Espirito Santo: A One-Off Or The Start Of A New EU Banking Crisis? - by Raoul Ruparel -

By Raoul Ruparel - 

The Good, The Bad And The Ugly Of Banco Espirito Santo's Resolution Plan, Link

Overnight it was revealed that Banco Espirito Santo (BES) would be resolved and split into a ‘good bank’ and a ‘bad bank’. As I have discussed, it has been circling the drain for the best part of a year now.

The details are these:

• BES will remain as a bad bank housing shareholders and subordinated debtors who will be written down against the bad assets formed mainly of exposure to the rest of the Espírito Santo and to the bank’s Angolan unit.
• A new good bank will be created (called Novo Bank for now) which will essentially house everything else – branches, employees, deposits, senior debtors and other viable assets. This will continue to operate using BES existing branding and framework.
• The good bank will be capitalised by €4.9bn from the bank resolution fund. This takes the form of a €4.4bn loan from the Portuguese state and €0.5bn in cash which the fund had from levies on the banking sector and previous injections.

The Good

• The proposal has been quickly put together and quickly approved by the Commission under its state aid rules – at least relative to the fact that the worst was only fully revealed in Wednesday’s financial results.
• There will be losses for investors and some level of bail-in. This is a positive step compared to the financial crisis when such a flagship national bank would likely have been bailed out directly and completely.
• This issue which has rumbled on for some time finally has a clearer end, ensuring it does not spill over into the rest of the Portuguese or eurozone banking sector.

The Bad

• The Bank of Portugal’s (BoP) claim that “this operation does not involve any costs for public funds” is at best hollow and at worst deliberately misleading. The state is clearly providing a loan which will continue to be at risk until it is repaid and which will at the very least divert funds from other avenues.
• Following from this, the plan for the repayment of the loan is far from clear. The BoP claims it “will be temporary and replaceable by loans granted by credit institutions” but exactly who will be willing to take on the role of fully capitalising a new bank is unclear. The resolution fund is meant to be financing by private sector contributions, however, forcing this cost on other banks will surely raise some moral hazard and competition issues.
• In any case, the idea that the loan or injection is temporary and easily repayable has been the generic qualifier used on all bank bailouts – it is sometimes proved true but often false.
• If the loan is not repaid by the end of the year, the state will have to issue €4bn odd extra bonds to meet its target of having a €10bn cash buffer for the start of 2015.
• Senior creditors have been protected. While this is in line with the state aid rules it is not in line with the upcoming Bank Recovery and Resolution Directive (which comes into force in January 2015). Some might argue this is not in the spirit of the regulation. After all, it is a bit strange that there would be such widely different rules for another bank which might run into problems in six months’ time, especially as the rules have already been agreed upon.

The Ugly

• What exactly will happen to the bad bank is unclear. As has been demonstrated the exposures to the rest of the conglomerate are a sink hole for funds and whether the value of existing shareholders and subordinated debtors will be sufficient is unclear. If it does require more funding it is not said where this might come from.
• As Frances Coppola points out, the Commission and the BoP don’t quite seem to be on the same page with regards to the future of the good bank and the repayment of the loan. As explained above the BoP expects the loan to be refinanced by the private sector with the good bank becoming a permanent institution. However, the Commission expects it to be a temporary “bridge bank” which will be sold off (as a whole or in parts) with the revenue repaying the loan. Exactly what this would mean for the Portuguese banking sector (of which the new bank remains a large part) and the majority of the 10,000 bank employees based in Portugal is unknown.
• In broader terms, the way this whole affair has been handled is a bit ugly. Serious problems were first revealed by auditors back in early 2013. Why it has taken numerous public and private audits to finally get a clearer picture of the mess within the bank is a serious question which needs to be answered.
• Investors who were convinced by the bank and those firms employed by the bank that the risk they were taking on in purchasing shares or subordinated debt was much lower than the reality will face large losses. They may have some legal recourse but this will be a long and messy process. Again the due diligence on such sales seems to have been well short of what is needed, checks and reviews need to be done here.

