The pedagogy of banking reform

Fernando Fernández. Professor. IE Business School

13 April 2012

Financial reform in Spain has mutated several times over the last few years. But, just like light, it has always stuck to the same straight line of action.

The government recently approved a new recapitalization plan for the banking system. Let’s hope it’s the last, not least because that would mean it had been a complete success. But it is also true that since 2009, when Spain’s Fund for Orderly Bank Restructuring (FROB) was approved, banks have been in a state of perpetual regulatory mutation, making any rational form of management impossible. Add to this regulatory chaos the changes of opinion of the European Banking Authorities, of the Basle Committee, and of the EU about provisions, capital, liquidity, transparency and deadlines, and the only thing that is certain is that confusion has been the norm, improvisation has been the general criteria for action, and general chaos has been the overall effect. Chaos in the sector, in academia, in the markets and in public opinion.

Regulatory stability and legal security are, after all, the most important objective of the latest reform. And we have to say that this time the government has tried everything; proposing further criteria and deadlines, keeping previous action criteria, and building on the basic approach that greater size means greater solvency. In fact they have stressed this last point so much that the process is beginning to be referred to as FROB III. All this means is that the approach is coherent with that of a previous hypothesis, namely that given that Spain is suffering from a confidence crisis, we must at all costs prevent any bank from having any kind of credit hiccup because it would damage the credibility of the system. This is feasible, and seems sensible in the current euro-crisis conditions and the financial-sovereign crisis loop, but it leaves a bitter-sweet aftertaste of not having tried something more radical that avoided moral risk by effecting a stricter form of market discipline. In other words, a system whereby whoever is responsible for something should pay for it. Particularly because in our country a good part of the problem stems from excessive complicity between local political power and the financial system through that atypical of organisms, the savings bank. We’ll come back to this subject later, because it will affect the chances of success of the reform.

If, in addition to stability as a condition, we add a dual political restriction, namely minimizing the cost for the taxpayer and not resorting to funding from the European Financial Stability Fund to combat uncertainties about the associated conditions, the result could not be more different. This is about increasing the transparency of bank balances and using the financial system itself to cover the losses that come out in the process as far as possible. This means placing the burden on shareholders by charging the cost to current or future profits, to creditors by forcing the conversion of preferential shares into capital to absorb losses, and to union interests and complicities by incentivizing bank mergers. This distribution of the cost of overhauling the system, in proportions that only time will dictate, is very easy to sell in political terms but leaves some question marks with regard to the future. There are two key questions: first, that the time it takes to digest this process may not be lost time but it will at least bring setbacks in terms of recovery of credit for the private sector; and second, how is the government going to attract the new capital needed for banks while implementing measures that will bring reduced profit levels?

They are not easy questions, and there are no simple political answers, as demonstrated by comparable international evidence. The government is so aware of these dangers that it has introduced into its own reform a highly accelerated mergers agenda, which would be even more accelerated if the savings banks had not spent the last two years putting off the inevitable, and a general norm that obliges banks to maintain credit levels, at least for banks that have opted to receive bailouts. This measure, which is very difficult to implement in practice without resorting to excessive regulation, because bailouts and credit are not granted in lockstep, is similar to that used in recapitalization processes in other countries, and is inscribed in general recommendations made by the EU. But whether it will be effective or not is by no means certain, no matter how many commitments to extending credit facilities are given by the banks that are going to be merged.

The reform also includes a chapter on good governance of banks, which in my opinion falls short of what is needed. Allow me to explain. It is expected that banks that form part of merger processes will implement measures that ensure quick and efficient integration. But the experience with bank mergers to date could hardly be described as positive in this respect. Several processes are aborted at the last minute due to internal power struggles among people who still feel they are there to represent political interests rather than serve as members of the board. And there are many cases of there being no rational or efficient decisionmaking or operational management structures in place, because the only ones that exist are based on wheeler dealing antics and tacit agreements. That is no way to run a bank, particularly in stormy times. Hence, it would have been desirable for the reform to have taken advantage of this opportunity to call all the shots, simplifying the governing organs of the banks resulting from the mergers of numerous saving banks and categorizing the original savings banks as blind foundations. It is the only way to eliminate the constant tension between territorial political power and economic efficiency.

Going beyond more or less relevant considerations, how the reform is finally judged will depend on two simple facts: whether or not popular opinion deems it capable of restoring a normal flow of credit into the economy within a reasonable timeframe, and whether or not the market sees it as capable of securing access by Spanish banks to international credit by virtue of increased transparency and solvency. These objectives are obviously related in a logical sequence. There are reasons to be optimistic, but there is still a great deal of work to do to ensure the implementation of a scrupulous, impeccable reform which leaves nothing subject to discretion. The Bank of Spain’s work is only just beginning. This is its big opportunity to win back some of the prestige it has lost.


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