Spain should let its small banks fail by Cyrus Sanati @FortuneMagazine May 31, 2012, 4:52 PM EST E-mail Tweet Facebook Google Plus Linkedin Share icons FORTUNE — Consolidation is no panacea for Spain’s banking woes. The announcement this week of yet another banking merger in Spain has done little to restore investor confidence in the country’s shattered banking sector. The Spanish government and the European Central Bank will ultimately need to work in conjunction with private investors to recapitalize and strengthen the nation’s banks before the situation turns critical. Since the start of the financial crisis in 2008, there has been increasing worry over Spain’s debt-ridden “cajas,” which are small banks, similar to savings and loans. Like S&L’s did in the 1980s in the U.S., the Spanish cajas helped fueled a commercial and residential real-estate boom in Spain in the last decade, which came to a screeching halt with the start of the credit crunch. The ruling left-wing government at the time thought the best way to avoid lots of bank failures was to smash all the cajas together in the hopes that they could better weather the crisis with a bigger balance sheet. It was believed that merger synergies could then be used to cover any losses resulting from the sour property loans. There has since been considerable consolidation in the sector since the crisis began. The announcement this week of a three-way merger involving Ibercaja, Liberbank and Caja3 reduces the number of cajas to 10 from 45. But instead of making things better, the mergers have made things worse. Bankia, an agglomeration of seven cajas, which came together just last July, reported massive losses this month and had to be partially nationalized. Analysts estimated that the poster child for Spain’s merger policy would need to be bailed out for 3 to 10 billion euros. MORE: More spending won’t rescue Europe’s six big spenders They were way off. Bankia announced last Friday that it actually needed 19 billion euros, which is nearly five times the amount of money available in Spain’s bank bailout fund. Now Madrid is hoping that the European Central Bank will come to their rescue and inject fresh capital into the bank to prevent it from failing. There have been conflicting reports as to whether or not the ECB will indeed help Spain’s government plug the hole in Bankia’s balance sheet. This uncertainty sent Spanish government borrowing costs to a euro-era high of 6.6%, which was near the 7% level that forced Greece, Portugal and Ireland to request massive government bailouts from the ECB and IMF. This weighed heavy on the euro’s value versus the U.S. dollar and drove equity markets down across the globe on the fear that this could be the flashpoint that could set off the collapse of the troubled common currency. Spain needs to change tack before its banking crisis spins out of control. The bank mergers didn’t work because the losses the cajas were registering from their property loans far outstripped any merger synergy. That shouldn’t be too surprising given the strong correlation that exists between non-performing loans and a country’s unemployment rate. Spain has the highest unemployment rate in the EU at a mind-numbing 24% with a youth unemployment rate that is around 50%, both of which show no signs of abating. For the conservative government to continue this merger policy with its unemployment rate so high would be nothing less than foolhardy. Bank losses emanating from the property bubble are estimated to be anywhere between 76 billion euros on the low end to as much as 153 billion euros on the high end, according to RBC Capital Markets. Using that estimate and given that the banking sector’s costs run at around 29 billion euros a year, even if they somehow achieved a top-notch cost-to-income ratio of 30% by reducing their costs by 40% a year, or 12 billion euros, it would take seven to 14 years to absorb all the potential losses from the bad loans. And given the low-ball loan loss estimates analysts ascribed to Bankia, you can pretty much be sure that it is going to be a much bigger loss at the end of the day. MORE: Europe’s best fix: A “New E.U.” But even more troubling, the merging of the cajas has also created a “too big to fail” problem for the Spanish government. Like throwing a big stone in the water, allowing Bankia to collapse in its current form would create a much bigger splash to the Spanish economy than what would have been the case if seven smaller pebbles hit the water at various times. Cobbling a bunch of zombie banks together has in a way created a monster that the Spanish government cannot afford to kill. Given all this, it would be irresponsible to allow Ibercaja, Liberbank and Caja3 to actually go through with their merger as it would again create yet another unruly zombie. Instead, the government should move to block further mergers and take a more active role in recapitalizing its banks so they can start lending again. If the ECB is unwilling to guarantee all Spanish bank deposits, as what was recommended by an EU body this week, then the Spanish government will need private funding to restore confidence in its banking sector. Investor cash is needed because the capital shortfall at the banks is easily 25% to 30% of Spain’s GDP. While the country has a relatively low debt-to-GDP ratio of around 68%, it cannot borrow enough money at today’s current high interest rates to both recapitalize its banks as well as cover potential losses. One possible solution would involve a mix of both private and public funds, using features from Sweden’s national banking reorganization in the 1990s and Ireland’s banking reorganization that going on today. The government needs to first do a thorough assessment of its banking sector and make an estimate as to the potential losses. It should then let the smaller, insolvent cajas and banks to simply fail. MORE: It’s time for Europe to choose inflation over austerity Meanwhile, the more solvent banks and cajas would have the majority of their bad loans taken off their balance sheets at current market value and moved into a special purpose investment fund. It would then allow the public to invest in that fund, which would help offset the realized losses in the bad loans. The Spanish government can entice private capital to invest by possibly guaranteeing the first 10% or even 20% of their losses. The tricky part would be the valuation of the assets. If it’s too high, it won’t attract investors. But if it’s too low, then the Spanish government will need to come up with more cash to cover the losses. If the market buys Spain’s solution then government borrowing costs would fall and the banks would be free to lend again. The hope is through austerity, the Spanish government will be able to generate a surplus that will cover the loan losses. But to lower the Spanish government’s burden, the cajas need to stay small so that they can fail without creating much of a ruckus. While Spain would cover depositor’s losses, they wouldn’t have to cover the loan losses, saving precious capital. The sooner the Spanish government realizes this, the sooner it can get its banking sector back on its feet.