The suspension of shares in a relatively minor Portuguese bank sent tremors through global credit and equity markets overnight. It's a useful reminder that risk hasn’t disappeared from the global financial system and that the eurozone remains the most likely source of any fresh disruption.
Banco Espírito Santo is Portugal’s second largest bank. Its shares were suspended after they began tumbling precipitously and its credit rating was downgraded after its major shareholder, Espírito Santo Financial Group, disclosed "material difficulties" in its own major shareholder, Espírito Santo International. ESI is a Luxembourg-registered holding company for a Portuguese family-owned conglomerate.
The suspension triggered falls in equity markets around the world and saw yields on Portuguese and Greek bonds rise sharply. A major bond issue by the Greek government was down-sized, and issues by a Spanish bank and Spain’s Grupo ACS construction giant (the ultimate parent of Australia’s Leighton Holdings) and an Italian pharmaceutical company were pulled.
It might appear odd that problems within a relatively minor European bank might have a global impact. However, its problems, which might require a bailout by the Portuguese government, play to a number of concerns that have been largely dormant for the past two years -- ever since the European Central Bank’s Mario Draghi made his famous "whatever it takes" proclamation.
The continuing reality of the eurozone is that it has done virtually nothing structural to address the flaws exposed during the financial crisis. Its economies remain weak and over-indebted and its banking system fragile.
Yet thanks to Draghi and the ECB, US Federal Reserve and the Bank of Japan continuing to flood the global financial system with liquidity, European equity and bond markets have been trading as if there were no continuing issues of concern.
Back in 2012, amid fears that it might be forced to exit the eurozone and impose massive losses on bond holders in the process, Greece’s sovereign bonds were trading at levels that generated yields in the mid-30 per cent range for investors. Portugal’s bonds traded at just under 15 per cent before the Draghi comments soothed investor fears.
Before the Banco Espírito Santo suspension, Greece’s bonds were trading at just under six per cent and Portugal’s at 3.6 per cent within the general global markets environment of virtually no volatility and diminishing risk premia. That’s despite Greece having a government debt-to-GDP ratio of more than 150 per cent and Portugal a ratio of about 125 per cent -- and despite the continued weakness of the eurozone economies.
An unintended consequence of the monetary policies being pursued by the Fed, ECB and Bank of Japan has been an asset price boom in Europe that is at odds with its underlying condition. Until the last few days Portuguese and Greek bonds were being priced at only a slight premium over those issued by Germany and the UK -- and being lapped up by investors -- which is absurd.
So, the ripples of fear that ran through markets overnight is a timely reminder that the eurozone, and particularly southern Europe, is still a potential danger zone for investors and for global financial market stability.
The problems at Banco Espírito Santo also play to another set of dormant fears: the state of the European banking system.
In previous rounds of stress tests the bank, along with the other big Portuguese banks, had passed with flying colours. The Portuguese central bank declared that "all four Portuguese banking groups revealed a high degree of resilience to the adverse scenario". The tests revealed no need for any new capital for the banks.
Banco Espírito Santo is said to need several billion euros of new capital now, which would make it the latest of a lengthening queue of European banks that passed the first two European Banking Authority stress tests only to need major injections of capital.
The Irish banks, for instance, passed the first round of tests only to nearly collapse immediately after them. A year later the Franco-Belgium bank, Dexia and Spain’s Bankia had to be bailed out by taxpayers after easily passing the second set of stress tests.
The condition of the eurozone banks is seen as a significant factor in the weakness of the eurozone economies, with the banks raising new capital and shrinking their balance sheets by scaling back lending and selling off assets in an attempt to ensure they can get past the latest round of stress tests, this time being conducted ahead of a transfer of supervisory authority to the ECB.
While there is still some cynicism about how stressful the tests actually are, they are regarded as having greater credibility than the previous rounds.
The ripples of fear generated by Banco Espírito Santo’s troubles will sharpen the focus on the real stability of Europe’s banks and dial up the pressure on the ECB to ensure that the latest stress tests and the remedial action (if any) that they reveal is required are both credible and conclusive.
The combination of weak and over-leveraged governments and banks will remain the major potential source of vulnerability for the global financial system until the Europeans shift from talking about doing whatever it takes to actually doing whatever it takes to address the fundamental weaknesses in their systems.