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Political Economy
Posted at 12:03 PM ET, 03/24/2011

Too big to fail or too small to save?

The credit raters at Moody’s provided an interesting insight Thursday on the “too big to fail” issue -- and on the possibility that Europe’s sovereign debt contagion may yet hit Spain.

The company downgraded the debt of 30 smaller Spanish banks, according to wire service reports, a move that in many ways reflects a healthy restructuring underway in Spain’s banking industry. Spain’s banks were weakened by the country’s collapsing real estate industry,a nd a reckoning over the extent of those losses is considered important in Spain’s effort to put its economy back on track.

Part of that involves determining how much more capital the banks might have to raise, and whether — as has often been the case throughout the financial crisis — the Spanish government might take responsibility itself for shoring them up. Given that guarantees to banks wrecked the Irish government’s accounts and forced it to accept an international bailout, Spain’s banking problems are one of the outstanding issues that could push the country closer to a crisis.

While the Moody’s downgrade may make it more expensive for the banks to raise money, in a larger sense it may actually be good news. According to wire service accounts of the company’s analysis, it concluded that the Spanish government is likely to let some of the banks fail or merge as restructuring takes its course.

“It seems increasingly plausible that hard choices will need to be made at some point over the rating horizon, balancing the sovereign’s incentive to support the banks with the need to protect its own balance sheet,” Moody’s wrote, according to Bloomberg’s account of the downgrade note. “It is, in Moody’s view, increasingly likely that the sovereign will not be prepared to write all banks a blank check.”

What’s interesting, however, is that none of the country’s major banks were included — precisely because, in Moody’s view, governments are not yet at the point where they are prepared to let “systemically important” institutions fail.

One of the grander aims of the post-crisis financial reform movement is to create a “bailout free” economy where no institution is so important it requires public help if it falters. Based on the Moody’s note, we are not there yet: Spain’s “cajas” may be too small to save, but its major lenders remain too big to fail.

With Portugal now heading toward an apparent crisis, and Spain’s banks exposed to the tune of $100 billion in their neighbor’s economy, the question now is how large and immediate the spillover might be from next door.

By  |  12:03 PM ET, 03/24/2011

 
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