Spain needs at least 20 billion euros ($26.35 billion) to secure the sale of three bailed-out banks and wants the rest of its hard-pressed banking sector to provide the cash in order to avoid putting more taxpayer money into the industry.
The Bank of Spain, which has already sold four state-rescued banks, has three more left to sell. It started marketing two of these: Banco de Valencia - a small listed bank based on Spain's east coast, and Catalunya Caixa - a mid-sized Catalonian savings bank, on Thursday.
But buyers will not be tempted unless they get guarantees to cover future losses from rotten real estate assets left over from Spain's decade-long property boom that ended in 2008.
These should be covered through a deposit guarantee fund, financed by annual contributions from banks, which originally covered retail deposits but now also guarantees other assets.
But the fund is nearly out of cash after providing guarantees against losses for two other bailed out lenders - Caja de Ahorros de Mediterraneo (CAM) and Unnim.
It only has around 2 billion euros ($2.6 billion) left - not enough to cover the remaining bank sales. The government wants the banks to provide money upfront to replenish the fund but this will be tough.
"The government is trying to make the banks pay for the loss guarantee scheme. Someone would have to put the money in advance and the banks will pay it back over the next eight years or so," said one Madrid-based banker.
Spain's ability to avoid an expensive state rescue for its fragile banking system is key to the country's efforts to keep its debts under control and avert a European bailout.
The country's economic problems are back in the spotlight as investors fear it could be the next trouble spot in the euro zone. Spain is probably already entering its second recession in three years with banks still fighting to rebuild their balance sheets from the 2008 property crash.
The European Commission said on Wednesday that Spain would not need euro zone financial help to recapitalise its banking sector.
The government, the regulator and the banks are looking at ways in which they can frontload capital backed by future annual contributions from the banks, bankers said.
"What is clear is that they are going to have to bring forward money because right now there isn't any (in the fund)," Jose Garcia Cantera, Chief Executive Officer at Banesto said this week at a banking conference in Madrid.
The key question is who is going to lend the money on the premise that it is paid back by contributions over a ten year period by an ailing, shrinking sector.
One option could be the fund issues bonds which are then bought by the banks, sector sources said.
The government in December demanded banks beef up their contributions to the fund to 2 euros for every 1,000 euros of deposits they hold in the Spanish system. Contributions to the fund are likely to be raised further this year, sources say.
Spain's banks contribute around 2 billion euros per year into the fund. Over 10 years this amounts to 20 billion euros, enough to guarantee future losses in the three bank auctions, a high-ranking financial sector source said.
ROBBING PETER TO PAY PAUL?
"There is a lot of confusion as to how they're going to fund this. Right now, it's probably the biggest question we have in Spain around the banks," said Jaime Becerril, a banking analyst at JPMorgan.
"The banks lend to the fund, which then finances the asset protection scheme of institutions that are eventually purchased by one of these banks. It's a very circular relation."
The Secretary of State for the Economy, Fernando Jimenez Latorre said on Wednesday the formula for financing the auctions had not yet been decided, but he reiterated there should be minimum cost for the state.
Also in question is whether the increased contributions to the deposit guarantee fund will start to eat into Spanish banks' profits, already brought low by strict capital raising schemes imposed by Europe and the Spanish government.
Banesto on Thursday reported a 88 percent plunge in first quarter net profit after putting aside 475 million euros in provisions against deteriorating real estate assets.
"If the whole clean up process falls on the shoulders of healthy banks, the burden will be very heavy," said Sabadell Chief Executive Jaume Guardiola.
Banco de Valencia is being marketed with guarantees on its 6 billion euro portfolio of real estate assets covering 80 percent of future losses over 10 years, said bank sources who had seen the prospectus.
The auction is likely to take place around mid-June with a definitive offer deadline of May 27 for prospective buyers, the sources said. Both banks are expected to be sold by the summer.
Banco Popular and Banco Mare Nostrum are the favorites to win the bid, according to Mediobanca and Bankinter , Santander, Unicaja, Liberbank and Ibercaja are also expected to bid.
The central bank took over Catalunya Caixa and NovaCaixaGalicia in September, valuing the lenders at practically nothing given their liabilities linked to toxic property assets.
Banco de Valencia, the smallest of the three with around 22 billion euros in assets, was taken over by the Bank of Spain in November with a 3 billion euro cash injection and credit line. ($1 = 0.7590 euros) ($1 = 0.7590 euros) (Additional reporting by Fiona Ortiz in Madrid and Douwe Miedema in London. Editing by Jane Merriman)