MADRID (MNI) – Spain must restore confidence in its financial
sector in order to avoid renewed pressure on its sovereign borrowing
costs and a pernicious feedback loop between the financial health of
banks and the government, the country’s central bank said in its 2011
annual report released Friday.

“In an environment like the current one, any sign of weakness in
the financial system carries an elevated risk of unleashing tensions in
the debt market and starting up perverse mechanisms of reverse feedback”
between the banks and the sovereign, the Bank of Spain warned.

“In order to avoid the materialization of these risks, it is
necessary to restore full investor confidence in the Spanish financial
system,” the bank added. The renewed solidity of Spanish banks will
allow them to finance projects in the real economy even as economic
agents continue downsizing their balance sheets, it said.

Spain’s economic policy must be based on three pillars, the central
bank said: bank restructuring, ambitious fiscal consolidation, and
structural reforms – particularly in the labor market.

At least in the short term, as Spain’s banks work to complete much
needed recapitalization and reorganization, they will continue to depend
on external financing support, the Bank of Spain said. Such support will
“allow for the correction of market failures whose impact tends to be
more pronounced in times of high tension, like the current ones, and
which can restrict credit access for institutions that are solvent but
whose credit-worthiness is nonetheless particularly difficult to
evaluate.”

The Bank of Spain’s report comes at a time when Madrid, after long
refusing EU aid to help recapitalize its banks, is now in negotiations
to secure such assistance. A big obstacle, especially for the government
of Prime Minister Mariano Rajoy, is that the statutes of the European
bailout funds, EFSF and ESM, do not allow them to inject capital
directly into the banks. They must provide the money to the government,
which would then use it to recapitalize its banking sector.

Spanish and European officials are reported to be working on a
compromise solution in which the money would go through a government
entity, Spain’s bank resolution agency FROB. The conditions attached to
the aid would be significantly lighter than those imposed on Greece,
Portugal and Ireland, which are in full bailout programs.

Some analysts have estimated that Spanish banks have capital needs
between E50 billion and E100 billion. But according to press reports, an
IMF evaluation to be released Monday puts the figure at closer to E40
billion. Nearly half of that amount would be accounted for by the
government’s rescue of Bankia, which will have an estimated price tag of
E19 billion.

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–Paris newsroom, +331=-42-71-55-40; bwolfson@marketnews.com

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