How to rip off a country, Espirito Santo style

In my latest post at Pieria, I took a hard look at the half-year results of Portugal's distressed Banco Espirito Santo. 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 minimising 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 recapitalisation - 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 capitalising 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

How to rip off a bank, Espirito Santo style


  1. What, no mention of the Angolan role in BES? Isabel, Kopelipa et. al.? There's a fascinating political economy story in here that nobody's properly explored yet, and it's also likely to help answer questions about why things have turned out as they have.

    1. I did briefly mention the Angolan role in the Pieria post - the long-drawn out sale of ESCOM, and the entanglement of the Angolan government in BESA's lending. I agree it's fascinating, as is BES's entire strategy in Africa and Latin America - the full year report is instructive. However, this particular story is about corruption and fraud within the Espirito Santo conglomerate - it's not just about BES. Members of the Espirito Santo family shafting each other as well as their colleagues, their customers and ultimately the Portuguese people. Thoroughly charming.

    2. If you want a similar story to BES, take a look at BANIF, another bank my country bailed out for 1.1bn. I'm afraid we'll only know how much these decisions really cost us within a few years...

  2. I agree with everything you are saying, particularly the question whether equity and subordinated debt holders will suffice, and yet: when I saw the news this morning, my gut reaction was: "Gee, for once someone acted swiftly and decisively. Pehaps not in the perfect direction but certainly in the right direction".

    Remember the exchange we had about the Austrian HAA? If Austria had reacted swiftly and decisively back in December 2009 (!), no one would talk about this issue any more. Instead, almost 5 years later, the issue is still not resolved.

    1. Yes, they have acted swiftly and decisively. They had to. The suspension of Eurosystem liquidity would have resulted in disorderly failure of BES within 24 hours. That would have been a Portuguese Lehman - worse, actually, because BES is much larger and more significant in the Portuguese economy than Lehman Brothers was in the US economy, and it is interlinked with other European banks, especially Spanish ones. I'm sure you can imagine what that would have done to the Portuguese economy, and indeed to the whole of Europe.

      But I don't think they've got this right. In ring-fencing all senior debt with no haircut, they've left the sovereign exposed. If BES's losses exceed its combined equity and subordinated debt, the sovereign will have to fund the "bad bank". This is in addition to the supposedly temporary loan to the resolution fund for "good bank" capitalisation. Portugal's sovereign is already highly indebted. It can't afford this. The Bank of Portugal is gambling on BES's losses not exceeding its combined equity and subordinated debt. Given the extent of the "unknowns", that's quite a risky bet.

    2. Frances, Outstanding work. Keep it up! Thanks

    3. I don't get this... The so called toxic assets that are in the bad bank are worth something between zero and their full value, right? If they are worht zero, subordinated debt and equity get nothing. How can the losses exceed equity and subordinated equity?
      Thanks for the great work Frances!

    4. If there are enforceable claims such as guarantees to third parties that exceed the value of the available equity and sub debt, then there will be a funding shortfall as these would be real money that would have to be paid unless a way could be found to render the guarantees unenforceable. Simply reneging on such guarantees would open the door to years of expensive litigation.

    5. But how can this enforceable claims be paid out of subordinated debt and equity? Aren´t these liabilities as well? The way I see it the bad bank is made up of doubtable assets, liabilities composed by subordinated debt and enforceable claims, being equity the residue of this. If in fact the enforceable claims are bigger then the assets then some funding will be needed, but it will never be from subordinated debt or equity. Im I thinking wrong?

    6. No, that's exactly the point. If the enforceable claims are larger than the written-down value of the assets then equity is negative, not zero. The question is who would be on the hook for providing additional money to meet those claims. As it was the decision of the sovereign to remove good assets and protect other senior claims, it could be argued that the sovereign should pay. Alternatively, there could be a claim against the good assets transferred to BancoNovo. Either way, the sovereign is potentially liable.

  3. Jefferson Goias4 August 2014 at 11:40

    And will anyone be investigated and prosecuted criminally for the "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"? The shareholders saw their savings evaporating but quid juris on the culprits? Are they walking care free? and keeping their personal assets?

  4. As in many other instances, namely Banco Português de Negócios, Banif, etc., the bank of Portugal, the vice president of the ECB, the Portuguese government, and many other institutions seem to be surprised by what everyone has known for a long time. And the "trojka"? Were they not interested? Will the assets of the responsible people be frozen until they are a court decision has been reached? Will an independent European party examine what is going on in the Portuguese financial and legal circles? Is the Holy Ghost bank the last one with criminal management? If not, only God can protect the Portuguese tax payers.

