Why there could be more European banking quakes to come

Portugal has had to rescue the venerable Banco Espirito Santo. But there could be more European banking quakes to come

Banco Espirito Santo was very much a family business. The origins of the Portuguese financial group stretch all the way back to Jose Maria Espirito Santo’s “Caza de Cambio”, which opened on a Lisbon backstreet in 1869.

Until last month the group’s bank, whose name means Holy Spirit, was run by Jose’s great-grandson, Ricardo. But what was once a proud family concern is now a ward of the state. The Portuguese central bank announced yesterday that it would be using €4.9bn (£3.9bn) in cash left over from the country’s international bailout fund to split Espirito Santo into a good bank and a bad bank.

The ordinary depositors and senior bondholders of the bank will be protected, but its shareholders and junior creditors will be wiped out in the restructuring.

The financial institution has been laid low by the incompetence of the current generation of the dynasty. It’s a pathetic end to a venerable Portuguese financial empire. And it might be the first in a series of painful reckonings that will hit Europe’s financial sector over the coming months.

The European Central Bank is in the middle of what it calls an “asset quality review” of 124 leading commercial banks across the European Union. Everyone else in the markets refers to it simply as a “stress test”. The results will be unveiled in late October, shortly before the ECB takes over as the eurozone’s official banking regulator on 4 November.

The purpose of the exercise is to restore investor confidence in the continent’s banking sector – confidence that has been sorely lacking ever since the global credit crisis began in 2007.

The Europeans are widely seen by investors as lagging behind the authorities of the United States and Britain in cleaning up their domestic financial systems after the global credit boom and bust of the 2000s.

The sector has a façade of calm thanks to the European Central Bank’s decision to fire-hose commercial banks with liquidity support, and also to the 2012 pledge from the ECB president, Mario Draghi, to do “whatever it takes” to prevent the eurozone breaking apart.

The six-month rate at which European banks lend to each other – known as Euribor – has dipped to just 0.3 per cent for six months. That’s down on the 2 per cent rate seen in 2011 and well below the 5 per cent peak during the global financial crisis in 2008, when mistrust was rampant.

But banks’ share prices are still trading below the nominal value of their assets, suggesting investors fear further write-offs. And with their equity values depressed, the banks themselves are not lending, which partly explains the eurozone’s feeble recovery from its double-dip recession.

Yet a question mark hangs over whether this latest stress test will be effective. This isn’t the first banking stress test that the European authorities have conducted. A similar exercise in 2011 by the European Banking Authority (EBA) quango – including, incidentally, Espirito Santo – failed to quell doubts about the solvency of the sector. Some European banks that were judged to have passed have since fallen into difficulties.

The Franco-Belgian bank Dexia had to be bailed out just three months after being given a clean bill of health by regulators. A damning report last month by the European Court of Auditors found that the EBA had lacked the staff and the powers to conduct an effective stress test.

The former Bank of England governor Lord King warned yesterday that this was likely to be a “last chance” for Europe to clean up its banks and win the trust of investors. Lord King, who was dealing with blowback from the eurozone banking system in 2011 and 2012 when he was in the Threadneedle Street hot seat, issued a warning: “Financial markets will be looking very carefully in the autumn at whether the statements made about the capital positions of different banks are really credible, and a lot hangs on this,” he said.

The president of the European Central Bank, Mario Draghi, has insisted that this time things are different. He has said that some banks will almost certainly fail the stress test and will need to raise more capital. “If they do have to fail, they have to fail. There’s no question about that,” he said last year.

If that is the case then some other institutions are likely to go the way of Portugal’s Espirito Santo. But which? The spotlight is likely to shine on the eurozone periphery. Data from the European Central Bank shows that banks in the crisis-hit states of Italy, Portugal and Spain had the highest non-performing loan ratios in 2012.

That fits with the analysis of the International Monetary Fund, which estimated last year that banks in Spain, Italy and Portugal face about €250bn in potential losses on their loans over the next two years. That equates to about a third of the total capital buffers held by the banks in those three countries. The IMF also cautioned that only the Spanish banking system currently has enough reserves to cover the expected losses.

If this is correct it implies that private investors in banks are soon going to be tapped for more capital. And if this is not forthcoming, national governments will have to step in. If the balance sheet holes are as big as some more bearish analysts fear, that could have tricky financial and political ramifications.

It could even set off a new leg of the eurozone crisis. But that’s assuming, of course, that Europe’s financial regulators do not, once again, decide to give the can of Europe’s hobbled banks one more kick down the road.

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