Espirito Santo Sets Creditor Pain Benchmark in EU Bank Rules

Aug 05, 2014 5:57 am ET

(Updates markets in fourth paragraph, adds bank bonds in eighth.)

Aug. 5 (Bloomberg) -- Portugal’s rescue of Banco Espirito Santo SA may have eased some doubts about Europe’s banking industry by showing investors how the European Union’s thinking has evolved on handling failing lenders.

The decision shielding some creditors spurred a rally in bank stocks and Portuguese assets yesterday as it demonstrated authorities were able to shutter a bank without sparking a fresh bout of market tensions that have roiled Europe since 2009. Instead of forcing losses on unsecured depositors and other senior creditors, as was required of Cyprus, Portugal is following Spain’s gentler approach that focused losses on junior debt and stockholders.

“This is bad for the bank’s shareholders and creditors, but it’s good for the wider banking industry,” said Stefan Bongardt, a European banking analyst at Independent Research GmbH in Frankfurt. “Everyone knows the rules of the game now and that draws uncertainty out of the market.”

The yield on Portugal’s 2-year bonds was down 1 basis point as of 11:49 a.m. in Frankfurt, near a euro-era record low. The Bloomberg European Banks and Financial Services Index rose 0.6 percent, after closing 0.3 percent higher yesterday, while Portugal’s benchmark stock gauge rose 0.4 percent.

“The systemic euro crisis is over,” Holger Schmieding, chief economist at Berenberg Bank in London, said in a note to clients. “While the euro zone still has issues, it now has a well-oiled machine to deal with them. The vicious contagion risks, which were the hallmark of the euro crisis, can be kept at bay.”

Bank Breakup

The Bank of Portugal unveiled a 4.9 billion-euro ($6.6 billion) bailout over the weekend that will leave shareholders and junior bondholders with losses, while sparing senior creditors and unsecured depositors. Banco Espirito Santo, once the country’s largest lender by market value, will be split in two, with depositors and healthy assets joining the newly formed Novo Bank while bad loans and junior creditors stay with the old bank until it can be shut down.

“To regulators in Frankfurt and Brussels, this must have seemed the safest way to isolate any residual and tail risks” related to the bank’s Angolan unit and loans to other parts of the Espirito Santo group, Citigroup Inc. analysts including Stefan Nedialkov wrote in an e-mailed report from London today. “The EU’s tough approach in the case of the BES resolution is likely to be the law of the land.”

Banking Union

The bank’s 750 million euros of 7.125 percent subordinated bonds fell 2 cents on the euro to 14.9 cents, to yield 52.3 percent, at 10:35 a.m. in Lisbon, according to data compiled by Bloomberg. Its senior, unsecured 4 percent notes rose 1.4 cents to 98.3 cents on the euro, to yield 4.43 percent.

EU leaders vowed in 2012 to create a banking union within the euro zone so that taxpayers would no longer shoulder the burden of repairing banks for investors’ benefit. Five of the currency bloc’s 18 members required aid during the worst of the crisis, which was fueled by bouts of contagion between sovereign debt and banks.

Banco Espirito Santo’s rescue takes place during the transition to the new oversight regime. The EU has tightened its rules on how banks can receive state aid, and the Frankfurt- based European Central Bank has begun its examinations. Later this year, the ECB will release its assessment of the balance sheets of the bloc’s largest banks before taking on its supervisory mantle. In 2016 a tougher set of bail-in rules will start for creditors of failing banks.

Timely Reminder

“With the ECB about to take up the reins, it’s a timely reminder of both how complex and resource intensive the process of supervision actually is, and the skeletons that could still be in the closet,” said Richard Barwell, senior European economist at Royal Bank of Scotland Group Plc in London.

When funds are spent to stabilize failing banks, the EU’s new framework calls for the money to be recouped from the private sector once the immediate crisis point has passed. In the case of Banco Espirito Santo, Portugal’s central bank will operate the “good bank” assembled from the bank’s viable assets, which will need to be spun off.

The country’s fledgling bank resolution fund, financed under normal conditions by all lenders operating in Portugal, will get a 4.4 billion-euro loan from the government to finance its investment in Novo Bank and will be repaid by proceeds from its sale. The EU on Aug. 3 approved the Banco Espirito Santo rescue as in line with state-aid rules.

“This is the route the EU will take from now on,” said Lutz Roehmeyer, who helps manages about 10 billion euros including senior bonds of Banco Espirito Santo at Landesbank Berlin Investment. “There’s only one significant way the approach will become stricter: I’m waiting to see the first large case of bailing in senior bonds.”

--With assistance from Anabela Reis and Joao Lima in Lisbon, Deborah L Hyde in London, Paul Gordon in Frankfurt and Esteban Duarte in Madrid.