Spain to force banks to park their toxic real estate assets

Spain agreed to commission an independent audit of its financial system on Friday, trying to dispel market concerns that a state-funded bank bailout, set to be approved by the cabinet, could strain public finances to breaking point.

At its weekly cabinet meeting, the government was to adopt a plan to force banks to park their toxic real estate assets in holding companies that would later sell them off, a move that could deepen losses for the lenders.

It was also expected to demand banks set aside a further 35 billion euros ($45 billion) to cover sound loans in their real estate portfolios. The government has already obliged banks to make provisions of 54 billion euros to cover bad assets.

A definitive clean-up of troubled banks, as well as an accelerated 2014 budget, are among reforms that could win centre-right Prime Minister Mariano Rajoy more time from the European Union to hit tough deficit targets, EU sources told Reuters, although Spain says it is not asking for leniency.

The European Commission published new forecasts on Friday showing Madrid will have to make big additional savings this year and next to meet its promise to cut the public deficit to 3 percent of national output in 2013.

The EU executive said Spain would have a deficit of 6.4 percent in 2012 and 6.3 percent next year unless policies change. The government has vowed to bring the shortfall down to 5.3 percent this year from 8.5 percent in 2011.

"Spain is walking on the edge of a cliff. If they fail to deliver, what has been so far a national crisis will degenerate into a systemic crisis for the EU," one senior source said.

Hoping to put an end to its four-year banking crisis, Spain effectively took over Bankia SA, one of the country's biggest banks, this week after days of market anxiety over thelender's viability.

Spanish stocks were down slightly shortly after noon, in line with other European markets, after getting a big boost on Thursday from the banking reform plans.

Spain's banks were hit by billions of euros of losses after the bursting of a decade-long property bubble in 2008 and concerns about them, and the country's overspending regional governments, have fanned fears of a new euro zone debt crisis.

The toxic assets now total 184 billion euros, but many fear the hole is even bigger. Successive waves of bank sector clean-ups have failed to convince investors.

Independent valuation

Economy Secretary Fernando Jimenez Latorre on Friday said the country has no problem with an independent audit of banks' assets as part of the new reform.

A senior euro zone source on Thursday said an outside audit of the banks' health was key to reassuring investors that the difficult situation of the banks would not push Spain into seeking an Irish-style bailout.

"There is no objection to that," Jimenez Latorre told reporters. "Anything which helps to dispel doubts about the financial system is most welcome."

Financial sources said the appointment of external auditors could lead the banks to recognise further losses on top of those already reflected in banking reforms presented in February.

This would eventually force a new wave of mergers between the smaller lenders as well as possibly additional takeovers. The government is also likely to inject billions of euros to recapitalise the weakest banks.

The government asked the banks to set aside 30 percent of their sound loans to housebuilders, up from a current 7 percent, but the banks, including major players Santander and BBVA, had pushed back with a lower number.

The creation of holding companies for each bank's problematic property assets would be voluntary for lenders able to make the provisions with no external help. But those thatcannot would be forced to set up liquidation schemes and request public money, the sources said.

Any delay in the new banking reform could have a devastating effect, as yields on benchmark Spanish bonds remain close to 6 percent, inflating the country's borrowing costs. "The pressure right now is very high and the discredit would be huge if the reform was not to be approved this Friday," a banking source said.