There are signs of progress and learning in this plan. It has been quickly put together and the use of good and bad banks (similar to what was done in Sweden 1990s) may prove more effective than the approach used during the financial and eurozone crises. That said, there is plenty of uncertainty and some incoherence. This remains  a messy situation and unwinding it will take some time and considerable effort, for which it is not yet confirmed that taxpayers will not foot any of the bill.

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By Raoul Ruparel - 

Espirito Santo: A One-Off Or The Start Of A New EU Banking Crisis?

It will not have gone unnoticed to most that European stocks, particularly banks, have taken a bath today led mostly by jitters around Portugal’s largest bank, Banco Espirito Santo (BES) which was down over 17% before trading was halted.

Eurozone market contagion, bank and sovereign jitters – it feels just like 2012 again. But is it a one off or the start of something bigger?

Firstly, there’s no doubt there are some valid concerns surrounding BES, the key ones of which are:

• The ownership structure is a mess. BES is 25% owned by Espirito Santo Financial Group, which is 49% owned by Espirito Santo Irmaos SGPS SA, which in turn is fully owned by Rioforte Investments, which is fully owned by Espirito Santo International (ESI) (last two are based in Luxembourg and aren’t included in the chart below from Zerohedge which highlights just how complex the structure is).
• The exposure between these level is equally opaque, with the WSJ highlighting back in December that ESI was utilising different branches of its structure, including BES, to fund itself up to the tune of €6bn. Currently, BES has admitted it has the following exposure: €980m debt from Rioforte, but it also helped place €651m of debt issued by Rioforte and ESI to retail customers and €1.9bn to institutional clients.
• This debt could essentially be worthless or massively written down. It’s not clear how open BES was about its conflicts of interest and if it mislead buyers. There is a serious risk of lawsuits here. Citi has put potential total losses at €4.3bn, this could wipe out BES capital buffer and force it to raise a similar amount again.
• BES also has a worrying exposure to its subsidiary in Angola which is draining €2bn worth of funding. This is substantial for a bank with a €6bn loan book. The bank has also required a 70% guarantee from the Angolan state, which itself has a poor credit rating meaning the usefulness of such guarantee may be limited (the fact it was needed at all says a lot). This has also been weighing on the share price.

All this culminates into some very real concerns. While there are plenty of unfounded rumours flying around, the fact is they are hard to disprove because the structure of the bank and its affiliates is so maddeningly complicated. The exposure has also been continuously underestimated and hidden so it’s only right to ask, what else might they be hiding?

But all of these are very specific BES problems, why has this suddenly sparked Europe-wide contagion? I believe there are a few factors behind this:

1. The market had pulled too far ahead and was looking for an excuse to pull back. It is also in a bit of a price discovery phase, still trying to figure out how to balance the issues of low inflation, search for yield, remaining eurozone risks and future ECB action. The lower volumes and liquidity in certain markets may also exacerbate the move. Lastly, with the recent market convergence, there is bound to be more spill over between and within markets. All to say, part of this may be the confluence of market factors and circumstances – such a situation can last but is more likely to be temporary.
2. More importantly though, investors are realising that, if the bank got into trouble it would have to rely on its sovereign for help. The bank cannot afford to recapitalise to the tune of €4bn. Equally though, Portugal (in the midst of trying to find further budget savings) would struggle to stump up the cash – hence the sovereign spill over. Talk of the sovereign-bank loop being broken are seemingly premature (as I have said before).
3. On top of this, investors are also looking at a lot of uncertainty about how a bail-out/bail-in might work and what the exact rules would be. The eurozone’s rules on bank bail-ins and the single bank resolution mechanism don’t kick in for some time (2016 and 2015 respectively) and while the state aid rules make it clear investors will take losses the exact format is very uncertain. These two points should once again peak investors’ concerns about how such bank resolutions might be handled. Throw the political obstacles in the mix surrounding a national flagship bank such as BES and one might wonder how much has really changed since such questions were asked at the peak of the crisis.
4. More generally, BES’s problems show some elements indicative to periphery banks (particularly in Portugal and Italy). It has a very old, complex and opaque structure and its exposures are still not well known. Too little attention has been paid to this in the past year. The loan books are also weighed down by investments and lending to zombie firms. Let’s not forget, these two countries did not suffer from bubbles but chronic low growth and high corporate debt levels – neither of which has been tackled.

