* Rating downgrade by single agency would hit bank costs
* Agency DBRS has negative outlook for Spain, Italy, Ireland
* Situation is not benign, says DBRS
* More Spanish bank bailout funds unlikely to trigger OMT
* Bank asset review next year may reveal more holes
By Paul Carrel and Sakari Suoninen
FRANKFURT, July 31 (Reuters) - Spanish banks risk their
troubles being compounded by a jump in the cost of lifeblood
funding from the European Central Bank.
A one-notch downgrade by a single credit rating agency is
all that stands between them and a financial blow that would
pressure the ECB to act, but probably not with its OMT bond-buy
Lenders in Italy and Ireland face a similar threat.
An ECB adjustment earlier this month of the haircuts - or
discounts - it imposes on collateral put up to obtain cash at
its refinancing operations means government bonds with 'A'
ratings are treated more favourably than previously, while
the penalty applied to those with lower ratings is more severe.
That liquidity has been a lifeline for many banks who have
been shunned by peers in the interbank lending market.
The bonds of Spain, Italy and Ireland sit in the top group,
but are dangerously close to slipping into the lower category.
A dent to banks in either Spain or Italy could further choke
off lending and prolong recession in the euro zone's south,
which is beset by sky-high unemployment even though Spain's
two-year slump shows signs of coming to an end.
"I would expect this to clearly hurt Spanish banks, they
need this like a hole in the head," said Sassan Ghahramani, CEO
of U.S.-based SGH Macro Advisors, which advises hedge funds.
The ECB looks at four agencies - Standard and Poor's,
Moody's, Fitch, and DBRS - when deciding on its haircuts, and
takes the highest rating of the four.
DBRS rates Spain, Italy and Ireland higher than the others,
at the lowest rung of 'A', but with negative outlooks for all
three. A cut for any of them would bring an automatic penalty.
"We are very much in a wait-and-see mode with all three
countries," Fergus McCormick, head of sovereign ratings at DBRS,
told Reuters. "The risks are to the downside, the outlook is
The increase in the ECB's average haircut for collateral in
'BBB' territory means that were DBRS to cut its rating for Spain
by just one notch, Spanish banks would get 8 billion euros
($10.6 billion) less in funds for 100 billion of government
bonds offered up.
Spanish banks' most recent use of ECB funds totalled 253
billion euros in June. It topped 400 billion last year, ECB data
A downgrade would reinforce the negative spiral between
indebted sovereigns and lenders, who have loaded up on their
governments' bonds but could steer clear in future, driving up
state borrowing costs in the process.
Government bonds are not the only assets banks use at the
ECB. Some 15 percent of the collateral deposited for use in the
operations is sovereign paper, ECB data shows.
However, given that Spanish, Italian and Irish banks
between them own nearly half of the total pool of sovereign
paper held by euro zone banks, it is fair to assume that far
more than 15 percent of their collateral is government debt.
Under the new rules, a DBRS downgrade would increase the
haircut to 13 percent from 5 percent for Spanish bonds with
outstanding maturity of more than 10 years.
"The obvious consequences are higher funding costs for
Spanish banks, especially smaller unlisted ones with lower
available collateral," said JP Morgan Executive Director Jaime
Corporate lending in Spain is already down by almost 10
percent in the last year, the most in the euro zone, and the ECB
has grown increasingly worried about weak lending data.
As a result, a DBRS downgrade could prompt an ECB policy
"If it proves a lasting problem, I think the ECB will end up
adjusting its haircut schedule to be more lenient on the BBB
rated sovereigns," said Andrew Bosomworth, a senior portfolio
manager at Pimco, the world's largest bond fund.
Relaxing the haircut rules is likely to meet resistance,
however, from risk-averse ECB policymakers like Bundesbank head
Political uncertainty in both Spain and Italy only adds to
In Spain, Prime Minister Mariano Rajoy has denied any
wrongdoing in a party financing scandal which has eroded his
credibility. In Italy, a tax fraud case against Silvio
Berlusconi could threaten the survival of a shaky coalition
McCormick said political risk was uppermost in the ratings
agency's thinking about the two countries. "I don't think the
outlook is very benign," he said.
A balance sheet assessment of euro zone banks, including an
asset quality review (AQR), that the ECB plans to conduct with
national supervisors and external experts starting in the first
quarter of next year will expose weak banks.
The outcome of the AQR is an added unknown for a sector
already facing an uphill battle in Spain, where larger banks
could be forced to make extra provisions whether they believe
they need them or not.
Spain has so far taken 41.4 billion euros of 100 billion
euros of euro zone aid made available for its banking sector.
"The incentives to take more of this ESM money are still
there and they will probably grow if they find a way that
doesn't affect the budget," said JP Morgan's Becerril.
Firing up the ECB's yet-to-be-used OMT bond-buy plan could
change investor sentiment about the outlook for Spain and Italy,
and relieve pressure on DBRS's ratings of their sovereign bonds.
"It would be a game changer for Spain or for Italy if the
OMTs, depending on the conditionality, did start to purchase
bonds on the secondary market," said McCormick.
He did not believe, however, that Spain asking to tap some
more of the ESM funds available for its banks would constitute
the full aid programme - with reform and budget conditions
attached - that the ECB wants a country to agree to before it
"Spain will do absolutely everything it can to avoid
requesting a programme," McCormick said. "It's like Hotel
California. You can check in but you can never leave."
Without outside intervention, Spain and Italy remain exposed
to risks that investor sentiment turns against them if their
reform plans stutter or growth fails to kick in - scenarios that
could prompt a DRBS downgrade, compounding their woes.
"It remains a very, very uncertain environment in Europe,"
($1 = 0.7545 euros)
(Additional reporting by Laura Noonan in London, editing by