By Don Quijones, Spain & Mexico, editor at WOLF STREET.

Correction: The Bank of Spain Bulletin described in this article appeared in December 2015, not in June 2016.

Bankers in the Eurozone’s core nations, in particular Germany, are fast losing patience with the European Central Bank’s rampant forays into the markets and with its ambitions to drive interest rates deeper into the negative. That now includes Germany’s two largest banks, Deutsche Bank and Commerzbank, that are in a coordinated manner and apparently with the backing of the government counterattacking the ECB for its destructive policies.

But it’s one thing for bankers and politicians in one of Europe’s most financially conservative nations to express dismay; it’s quite another when the supposed biggest beneficiaries of ECB policy begin complaining. This is precisely what is happening in the Eurozone’s fourth largest economy, Spain.

The first shot across the bow came from Francisco González, the president of Spain’s second biggest bank, BBVA, who moaned a couple of weeks ago that the ECB’s negative interest rate policy “is killing banks.” Now, a new complaint has emerged, this time from someone who actually has a seat on the ECB’s board: the governor of the Bank of Spain, Luis María Linde.

A Dangerous Dependence

In a Bank of Spain’s Economic Bulletin, Linde cautioned about one of the primary effects of the ECB’s monetary medicine on Spanish households: the growing dependence of Spanish household wealth on the performance of Spain’s stock market. While Linde describes this trend as a “side-effect” of ECB policy, the reality is that pushing savers into riskier investments — in particular, into stocks — was always one of the overarching goals of central banks’ financial repression.

With interest rates in the Eurozone at their lowest point in history and yields of even some corporate bonds below zero, yield-seeking savers feel they have little choice but to invest their money in riskier assets. An investigation by the Bank of Spain confirms the gathering loss of weight of low-risk, low (or even zero) return assets in investment portfolios as investors are lured into variable income assets. Six years ago, guaranteed and fixed-income assets accounted for 82% of investments on the market; today they represent 62%.

Spanish households currently own 26% of all listed shares, according to data from the Spanish stock exchange, or BME. It is the highest level in 12 years and double the EU average. In other words, ECB policy is working a treat in Spain.

The problem is that the Madrid Stock Exchange General Index (MADX) is not exactly firing on all cylinders, despite all the increased demand among retail investors. In fact, it’s down 14% so far this year and according to the Bank of Spain’s forecasts, is likely to lose a further 6% over the remainder of the year. If the forecast rings true, it will be only the third year on record that the MADX has suffered a contraction of more than 20%, following a 23% slide in 2002 and a 40% collapse in 2008.

That will not be good news for Spanish households, whose late entry into the markets will allow large institutional investors, banks and hedge funds a timely opportunity to dump equities before things get really bad.

The Real Fear

The Bank of Spain has even bigger reasons to be concerned about the direction of ECB policy. Most importantly, its primary constituency — Spain’s big banks — are beginning to feel the brunt of Draghi’s negative interest rates, as shrinking margins take a heavy toll, and their already deeply compromised balance sheets don’t give them much leeway.

Spain’s sixth largest financial institution, Banco Popular, is urgently seeking to raise new capital in a desperate bid to shore up its finances. The bank is allegedly offering loans to its customers on the scandalous condition that they subscribe to the rights issue.

One of the reasons why Popular is in such dire straits is that it’s no longer able to benefit from the huge margins it was able to earn through the so-called floor clauses that it, like most Spanish banks, introduced into its variable-rate mortgage contracts in 2009. These clauses set a minimum interest rate — typically of between 3% and 4.5% — for variable-rate mortgages, even if the Euribor dropped far below that figure.

In April this year a Spanish judge ruled that these clauses are abusive (but not illegal) and lack transparency. Following the latest ruling, the banks named in the suit must reimburse clients all the money they’ve surreptitiously overcharged them since May 2013, when Spain’s supreme court changed the law, effectively banning the current use of floor clauses.

That alone is expected to set the banks back €5.26 billion, but if next month the European Court of Justice (ECJ) rules that the refunds should extend all the way back to the first mortgage payments, the rationale being that if a clause is declared void, “it is so from its origin,” the banks could end up owing many more billions. And that doesn’t include the billions of euros of profits the banks can no longer generate each year from applying the floor clauses.

In an ominous sign of what could lie in store, the ECB has instructed all six of Spain’s biggest banks — Santander, BBVA, CaixaBank, Bankia, Sabadell and Popular — to include the potential impact such a ruling would have on its balance sheets for their next round of stress tests. The results are unlikely to be pretty given that a) profits in Spain’s banking sector are already shrinking at a blistering pace; and b) the total cost to the banking sector of the floor clause fallout is estimated to be anywhere between €11 billion and €15 billion over the next three years.

Real-World Stress

Granted, failing an ECB stress test these days is a practical impossibility. As we reported in February, the European Banking Authority decided that for this year not a single bank will be allowed to pass or fail the test because, in the EBA’s own words, European banks are in a “steady state” and are expected to remain that way.

But in the real world, bank problems can quickly escalate out of control. It was the fear of banking failure that drove Spain’s Supreme Court to rule in May 2013 that reimbursements to floor-clause victims should only apply to payments from that date. In four weeks’ time the ECJ could overturn that decision. If it does, the banks will be made fully liable for every centimo they have cost their customers.

The resulting fallout could end up crippling the banks’ finances, as the Supreme Court feared, just at a time when even Europe’s biggest financial institutions are struggling to cope with the debilitating side effects of the ECB’s NIRP medicine. By Don Quijones, Raging Bull-Shit.

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