There are clearly some lessons in this situation for eurozone investors and they would do well to remember the short comings in the eurozone architecture, particularly when it comes to the banking sector which is yet to be cleaned up even after six years of crisis. That said, given the specific nature of the problems it is unlikely to mark a huge turnaround in market sentiment. Sure, the market will pull back a bit but we still have the injection of the new ECB lending operations (TLTRO) to come and the hope of some positive data on the GDP and inflation front.

One final point out of all of this is to watch how BES does in the upcoming ECB Asset Quality Review (AQR) and bank stress test. If it is not seen to have been rigorously assessed and problems highlighted then serious questions will begin to be asked about the credibility of an exercise. Now, the failure of the AQR would really be the start of bigger problems for the eurozone.

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Dominoes Fall At Espírito Santo

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As I warned a couple of weeks ago, the complex ownership structure of Banco Espírito Santo (BES) and its parent companies could yet reveal a few surprises. So it has proved – despite many analysts still having a buy recommendation on the bank up until the past few days.

Things have gone from bad to worse for the bank and the broader conglomerate.

Espírito Santo International (ESI) – the parent company of the entire conglomerate – was the first to file for creditor protection. Two of the conglomerate’s holding companies Rioforte and Espírito Santo Financial Group (ESFG) followed suit over the past couple of weeks, bringing the crisis right to the bank’s doorstep (as if it wasn’t already), saying they were unable to fully repay their debt obligations. This has also highlighted a concerning web of inter linkages between the various parts of the conglomerate.

It then emerged that former BES Executive Chairman Ricardo Espírito Santo Salgado was under investigation for tax evasion and money laundering, some of which is alleged to have taken place during his tenure at the bank. The group itself was then thrown under the spotlight as Portuguese prosecutors said they were investigating parts of the group for abuse of privileged information and trust.

The real death blow came with the release of yesterday’s financial results which are frankly a mixture of the bad and baffling. BES revealed a loss of €3.49bn for the second quarter of the year, mostly driven by a €1.73bn write down on exposures to the wider conglomerate, €880m to cover costs related to the misspelling or mispricing of bonds of the group and €181m from its subsidiary in Angola. Possibly more worrying than this were the declarations that the existence of some of the Special Purpose Entities (SPEs) used to purchase and repackage the debt of the wider Espírito Santo Group for the bank were unknown to the current board, along with promises regarding the creditors of parts of the group. This prompted the Bank of Portugal to announce another audit of the bank and remove some of the key personnel involved in risk and oversight from their positions.

This all resulted in BES’ tier 1 capital ratio falling from 9.8% in March to 5% June and the banks shares collapsing by another 35% at the time of writing.

What now?

A recapitalisation needs to be done immediately essentially. However, despite stating there is interest and support from investors there has not been a clear plan drawn up – this adds to uncertainty. If BES is to fully restore its capital ratio it will need at least €3bn – this could easily increase if further losses are found and if the banks commercial situation deteriorates further (which looks very possible).

Is there any good news?

It’s very limited but there are a couple of positive points (although I wouldn’t go as far as calling them a silver lining):

• Some international investors have shown interest in the bank and it has succeeded in issuing new shares over the past quarter.
• If needed, Portugal has a decent amount of funds – around €6bn – left in its bank bailout fund from its EU/IMF bailout.
• The wider negative sentiment from this event seems to have been limited and temporary (as my colleagueFrances Coppola correctly predicted when the crisis flared up). It is now clear that this issue is mostly localised due to problems within the conglomerate.

All that said, this issue is set to rumble on for some time. One point to keep in mind is that any public recapitalisation would likely come with strings attached and write-downs for bond holders can certainly not be ruled out at this stage. There are also a few questions to keep in mind. Why exactly has it taken so long for all this to come to light, the BES crisis has been rumbling for almost a year now? In particular, what did earlier audits of the bank find or not find? Finally, how will BES do in the upcoming Asset Quality Reviews and Stress Tests? As I mentioned before, we now have a useful bellwether to test the credibility of the review.

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Obs: Um quadro geral de análise muito sustentado do desastre que se anunciava. Com a vantagem de o "olhar exterior" gozar duma objectividade, distanciamento e isenção acrescidos. 

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