Spain’s banks face more loan losses as the pace of an economic slump risks turning a worst-case scenario dismissed in stress tests into reality.

Bad loans as a proportion of total loans reached a record 9.86 percent, or 169.3 billion euros ($222.1 billion), in July, and may rise further when the Bank of Spain publishes data for August Thursday in Madrid. The ratio, which has risen for 16 straight months, climbed from 0.72 percent in December 2006 before Spain’s property boom turned to bust.

Spanish bank stress tests by management consultants Oliver Wyman have factored in an economic contraction totaling 6.5 percent between 2012 and 2014 in an adverse scenario that the government and Bank of Spain said has a probability of about 1 percent. Analysts at Nomura and Citigroup disagree, saying spending cuts and economic conditions mean the worst-case outcome already looks feasible.

“You can’t attach a 1 percent probability to a scenario that already looks realistic,” Silvio Peruzzo, a European area economist at Nomura in London, said in a telephone interview Wednesday. Spain’s gross domestic product will shrink by 6.2 percent between 2012 and 2014, he estimated.

Spain’s request for 100 billion euros of European Union financial aid to shore up its banks is increasing concern about the nation’s growing liabilities. Standard & Poor’s downgraded the country’s debt rating by two levels to BBB-, one step above junk, from BBB+ on Oct. 10, saying it wasn’t clear who will bear the cost of recapitalizing banks. It cut the ratings of 11 lenders including Banco Santander SA and Banco Bilbao Vizcaya Argentaria SA, Spain’s largest, two days ago citing the sovereign downgrade.

Capital Shortfall

Under Oliver Wyman’s worst-case projection, an economic contraction of 4.1 percent in 2012, 2.1 percent in 2013 and 0.3 percent in 2014 would contribute to 270 billion euros of credit losses and a 59.3 billion-euro capital shortfall for banks. The base case foresees shrinkage of 1.7 percent this year, 0.3 percent in 2013 and an expansion of 0.3 percent in 2014. A deeper recession raises the risk that banks will have to raise more capital to cover losses.

The company won’t comment on estimates laid down in the stress tests, an official at Llorente y Cuenca, a Madrid public relations firm representing Oliver Wyman, said in a telephone interview Wednesday. Spain commissioned the review as part of terms for its European bailout.

Spanish banks’ loan losses will continue to grow because of the deteriorating economic outlook and rising unemployment, said Ebrahim Rahbari, a London-based economist at Citigroup Inc. He predicted a 5.8 percent contraction for Spain’s economy between 2012 and 2014.

Economic Growth

“The adverse scenario of the test looks closer to a forecast of economic performance over the next three years than a stress case,” Rahbari said in a phone interview. “That surely has consequences for loan loss rates and the one we are most concerned about is household mortgages.”

Deutsche Bank AG says the economic slump in Spain will be less pronounced, predicting a 1.7 percent decline in GDP over the period. The economy will grow 0.7 percent in 2014 after a 2.6 percent slump this year and in 2013, it says.

In a Bloomberg survey of 37 analyst estimates for Spanish economic growth, the average forecast is for a drop of 1.6 percent in GDP this year and 1.4 percent in 2013, followed by growth of 0.2 percent in 2014.

“A contraction of 2.6 percent over two years is still a hell of a contraction,” Gilles Moec, Deutsche Bank’s co-chief European economist in London, said by telephone yesterday. A pledge by European Central Bank President Mario Draghi to help bring down Spanish borrowing costs will probably help Spain avoid being sucked into a recessionary “spiral,” he said.

Mortgage Arrears

The default rate for 604 billion euros of Spanish home mortgages stood at 3.2 percent in June, according to the Bank of Spain. Banco Santander SA Chief Executive Officer Alfredo Saenz said in April that anyone saying mortgage defaults are a problem for Spanish banks was “saying something stupid.”

Bad loans and the jobless rate are bound to increase as Spain attempts to cut its budget deficit to 2.8 percent of GDP in 2014 from 9 percent at the end of last year, Simon Maughan, a financial industry strategist at Olivetree Securities in London, said last week by telephone.

In the worst case scenario, Oliver Wyman’s stress tests predict unemployment of 25 percent this year rising to 27 percent in 2014. The rate will peak at 26 percent in 2013, according to the average estimate in a Bloomberg survey of 13 analysts.

It may be wrong to suggest, as the Spanish authorities do, that the higher rates of economic contraction estimated by Oliver Wyman are a remote possibility, said Daragh Quinn, a Madrid-based banks analyst at Nomura.

“I think that talk of 1 percent probability is going to come back to haunt them,” Quinn said in a phone interview.