Initial address by Governor Carlos da Silva Costa before the Parliamentary Committee of Inquiry into the management of BES and GES
24 March 2015
Good afternoon Mr Chairman, ladies and gentlemen.
A little over seven months have passed since the Board of Directors of Banco de Portugal decided to apply a resolution measure to Banco Espírito Santo, S.A. (BES).
Today no one questions that the resolution measure allowed the stability of the national financial system to be preserved:
- The deposits were protected;
- The ongoing financing of the economy was secured; and
- The interests of the taxpayers and public funds were safeguarded.
Today, there is also very clear evidence of BES's decapitalisation operations and failures in its governance model. The forensic audit commissioned by Banco de Portugal and the work of this Parliamentary Committee of Inquiry (PCI) have been key for the investigation of that evidence and for providing an understanding of the reasons behind the collapse of Grupo Espírito Santo (GES) and BES.
From the outset, Banco de Portugal has collaborated actively with this Committee, supplying the considerable documentation requested and providing further information that might help with an assessment of the facts.
In this initial address I would like to:
- Note the most important developments following BES's resolution;
- Clarify some key issues that have arisen in this Committee; and
- Conclude with some lessons for the future.
I. Important developments following BES's resolution
I would like to note four developments following the resolution measure.
First, the resolution of BES was not a measure to destroy the institution, but rather a measure to preserve financial stability.
It is important to bear in mind that safeguarding the stability of the financial system is one of Banco de Portugal's primary missions.
The goal of banking supervision is to promote the safety and robustness of the banks and the banking system; it is not to protect an institution's shareholders and subordinated creditors at all costs when its financial situation proves unsustainable and it is in grave and imminent danger of being unable to fulfil its commitments.
On 1 August 2014, due to serious and unforeseeable facts revealed in BES's first-half accounts, Banco de Portugal faced two and only two options: resolve BES or wind it up.
Winding up BES, the third largest bank in the country:
- Would have had the immediate consequence of ceasing payments and interrupting all the financial services provided by the institution;
- It would thereby have shaken depositors' confidence in the Portuguese banking system;
- It would have entailed high financing costs through activation of the Deposit Guarantee Fund;
- All this means losses for shareholders and subordinated creditors that would certainly not be lower than those resulting from the resolution measure.
Second, the management of Novo Banco has allowed confidence in the institution to be restored.
The accounts of Novo Banco at the end of 2014 show a Common Equity Tier 1 ratio of 9.6%, above the regulatory minimum.
Novo Banco's liquidity situation has improved considerably. Since October 2014, customer deposits have made a significant recovery, and at the start of March 2015, they were about EUR 4 billion higher than their 4 August 2014 level. The increase in deposits, along with the sale of assets, has allowed financing from the Eurosystem to be greatly reduced.
Third, the sale process is proceeding favourably.
The sale of the Resolution Fund's shareholding in Novo Banco is proceeding normally, with strong interest shown by potential investors.
It is an open, transparent, non-discriminatory and competitive process. This process has been monitored by the European Commission and will also be scrutinised by the Court of Auditors.
The sale process, that started on 4 December 2014 with the publication of the invitation to tender, is proceeding normally and in accordance with initial expectations, without substantial delays.
Seven entities presented non-binding offers by the 20 March deadline to acquire Novo Banco. Banco de Portugal is currently analysing these proposals and will choose a restricted number of potential buyers for the next stage of the process, which involves the presentation of binding offers. Banco de Portugal's choice will be guided by the criteria defined in the tender specifications that were made public.
Novo Banco's new shareholder structure should be known in the summer of 2015.
Fourth, Banco de Portugal has been working intensively on the legal enforcement aspect.
Members of Parliament, as you know, at the start of July 2014, before the resolution measure, Banco de Portugal decided to commission a forensic audit, to:
- Assess compliance with Banco de Portugal's prudential supervision decisions;
- Assess and document the existence of evidence of any serious illegal practice on the part of BES Group or members of its corporate bodies.
This audit, carried out by Deloitte, is now coming to an end. The summaries for the first two workfronts have already been provided to this Committee.
