pressure on Europe to solve Spain 's problems are growing. Earlier this week Spain warned that its banks needed help and that the government itself is losing access to capital markets.

Spain's Mr. Rajoy said at a news conference, after meeting his Dutch counterpart Mark Rutte, that he won't disclose any figures on the cleanup of Spain 's banking system until the International Monetary Fund releases its assessment of the country's banking sector. He added that the government would also wait to disclose figures until it receives in the coming weeks an evaluation of the banking system commissioned to two foreign consulting firms, Roland Berger Strategy Consultants of Germany and Oliver Wyman of the U.S.

Spain is struggling to recapitalize a banking system that has suffered hefty loan losses after the collapse of its once-mighty real estate market, while at the same time trying to close a gaping budget deficit.

Policy makers had been focusing on the scheduled publication by the International Monetary Fund on Monday of an assessment of Spanish banks' capital requirements before making decisions on whether Spain might need help. But by this week it was clear from the spike in the Spanish government's borrowing costs that investors were becoming increasingly edgy over the possibility that an ailing banking system would force the Spanish government to seek a bailout.

Germany, in particular, has resisted calls from Spain and other euro-zone countries to allow Spanish banks to directly tap Europe's rescue fund, the European Stability Mechanism, set up to bail out governments in fiscal straits. The Group of Seven leading industrialized nations have pressed European leaders to act more aggressively to contain Spain 's problem before the euro-zone debt crisis inflicts more damage on the world economy and financial markets.

Fitch on Thursday lowered its long-term issuer default rating on Spain to triple-B, two steps above junk grade. The outlook is negative, reflecting risks associated with a further euro-zone deterioration, including possible contagion from the Greek crisis.

The agency sees the likely cost of restructuring and recapitalizing the Spanish banking sector at around €60 billion to €100 billion ($75 billion to $126 billion), or 6% to 9% of GDP, compared with a previous expectation of €30 billion.

U.K. Chancellor of the Exchequer George Osborne said Thursday that Spain 's banking system needs an injection of money to recapitalize it without worsening the country's sovereign debt situation as part of a wider effort to tackle the euro-zone crisis.

"You would need to sort out immediately the situation in the Spanish banking system and resolve the uncertainty there," he told BBC radio when asked how the single currency area should solve its debt and economic crisis.

Prime Minister David Cameron is likely to convey that message directly to German Chancellor Angela Merkel during their meeting in Berlin later Thursday. Mr. Cameron has said decisive action is needed to tackle the euro-zone crisis or it could break up, and urged countries at the core of the currency area and the European Central Bank to do more to support demand and share the burden of economic adjustment in the member states that are in trouble.

Dutch Prime Minister Mark Rutte is aligned with Ms. Merkel in staunchly opposing the proposal to allow Spanish banks to tap the EU bailout fund.

European Internal Markets Commissioner Michel Barnier fanned expectations of a possible deal on Wednesday, when he said it was important for the EU to "adopt emergency policy measures" to help Spain solve the problem of its banks.

The immediate needs of Spanish banks have overshadowed EU discussions for longer-term solutions for regulating and safeguarding its banking system. Earlier this week, Ms. Merkel signaled acceptance of the need for an EU-wide bank supervisor for the largest banks. On Wednesday the EU proposed legislation for dealing with failing banks that aims to shift the cost of future bank collapses away from taxpayers and onto investors.

Such plans will likely take months or years to crystallize and won't arrive in time to address Spain 's immediate crisis.

"The Spanish banking system is the most important thing to deal with in the short term," said Swedish finance minister Anders Borg, who was speaking at the International Institute of Finance's spring session in Copenhagen .

In one possible scenario, the ESM could lend money directly to Spain 's state-backed Fund for Orderly Bank Restructuring, known as the FROB, according to one EU official. But this official stressed that the Spanish government would have to guarantee any loans going to its banks or the FROB. This idea would fall short of having the ESM—and thereby the rest of the euro zone—take on full liability for financial aid to Spanish banks. But it would nevertheless require changes to the ESM treaty, which still hasn't been ratified by all euro-zone states and most notably Germany .

It isn't clear whether lending to the FROB and not Spanish banks directly would placate Berlin , but the sense that EU leaders are closing in on a solution galvanized European financial markets Thursday, providing rare relief for the euro and Europe 's government debt markets. Spanish bank shares rose amid hopes that European leaders were moving forward with plans to provide funds to ailing Spanish lenders. Shares of local heavyweight Santander SAN.MC +1.66% were rising, while crosstown rival BBVA BBVA.MC +1.15% was also up. Both were among the most actively traded stocks on Thursday. Shares of ailing lender Bankia BKIA.MC -1.54% were lower.

Spain's borrowing costs saw little relief, however, with the yield the government had to pay at its newest 10-year bond auction Thursday rising from 5.7% at the previous auction to 6.0%, price levels at which most economists say a borrower's debt is unsustainable. In the secondary market, the yield on Spain 's 10-year bond declined 0.15 percentage point to 6.10% in the hours following the auction.

Source: WSJ