Rojo Saves Spain From Worse Pain as Defaults, Jobless Surge

By Charles Penty
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Aug. 7 (Bloomberg) -- In Spain, unemployment is rising, the housing industry has collapsed and the finance minister says the near future may include ``zero growth.''

It could have been worse.

In 1999, the Bank of Spain began requiring banks to boost reserves in anticipation of future write-offs for bad loans. The rules forced Spanish lenders to build provisions that were as much as five times greater than those in the U.K. or Italy before the credit crunch, according to the International Monetary Fund.

``The other central banks looked at us and said, `This is just silly,''' says Luis Angel Rojo, 74, the former Bank of Spain governor who imposed the set-asides. ``I thought a system was being built that was going to blow up, and it was better to be forewarned.''

The regulations, designed to prevent a repeat of the 1980s crisis that led to the demise of a third of Spain's lenders, shielded domestic institutions from the worst of the credit woes that have prompted the breakdown of 11 U.S. banks since 2006.

By contrast, Banco Santander SA, Spain's biggest bank, will earn a record 10 billion euros ($15.5 billion) this year, even as the country's decade-long spending spree comes to an end, Chairman Emilio Botin told shareholders June 21. The ratio of defaults to loans in Spain doubled to 1.53 percent in May from the same month a year earlier.

`What Would Have Happened?'

Under the Bank of Spain's rules, lenders were forced to make provisions for potential losses when the loans were granted, rather than waiting for them to go sour as in other countries. The guidelines had the effect of increasing the default cushion during good times, which smoothed out the highs and lows of lending cycles.

The proportion of bad loans covered by provisions rose to 270 percent in 2006, compared with 137 percent in the U.S., 55 percent in Britain and 46 percent in Italy, according to the IMF. In Spain, the figure has dropped to 150 percent, according to the Spanish Banking Association.

``It's true that there was a lending boom in Spain and we're now living with the consequences,'' says Jose Manuel Campa, a finance professor at IESE business school in Madrid. ``The other way to look at it is to ask what would have happened if Rojo's system wasn't in place.''

Paul de Grauwe, an economics professor at the Catholic University of Leuven in Belgium, says those restrictions should be widely adopted to avoid future blowups elsewhere.

`The Right Approach'

Other promoters of the Spanish model include Bank of Mexico Governor Guillermo Ortiz and Claudio Borio, head of research at the Bank for International Settlements, who says Spain's rules are a ``built-in stabilizer.''

``I'm really impressed,'' says De Grauwe, who was twice Belgium's candidate for the European Central Bank board. ``It was the right approach given that they lost interest rates as a tool'' when Spain adopted the euro.

Back in the late 1990s, though, Spanish banks complained that the regulations made them less competitive and reduced shareholder returns.

``The banks didn't like it at all,'' says Miguel Blesa, chairman of Caja Madrid, Spain's second-biggest savings bank. ``It's appreciated now.''

Santander, which earns about a third of its profit in Latin America, has dropped 15 percent since June 2007, just before the global credit crunch began. Banco Bilbao Vizcaya Argentaria SA, which makes just under half of its earnings in the region, has slumped 37 percent.

Troubled Banks

In July, Pasadena, California-based IndyMac Bancorp Inc., once the U.S.'s second-biggest independent mortgage lender, was seized by regulators after racking up $900 million of losses as house prices tumbled and foreclosures climbed to a record. The Federal Deposit Insurance Corp.'s list of troubled banks grew to 90 in the first quarter from 76 in the previous three months, the agency said in May.

The Spanish banking rules now face their biggest test, says Piers Hillier, head of European stocks at WestLB Mellon Asset Management U.K. in London, which oversees $35 billion.

``Anyone investing in financial stocks knows there's a huge shock around the corner and that applies whether you're in Spain or anywhere else,'' Hillier says.

Last month, Finance Minister Pedro Solbes cut his forecast for the economy after the housing slump helped send the unemployment rate to 10.4 percent in the second quarter, a 3 1/2- year high.

Spain's economy ``may have at some point practically zero growth,'' he said.

Lending Surge

Rojo's rules didn't prevent banks from fueling Spain's housing and consumer boom.

Lending has surged an average of 15 percent annually since 2000, compared with a euro-area average of 7.3 percent, according to ECB data.

``The fact that the Bank of Spain required these provisions certainly helps,'' says Andrew Lynch, who manages $2.5 billion at Schroder Investment Management Ltd. in London and sold his Spanish bank holdings more than a year ago. ``It buys some time, but it's not going to stop the economic decline.''

The regulations have their roots in an eight-year financial crisis that culminated in 1985 and led to the collapse of more than 50 of the country's 160 banks, says Aristobulo de Juan, the head of banking supervision from 1982 to 1986.

Industrial holding companies that owned banks lent too freely, and Franco-era laws left the central bank too weak to act, says Alvaro Cuervo, an economics professor at Madrid's Complutense University.

Inspired by Aesop

Regulators took inspiration from a fable by Aesop about a grasshopper who chirps all through the summer while mocking an ant who busily stores food, De Juan says. When winter comes, the ant thrives and the grasshopper dies.

``We applied the lesson of the ant and the grasshopper,'' De Juan says. ``Without a good crisis, you don't learn how to do things well.''

Spain cut its interest rate to 3 percent in 1998 from as high as 9.25 percent in 1995 as borrowing costs converged among euro nations. Spanish officials, convinced rates were too low, wanted to limit lending excesses, Rojo says.

In addition to increased provisioning, the central bank also forced Spanish banks to account for off-the-books structured investment vehicles as if they were on the balance sheet, effectively discouraging their use.

Stress Test

Worldwide, SIVs with at least $31 billion of debt have defaulted since October after investors stopped buying their notes because of contagion from subprime mortgages.

Bank of Spain studies suggest lenders can weather the default storm. In a ``stress test'' scenario of four quarters of declining gross domestic product, losses would amount to 70 percent of provisions, according to Spain's April Financial Stability Report.

``When conditions were good, the banks wanted to drive sports cars,'' Campa says. ``Now they've got worse, they're happy the central bank made them drive a safer model.''

Rojo, a board member at Santander since 2005, says Spain's credit boom went too far even as provisioning rules left lenders ``well-covered.''

His advice for Spanish bankers today?

``Be careful.''

To contact the reporter on this story: Charles Penty in Madrid at cpenty@bloomberg.net