After 18 months of insisting that Spain's banking system is one of the best in the world, superbly regulated, well provisioned and with no exposure to toxic debt, the truth is out - they need help!

So what has happened?  Well, while the regulators did indeed successfully manage to limit Spanish banks' exposure to the US sub-prime market, and other forms of international "toxic" debt, they failed to adequately regulate their banks' domestic lending, thus creating their very own sub-prime crisis.

Spain, like the UK 15-20 years ago, has a two tier retail banking system: traditional banks and regionally based mutual savings banks ("cajas"), i.e. building societies.  It is with the latter where the biggest problems now arise.

The problems are twofold - liquidity and credit risk.  On the first point, Spanish banks and cajas have traditionally issued long term mortgage backed securities "titulaciones" to finance their mortgage lending.  However, as the domestic property and credit boom gathered pace they also relied increasingly on the short term wholesale money markets to finance their long term loan and mortgage portfolios - shades of Northern Rock!

The advent of the euro made access to these markets easier while cheap money fuelled a consumer led boom.  The credit crisis effectively closed both sources of funding and it is a fact that over the last eighteen months Spanish financial institutions have been the biggest users of the European Central Bank liquidity window, regularly borrowing more than ?40bn.  The Spanish government has also been guaranteeing the bond issues of a number of banks and cajas - an action that seems to contradict re-assurances that the Spanish banking system is in rude health.

However, while the liquidity crisis may finally be easing, the emphasis has now shifted to the asset side of the balance sheet.  The Spanish banks and cajas fuelled the country's property boom by lending vast sums of money to property developers - recent estimates put the sum at ?318bn, and then to consumers to buy their finished products.

Initially, the lending to developers was based on using the land and the properties themselves as security.  But, as the boom continued, the lending became increasingly speculative with banks lending money to companies or businessmen to buy shares in other property companies and, in return, using shares in these companies as security.  At the same time, consumer lending, both mortgages and personal loans, continued to boom.

Unfortunately, as the credit crisis took hold, the house of cards collapsed.  In the last twelve months virtually every major Spanish property company, quoted or private, along with a myriad of smaller developers, have either had to: enter into creditor protection schemes, e.g. Fadesa Martinesa, Habitat; negotiate debt for equity swaps, e.g. Metrovacesa, Colonial; or attempt to re-negotiate their debt.  Assets sales and restructurings are rife and the banks and cajas are now the biggest owners of property in Spain.  Combine this with falling property values (and sales), unemployment scheduled to reach 4 million this year and many customers who cannot afford to pay their mortgages, and the problem is evident.

For example, in February of this year, bad debts accounted for over 4.13% of loans and this is expected to rise to over 6.0% by the year end.  As the economic environment deteriorates further, lenders are re-negotiating mortgage terms with borrowers to avoid having to make further provisions.

In truth, it is the cajas that have the biggest problem due to their over exposure to both developers and consumers and last month the government had to rescue Caja Castilla La Mancha.  It is not expected to be the last and similar rescues are expected in the coming months.  At the same time, in May Moody's, a leading credit rating agency, announced that it is studying the potential downgrade of 32 Spanish banks and cajas due to their deteriorating balance sheets and high levels of bad debt.

With all the international focus on the mismanagement of banks it is interesting to consider why Spain's caja's, who have traditionally been the mainstays of their local communities, find themselves in such a position.

The first is the de-regulation several years ago which allowed them to expand into other regions - previously they could only operate in their home "region".  This has led to a massive geographic expansion by many cajas and vastly increased competition between themselves and the banks for customers.

The second is their ownership/management structure.  The caja's are mutual, non profit organisations whose primary role was to support the local community.  As such, under their statutes their governing bodies are predominantly made up of local politicians who are not known for their banking or management skills!

Thirdly, rapid expansion, and an increase in competitiveness, along with the range and complexity of products, has stretched management capabilities and exposed poor risk management policies, systems and processes.

In summary, Spain's banking system is not as safe as houses - as the sea withdraws the rocks are being exposed.  Having said that, it most economic and political commentators agree that it is inconceivable that the government will allow any leading bank or caja to fail - not just because of the domestic consequences but also because their much lauded regulatory system will be seen to have failed.a