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In my latest post at Pieria, I took a hard look at the half-year results of Portugal's distressed Banco Espirito Santo (OTCPK:BKESY). They are pretty grim reading. No, they are worse than that. They read like an instruction manual for how to rip off a bank. It's no surprise that the losses are appalling.

But now it seems that Banco Espirito Santo is to be bailed out by the Portuguese government. The rescue plan was announced by the Bank of Portugal late in the evening of 3rd August, and the European Commission confirmed that it complied with existing state aid rules.

The Bank of Portugal's statement describes the dramatic events that led to the decision to rescue BES (my emphasis):

On July 30, Banco Espírito Santo, SA announced losses which greatly exceeded those anticipated from the information previously provided by Banco Espírito Santo, SA and its external auditors. Results released on July 30 reflect management acts seriously prejudicial to the interests of Banco Espírito Santo, SA and infringement of Bank of Portugal decisions forbidding increased exposure to other entities of the Espírito Santo Group. These events took place during the tenure of the previous administration of Banco Espírito Santo, SA. Management acts at a time when the replacement of the previous administration had already been announced translated into an additional loss of the order of €1.5 billion compared to that expected from the statement of Banco Espírito Santo, SA to the market on July 10 . This had several consequences:

i) placed Banco Espírito Santo, SA in a position of non-compliance with minimum solvency ratios in force (Common Equity Tier 1 ratio of 5 percent, three percentage points below the regulatory minimum);

ii) determined a decision to suspend access by Banco Espírito Santo, SA to monetary policy operations and therefore, the liquidity of the Eurosystem;

iii) generated a growing pressure on the Treasury of Banco Espírito Santo, SA;

iv) worsened the public perception of Banco Espírito Santo, SA, as evidenced by the strongly negative performance of the respective titles, injurious situation for the confidence of depositors. This negative public perception led to the suspension of transactions on the afternoon of Friday, August 1, at the risk of infecting the perception relation to other institutions of the Portuguese banking system;

v) worsened the uncertainty about the balance of Banco Espírito Santo, SA, invalidating a privately funded solution in a short time.

This framework created continuity problems for Banco Espírito Santo, SA activities. Given the importance of the institution in the whole banking system and the financing of the economy, these problems jeopardized the stability of the payment system and the national financial system.

So when BES's eyewatering losses were declared, which forced it into regulatory insolvency, it was denied access to Eurosystem liquidity and trading in its shares and bonds was suspended. The Bank of Portugal's strong language in this statement echoes that from the new Board of BES: neither seems in any doubt that the activities that directly caused BES's collapse were illegal. As I noted in my Pieria post, the Board's statement amounted to an allegation of fraud. The Bank of Portugal's statement in effect alleges embezzlement, non-compliance with regulatory decisions and failure of fiduciary duty to shareholders. Wow.

BES is to be wound up. The "good" assets of BES are to be placed into a new credit institution, along with ordinary deposits and senior bonds: the remaining assets, along with shareholders' funds and subordinated debt, will remain in BES and be run down over time. No haircut is to be applied to senior unsecured debt. Bondholders and large depositors are no doubt breathing a huge sigh of relief: eighteen months later and they would have been facing losses. The Cyprus solution - haircuts on large deposits and senior bonds to protect the sovereign balance sheet - will become law across the whole EU from January 2016.

But there is something of a puzzle here. The Bank of Portugal calls the new "good bank" Banco Novo, or "New Bank", and seems to expect it to remain intact for the foreseeable future. But the European Commission calls it the Bridge Bank, and describes it as a "temporary credit institution". The reason appears to be the different objectives of the two institutions: the Bank of Portugal is primarily concerned with preserving financial stability and ensuring that BES customers suffer as little disruption as possible, whereas the European Commission is primarily concerned with minimizing the impact of this bailout on the fragile finances of the Portuguese state.

The problem is the approach to funding the "good bank". Banco Novo (or Bridge Bank) is to be provided with capital to the tune of E4.9bn from the Bank Resolution Fund. But the Resolution Fund actually doesn't have this money or anything like it. So the Portuguese state will lend it E4.4bn from funds already earmarked for bank recapitalization - that's around 2/3 of the earmarked funds. Earmarked it may be, but it is still public debt: unless it can be refinanced with private sector money VERY fast, the Bank of Portugal's statement that capitalizing the new bank "does not entail cost to the public purse" is not remotely realistic.

The Bank of Portugal describes this loan as "temporary and replaceable with bank loans". I would like to know how long is "temporary" and which banks would replace the loans. But the European Commission has a different view of the means by which the loan will be repaid:

Portugal's Resolution Fund will provide EUR 4,9 billion as capital to the Bridge Bank. To this end, the Resolution Fund will receive a EUR 4.4 billion loan from the Portuguese State. This loan will be primarily reimbursed by the proceeds of the sale of assets of the Bridge Bank.

It seems that the Commission expects the "good bank" to be broken up and sold piecemeal. Oh dear. Clearly there will have to be some negotiation about this.

But the funding of the "good bank", confused though it is, at least should be adequate to allow the new bank to operate. And if a buyer could be found for the whole thing, or a successful flotation achieved, then the loan could be paid off without breaking up the bank. This has to be the best solution for BES's customers. So the fact that the Commission has not recommended this just shows how narrow its focus is. Never mind the people affected, worry about state finances. Hmm.

To my mind the bigger problem is the inadequate funding of the "bad bank". Both the Bank of Portugal and the European Commission assume that once the good assets and senior debt have been removed to the new bank, the remaining shareholders' funds and subordinated debt will be sufficient to enable BES to be wound up without further funding. I'm afraid this is a very dangerous assumption. The Board of BES made it clear in the half year results that the extent of BES's exposure to ES Group liabilities is unknown and considerable risks remain: it seems likely that there will be more losses, possibly very large ones. The final bill could be far higher than the combined shareholders' funds and subordinated debt. But neither the Bank of Portugal nor the European Commission has considered the effect on Portuguese state finances of the "bad bank" BES incurring losses in excess of the value of shareholders' funds and subordinated debt. Protecting senior creditors could turn out to be a very bad decision.

And the decision to rescue BES fails to address the problem I raised in my previous posts about BES (see reading list below), namely the moral hazard that setting such a precedent creates for non-bank conglomerates with embedded banks. Yes, those responsible for the failure of BES may face litigation at some point. But from the record of the last few years, I am not hopeful that it will succeed. And even if it does, I doubt if the amounts recovered will in any way offset the losses suffered - ultimately, I suspect, by Portuguese taxpayers. I stand by what I said in my most recent Pieria post. Those who brought down BES will walk away with the proceeds, and ordinary people will pay.

Related reading:

Banco Espirito Santo: a Portuguese disaster, not a European crisis

Espirito Santo: complexity, opacity and moral hazard

Source: How To Rip Off A Country, Espirito Santo Style