Monday, August 4, 2014

Bank Failure: Banco Espírito Santo

Last night Portugal threw its entire bank bailout fund at Banco Espírito Santo, in the most complicated bank resolution I can remember seeing. The funds were used to set up a new bank, tentatively Novo Banco, which is taking over Banco Espírito Santo’s deposits and its regular banking assets.

The old Banco Espírito Santo is now what is called a bad bank. It is left with no banking operations in Portugal. It owns essentially only the loans to the two bankrupt Espírito Santo parent companies and their various subsidiaries, along with the banking subsidiary in Angola. The stockholders of Banco Espírito Santo own only this bad bank, so the stock is almost certainly worthless, although there are some unknowns. Trading in the stock has been suspended. At the close of trading Friday, the bank’s market capitalization had fallen below €1 billion, down 97 percent from its 2007 peak. The €1 billion level is significant because the bank had issued €1 billion in new stock in the middle of June, a move that in retrospect can be seen as a mistake, now that the entire bank is not worth the selling price of the new stock. Nothing can be paid to the stockholders until the bondholders are paid. Bondholders will surely get something from the expected liquidation of the Espírito Santo companies. They can probably expect to eventually get about half of their principal back, but shouldn’t hold their breath in a messy bankruptcy process spread across at least three countries.

The Espírito Santo family owned more than a third of the bank, but other stockholders and bondholders include some of the large banks in Europe. France’s Credit Agricole was apparently the largest single stockholder and has lost something on the order of €1 billion on its investment.

Although Novo Banco will operate under the Banco Espírito Santo name for now, I don’t think that can last. The association with the Espírito Santo family name won’t be good for business while bankruptcies are in court under the same name and family members are being investigated and possibly tried. Thinking pessimistically, that could be going on for the next five years. The central bank will be looking for a buyer for the bank, and a name change could follow when a buyer is eventually found.

Selling the largest bank in the country will not be an easy task, and it will depend on showing that the bank can earn a profit from operations. That remains an open question. The bank had been reporting losses for years even before it was forced to write down loans to its bankrupt affiliates. Portugal’s economy is improving but the real estate loan portfolio will surely suffer more losses before things turn sunny again.

This bank resolution did not follow the pending euro zone bank resolution guidelines, though observers consider it a step in that direction. It is the first bank resolution in the euro zone to even come close to the traditional legal framework for the treatment of a failed bank. It made at least a pretense of protecting taxpayers from losses. Notably, it followed the model of Iceland more closely than the precedents to be found within the euro zone. Senior bondholders were protected, though, something that will surely cause hand-wringing in the months to come. Under next year’s rules, bondholders cannot be treated as too big to fail.

There are two main bank governance questions raised by the Banco Espírito Santo failure. The failure was caused by bad loans to affiliated companies, and the bank’s accounting records disguised both the extent and the quality of these loans. Then, auditors failed to notice the flaws in the bookkeeping. It was almost a repeat of Europe’s last giant bank failure, CorpBank in Bulgaria. This raises policy questions about banks’ loans to affiliates. Should there be more strict rules of disclosure when a bank makes large loans to parties closely affiliated with large stockholders? This could make it harder for banks to disguise the identity of the borrower in these loans. It is common enough in Europe for banks to directly own industrial and hospitality businesses, a situation that presents many of the same conflicts of interest. The secrecy surrounding the high-risk loans at Banco Espírito Santo raises question about audits and oversight. Is it reasonable to expect auditors and regulators to unmask the risks involved when a bank is secretly being used to finance affiliated companies?

Observers are looking at the Banco Espírito Santo resolution as a precedent for a reason. The assumption is that there could easily be one or two more giant bank failures in Europe before the new bank resolution rules take effect next year.