The bursting in 2008 of a real estate bubble that powered the economy for more than a decade has saddled banks, particularly Spain's savings banks or 'cajas', with enormous amounts of bad loans. The country's central bank, the Bank of Spain, says the sector is still burdened with about €175 billion ($230 billion) in "problematic" real estate holdings.
As the second recession in three years bites further, bad loans are expected to surge while plunging house prices will lower the value of the vast sea of repossessed or unsold homes the banks already own.
The government has been pushing the lenders to strengthen their finances by merging. It has also introduced rules that require banks to set aside an estimated total of €50 billion ($65.7 billion) more in provisions by the end of the 2012 to cover their toxic real estate assets.
Banks unable to raise extra capital on their own by the end of May must present plans for a merger. The government will help finance these tie-ups by offering loans from an existing bailout fund.
But one big fear is that if the plummeting real estate market takes too much of a toll on banks, the government would not have enough money to save the sector.
__NO EASY FIX
Spain's financial stability depends largely on whether it can borrow money from investors at affordable interest rates.
To help out Spain, the rest of the eurozone could promise to compensate investors against a first round of potential losses on Spanish bonds. That would make those bonds a safer investment and hopefully lower interest rates. Spain could also ask for more targeted loans from the eurozone emergency fund to, for example, fund bank rescues and then continue to foot the rest of its bills independently.
Given the limits of the eurozone's firewall, many analysts argue that the ECB is the only institution with the power to save large countries like Spain. The ECB could buy up hundreds of billions of euros worth of Spanish bonds from banks on secondary markets. This would lower the interest rates Madrid pays. But the ECB has so far insisted that such large-scale intervention would break the EU treaty. Alternatively, the ECB could launch another massive round of cheap loans to banks. But these loans do little to solve the underlying problems of the Spanish economy.
Above all is the fear that investors would not want to lend money to Spain if it is seen to be teetering. Some analysts warn that admitting it needs help could quickly push the country all the way to a full bailout.
All eyes will be on Spain's next round of bond auctions — 12- and 18-month bills on Tuesday, and benchmark 10-year bonds on Thursday. The government has insisted that it will have no trouble financing itself this year and that auctions held so far have gone well.
That was true until last week, when an auction of medium-term debt hit the bottom end of what Spain was expected to raise, sending yields up and pushing the country firmly back into the eurozone debt crisis.
Gabriele Steinhauser contributed from Brussels.