  5. " 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." I read somewhere that large bondholders were under a legal obligation to take a hair cut under EXISTING law during the recent crisis, but that they had good enough political connections to persuade European governments to rob taxpayers instead. Anyone know if that's true? If it is, the above 2016 law may turn out to be a farce.

    1. Ralph,

      No, large bondholders are currently under no legal obligation to take a haircut. In a bank insolvency they may lose money if the state does not decide to protect them as it has in this case.

  6. Thank you very much for the nice building for "Banco de Portugal". I've never seen it though I live nearby.

    1. Ah. I didn't know that. I will find a proper picture.

    2. Dear Frances, the picture is in Portugal and the building is of Banco de Portugal (Bank of Portugal) head office building in Porto, at Praça da Liberdade, down Av. Aliados, downtown Porto. So you can use the picture, since its correct although not in Lisbon.

  7. This picture is not in Portugal.

  8. It is in Portugal. That comment makes me realize 1. you're not (in any way) Portuguese 2. you can't search pictures through google. Oops for you...

  9. Everyone, I've changed the picture because it seems that Wikipedia misled me about what the Bank of Portugal looks like. At least I can't go wrong with a picture of a BES branch!

    1. Oh dear, so many comments on the building... yes, we can get ripped off, Holly Spirit style, we can wake up in the morning, listen to the news and find out we now have a Good Bank and a Bad Bank (blimey, how do they come up with these names?), we can start reading the press and laugh cause it seems like a Private Eye parody and then cry cause it's true, it's happening again, it's coming out of our pockets, it's going to make our lives worse... it's, again, that original solution of nationalizing the debt of a Bank. Not a Bank, mind you, but its debt. But won't someone please think of the building??? Many thanks, Frances, for changing the picture - I feel much better now. On a more serious note; great article and, by the way, your conclusion - spot on! Cheers!

  10. No problem, It's in Portugal - "Palácio da Bolsa", Porto

    "The Palace was built in 1842 from the ruins of the former S. Francisco Convent, which were donated to the Porto Trade Association by Her Majesty, Queen D. Maria II. It is presently the Association’s headquarters and was once the Court of Commerce. Later, it became the Porto Commodities and
    Stock Exchange, thus giving origin to the Palace’s name.

  11. The situation in Portugal will start to change when people start to die over it - we are sick and tired of paying for bad management and for the rich few to get richer without any kind of responsibility - as always our government is weak, we have no business in rescuing bank - let them fall, let the private banking all fall because if they fail is their own fault not the state which is funded by peoples taxes and lack of choices. We need revolution now, we need occupation and we need action.

  12. Dear Frances,
    Thank you for your clear perspective on this dark subject. I have some BES senior debt, so far protected but, as I understood, that may not last forever. I think I'll have to sell it as soon as possible, but where shall it be safe to invest? It's a conundrum, in the actual portuguese landscape.

  13. I want to help you. I'm sending a link to a photo of Banco de Portugal ( Be my guest. Concerning the "Case of the BAD-BES BANK" it comes after at least another two (bank) misteries "THE STRANGE CASE OF BPN BANK" and "THE ODD CASE OF BPP BANK". The "NEW (GOOD) BANK" will remain a good bank to the day it will become an "OLD NOT SO GOOD NEW BANK". Portugal seems to be a good nest for good/bad/good/bad banks. God help us as the holy spirit (Espirito Santo) didn't.

  14. It's unbelievable how bank of Portugal didn't noticed anything until now ...

  15. You only have to look at the complex and opaque structure of the group, with its holding companies, cross holdings, circular holdings, intra group loans, intra group guarantees, SPes [SPIVS?], and minority stakes carrying majority votes to know this was not set up for transparency, accountability or the protection of depositors.

    Wherever and whenever you see such a structure ask yourself this: if an edifice is propped up by its own complexity, what happens when one part of the structure collapses under the weight?

    Regulators should ban outright any such arrangements in financial companies, particularly commercial banks.



  16. Why are you assuming that " If BES's losses exceed its combined equity and subordinated debt, the sovereign will have to fund the "bad bank""??
    The 'bad bank' (BES) is now nothing but a variety of bad credits to ES Group's companies, which by the way went bankrupt... so why the need to "fund it"??
    I am obviously missing something on your reasoning.

