(James Saft is a Reuters columnist. The opinions expressed are
By James Saft
July 15 Banco Espirito Santo's woes may not
reignite the euro crisis but could give useful information about
who will pay the inevitable costs.
Under pressure after the discovery of financial
irregularities at its family-controlled parent, BES is
shaping up as a potential test case of the euro zone's
commitment to punishing bad decisions and rewarding good ones.
The long-term rewards could be considerable but they would
come at a short-term cost, especially for investors.
At issue is who will foot the bill for any shortfall if
losses accruing to BES swamp its capital. While BES, Portugal's
largest listed bank, said last week that it had 2.1 billion
euros in capital above regulatory minimums, against only 1.15
billion in exposure to the Espirito Santo family empire, Moody's
and Standard & Poor's both slashed its credit ratings further
into junk territory.
One eyebrow-raising aspect of the ratings agencies'
judgement was that both held BES's senior debt rating to be
better than that of its parent, the reverse of the norm. Both
agencies explicitly cited the possibility that Portugal might
support the bank, potentially bailing out both it and its
Thankfully Pedro Passos Coelho, Portugal's prime minister,
appeared over the weekend to rule out a moral-hazard-inducing
"Private businesses have to suffer the consequences of the
bad deals they make. Taxpayers will not be asked to bear the
losses of private companies," Passos Coelho said.
That, as it should, was heard in the bond market, causing
Portugal's debt to rally and yields on a BES junior bond to
spike to above 10 percent. While it is impossible to know if or
to what extent the bank might need support, those price
movements reflect a belief that creditors to the bank would be
bailed in if push comes to shove.
A bail-in, really nothing more than allocating losses to
creditors depending on where they sit in a firm's capital
structure, is a concept that, while enshrined in an EU directive
covering bank resolution set to come into force at the end of
next year, has often been avoided during the long global banking
crisis, either out of political or operational expediency. Its
flip side, of course, is the bailout, in which creditors and
sometimes equity holders are shielded from losses by government
The 2013 resolution of the Cyprus banking crisis was a
notable exception, with creditors including depositors sharing
in the pain when its largest bank was restructured and its
second-largest shut down. Cyprus was forced to put in place
capital controls to stop depositor flight but the longer-term
impact on bank funding elsewhere in the euro zone has been
All of this was bitterly resented by those affected but
largely ignored by those not. This may well be because Cyprus
was both small and an utter mess, allowing investors to tell
themselves that their holdings elsewhere in Europe would never
face a similar situation.
LOOKING FOR THE RIGHT READ-ACROSS
A potential but real risk to a bail-in is that it spooks
those who lend to banks, driving up the cost of bank fund
raising and complicating efforts to shore up capital. That risk
isn't to be under-rated. Europe's banks remain, on the whole,
undercapitalized and are all too often opaque and difficult to
A funding spike after an exemplary bail-in, however, might
end up being a short-term payment on some real long-term
Firstly, as a bail-out in Portugal would be hugely unpopular
elsewhere in the euro zone, if Portugal sticks to its principles
it will go a long way to demonstrating that things really can
change and are changing. Secondly, an allocation of losses based
on law and contract would show capital markets are functioning
and that risk and reward (and loss) are properly related.
The resolution of BES, should it prove necessary, might
bring other benefits. Guntram Wolff, a director at European
think tank Breugel, argues that it might ultimately lead to
'de-zombification' in Portugal. Zombie banks are those impaired
enough that their energies are used in keeping themselves
upright rather than in playing their role within the economy.
National authorities, notably Japan in the past, often abet
zombie banks as the easier course, but doing so can leave the
rest of the economy without the credit it needs to recover.
Given the euro zone's dependence on bank financing rather
than capital markets, this is no small issue. If zombie banks
are allowed to fail, ultimately credit flows improve, perhaps
both in volume and impact.
A bail-in may well not be needed and would definitely be
painful, but if it is it should be welcomed.
(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be
an owner indirectly as an investor in a fund. You can email him
at email@example.com and find more columns at blogs.reuters.com/james-saft)
(Editing by James Dalgleish)