Prime Minister Mariano Rajoy is battling to convince investors Spain's finances are under control after his refusal last month to meet deficit targets set by the European Commission. By seeking to cut the budget deficit to 3 percent of gross domestic product from 8.5 percent over two years, he risks driving bad loans as the deepest austerity measures in three decades push the economy back into a recession.

“A lot of our doubts are based on the grounds that non-performing loans should increase,” said Tobias Blattner, an economist at Daiwa Capital Markets in London, adding that he expects house prices still may fall by as much as 20 percent. “That could make a further hole in balance sheets of the banks.”

Bank shares extended declines today after the bad-loan figures were released. Banco Santander SA, Spain's biggest lender, fell as much as 3 percent and CaixaBank SA, the fourth largest, dropped as much as 3.3 percent.

Bonds Rise

Spanish bonds rose for a second day as the extra yield that investors demand to hold 10-year debt instead of German bunds narrowed to 404.5 basis points from 413.7 basis points yesterday.

Rajoy's government announced plans in February to force banks to take their share of costs of 50 billion euros ($65.6 billion) for building provisions and capital to make them recognize losses on real estate piled up on their balance sheets during the country's housing bust.

The Bank of Spain said late yesterday that lenders will take a total of 53.8 billion euros to meet the new requirements, including 29.1 billion euros in provisions and 15.6 billion euros to create capital buffers. While most companies would be able to comply “without major difficulty,” the central bank would tighten its vigilance over lenders that may struggle to meet the requirements, it said.

The plan implies a loss ratio for those assets of about 25 percent based on the fact that banks have already made provisions of 50 billion euros against total real estate risk of 340 billion euros, said Daragh Quinn, an analyst at Nomura International in Madrid.

Depending on how much the economy contracts and asset prices fall, further provisions of as much as 40 billion euros may be needed, said Daiwa's Blattner.

“In light of the bleak profitability outlook for the Spanish banking sector, we are concerned whether banks will be able to put aside the provisions the government has requested,” he said.

So far the government's efforts to bolster confidence in the banks has focused on making them recognize losses linked mainly to real estate. Banco Espanol de Credito SA, a Spanish consumer bank controlled by Banco Santander SA, said April 12 that first-quarter profit fell 88 percent as it made provisions to cover about half of the 1 billion euros in real estate charges the company must make this year to comply with the government's order.

Other Loans

Still, Spain's deteriorating economy means other classes of loans apart from those linked to real estate are also at risk of going sour, Blattner said.

The Bank of Spain, which says banks are burdened with about 176 billion euros of “troubled” real estate assets, lists about 21 percent of the 298 billion euros of loans linked to property developers as non-performing. The bad-loans ratio for industry excluding construction has jumped to 5.4 percent from 1 percent in 2007, according to the Bank of Spain.

“The 50 billion euros of extra capital looks like it's in the ballpark,” said Bosomworth, referring to the government's cleanup plan. Still, the “balance of risks” suggests more funds may be needed given what's happening in the economy, he said.

One option open to Spain should it need to recapitalize banks further would be to take funds from the European Financial Stability Facility, the euro-area's temporary bailout fund, said Daiwa's Blattner.

That would come with a “certain stigma attached” because it may signal the government has lost market access, he said. Spain can weather its troubles without a bailout and widening bond spreads are a “warning shot” from investors, Norbert Barthle, the parliamentary budget spokesman for German Chancellor Angela Merkel's Christian Democratic Party, said by telephone yesterday.

Spain has managed to stop the cleanup of the banking system from hurting government finances by making the industry absorb the cost by contributing more to the deposit guarantee fund. The fund has helped to finance the state's sale of failed lenders including Caja de Ahorros del Mediterraneo and Unnim by covering future losses for buyers.

Bankia Concerns

To be sure, investors have better information on the risks facing Spanish banks as the industry has shrunk and the Bank of Spain has made them unveil their real estate exposure, said Nomura's Quinn.

Bankia, a grouping of seven former savings banks with about 300 billion euros in assets, has become a focus of analyst concerns about Spain's banking system.

Deutsche Bank AG analyst Carlos Berastain said in an April 11 he was downgrading Bankia to sell from hold because of its “very low” profitability and the weak solvency position of its parent company. While Spanish banks face their “toughest year to date” in terms of profitability, 2012 also may be the “turning point” toward earnings that are more normal in 2013 on reduced needs to make impairments, Berastain wrote.

“Everyone, even the Eskimos, knows that bad loans in Spain are going up,” said Antonio Ramirez, a banking analyst at Keefe, Bruyette & Woods in London. “The sovereign is affected by the view in the markets that the banks are in difficulties and in a circular loop the banks are affected by the market view that the sovereign is weak.”

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