    1. Unfortunately the debts are not all intragroup. If they were, then I agree that writing off the debts would be sufficient. But on the other side of many of these debts are third parties. Many of these are retail investors who were sold the bonds of ESI and Rioforte, as well as BES itself, through BES's retail branches: they were offered these bonds as an alternative to deposits, and were assured they were "fully guaranteed". The guarantee was from BES's parent ESFG. ESFG's bankruptcy forced BES to honour those guarantees - I believe at the regulator's insistence.

      Including these guarantees in the "bad bank" means that these investors - senior bondholders in ESI and Rioforte - may not get all their money back, unlike senior bondholders in BES itself who have been protected by the creation of BancaNovo. This seems unfair, because the same packaging was used by BES for both its own debt and the debt of ESI and Rioforte: how were retail investors supposed to know that BES's debt was safer than ESI and Rioforte's? Why should those who were sold BES bonds be protected when those who were sold ESI and Rioforte bonds have to accept losses? These people wanted deposit accounts really - which would have been insured - and they were told their money was safe. There is a huge ethical problem inherent in the assumption that ESI and Rioforte senior bondholders can take losses but BES senior bondholders cannot.

      There may also be a legal problem, too. If I were a guaranteed ESI or Rioforte bondholder, I would now be considering legal action because of the compulsory downgrading of my assets. These people did not buy subordinated debt, which can be converted to equity in insolvency. They bought senior debt. By putting the guarantees in the "bad bank", the Bank of Portugal is effectively converting their holdings to subordinated debt, which reduces their value and increases the risk of losses. The bondholders haven't agreed to this and as far as I know there is no provision for such a downgrade in the legal agreements governing their bondholdings. They may argue that their guarantees should be ranked pari passu with BES's senior debt - in which case they would have a claim against BancaNovo for which the sovereign has not provisioned in its recapitalisation plan. In practice the sovereign would probably prefer to reach a settlement with them rather than risk BancaNovo's capital position. Hence my argument that the "bad bank" may have to be funded. We do not yet know the scale of these exposures, nor what case these bondholders will make for compensation.

    2. Its not important, but the picture that everyone seems not to know where it is, its in Portugal, in Porto, and its the Bank of Portugal head office building in Porto, at Liberdade square (Praça da Liberdade), downtown Porto. Its definitively not Palacio da Bolsa, also in Porto.
      Sincerely hope I´ve helped clear this question but with a little sorrow to see that none of the Portuguese comments guessed what the picture was all about...pitty really.

    3. I don't see how the senior bondholders in ESI and Rioforte can claim parity with the senior bondholders in BES. In true, both bondholders shouldn't except anything other than an Insolvency procedure and probably they wouldn't saw any money at all. The Portuguese state choose to "save" the bank creditors, because of fear of the negative impact on the Economy, financial system, etc. Public recapitalization isn't something that is guaranteed (it may be implicit, but it's only an assumption from the market). So to think than ESI and Rioforte bonds were as saver as the BES bonds, just because of an assumption that if they became bankrupt the State would also pay for them has no legal basis, IMHO. In my view there’s no downgrate of the senior debt of the now “bad bank”, there’s simple a extra protection (a posteriori) of the senior debt of the “good bank”. The senior debt of ESI and Rioforte will still be the first to be paid on the assets left in the “bad bank”. There’s no downgrate.
      Basically, the sovereign may choose to save them, but there's no case for it. However, the decision to create a "bad bank", which "cut" access for the investors stuck on them from the good assets, is another story, and most certainly will lead to litigation.

      Next year is an election year and if party in government thinks they have the slightest chance of re-election they cannot in no shape or form think to use public funds to pay for the investors stuck in the "bad bank". The Portuguese people have endured 4 years of austerity, 7 years of economic crises and there no way they would accept that outcome. This may be what’s undercover by the Bank of Portugal and the Government in their solution, sadly, but I reckon that there will be consequences (at least political). Private business. Private Risk.

    4. Frances, thank you for your detailed reply. I'm having trouble following your reasoning regarding ESI/Rioforte and BES senior debt though.

      It seems rather straightforward. ESI/Rf senior bonds are considered toxic assets because ESI/Rf aren't expected to be able to pay their debt. BES on the other hand was considered to be sufficiently solvent to honour its commitments with senior bond holders (whether that will reveal to be true or not is another story).

      I don't see why both should be equivalent in any way.

    5. Sadly it is not straightforward at all.

      1) If you read my Pieria post on BES (link in the reading list), you will see that BES is no more solvent than its parents. The decision to rescue BES's senior bondholders was about financial stability, not BES solvency.