The first workfront analyses compliance by BES and ESFG with Banco de Portugal's specific decisions. The conclusions indicate evidence of violations of the ring-fencing process, with considerable relevance for and significant impact on BES's financial position and assets. These violations appear to have arisen from the deliberate intention of certain members of BES's Board of Directors. Furthermore, there is strong evidence of practice liable to be categorised as malicious acts of wrongful management to the detriment of depositors, investors and other creditors, carried out by members of the corporate bodies.
The second workfront relates to the relationships between BES and its Angolan subsidiary, BESA. This identified the following:
- Failures in BES's internal control system;
- Inadequacy in ESFG's internal control system;
- Absence of anti-money laundering and terrorist financing measures in BESA;
- Failure to comply with the duty of communication to Banco de Portugal by BES's Board of Directors and its members, regarding situations at BESA with a possible impact on BES's financial equilibrium;
The support documentation obtained in the audit will be taken into account for the purposes of the checks in progress by Banco de Portugal, in the context of the penalty procedures in progress or to be initiated. As situations with possible criminal relevance were identified, the reports from these forensic audit work fronts have already been communicated to the Prosecutor General's Office.
As a result, Banco de Portugal currently has investigations under way that may be grouped under the following headings:
- Failure to comply with specific decisions of Banco de Portugal in the ring-fencing process;
- Assessment of compliance with the internal control rules by BES/ESFG Group, namely in regard to relations with BESA;
- Assessment of the legality of the operations conducted with or through Eurofin, an entity under Swiss law with links to Ricardo Salgado and GES.
These major assessment workfronts in progress are expected to complete their investigation phases progressively through 2015 and early 2016. Where evidence is found that warrants legal action, the relevant accusations will be made against those responsible.
II. Issues arising in the BES PCI
Among the developments that I see as most important since the resolution of BES, allow me to deal with three themes that have resurfaced in this Committee's hearings.
First, why was the senior management of BES not removed at the end of 2013, or at least its Chief Executive Officer?
At the end of 2013, Banco de Portugal did not have established facts that allowed, given the legal framework then applicable and the case law, a formal suitability reassessment process for the members of BES's Board of Directors to be opened, in particular for its Chief Executive Officer.
The risk of decisions by Banco de Portugal in this area being cancelled by the courts was very high and could not be ignored. In addition, for a listed company of systemic importance, an investigation process and subsequent forcible removal of the senior managers could seriously affect confidence in the institution and stability within the financial system, and would also jeopardise BES's reputation in the capital markets.
As a result, given the facts that were coming to light, Banco de Portugal took two parallel lines of action:
- Firstly, Banco de Portugal did not approve the registration requests to take up administrative roles in other Grupo BES entities that were submitted in May 2013 by various members of the Board of Directors of BES. Further explanations and clarifications were requested and ultimately the decision was taken to withdraw the registration requests in March and April 2014;
- Secondly, extensive due diligence was carried out among BES's key shareholders, especially Crédit Agricole, towards a succession plan for its Board of Directors, as part of a transition to a professionalised management model, involving the appointment of an independent administration. This process led to Ricardo Salgado's presentation in mid-April 2014 of the timetable for his succession and a plan that assumed the exit of family members from BES's executive body. The process is described in detail in documents duly sent to this Committee.
In sum, even before the supervening facts came to Banco de Portugal's attention that established a robust case for initiating formal processes of reassessing suitability – which only came about in May 2014 – the succession plan had already been communicated to Banco de Portugal.
A second issue that I see as important to clarify is how could Banco de Portugal not have known what was happening in BESA?
As BESA is a credit institution under Angolan law, Banco de Portugal's work depends on the sharing initiative
- • Of information from Banco Nacional de Angola (BNA);
- • Of audits carried out by KPMG.
Indeed, Banco de Portugal is not responsible for the individual supervision of the overseas subsidiaries of Portuguese credit institutions, even though these fall within the perimeter of supervision on a consolidated basis. These subsidiaries are subject for all legal purposes to supervision by the authorities of the countries where they are located.
