Spain faces daunting task in bank reform

The government of Spanish Prime Minister Mariano Rajoy is expected to announce new steps to stabilize the nation?s banking sector Friday.

NEW YORK (CNNMoney) -- Spain will need to strike a delicate balance as it seeks to clean up the banking sector in the midst of a sovereign debt crisis and economic recession.

The government in Madrid is expected to announce a new round of financial sector reforms Friday, after the Bank of Spain effectively nationalized one of the nation's largest banks late Wednesday.

Spanish banks have been struggling for years with the fallout from the nation's housing bust, which saddled them with billions of euros worth of bad property loans.

While the government has taken steps to support banks, analysts say more needs to be done to fix the problem once and for all.

"Given the public financing situation in Spain, there's a limit to how much money the government can put in the banking sector," said Enam Ahmed, a London-based economist for Moody's Analytics.

Spain has injected several billion euros into the banks, but Ahmed estimates that it will take hundreds of billions of euros to resolve the problem. "That's something the Spanish government cannot afford," he said.

Madrid has already warned that its budget deficit will be larger than expected this year, which has made investors in the bond market nervous. The yield on 10-year Spanish bonds eased Thursday after rising above 6% the day before.

"If the state takes over a significant share of this gigantic mountain of bad debt, accumulated over a decade, it will lose whatever little trust it still enjoys in capital markets," said Hans-Joachim Voth, a professor of finance at Universitat Pompeu Fabra in Barcelona. "Interest rates will spike up, its deficit will grow, and the whole country will effectively slide into a Greek-style downwards spiral."

At the same time, Spain needs a healthy banking sector to get its economy growing again and create jobs. The Spanish economy fell back into recession in the first quarter and unemployment rose to 24.4% -- the highest in the eurozone.

"They're walking a tight rope," said Jay Bryson, global economist at Wells Fargo Securities. "Something needs to be done to revive the economy, but the markets are very nervous about the deficit."

Managing assets through a bad bank. In addition to requiring banks to increase loan loss provisions, Spain is expected to announce some sort of framework Friday to remove bad assets from the banking sector.

While the details remain sketchy, there is speculation that the government will set up a real estate holding society, or a bad bank, to house distressed property loans.

The goal is to segregate bad assets and give banks a chance to start lending again, but it remains to be seen if the government will take losses or try to sell the assets at a later date.

Voth thinks the scheme probably won't work. He said bad banks are only effective when banks' debts are small and the government has sufficient funding and good credit.

"This is not the case in Spain," said Voth. "The banks are large, their bad debts are large, the government is already running high deficits, and it has massive debts as it is, without a bad bank."

Meanwhile, the government is also expected to require that banks set aside an additional €30 billion, which would raise provisions against property loans from 7% to 30%, according to analysts at Nomura Securities.

Nationalizing Bankia. The Spanish central bank announced late Wednesday that Bankia, the nation's third-largest bank, had recommended that €4.5 billion in existing state aid be converted into ordinary shares.

The move gives the Spanish government an overall stake in Bankia worth 45% -- effectively nationalizing the bank.

The investment is aimed at "enhancing the bank's soundness and restoring full market confidence," the Bank of Spain said.

In addition, Bankia said Jose Ignacio Goirigolzarri, a university professor and former BBVA (BBVA) executive, would replace Rodrigo Rato as chairman. Rato, a former right-wing politician, oversaw the bank's initial public offering last year.

Bankia was formed by combining the operations of seven regional banks, or Cajas, which were among the hardest hit by the housing bust.

"I think people are underestimating the Bankia issue," said Antonio Barroso, an analyst at political research firm Eurasia Group. "Bankia was a big obstacle in resolving the banking problem."

While many questions remain about the strategy going forward, Barroso said it is encouraging that the government is tackling the problems in the banking sector.

"Many challenges remain and investors are very skeptical," he said. "But it's good the government has the will to do something."