EU Bank-Aid Rules Await Test as Espirito Santo Wobbles

Banco Espirito Santo SA could become a test case for European Union rules on creditor losses at failing banks, adding to pressure on Portugal’s second-biggest lender as it tries to avoid collapse.

Prime Minister Pedro Passos Coelho last week urged Banco Espirito Santo’s corporate group to negotiate with creditors “as soon as possible,” while ruling out the need for a bailout. The bank roiled markets on July 10 when a parent company called Espirito Santo International SA missed some payments on commercial paper.

Passos Coelho’s comments highlight the twofold challenge facing equity and junior debt investors: bank bondholders would face losses both if the bank collapsed on its own and if it received a government capital injection, because of EU rules put in place at the height of the debt crisis.

“You have to do the bail-in at some stage in order to give a credible signal to investors so that investors adjust their exposures,” Guntram Wolff, director of the Bruegel research group in Brussels, said by telephone.

EU leaders have vowed that taxpayers will never again pick up the tab for failing banks after financial-crisis contagion forced five euro states to seek aid. To make good on that promise, the 28 nation-bloc tightened its rules on when banks can receive state aid, assigned supervision of euro-area lenders to the European Central Bank, and passed an even tougher law on creditor losses that will be phased in over the next few years.

‘Many Rules’

German Chancellor Angela Merkel said Portugal’s banking-sector woes threaten the euro area’s hard won stability and reinforce its need to follow the “many rules” put in place to avoid further crises. Whether with Banco Espirito Santo or another struggling lender, regulators may soon have to follow through on their pledge that creditors won’t be spared.

“You have two competing objectives: on the one hand you want to preserve the taxpayer from putting more resources into banks, and on the other hand you want to avoid financial system havoc,” Wolff said. “You’re always walking this very fine line: if you do too much bail-in you risk creating financial instability, while if you do too little, you risk jeopardizing debt sustainability and undermine public support.”

The EU hasn’t had to follow through on a high-profile case this year. When Bulgaria lent a helping hand to two of its biggest lenders, sending Bulgarian stocks soaring, the bail-in rules weren’t triggered.

ECB Oversight

Junior bondholder and equity losses were imposed in Spain when it restructured its banks as part of a euro-zone rescue program. Yet that experience may not apply to other nations.

As a result, countries that see problems at one or more of their biggest banks may tread new ground. The issue is likely to come into even sharper focus later this year, when the ECB wraps up stress tests and balance-sheet assessments at euro-area lenders ahead of taking on its new oversight duties.

The EU’s state-aid rules allow governments to provide some support to banks if financial stability is under serious threat. Last month, Bulgaria’s worst financial crisis in 17 years forced the ruling Socialists to extend a 3.3 billion-lev ($2.3 billion) credit line to First Investment Bank AD and Corporate Commercial Bank AD, the country’s third- and fourth-largest lenders by assets.

The European Commission approved the credit line, saying it accorded with state-aid rules, helping calm the situation and ending a bank run. “These requirements apply to capital and impaired-asset measures, not liquidity support,” meaning the Bulgaria case didn’t trigger creditor losses, said EU spokesman Antoine Colombani.

Missed Payment

Portugal’s central bank sought to stave off a run last week, urging Banco Espirito Santo customers to stay put after the missed short-term debt payment.

“The safety of the funds entrusted to BES is not undermined and BES depositors may rest assured,” Bank of Portugal said in a July 11 statement from Lisbon.

The bank saw its subordinated bonds and stock tumble as 847 million euros ($1.1 billion) of short-term debt sold by a holding company linked to the Portuguese lender fell due yesterday. Rioforte Investments SA, a holding company of the troubled Espirito Santo group, owes the money to Portugal Telecom SGPS SA, according to a June 30 regulatory filing by the nation’s biggest phone company.

A Banco Espirito Santo spokesman declined to comment yesterday.

Market Access

Portugal’s outlook has improved since it exited its 78 billion-euro bailout and regained access to sovereign bond markets, according to Moody’s Investors Service. At the same time, Banco Espirito Santo’s problems pose challenges to the nation’s entire banking sector even though the problems are localized in one lender.

“The likelihood that the Portuguese government or bank regulator will intervene to sustain the viability of BES has increased, and in that case, BES subordinated debtholders are clearly at risk of bail-in as a condition for the European Commission to approve any systemic support,” Moody’s said in a July 14 note to clients.

“Because the European Bank Recovery and Resolution Directive, which requires the bail-in of senior creditors, is not yet law in Portugal, the bail-in of senior creditors is less likely,” Moody’s said. Those rules are slated to take effect across the EU beginning in January 2016.

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