In these cases, Banco de Portugal's activity as consolidating supervisor, depends on:
- • The nature and quality of the assessment carried out by the local supervisors;
- • The information shared by these under the cooperation process;
- • The analyses carried out by the respective local auditors.
No facts were identified in the information provided either by BNA or by KPMG Angola and KPMG Portugal on the legal certifications of the accounts of BESA and BES that indicated the seriousness of the situations that came to light in June 2014 regarding the risk in the Angolan subsidiary's credit portfolio.
Furthermore: the conclusions of the forensic audit suggest that these situations were known to members of the Board of Directors of BES, who had the duty to communicate to Banco de Portugal, which also never took place. This non-compliance is a serious violation and has been included in the administrative offence proceedings already brought by Banco de Portugal.
In early January 2014, BES informed Banco de Portugal that the Angolan State had provided BESA an independent guarantee to the value of USD 5.7 billion on 31 December 2013, to cover any losses on the credit and property portfolio. The terms and basis for the guarantee were never based on specific problems in BESA itself, but rather on the need to support a set of Angolan companies under the development plan for Angola for 2013-2017.
Banco de Portugal did not question the guarantee's eligibility for prudential purposes on the grounds of insufficient demonstration of compliance with conditions required to guarantee that eligibility. In particular, Banco de Portugal was informed of the terms of the guarantee, but not of the list of specific credits for which the guarantee was given and that had appeared in an Annex of whose existence it was never aware.
Banco de Portugal never queried the validity of the guarantee for covering risks of any losses in BESA's credit portfolio, given that that assessment was the exclusive responsibility of BNA. Also, the validity of the guarantee was recognised by KPMG Angola in the report issued on BESA's 2013 Annual Report.
In early June 2014, Banco de Portugal became aware of certain very serious situations with material significance for BESA's credit portfolio. In the absence of the Angolan State's guarantee issued on 31 December 2013, the situations identified would have compromised BESA's financial situation, and, as a result, that of BES. For this reason, Banco de Portugal immediately asked for detailed clarifications from BES, KPMG and BNA.
On 14 July 2014, BNA sent Banco de Portugal a June 2014 risk assessment of BESA referring to 31 December 2013, revealing only on that date an amendment to a 'high risk' rating for BESA's credit, but mentioning that the risk was supported by the Angolan State's guarantee. The BNA also announced that it had requested an independent audit to assess the quality of BESA's credit portfolio.
The information in question sent by BNA contradicted that provided before. This is a very important issue because, as I mentioned in my hearing of 17 November on the Grupo BES consolidated accounts, the level of financing provided by BES to its Angolan subsidiary did not have any impact on capital requirements. What is important for the capital requirements on a consolidated basis is the risk assessment of BESA's credit portfolio. And in that assessment, as I mentioned before, Banco de Portugal depended fully on the external auditor and BNA.
Thus, up to the end of July 2014, Banco de Portugal did not have information that allowed foresight of a significant material impact on BES's capital position as a result of its Angolan subsidiary's financial situation.
Banco de Portugal's expectations changed significantly after 27 July, when BNA announced that, following the inspection ordered for BESA, part of the problematic credits were not covered by the state guarantee, requiring recognition of impairment in the BESA accounts and a broad restructuring of the credit line to BES and BESA.
On 1 August, two days before the application of the resolution measure to BES, BNA decided to reorganise BESA, imposing a wide set of corrective measures, including the exclusion of certain credits from the scope of the guarantee provided by the Angolan State. This information clearly indicated a partial loss of the credit of BES and BESA even before the resolution measure applied to BES, as has been otherwise recognised in various hearings before this Committee.
The third and final issue relates to the situation of the retail customers that acquired commercial paper issued by GES companies from BES branches.
Over the last few weeks, the claims of those that made investments in debt instruments issued by entities forming part of GES have intensified.
As is known, Banco de Portugal has always given attention to this topic and has based its work on strict compliance with the law, whose primacy may not under any circumstances be compromised.
