(Adds government comment on economic impact, Bradesco not interested in increase)
By Laura Noonan and Andrei Khalip
LISBON/LONDON, July 31 (Reuters) - Portugal's hopes of drawing a line under the financial and governance troubles of Banco Espirito Santo were dashed on Thursday as investors took fright at massive losses and revelations of potential illegal activity at the country's largest listed bank.
Shares in Banco Espirito Santo, or BES, plunged 42 percent a day after the bank posted a 3.6 billion euro loss and higher than expected provisions to cover its exposure to companies owned by its founding Espirito Santo family. The bank's ambition of raising capital, without seeking state aid, is now an uphill challenge.
Among the revelations were two letters issued by the bank in favour of Espirito Santo creditors but never registered in the lender's accounts.
Portugal's central bank suspended top officials at the bank, but investors worry about what other surprises may lie ahead.
Brazil's Banco Bradesco which has a 3.9 percent BES stake, said on Thursday that it had "no interest" in the capital increase.
Cabinet Affairs Minister Luis Marques Guedes expressed concern that the crisis around BES and the Espirito Santo family's other holdings will hamper the country's recovery from its worst recession in four decades.
"The economy gets necessarily affected by a grave situation in such a major economic group," Marques Guedes told reporters though he said the economy should keep growing.
BES was the only Portuguese bank not to take a bailout during the financial crisis. Its new management, who were appointed on July 14 after the Espirito Santo family lost control, want to keep that status.
Late on Wednesday, Portugal's central bank said public funds were available if any bank needed them. Portugal, which ended its international bailout in May and has been eyeing economic recovery, has 6.4 billion euros of funds for any bank recapitalisation.
Yet the central bank reiterated that private capital was its preferred solution for BES, which had a common equity tier one ratio of just 5.0 percent at the end of June, below Portugal's regulatory minimum 7.0 percent.
"Bank of Portugal and BES' new CEO have commented that private investors are willing to step in. But would the state and/or junior bondholders have to get involved?" Citi analyst Stefan Nedialkov wrote in a note to clients.
BES has not said how much capital it would seek. Joao Lampreia, an analyst at Banco BiG in Lisbon, estimated it would be around 3 billion euros.
BES has been swept up in a growing financial drama involving its founding family. Three of the Espirito Santo holding companies have filed for bankruptcy protection in past weeks after revealing debts and accounting regularities.
BES last raised capital on June 11, selling 1 billion euros of discounted shares to existing investors in an exercise that diluted the family's once-majority stake in the bank. Top family members who had run the bank stepped down as Portugal's central bank has tried to come to grips with how deeply exposed the lender was to one of the country's most prominent families.
In its Wednesday statement, BES said its bigger than expected losses were partly the result of 4.25 billion euros of impairment charges. Those included 1.2 billion euros of provisions taken because of the bank's exposure to Espirito Santo companies as well as repayment of debt issued by those companies to BES' own clients.
The bank also booked losses of 198.2 million euros for its troubled Angola unit and noted that it could lose its majority stake in the bank if it does not participate in the "substantial reinforcement of its equity" that it needs.
The Bank of Portugal said "forensic auditing" they ordered at BES will establish whether the bank's former chief executive, chief financial officer and other top executives that have stepped down bear individual responsibility for the losses. "In case illegal practices are confirmed ... possible consequences of criminal nature may follow," the regulator added.
BES is now expected to undergo a major restructuring and to hold a shareholders' meeting to approve the recapitalisation plans "within a reasonable time frame".
Last week more than 20 investors held talks with the Bank of Portugal about a possible investment, people familiar with the discussions told Reuters. U.S. hedge fund DE Shaw and clients of Goldman Sachs have already taken a combined stake of 5 percent.
One hedge fund manager who is considering investing said a bailout was not inevitable. "If there really was no prospect of getting any cash, the stock should probably be at zero," he said.
He said there was precedent for a bank raising far more capital than it has, pointing to Italy's Monte dei Paschi raising 5 billion euros despite its market value being just over 2.5 billion euros when it approached investors.
(Additional reporting by Daniel Alvarenga in Lisbon; Editing by Alessandra Galloni)