Espirito Santo Turmoil Shows ECB Systemic Risk Challenge

The Espirito Santo saga is giving believers in the end of the euro-area crisis cause for pause.

Although a return to the panic days of the crisis may be unlikely, the case, involving the inability of a parent company of a bank in Portugal to make some short-term debt payments, has sent government bonds of Europe’s most-indebted nations and the stocks of lenders tumbling, showing how fragile investor confidence in the region’s banking recovery is.

“This shows that even a bank in a peripheral country can have systemic reach,” said Jerome Forneris, who helps manage $9 billion at Banque Martin Maurel in Marseille. “A solution must be found, but it must be found quickly.”

Banco Espirito Santo SA, the bank at the heart of the turmoil, is Portugal’s second-largest lender by market value and has assets equal to less than 0.3 percent of the euro-area’s total banking assets. Its ability to roil markets shows the task confronting the European Central Bank as it works toward a banking union with the creation of a supervisory body for the bloc’s lenders.

The ECB has been charged with overseeing the euro-area’s banks to prevent a repeat of the taxpayer-funded bailouts during the financial crisis. Lenders are currently being subjected to an unprecedented, yearlong review of their assets, the results of which will be released in October.

Lenders from Italy’s Banca Monte dei Paschi di Siena SpA to Banco Espirito Santo bolstered capital as the ECB reviewed their balance sheets. European banks and insurers sold $55 billion of stock this year, already exceeding the $49.3 billion raised in all of 2013, data compiled by Bloomberg show.

Confidence Shaken

“The implication of what’s happening are huge,” Inigo Lecubarri, who helps manage the $800 million Abaco Financials Fund in London. “Investors are finding out new information just weeks after the regulators and the underwriters scrutinized the bank before its rights offer. This is a blow to confidence in regulators and supervisors and it puts the risk premium up.”

An ECB spokeswoman declined to comment on Espirito Santo.

The Portuguese central bank’s assurances that Banco Espirito Santo’s solvency is solid failed to ease investor concern yesterday, when its shares were suspended after tumbling 17 percent and its bonds dropped to record lows. Portuguese government debt fell along with securities from other European nations, while banks dragged stock indexes in the region down more than 1 percent.

Selloff ‘Overdone’

While Banco Espirito Santo remained suspended in early trading, European banking shares pared yesterday’s losses and government bond yields fell.

“The selloff may be overdone based on what we know,” said Peter Braendle, who helps oversee about $565 million at Swisscanto Asset Management in Zurich. Braendle, who participated in Banco Espirito Santo’s rights offer, has since sold the stock and bought shares of Banco Comercial Portugues.

The Banco Espirito Santo case is complicated by the complex holding structure of the group controlled by Portugal’s Espirito Santo family, and its intergroup borrowings.

Espirito Santo International, which missed some debt payments, has holdings in entities through which it controls businesses including a hotel chain and an insurer. It is an indirect shareholder of Espirito Santo Financial Group, which in turn is the biggest holder of Banco Espirito Santo.

“The main problem is the structure of the company, with its holdings and lots of subsidiaries, and not knowing how the problems in the holdings affect the rest,” said Gonzalo Lardies, a fund manager at Banco Madrid. About 2.8 percent of the 123 million euros he manages was invested in Banco Espirito Santo shares, which he sold last week.

Sufficient Capital

The bank said in a filing last night it has exposure of 1.18 billion euros to companies of Grupo Espirito Santo in loans, securities and other items as of June 30.

Banco Espirito Santo had a capital buffer of 2.1 billion euros above the regulatory minimum common equity Tier 1 ratio of 8 percent as of March 31, after last month’s capital increase, the bank said. The “executive committee believes that the potential losses resulting from the exposure to Grupo Espirito Santo do not compromise the compliance with the regulatory capital requirements,” it added.

Early indications of trouble within the group emerged when Banco Espirito Santo sought to raise 1.04 billion euros, its second capital increase in two years, with a rights offering last month to meet ECB capital ratios. It noted accounting irregularities at holding company Espirito Santo International, which has borrowed money from Espirito Santo Financial Group.

‘Serious’ Situation

Banco Espirito Santo said in its share-sale prospectus on May 20 that there was a “serious financial situation” at holding company ESI that could be damaging to the bank. ESFG included a 700 million-euro special provision in its 2013 accounts related to potential risks associated with exposure to non-financial activities at Grupo Espirito Santo.

“Although we don’t know exactly where all the problems lay within the unlisted parts of the group we can safely say that collectively it is over-leveraged and short of cash,” Roger Francis, a credit analyst at Mizuho International Plc in London, said in a telephone interview July 7.

Banco Espirito Santo CEO Ricardo Salgado said in a June 11 interview that the group planned to offer to buy shares from minority holders of Espirito Santo Financial Group and could de-list it as part of the reorganization of the group. The bank is currently in the process of finding a new CEO who’s independent from the family.

Redoing Bank

Other parts of the family group are looking into selling assets as they work on untangling its structure. The Bank of Portugal said in a statement on July 5 that the changes would lead it to supervise the bank instead of Espirito Santo Financial Group.

While Banco Espirito Santo works on putting its house in order the ECB’s health check has also had consequences for other banks. Erste Group Bank AG, the Vienna-based lender that earns most of its income in eastern Europe, said last week it will post a loss of as much as 1.6 billion euros this year. That’s in part because of rising loan-loss provisions in Romania, where the central bank is pressuring lenders to clean up their balance sheets amid the ECB’s exams.

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