BES: a new model for banking failures

The plan: The solution designed by the Bank of Portugal under the guidance of the ECB and the EU Commission is set to become the new model for solving banking failures in Europe. The plan involves setting up two banks, one, called “Novo Banco”, held by the Portuguese financial sector through the recently created resolution fund and partly financed by a loan from the State, will receive all assets from Banco Espírito Santo (BES) except the most risky ones. The assets to be included, a list has been provided by the Bank of Portugal, includes all assets related to the family’s non-banking business and risky banking businesses, such as the Angolan bank and Espírito Santo Bank. These risky assets belong to Banco Espírito Santo SA and are held by BES shareholders.

 

The pros:  This solution has several advantages over previous rescuing operations both in Portugal and in Europe:

  • It limits the contribution from the State, and therefore taxpayers, to a loan to the Resolution fund.
  • It deals with moral hazard, as shareholders are forced to take the losses from mismanaged banks that are deemed to be too big to fail or to represent a systemic risk to the banking sector.
  • It reduces systemic risk to the financial system, as deposits remain safe.

The cons: Despite its advantages, this model is not without problems:

  • It is unclear whether the Novo Banco is really worth its 4.9bn capitalisation, BES, like other Portuguese banks, had a significant portion of bad and risky loans that may prove impossible to recover. Should it sell at a lower price in the future, the Portuguese banking sector may suffer losses which, in a system that remains fragile, increases the risk to the safety of the financial system. In that scenario, the loan to the State may not be repaid, in part or in full, therefore calling taxpayers to contribute.
  • Many small shareholders were actually convinced to invest or to keep their investments in BES at the time of the last capital increase. They now blame the Bank of Portugal for misleading them. They may try to impeach the resolution procedure. The best chance for these investors to recover some of their investment is if Novo Banco is sold for more than 4.9bn, as the extra funds would go back to Banco Espírito Santo SA.
  • The resolution fund is being fully used in this operation and the other banks’ capacity to contribute to other banking failures has been exhausted. This meas that today’s model cannot be replicated in these terms should another Portuguese bank fail. At the moment most of them appear to be relatively sound but any sudden downturn  in the economy may put the financial sector under stress again.

Our analysis: though there are several non negligible risks ahead, both related to the bad bank and the good bank, this solution appears to be the best way to safeguard taxpayers while preserving the stability of the financial system. Financial markets have reacted positively to the news which should reassure authorities that the systemic risk to the system is low. Though many small investors will suffer significant losses, this still represents the best solution to increase banks’ shareholders awareness and put pressure on banks’ management to avoid excessive risk.