-Banco Espirito Santo (BES), one of Portugal’s leading banks, posted losses in the first half of the year that wiped out 40% of its equity capital. Currently undergoing restructuring (some of its assets will be transferred to a « bad bank »), the bank owes its survival to its recapitalization by the Portuguese bank resolution fund.
-The scale of the losses is mainly due to BES’s exposure to other entities in the Espirito Santo group, in the form of receivables and guarantees, the revaluation of its bond debt, a significant portion of which is held by its own customers, either directly or indirectly via financial products issued by SPVs, and a more conservative assessment of credit risk in the context of the AQR.
-From an accounting perspective, these expenses mainly correspond to exceptional provisions.
-The extent of the operational malfunctions at BES and the regulator’s inability to diagnose the bank’s fragility have not yet been explained.
Banco Espirito Santo (BES) reported first-half losses that wiped out 40% of its equity (net loss of €3.6 billion), leading to its recapitalization by the Portuguese government (via the Portuguese bank resolution fund) and its restructuring (split of the bank into two entities with the creation of a « bad bank ). Where did these losses come from?
BES’s losses stem mainly from « exceptional » (€3.4 billion) provisions (1), i.e., provisions not related to the bank’s « normal » business activities.
BES’s losses stem primarily from its exposure to other entities in the Espirito Santo group (€2.1 billion in provisions). BES had granted loans to other entities in the Espirito Santo group and had guaranteed the repayment of their bonds, a significant portion of which were subscribed by BES customers (amounting to €3.1 billion). The deterioration in the financial situation of the other entities of the Espirito Santo group affected BES in the form of an increase in provisions to account (in advance) for defaults on these loans and the costs associated with activating the guarantees on the bonds issued by these entities. Behind these provisions lie significant operational dysfunctions, some of which were revealed when the accounts were published. The first is that a significant number of loans granted by BES to other financial companies in the Espirito Santo group bypassed the committee responsible for reviewing intra-group transactions (3), in a context where BES’s intra-group exposure had more than doubled in six months (reaching €1.6 billion at the end of the half-year). The second is that BES had purchased securities held by another financial company in the group (Rio Forte) in order to help it repay its debt (thus providing it with cash, as the securities in question were not very liquid), but at the closing date of the accounts, BES was still not in possession of these securities.
The second source of loss relates to the revaluation of bonds issued by BES and sold to BES customers, either directly or indirectly via financial products issued by SPVs (2) (€1.2 billion in provisions). As BES’s customers have expectations regarding the liquidity of the securities sold to them (so that they can resell them), BES may be required to repurchase some of these securities. The provisions recorded reflect the expected losses on these potential repurchase transactions (value at the close of the accounts minus value at the date of issue). It is these losses that seem to have surprised analysts/investors the most.
The third source of loss (€0.4 billion in provisions) is mainly due to a more conservative assessment of credit risk. With the ECB currently conducting a review of the quality of the banking assets of the main banks in the eurozone (AQR), BES has decided to adopt its guidelines on provisions for receivables and derivative contracts. In this way, BES is seeking to limit the potential for bad news when the AQR results are announced: by setting aside provisions today, all other things being equal, BES will have to set aside fewer provisions tomorrow.
Several questions remain unanswered: why did the regulator fail to notice BES’s fragility? How could the bank have experienced so many operational problems? Has the recognition of these exceptional charges really been completed?
Notes:
1 – A provision allocation corresponds to an increase in the amount of provisions. A bank makes provisions to cover probable losses on its receivables, securities portfolios, or other banking risks, with the aim of providing a net result that gives as accurate a picture as possible of the past financial year.
2 – An SPV (special purpose vehicle) is a legal vehicle used by banks in securitization transactions. Generally, the bank transfers assets to the SPV, which purchases them through the issuance of securities. The risk of these securities can be « decoupled » from that of the transferring institution when only the transferred assets play a role in the repayment of the securities. The SPVs mentioned here are slightly different in that they did not hold assets transferred by BES, but bonds issued by BES. [Author in8] and other entities of the Espirito Santo group, with the aim of « repackaging » them into financial products, sold in particular to BES’s own customers. [Author in9] The names of these SPVs are: Top Renda, EuroAforro Investments, Poupanca Plus Investments, and EG Premium.
3 – Intra-group transactions refer to transactions carried out by BES with other entities of the Espirito Santo group, such as granting them loans (intra-group receivables).
Reference:
Espirito Santo banking group activity report for the first half of 2014
