Spain will demand banks set aside another 35 billion euros ($45 billion) against loans to the ailing building sector, financial sources said, raising the possibility more public cash will be needed to rescue the country's lenders.
The government and banks are belatedly recognizing a multi-billion funding gap in the financial system linked to a 2008 property crash that has heightened fears the country may need an international bailout.
Lenders, already trying to write down 54 billion euros of losses on bad property investments, are unlikely to be able to find the extra funds without public help. Some also doubt whether the additional provisioning will be enough.
"There's no way we can meet these provisions by ourselves - the whole sector would fall into losses," said a source at one savings bank who declined to be named.
The demands — which another source said could be between 20 and 40 billion euros — are set to be announced after a weekly cabinet meeting on Friday and will form part of a wider banking reform which will include an estimated 10 billion euro injection of public cash into troubled lender Bankia.
The Economy Ministry declined to comment.
"The banking issue has been allowed to fester for three years. More public cash will raise funding costs for the government but it's worth the risk," said Gilles Moec, an analyst at Deutsche Bank.
Spain's banks have around 300 billion euros in total exposure to the building sector, including property seized as collateral, equivalent to around 30 percent of the country's gross domestic product. Of that about 60 percent is problematic.
Spain is suffering its second recession in three years and has the highest unemployment rate in the European Union at 24.4 percent, pushing more Spanish businesses and individuals to default on their debt.
The government recognizes some banks will not be able to make the new provisions but is still working on a plan for those cases, a government source said.
The premium investors demand to hold Spanish over German debt rose to its highest level since November on Wednesday, up around 18 basis points from the close on Tuesday to 450 bps. .
Bank shares plunged as investors anticipated more pressure piled on lenders to find the capital by booking against profits. Even Spain's large healthy banks have reported falls in profit as they write off losses on their real estate portfolios.
Shares in Spain's fourth largest lender, Bankia, fell a further 6 percent on Wednesday before an expected formal transfer of power at the bank to Jose Ignacio Goirigolzarri from Rodrigo Rato, who resigned on Monday.
The government wants Goirigolzarri to be in charge before it announces the details of the bank's rescue, the government source said.
Shares in Bankia have fallen 15 percent since Monday when it emerged that Spain was readying a bailout for the bank, which holds 10 percent of the banking system's deposits.
Spain's banks, even strong international lenders like Santander and BBVA, are already posting big falls in profit as they write off losses on bad property investments and increase capital to protect against sovereign default under European guidelines.
Goldman Sachs estimates banks need a further 58 billion euros to cover future losses, b beyond the 54 billion that the banks are already putting aside.
The government will demand banks raise provisions to a level equivalent to 30 percent of loans to housebuilders, one of the sources told Reuters late on Tuesday, up from a current 7 percent.
The conservative government had said for months it would not put more public money into rescuing the banks, but Prime Minister Mariano Rajoy said on Monday he would consider putting state money into the sector.
The turnaround came after an International Monetary Fund report on Spain's banks last week warned of the vulnerability in the sector, and after auditors did not sign off on Bankia's 2011 accounts.
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