Five of Spain's smaller regional lenders, known as cajas, were among the seven banks to fail the European Union stress test. 

This means the banks would face a capital shortfall of €3.5 billion in another recessionary scenario.

Only banks that, following the application of the stress, ended up with a Tier 1 capital ratio of less than 6% were considered to have failed the test.

The other two banks that failed the test did come from the expected regions, but saw only one bank from each not pass the test. State-owned Hypo Real Estate was the only German lender to flunk and state-controlled ATE Bank was the only Greek bank to fail.

According to a Financial Times article, bankers and analysts earlier this week expected 10 to 20 of the 91 institutions tested to fail the stress tests. The financial institutions widely expected to fail the criteria were the Spanish cajas, the German Landesbanks and the Greek banks.

"Due to their unlisted nature, Spanish cajas in particular cannot raise fresh capital simply by issuing new shares in the equity markets," Barclays Capital analysts said. " And while these savings banks can generate new capital via retained earnings, it is unlikely their earnings will be high enough to cover the regulatory capital shortfall to be revealed by the stress tests any time soon."

In Search of Liquidity

According to Barclays estimates, the Spanish cajas combined will need €36 billion of fresh capital. It's unlikely that these banks will make up this shortfall through the equity markets. They are also equally unlikely to generate enough retained earnings to build up their regulatory capital to the level that would allow them to pass the stress tests.

The banks, according to Barclays analysts, will instead raise the added risk capacity from the Spanish Fund for Orderly Bank Restructuring (FROB).

The FROB was a fund that was established in June 2009 to foster consolidation in the Spanish savings bank industry as well as to facilitate crisis resolution at non-viable institutions. The Bank of Spain manages the Fund.

The FROB has reached €99 billion. This amount is split between an upfront €9 billion in funding (75% from theSpanish treasury and 25% from the deposit guaranty funds) and €90 billion in borrowing capacity in the form of government-guaranteed bonds.

The fund has raised a total of €12 billion in cash so far. As of July 9, just more than €11 billion had been allocated to specific cajas.

According to Barclays analysts, the fund's remaining borrowing capacity of €87 billion and the cajas may need “only” an additional €25 billion, or €36 billion minus €11 billion, following the stress tests.

"The FROB would appear to easily have enough spare capacity to offer the cajas the additional required capital," they said. "Consequently, it appears highly that most, and quite possibly all, Spanish cajas will be bailed out by the Bank of Spain via the FROB. For the European ABS investors, this also means that operational disruptions at the cajas – and hence servicing interruptions in Spanish RMBS and other ABS transactions – as a result of Spanish cajas failing the European bank stress tests remain unlikely."

This is an update to the story called Only Seven European Banks Fail Stress Test published today in

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