The following results from the legal framework in place:
- The reimbursement of GES debt is the exclusive responsibility of the respective issuers, such that BES debt is not at stake and that this responsibility could never be transferred to Novo Banco;
- The hypothetical attribution to Novo Banco of responsibility to pay debts that are not BES's responsibility to pay at the date of the application of the resolution measure would constitute non-compliance with the legal obligation to respect the hierarchy of BES creditors, placing these debt-holders in a more favourable position than the BES subordinated creditors;
- Furthermore, any losses arising therefrom for the Resolution Fund would be absorbed by the institutions that participate in that fund and temporarily would be reflected in the State accounts.
Indeed, unless BES is the proven debtor at the time of the application of the resolution measure, the holders of debt instruments issued by GES were not creditors of BES and could not be creditors of Novo Banco. Were Novo Banco to assume losses to the benefit of those investors, it would not only be unjustifiable but also illegal.
The holders of GES commercial paper have the right to claim credits on the insolvent estate of the issuing entities. According to the expected recoverable value of these credits, Novo Banco may develop commercial initiatives for its customers, through proposals to purchase the commercial paper based on market value, thereby attributing a value to that commercial paper and mitigating the losses arising from the customers' investments.
Naturally, Novo Banco is bound by good management criteria, and so initiatives like these may only be developed if they create value for the bank. This includes not jeopardising capital ratios and allowing the commercial relationship with its customers to be preserved.
In that regard, any commercial proposal has to be based on the principle of financial equivalence, according to which Novo Banco must pay the value corresponding to those instruments' actual estimated recoverable value for the securities that it potentially acquires from its customers.
Given that it is in Novo Banco's interests to preserve the commercial relationship with its customers, Novo Banco may offer a premium on the estimated recoverable value for the GES securities that these customers hold (where such a premium is justifiable in the light of the principles of good management and the legal constraints under the resolution measure). This premium may be seen as a legitimate counterpart to the benefits for Novo Banco from preserving the commercial relationship with its customers and their impact for the bank may be limited by the creation of a surplus of own funds that those investors help to create.
However, one must bear in mind that the situation of the holders of GES securities varies.
In particular, two situations may be distinguished:
- Firstly, customers that are proven victims of sales practices of securities unsuited to their risk profile or degree of financial literacy. These investors must appeal to the market authority, and where their appeals are upheld may be deemed holders of compensatory rights over BES. Given that they are common creditors, these investors will take precedence over the majority of BES creditors, who are subordinated creditors.
- Secondly, customers that do not benefit from any contractual guarantee and for which there is no evidence of mis-selling. This category of customers holding GES commercial paper only has rights over the issuing entities, notwithstanding Novo Banco proposing a commercial solution to this category, as I mentioned above.
Another set of considerations relates to the fact that Banco de Portugal ordered provisions to be made in the accounts of ESFG and later BES, for reputational risk, which could lead to a run on the bank, arising from potential defaults by issuers of GES commercial paper.
In this regard, it is important to make clear firstly that a provision is an accounting record that aims to address the uncertainty and take precaution in the accounts for a potential liability, in accordance with principles of prudence. It does not represent a liability due nor rights invocable by third parties. The provision constituted in ESFG was cancelled by the insolvency of the institution itself. The provision constituted in BES remained on the balance sheet of that institution.
In the first months after the constitution of Novo Banco, provisions were deemed appropriate for:
- The possibility of guarantees provided by BES within the scope of the sale of GES debt securities; or
- The presentation by Novo Banco of a commercial offering to those customers.
As these situations had not materialised up to the publication date of Novo Banco's initial balance sheet (in December 2014), no provision was constituted as a result.
In these conditions, given the net positions of ESFG and BES and the accounting nature of a provision, the efficacy of the provisions made was neutralised.
III. Lessons for the future
As I mentioned in my hearing in November, the BES case has revealed:
- Various weaknesses and limitations on the supervisory legal frameworks in different jurisdictions;
- Inadequate governance, risk management and control and audit practices;
- Serious gaps in financial literacy.
