FORGET for a moment the hysteria over a possible break-up of the euro zone because some member countries may be unable to stay financially afloat.

 

Instead, focus on how these countries got themselves into such a big financial mess in the first place.

 

Theirs is a cautionary tale of why regulators should take an active approach in pricking a financial bubble before it becomes so big that when it finally explodes, it hurts large segments of the economy.

 

The best example is Spain, regarded by several commentators as the real ground on which the battle for the single European currency's survival is being fought.

 

Greece may have attracted most of the headlines but Spain is the much bigger economy.

 

Its banking crisis does not involve the new-fangled financial weapons of mass destruction such as the collateralised debt obligations that slayed investment bank Lehman Brothers four years ago.

 

It does not even involve the complicated derivatives that tripped up banking giant JPMorgan recently.

 

The fiasco is simpler in origin, with a familiar ring to it. A debt binge by Spanish households in the past decade had fuelled such a large property bubble that it left the country owing foreigners almost €1 trillion (S$1.6 trillion).

 

After the bubble burst, Spanish banks were hit the hardest as they were saddled with about €180 billion in bad debts.

 

So far, Spain's dithering efforts to salvage its banking system have caused further problems.

To shore up investors' confidence, Spain merged seven of its domestic savings banks - badly hit by the mortgage crisis - to form Bankia.

 

It was then floated on the Madrid stock market in July last year, attracting thousands of small savers to its IPO.

 

What was supposed to be a simple bank recapitalisation issue then became a bigger headache, as these people found their investments all but wiped out by the country's latest move to nationalise Bankia as its real estate losses deepened.

 

Worse, cash-strapped Spain's efforts to recapitalise Bankia failed to inspire investors' confidence.

Instead of giving the bank cash, it said it planned to offer over €19 billion of government bonds, which it hoped Bankia could monetise into cash at the European Central Bank's (ECB) refinancing window.

 

Unsurprisingly, the ECB deemed the proposal unacceptable, rejected it, and told Spain to devise a proper capital injection plan.

 

But such antics can be costly: It caused Spain's already sky-high borrowing costs to escalate further on the international bond market, and made the jittery European stock markets suffer another attack of the nerves last week.

 

To catch a glimpse of Spain's eventual fate, look no farther than Ireland - another euro zone country - which is being punished for its own banks' reckless lending.

 

Because of a government guarantee to pay off the massive debts incurred by the insolvent Irish banks, the entire country now finds itself on the hook for the mess created by its lenders.

 

In a recent article in the Financial Times, Irish economist David McWilliams highlighted the plight faced by the depressed Irish economy as it deleverages.

 

'Many Irish people's balance sheets are broken because we have assets - houses, land and apartments - that are falling in value, but debts which are fixed,' he wrote.

 

As a result, people do not want to borrow because they have too much debt, and banks do not want to lend because they have too much bad debt.

 

It has turned the laws of economics on their heads, he said. When prices fall, demand does not go up but plummets instead, because with the drop in prices, people are convinced that they will fall further and delay their purchases.

 

This has resulted in an explosion of Ireland's savings rates to 17 per cent of income, even as its economy contracts and unemployment soars.

 

The Irish debacle explains why Germany is wary of providing bailouts to Spain and other heavily indebted European countries. It fears being ensnared in a financial morass which it had little to do with in the first place.

 

For those of us watching the banking crisis unfold in Europe from the safety of Asia, it is a useful reminder that traditional banking is also not a low-risk activity.

 

Just because the economy is booming and property prices are rising does not mean that banks can throw caution to the wind and lend recklessly to the sector.

 

It is just as well that regulators here took a tough stand by launching a series of draconian measures to stamp out speculative buying of residential property in Singapore, in order to nip any nascent property bubbles in the bud.

 

To paraphrase the investment advice once given by legendary investment guru Warren Buffett: Rule No. 1 is never to allow a property bubble to develop. Rule No. 2 is never to forget Rule No. 1.

 

Otherwise, the consequences can be horrendous, as the nightmarish experiences in Spain and Ireland can attest to.