FRANKFURT (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 plan.
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 favorably 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 negative."
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 totaled 253 billion euros in June. It topped 400 billion last year, ECB data shows.
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 Becerril.
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 shift.
"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 Jens Weidmann.
Political uncertainty in both Spain and Italy only adds to the risks.
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 government.
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 program - with reform and budget conditions attached - that the ECB wants a country to agree to before it will intervene.
"Spain will do absolutely everything it can to avoid requesting a program," 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," said McCormick.
($1 = 0.7545 euros)
(Additional reporting by Laura Noonan in London, editing by Mike Peacock)