As Spain wrestles to contain its budget deficit which in turn is leading to a drop in bond market values, local banks are having a difficult time in locating funding due to their holdings of underwater government debt.

Chairman for one of Spain’s largest banks, Francisco Gonzalez said yesterday that for many of the country’s financial institutions, the “international capital markets are closed”. In addition, Spain’s Treasury secretary, Carlos Ocana said that the current environment for banks and corporations was “definitely a problem”.

Generally, European banks rely heavily on lenders from abroad for funding and less so on traditional deposits according to The Economic Times. They turn to the international capital markets in both money market land and in longer-term debt, to finance about 40 percent of their 33 trillion euros of assets. The remaining amount comes from deposits which is about half and the balance through equity.

With the inability to attract funding as evident by the rise in the interbank short term lending rates, Spanish banks are turning to the European Central Bank as a lender of last resort.

According to a Financial Times article, Spanish banks borrowed 85.6 billion euros from the ECB last month which was twice the amount needed right before the last credit crunch which was triggered by the fall of Lehman Brothers in September 1998. Furthermore, it is the highest amount since the beginning of the Euro Zone in 1999. Comparatively, the borrowing is an increase of about 14.4 percent from April’s tally of 74.6 billion euros.

With local banks having a difficult time which removes them as buyers for sovereign debt, the Spanish government is also having trouble finding lenders as interest from abroad abates.

On Tuesday, the Spanish government raised 5.2 billion by auctioning off short term bills. The rate was set at 2.3 percent, a massive increase of 70 basis points from May’s auction.

In mid-May and shortly after the EU bailout announcement of the Stabilization Fund and ECB bond intervention that was designed to quell market concerns, the Spanish government almost experienced a failed auction. Spain had planned to issue 8 billion euros in 10-Year notes but had to reduce the size of the sale by nearly 1.6 billion due to insufficient demand.

Since then, government bond yields have done nothing but increase amid declining investor confidence supplemented by a Fitch downgrade from a lofty AAA status to AA+. 10-Year bond yields have jumped almost 90 basis points on the long-end of the maturity spectrum dating back to mid-May. Short term yields are higher by 140-150 basis points.

10-Year Spain Government Bond Yields – 88 basis point increase since Last Auction

Despite Ocana saying that the country does not need additional financing from any international institutions in response to rumors from a German newspaper, the possibility looms that Spain could be the first country to tap into the recently unveiled European Stabilization Fund if conditions do not improve.

While bold, statements like that need further proof in order to ease concerns from the market since Greece denied assistance until market conditions shut the country out from access to the debt capital markets.

Spain has further funding issues in the pipeline. The country has 16.2 billion euros in redemptions that needs to be addressed next month. Thursday, Spain is set to auction off 3.5 billion in both 10 and 30-Year bonds. Tomorrow’s bond sale should be a good indicator on whether or not it needs any future assistance.