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The Eurogroup has finally agreed to do what commentators and economists, including myself, have been asking for for months: a deal to use EFSF/ESM money to help restructure the Spanish banking system. So is this a good ? Of course, international commentators were quick to argue that it is all in vain and does not meet the necessary elements to be considered a sensible solution to the crisis or a stepping stone towards a banking union. I disagree. Here is why:

1. A common argument is that the deal would increase Spanish debt by 10% of GDP thereby making it more difficult for Spain’s government to keep market access. This is very unclear, however. In fact, the current market price for Spanish debt incorporates already the implicit liability resulting from the over-indebted banking system. In fact, there is abundant research (e.g. ) showing that liabilities in the banking system imply higher yields for sovereign bonds. By making these implicit liabilities explicit, the price of Spanish debt should not change overall. Moreover, by providing the loan at a very preferential interest rate, the actual burden is actually going down. While the face value of debt increases, debt sustainability may actually improve.
2. A sophisticated variant of the argument worries that by giving a loan to the Spanish FROB with preferential creditor status, all other debt will become much more expensive as private creditors will be treated junior. This argument appears to be pretty overstated. In fact, the official loan is very small compared to the outstanding debt. Even if it was to be treated senior to the outstanding debt, this hardly changes the equation.
3. The details of the restructuring of the Spanish banking system are the most crucial determinant of the actual liability to the Spanish tax-payer. In fact, if the Spanish FROB injects capital into Spanish banks, it also acquires a significant equity share in those banks and therefore acquires an asset. In the US, government-led bank rescues typically did not result in a loss to the government but rather in a profit. If the Spanish government were to act in the same way, then the increased debt level would be off-set by an increase in valuable assets. Of course, if Spain was to follow the Irish example, things would look worse.
4. Saturday’s deal leaves a key question unanswered. Who will bear the losses accumulated in the Spanish banking system? Ideally, one would like to minimize the cost to the tax payer and impose losses on the shareholders, junior debt holders and maybe also senior bond holders of Spanish banks. If done well, the Spanish government could then even make a profit.
5. Who should do the restructuring? Many have argued that this should be done exclusively by an international resolution authority and that the agreement again fails on that front. I would argue that the current solution gets as close as possible to that solution. In fact, the EU does not have the authority to do bank resolution and it would take years until the necessary legal and practical challenges were to be overcome. Banks located in Spain fall under Spanish law and jurisdiction and that cannot be easily changed. The current programme nevertheless addresses this by de facto moving control of banks and the financial system to the Commission (in liaison with EBA, ECB and IMF). In fact, it is clearly stated that the Commission will exercise strong conditionality on policy actions taken on banks. So in reality the European Commission has become the resolution authority even though the Spanish government may still be able not to follow Commission’s conditionality.

The key to a successful resolution of the Spanish crisis is now that the Commission submits all the Spanish banks to a very rigorous test and then restructures the Spanish banks with minimal costs to the Spanish tax payer. By providing outside finance at preferential rates, the deal will reduce the interest rate pressure on outstanding Spanish government debt. Undoubtedly, Spain faces a very severe external debt problem. The best way to reduce that debt problem is by imposing losses on international and local creditors to Spanish banks. If this does not happen soon, Spanish government debt may indeed become unsustainable. It is now time for the Commission together with the Spanish government to do the right thing.