Banco Espírito Santo Gets a Bail-in

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Investors got their first look at how the EU's new banking union will handle teetering banks Sunday, when the European Commission and Portugal's central bank decided to wind down troubled lender Banco Espírito Santo (BES). In a refreshing turn of events, they stuck to the framework the entire EU agreed on last summer, forcing investors to absorb some losses before regulators could inject capital from a special fund. While this is a negative for the investors impacted directly, the decision does help resolve some of the lingering uncertainty around the EU's banking union-a small positive for sentiment in the region.

As we wrote here last month, BES's problems don't mean the eurozone crisis is back-this is a one-off issue at one company, not a sign of deeper banking problems in Portugal, the eurozone periphery or the full eurozone. Occasional, company-specific banking issues aren't unusual, even during a strong bull market. BES's troubles stem from a corporate governance at its main parent company, Espírito Santo International SA (ESI)-a privately held, family-run holding company that sits at the top of the Espírito Santo Group conglomerate. ESI, which lacks the disclosure requirements typical of publicly traded firms, had some accounting irregularities and questionable financial arrangements, and BES was tangled up in its mess.

Last month, ESI defaulted on some commercial paper, sending BES's stock price into a tailspin as investors questioned whether the bank would have enough capital to offset its exposure to its parent company. Initially, BES said its €2.1 billion in excess reserves would more than cover its expected losses. But last Wednesday, after ESI and four subsidiaries had filed for bankruptcy, BES admitted it had continued lending to its parent and affiliates even though regulators had told it not to, and its losses would exceed prior estimates: €3.6 billion for 2014's first half, which brought its capital ratios under the EU minimum. Investors fled, and by the time trading in the bank's shares was halted, they'd lost about 70% for the week.

At that point, BES and regulators had three options. One, BES could try to raise capital on its own, by selling assets or issuing new equity. Two, regulators could decide it was time to "resolve" the bank, "bailing in" investors until the private sector had assumed enough losses to qualify the bank for a capital injection. Three, they could deviate from the blueprint and massively intervene in the name of financial stability.

The first option was largely a non-starter, and regulators resisted the urge to overreact with a full bailout-a positive, in our view, as deviating from banking union's official framework would have introduced uncertainty about future bailouts, which would run counter to the larger goal.

That left option two, the bail-in and orderly wind-down. BES will be split into a "bad bank" and "good bank," which was aptly renamed "Banco Novo." For now, Banco Novo will operate under regulators' control, but the longer-term goal is to return it to the private sector as a fully functional lender. Shareholders and junior bondholders were lumped with the bad bank, putting them on the hook for losses (potentially up to $6 billion). But all depositors and senior bondholders are in the good bank, and they'll remain whole. The good bank also gets a €4.9 billion ($6.6 billion) capital injection from the Portuguese Resolution Fund, which is acting as a stand-in for the European Stability Mechanism (ESM). The ESM's resolution fund will eventually hold €55 billion, all funded by EU member-state banks, but it won't be fully up and running until 2018. So Portugal stepped in, using money left over from its 2011 bailout.

Portuguese money aside, this is all very much according to the EU blueprint. Under that agreement, shareholders and junior bondholders must take minimum losses equal to 8% of total liabilities or 20% of risk-weighted assets-and junior bondholders wiped out-before the bank can receive official sector money. Check and check. Insured deposits would remain safe, and uninsured deposits would be hit only in the most severe failures. Check and check. Direct recapitalization can't exceed €60 billion. Check. All very transparent and by-the-book.

BES's wind-down also answered another question: At what point does the ECB decide a bank has "failed"? The banking union's framework left a considerable amount of wiggle room here, with anything from outright insolvency to simply failing a stress test, potentially, triggering "bail-ins" if the ECB saw fit. At least in this case, Common Equity Tier 1 falling to 5%-below the Basel III minimum of 7%-constituted "failure." Now, whether or not that definition is appropriate is a topic for another day. But simply gaining more clarity on where the ECB prefers to draw the line should help investors set expectations and shore up confidence-a longer-term positive.

As for the other near-term issue on investors' minds-contagion-BES's troubles shouldn't drag down its peers. Other financial firms do have exposure, but risk is spread out. Most of the bondholders are asset managers, not banks, and most holdings appear small. On the equity side, French bank Credit Agricole appears to be the largest concentrated shareholder with a 14.6% stake, but its shares have taken the news of BES's impending demise in stride-probably because potential losses pale in comparison to its €1.7 trillion in total assets as of 2013. Markets appear to realize BES's losses are quite contained.

In short, the wind-down of BES went about as smoothly as markets could hope for. There are still some unknowns in eurozone banking-we still have yet to see how the ECB will handle any banks failing the Asset Quality Review and stress tests, which wrap up this autumn-but for now, the early indications of consistency should help boost sentiment in the region.

(Hat Tip: Scott Botterman, Christo Barker, Pete Michel and Philip Lee)