Spain is facing a severe banking crisis, reflecting the bursting of a housing and credit boom, which has resulted in a high debt burden of the private sector and a deep recession. The mutual dependence of the banks’ and the government’s funding conditions has deepened the crisis, although the planned development of a banking union in the euro area may soften these feedback loops. Deleveraging is progressing, but is likely to weigh on economic growth for several years. Rapid and comprehensive recognition of bank losses is key for restoring confidence in the banking sector and moving towards economic recovery. This requires the rapid resolution of non-viable and the recapitalisation of viable banks with capital needs. The government has taken important steps by tightening the provisioning rules on the banks’ real estate exposures. A euro area credit line of up to 100 billion euros will provide funds at favourable terms to capitalise banks, subject to conditions which, when met, will help overcome the banking crisis. Action needs to be taken to force the holders of the substantial hybrid capital and subordinated debt issued by banks to absorb losses, especially when the holders of these instruments are institutional investors. Reform of bankruptcy procedures would help shifting resources from insolvent companies to productive use and could provide more effective relief for those households who have no reasonable prospect of being able to repay their debt.