Good news for investors – Europe’s banking crisis is back

BES: shares suspended

You might have thought that Portugal was on the road to recovery.

In May, its post-crisis bailout from the International Monetary Fund and others was wound up. And the Portuguese government’s borrowing costs had fallen back nicely.

But as we saw yesterday, things are a long way from being back to normal.

Markets around the world took a knock as problems at one of Portugal’s leading banks exploded into the open.

It’s even possible that a government bailout could be needed, which could start investors worrying about sovereign solvency all over again.

What’s more, other banks in the eurozone may be just as vulnerable.

So is it time to bail out of the eurozone then? We don’t think so – here’s why…

Complex corporate structures are never a good sign

Banco Espirito Santo (BES) was Portugal’s largest private-sector bank by market value. Until yesterday that is, when its shares were suspended.

For most of its 94-year history, the bank has been controlled by the Espirito Santo family. The family exercises its control via two companies. It gets a little bit complicated here – which is one reason that markets are freaking out, because they’re not sure who owes what, and to whom – but bear with me.

The first company is called Espirito Santo International (ESI). This is basically a family holding company. ESI then owns a 49% stake in Espirito Santo Financial Group (ESFG), which is a banking and insurance company based in Luxemburg.

ESFG then has a 26% stake in BES.

The trouble began earlier this year when the Bank of Portugal ordered an audit into all three companies on concerns that ESI was struggling. In May, BES reported that the audit had discovered that the ESI holding company was in a ‘serious financial condition.’  Auditors had also discovered accounting irregularities.

Then this week ESI, failed to make scheduled payments on commercial paper it had issued. In other words, it failed to pay the interest on some of its debts. This sparked fears that the two subsidiaries, ESFG and BES, might be exposed to these problems. For example, BES may have lent money to ESI.

All this bad news sparked share price falls for both BES and ESFG this week, and then both companies’ shares were suspended from trading yesterday.

The Bank of Portugal has attempted to reassure markets that BES is stable, but markets are in no mood to listen.

As Richard Thomas, analyst at Bank of America, told Bloomberg: “There’s a vacuum of information from the bank, but a lot of nasty information coming through from the group… they’re saying it’s ringfenced, but the market is saying ‘give us the numbers and we’ll assess’.”

There’s also a lack of clarity on ESI’s corporate structure and how it’s linked to BES, and that’s a big part of the problem. BES has attempted to address that this morning by outlining its exposure to the group, so we’ll see how markets take to that today.


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So what next?

There’s a chance that BES will convince the market that it’s not exposed to ESI’s problems, and things will return to normal at the bank. But there’s also the risk that markets will remain jittery enough to force a bailout from the Portuguese government.

Trouble is, Portugal’s finances are still very stretched. So a bailout for this bank could mean the government needs further help – just as it’s stepped out of the bailout programme. This is what caused the eurozone panic in the first place – the risk that nations with no money would have to stand behind banks with no money, leaving them with too little money to service their debts.

Your average Portuguese citizen is probably pretty worried at the moment, and they have my sympathy.

And any instability could spread to other southern European countries such as Greece, Spain and Italy. In fact, it already has. A bond auction by the Greek government was less successful than expected yesterday, while a Spanish commercial bank shelved a bond auction.

There’s a silver lining here

We’ve been pointing out for a while that Europe’s banks are still troubled. So it was probably only a matter of time before something like this happened.

While banks in the US – and Britain, to an extent – have been forced to recognise their bad debts and deal with their problems, the politics of the eurozone have prevented the same sort of ‘confession and capital-raising’ process from happening in Europe.

However, there is a silver lining to all this. As we’ve also pointed out, the troubles at Europe’s banks are also the main reason that we think the European Central Bank (ECB) will eventually have to do full-blown quantitative easing (QE), or money printing.

Now, QE certainly has its downsides. But judging by experience elsewhere, it also boosts share prices – just look at what’s happened in the US and UK since 2009. QE can’t cure Europe’s economic problems or the fundamental contradictions at the heart of the eurozone, but it would help to contain the problems in Portugal and BES. It would also boost European share prices.

So this still looks like a pretty good time to invest in Europe. I wouldn’t go mad and put all your money in, but investing a modest portion of your portfolio – perhaps by drip-feeding money in on a monthly basis – looks a good idea.

And if you already own some European shares, don’t panic. We might see some falls in the near future, but I’m pretty confident that you’ll do fine in the medium term.

You can read more about what QE might do for Europe in James Ferguson’s recent cover story for MoneyWeek magazine: Why Europe needs QE now (Sign up for a four-week trial to MoneyWeek and you’ll get four free editions of the magazine plus access to our full web archive including James’s article.) We also highlighted some of the best ways to invest in Europe in the article.

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  • Chester

    As we have seen elsewhere, full blown European QE won’t solve the underlying issue of systemic European defaltion, or reverse the swing to negative social mood that will drive markets into a significant wave down

    When equity markets in the US and UK deflate, how much liquidity Draghi generates will be irrelevant – the flight to safety will be paramount. Safe cash, and the one everyone lovest to hate – the US$, would be better options until stability returns

  • mikeT

    I am definitely not a europhobe but invest in the EU? The Euro looks in terrible shape for a UK-based investor – I’ve heard a 3 month target GBP/Euro of 1.40 (v currently 1.26ish). Bank shares in countries like Spain are vulnerable; they have all gone through the roof in the last year, doubtless in the belief that QE is on the way (and that they are too big to fail even if the October stress tests paint a nasty picture of the true quality of their assets). However, I do not think that the ECB (well, Bundesbank) is another Fed; full-blown QE, with its somewhat misleading public perception of “money printing”, is not the racing certainty everyone seems to think it is.

    • Clive

      My European investments (unit trusts) are outperforming my UK stuff in 2014.

  • Sage of Aldershot

    The more I read about the incomprehensible and obscure juggling of massive amounts of money by banks and governments, the more I want to take my savings out of investments and into a deposit account or under the bed. There’s then a good chance that I will not lose more than the annual rate of inflation, currently low. Worth the price, just for the peace of mind. The whole financial industry seems to have forgotten that their bedrock is public confidence.

  • IJ1

    So a “smart investor” these days is one who’s noticed that qe has fuelled a bubble in share prices in one region, sees potential for qe elsewhere because of bad news, and says “aha…”?

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