Espirito Santo: complexity, opacity and moral hazard
Here's the corporate structure of Portugal's Espirito Santo Group (GES) according to Zero Hedge (reported by Raoul Ruparel at Forbes):
And here is the ownership structure of Banco Espirito Santo (BES) (h/t econgirl):
Spot the differences, anyone?
The most glaring omission is the absence of Rioforte and its parent Espirito Santo International (ESI) from the first chart. To look at the first chart, you would think that ESFG (ESF in the first chart) is 100% owned by Espirito Santo Group (GES). No it isn't. Espirito Santo Group owns 56% of Espirito Santo International, which owns 100% of Rioforte Group. Rioforte owns 100% of the shares in Espirito Santo Irmaos, which in turn owns 49.3% of the shares in ESFG, which is the regulated parent of BES in which it has a 26.1% ownership stake. Yes, you did read that right - the second chart says ESFG's ownership stake is 26.1%, whereas the first chart has its ownership stake as 40% in a holding entity called BESPAR which itself has a 67% stake in BES Group. This apparent inconsistency we can solve, though: BESPAR was dissolved in May 2014 leaving ESFG as the largest shareholder in BES and Crédit Agricole as the second largest. Zero Hedge's structure is out of date. But more importantly, the convoluted ownership structure means that GES really can only be said to own about 13% of BES - which is less than Crédit Agricole's holding even after its recent dilution. Is BES really a Portuguese bank at all?
Ruparel explains the absence of Rioforte and its parent Espirito Santo International from the first chart thus (my emphasis):
"BES is 25% owned by Espirito Santo Financial Group, which is 49% owned by Espirito Santo Irmaos SGPS SA, which in turn is fully owned by Rioforte Investments, which is fully owned by Espirito Santo International (ESI) (last two are based in Luxembourg and aren’t included in the chart below from Zerohedge which highlights just how complex the structure is)."
Well, well. So the Espirito Santo Group has incorporated large parts of its business in a tax haven. That explains why the first chart completely omits Rioforte and ESI. They aren't Portuguese. And they aren't banks, either. Rioforte's interests, according to its 2013 report & accounts, include real estate, healthcare, agriculture, energy and tourism in addition to comprehensive financial services (not just commercial banking).
Here's a slightly simpler chart (h/t Tracy Alloway, FT) which gives a little more detail about the activities and financing of each of the entities:
The relationship of Rioforte, a conglomerate, to ESFG and BES (respectively, financial holding company and commercial bank) reminds me of the Co-Op Group. And it causes similar problems for financial regulators. The regulated entity is BES's direct parent, ESFG - not its owners further up the chain. The Portuguese central bank is powerless to regulate financial dealings between BES and those owners, not least because they are not Portuguese. Banks embedded in multinational structures like this really cannot be effectively regulated by domestic regulators. They must be regulated by a supra-national regulatory body. Step forward, ECB....
But structures like this can prove impossible to regulate in practice. A multinational corporation that is really determined to avoid the regulators' eye can always find somewhere to hide. To my mind, complex, opaque structures involving offshore entities and multiple jurisdictions are never a necessary part of multinational operations. They are created for one purpose only - and that is to hide dodgy dealings. BCCI and Enron are two examples of organisations whose opaque multi-jurisdictional structures hid the corrupt and illegal nature of their activities: there are of course many more. When regulators don't know who is responsible for regulating what (BCCI) or have no idea how the corporation is structured or who really owns it (Enron), fraud is never far away.
For a subsidiary to criticise its parent so sharply hardly demonstrates intra-Group solidarity. But then ESFG, because it is BES's holding company and its largest shareholder, is subject to regulation by the Portuguese central bank. ESI is not. It seems that ESFG shafted ESI in order to fob off Portuguese regulators. Nice - though ESI probably deserved it (and would no doubt do the same to ESFG if it got the chance). And actually for ESFG to fail to disclose these concerns could have led to litigation by BES shareholders, who were being asked to cough up more money in a rights issue to improve BES's capital in advance of the ECB's AQR and stress tests.
Rioforte is not under investigation for accounting fraud. But it is fast running out of money. It has defaulted on an interest payment on commercial paper owned by Portugal Telecom, and is expected to file for creditor protection shortly. It is, in short, bust. And that causes something of a problem for BES.
Here's a nice clear chart of the murky funding relationships between BES and its parents (h/t Jamie McGeever, Reuters):
So BES has been lending both to its direct parent, ESFG, and to Rioforte. If Rioforte goes bust, not only is BES unlikely to see its loans repaid - it may find itself with an abrupt change of ownership. No wonder the ratings agencies have taken a hatchet to its credit rating.
But actually that chart is a bit too clear, and the numbers aren't big enough. Here's a table showing BES's current intragroup exposure (h/t econgirl):
To summarise (since the table isn't all that clear), BES's total intragroup exposure is actually nearly 1.2bn Euros, of which 224m Euros is loans to Rioforte (including subsidiaries), and 929.8m Euros is loans, advances and investments in ESFG (including other subsidiary banks). BES says its capital is 2.1bn Euros, which should be enough to cover this - but we still don't know the scale of its liabilities to GES's customers (see box in Chart 2).
Nonetheless, it is not really BES that is the big story here. Admittedly BES has problems; it has a large portfolio of risky loans in Angola with a government guarantee of questionable quality, and its capital position is on the weak side. It is probably not going to do too well in the ECB's stress tests. But even if its current capital proved insufficient to cover its liabilities to its parents and their customers, it has a reasonable cushion of junior debt that could be bailed in, and as a last resort senior debt could also be bailed in. It isn't going to be rescued by the Portuguese sovereign, but there is no reason to suppose that it will fail. I find it interesting, therefore, that all the focus so far has been on BES rather than Rioforte. Am I alone in thinking that the failure of a multinational conglomerate is a big deal, whether or not it takes the bank down with it?
And bank regulation is not really the issue here, either. Companies within a structure can and do lend to each other even if they are not banks. Draining a subsidiary to prop up a failing parent is not uncommon, and it is not illegal (though it may be immoral). The problem here is that the subsidiary is a bank, but the failing parent is not a bank - and part of the bank's funding (small deposits) is guaranteed by government. As I've noted before, this creates moral hazard. Indeed whenever a bank is owned by a conglomerate with significant non-financial interests, moral hazard is inevitable: the conglomerate is likely to use the bank as a captive source of funding for risky activities that it could not fund commercially. Forcing the bank to hold more capital and improve the stability of its funding doesn't solve this problem.
It may be too draconian to ban conglomerates with non-financial interests from owning banks. But consideration needs to be given to ways of limiting moral hazard and preventing circular funding arrangements such as those between BES and its parents. At the very least, regulators should have the power to enforce disclosure of corporate structures that incorporate banks, and rip them apart if they are unnecessarily complex and opaque. But to achieve this in a multinational world requires coordination and cooperation of regulators in different jurisdictions. We are, unfortunately, a long way from that.