      2) BES sold senior bonds issued by ESI and Rioforte through its retail branches to ordinary people as an alternative to deposit account. Those bonds carried a guarantee from ESFG as an equivalent to deposit insurance, and it seems that BES staff told people that their money was "safe" because of this guarantee, which simply did not provide the same degree of safety as an insured deposit account. It is possible therefore that retail investors would have a claim for compensation.

      3) More importantly, though, you're ignoring the effect of guarantees. If a guarantee is binding, the liability falls on the guarantor. It seems that because the seller was BES, the guarantee rebounded to BES when ESFG failed. So it really depends whether the guarantee is binding on BES - and that hangs on what is in the legal agreement. I think there could be years of litigation.

  17. There are some issues i fail to understand in your post and unless you have other sources I can't agree with:
    -You said in an answer :"If BES's losses exceed its combined equity and subordinated debt, the sovereign will have to fund the "bad bank".

    Considering that you now have 2 different Banks : the "Old" Bes with all the toxic assets, (mainly all credits given to GES) and those are worth something between zero and their full value, depending on the value the asset sales in ESFG and ESI generate. Even all asset sales fail to generate any value and are worth 0 all subordinated debt and equity get 0. How can the losses exceed equity and subordinated equity?
    And even if possible, since they are now 2 separate Banks, how will you "make" senior bond holders from the New Bank pay for anything? From what i read, senior bond holders are only liable to pay anything on the New Bank, there are no cash flows going from the new to the old except if the sale value on the new bank exceeds 4.9 bn.

    You do have 1 error in your post. you wrote "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.

    Actually "BES's eyewatering losses were declared" on Wednesday the 30th of July at 22 p.m and shares and bonds were only suspended on friday the 1st of August at 15:48 pm. The regulator allowed it to trade from 10 am on the 31st of july to the suspension hour on teh following day, when finally someone understood it should have never traded after they declared being at 5% tier 1 ratio.

    With all this written i still fail to understand how the taxpayers will be called to pay for anything.

    Again, from what I read if the New Bank is sold for a value bellow the value the Portuguese state injected, the Banks are called to pay the difference (they already have €500M in)

    I agree with the "sovereign debt increase" but if you recall, the Portuguese state already had €12Bn available to use for the Banking sector bailout and the 4.4 Billion that are to be injected in New Bank coem from those funds, through the Resolutin Fund. Isn't that line already accounted in the Sovereign debt since 2011?

    1. There are no errors in my post. The Bank of Portugal's statement, which I quoted, clearly states that BES was denied access to Eurosystem liquidity. This is a different matter from the suspension of trading of its shares and bonds, which the Bank of Portugal ALSO mentions in a different bullet point. You have confused the two.

      Regarding the possibility that the sovereign will incur presently unknown losses. I refer you to the BES half-year results, which I have discussed at some length in the Pieria post "How to rip off a bank", link in the reading list above. If you have not read this I suggest you do so. Among other things, it explains the liability of BES for guarantees to third parties of GES debt. I expect there to be litigation to force BES to honour those guarantees in full.

      I have not suggested that senior bondholders can be made to pay anything. On the contrary, by moving senior debt to a new entity the Bank of Portugal has ensured that they cannot, unless Banca Novo itself goes bust. You have misunderstood what I wrote.

      If you want to understand how taxpayers can end up with losses, I suggest you look at Ireland. As Megan Greene pointed out, this is eerily similar to what happened there.

  18. Wow, awesome blog layout! How long have you been blogging for? you make blogging look easy. The overall look of your website is great, let alone the content!

    PIC Scheme Singapore

  19. "The decision to rescue BES's senior bondholders was about financial stability, not BES solvency."

    The financial stability card is what leads to TBTF. So if I were the CEO of a SSTICF (So small that I can fail) then my only goal is to become TBTF (load myself up with the ZIRP Fed Money). Where do you think this will lead to. This is what happens when you create moral hazard and not allow institutions to face the consequence of its actions. The reasoning only is different... financial stability, protecting main street, it would have been worse, unemployment. I can come up with many more. The point is by trying to remove risk out of the equation, the regulators are creating more risk at a later date.

    1. On this occasion the bank has faced the consequence of its actions. It has been stripped of its good assets and will now been wound down.

      However, I have criticised the decision not to bail in senior bondholders. I am not convinced that the loan from the Portuguese government will be repaid, and I think it sets a bad precedent. Unsecured creditors need to re-learn that their money is at risk.


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