Therefore I believe it is key that lessons are drawn from this process to reduce the possibility of a similar situation occurring in the future.
The result as I see it is that this could be one of the main outcomes of this Parliamentary Committee of Inquiry.
I believe that the improvements to be introduced should include the following:
1. Regulatory amendments in regard to the composition of the banking groups and the relationship with related parties and with entities located in other jurisdictions.
- Firstly, I recommend that at European level, banks should not be allowed to be part of mixed conglomerates, because this favours contagion mechanisms that are difficult to control;
- Secondly, I believe the legal framework and prudential requirements for institutions that have subsidiaries located in jurisdictions with limitations on access to relevant information should be revised. We have to ensure that there are no havens and that regulatory arbitrage, in this case prudential arbitrage, is not possible.
- Thirdly, I believe that it is impossible for us to continue with jurisdictions in Europe that do not control entities that issue very high volumes of debt securities which in turn are placed in other Member States, without penalties or severe curbs.
2. Regarding institutions' governance models:
- Autonomy and independence of the members of the audit and control bodies in banking institutions must be strengthened and they must fully and effectively exercise the duties attributed to them by law. It is also important to ensure that the effective practice of the institution complies with the rules of its governance model. For this, systematic scrutiny by the supervisor of the governance practices is essential, backed up by external auditors. In terms of the senior management, a limit on the number of terms should be introduced to avoid the excessive informal power associated with very long mandates;
- Furthermore, improvements must be made to the quality of the accounts provided by the different economic agents. The accounts provided and their auditing must be areas of public accountability;
- The external auditors must be supervised by an independent entity and their appointment must have a compulsory time limit.
This indeed is an area already subject to improvements. Under the aegis of the National Council of Financial Supervisors (Conselho Nacional de Supervisores Financeiros – CNSF), we have studied ways to improve the current regulatory and institutional framework for supervision of auditing with a view to ensuring that there is an effective supervision of this activity that is adequately resourced, that contributes to improving the credibility of the information released to the public by companies. The proposals that will soon be issued by the CNSF will naturally be consistent with the new EU regulatory framework.
3. One other area in which improvements are necessary relates to the protection of bank customers. Various measures may be considered in this area:
- Separation of the physical and functional areas of selling standardised banking products and investment products;
- Strengthened standardisation of investment products' pre-contractual information;
- Definition of principles and rules for intrusive regulation of the institutions' policy over incentivising their staff in selling financial products, in particular those issued by the institutions themselves;
- Continued investment in the active promotion of financial literacy with a view to improving financial knowledge among the general public, even though the results are mainly produced in the medium and long term.
Furthermore, I believe that this event shows that the resolution system, that is one of the pillars of the Banking Union, is effective in preserving financial stability, even in a situation of serious financial imbalance of a large-size credit institution.
We now know that the "too big to fail" paradigm is not valid and that there are mechanisms that allow the provision of financial services to continue, even in the case of the collapse of the institution where the imbalances are created.
And even if we accept that the efficacy of Banco de Portugal's intervention may only be assessed when it is known whether there are losses to be borne by the Resolution Fund, and what their size is, the truth is that as I said at the start, seven months after the application of a resolution measure to BES, no one questions that it allowed the stability of the Portuguese financial system to be preserved. Thus it fulfilled one of the primordial missions of Banco de Portugal.
In conclusion, I would like to say that Banco de Portugal is also undertaking its own assessment of its experience in this case.
I decided to set up an independent commission to assess Banco de Portugal's activity as supervisory authority over banking during the three years before the application of the resolution measure to BES. The commission includes specialist external consultants with international experience and operates independently of the Board of Directors of Banco de Portugal. The goal is to assess improvement opportunities within the organisation and the supervision processes and to identify regulatory and/or legislative initiatives that help strengthen the efficacy of the supervision of the Portuguese financial system.
Also, along similar lines, a working group was established to analyse the models and practices of governance, control and audit of the financial institutions in Portugal. The objective is to produce recommendations that allow any limitations and failures found to be addressed, based on best practice.
Thank you very much.