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Initial address by Vice-Governor Pedro Duarte Neves before the Parliamentary Committee of Inquiry into the management of BES and GES

17 November 2014

Mr. Chairman,
Ladies and Gentlemen,

I would like to thank you for the opportunity to address this Committee and provide all the clarifications that may contribute to a better understanding of events at Banco Espírito Santo.

My address will be divided into three parts.

In the first part I will focus on the remarkable progress achieved in the past few years by Banco de Portugal’s supervision function, which often preceded changes that also occurred at the European supervisory level. In the second part, I will describe the monitoring and supervision of Banco Espírito Santo and the Espírito Santo Financial Group until mid-2013. Finally, in the third part, I will explain the actions of Banco de Portugal from the moment irregularities were detected outside the perimeter of supervision, following a markedly intrusive supervisory action.

1. The reinforcement of Banco de Portugal’s supervision


Banco de Portugal’s supervision has been reinforced in the past few years through development of the following lines of action: increase in minimum regulatory capital and reinforcement of prudential rules in various fields; adoption of an intrusive supervision model; regular asset portfolio reviews; reinforcement of the prospective aspect of supervision; development and consolidation of market conduct supervision and promotion of financial literacy. Allow me to summarise the features of each:

  • a) As of 2008 Banco de Portugal issued a series of determinations and recommendations, successively raising minimum capital ratio requirements to be complied with by institutions. These determinations and recommendations have made a decisive contribution to the resilience of the Portuguese banking system, by promoting the reinforcement of the banking institutions’ solvency levels: recommendation  of a Tier 1 ratio of more than 8 per cent as of 30 September 2009, determination for a Core Tier 1 ratio of more than 9 per cent as of 31 December 2011, and determination for a Core Tier 1 ratio of more than 10 per cent as of 31 December 2012;
  • b) As of mid-2011, Banco de Portugal carried out – within the framework of its regular supervision of the banking system and with the purpose of a permanent assessment of the banking system’s asset quality – a series of horizontal inspections on global credit portfolios, with particular focus on exposures that are more sensitive to the adverse macroeconomic context characterising the Portuguese economy. This sequence of supervision exercises, carried out exclusively on the initiative of Banco de Portugal, was – for its complexity, comprehensiveness, recourse to independent auditing firms and finally the significant number of bank and non-bank personnel involved – a pioneering experience in Europe, which has subsequently been used as a benchmark for various European supervisors and in the design of the comprehensive assessment of European banks conducted under the Single Supervisory Mechanism. The results of these exercises were incorporated into institutions’ financial statements, through a very substantial reinforcement of impairment levels (around €4 billion), in accordance with the determinations of Banco de Portugal;
  • c) Banco de Portugal has developed and implemented a prospective supervisory approach through the quarterly analysis of the main banking institutions’ capital and financing plans for a two to three-year horizon, thus widening the traditional scope of supervision. This analysis – which is a supplement to the usual prudential reporting analyses focusing on a given past moment in time – was complemented by regular stress tests to assess the ability of each institution and the banking system as a whole to face adverse shocks. Taking a prospective supervisory approach is one of the most striking features of Banco de Portugal’s supervision, allowing for the identification of possible liquidity or capital shortages early enough to allow for mitigating decisions;
  • d) Finally, it is important to refer that in 2008 Banco de Portugal was assigned by law responsibilities for the market conduct supervision of retail banking markets. Banco de Portugal’s market conduct supervisory role involved the development – particularly intense at an initial stage – of a regulatory framework governing retail banking markets and a progressive reinforcement of supervision. In this vein, it is important to stress that Banco de Portugal’s responsibility is limited, under the law, to ‘retail banking products’, a concept that covers demand deposits, (simple, indexed or dual)  time deposits, mortgage credit (including housing and related loans), consumer and business credit. Banco de Portugal is also responsible for supervising payment services, such as transfers or direct debits, and payment instruments, such as debit cards. The law does not grant Banco de Portugal the power to supervise other financial instruments, even if these are traded at the branches of credit institutions.

In sum, over the past few years there has been a considerable reinforcement of Banco de Portugal’s supervisory actions. Banco de Portugal has developed a considerably more permanent and intrusive approach that has in many ways preceded a number of European supervisory trends.

2. Monitoring and supervision of Banco Espírito Santo and Espírito Santo Financial Group


The monitoring and supervision of Banco Espírito Santo involved, naturally, the full use of instruments to reinforce Banco de Portugal’s prudential supervision. I will now go into detail on the main aspects.

The capital of Espírito Santo Financial Group – an entity that is subject to supervision on a consolidated basis by Banco de Portugal – increased by around €1.7 billion from December 2008 to September 2013; capital eligible for Tier 1 increased in the same period by about €2.3 billion; capital eligible for Core Tier 1 that is thus of better quality to absorb adverse shocks increased by around €3.1 billion (from €3.3 billion to €6.4 billion). As risk-weighted assets stood in September 2013 at a value close to that of December 2008, i.e. around €61 billion -€62 billion, the solvency ratio increased in this period from 9 to 11.5 per cent, the Tier 1 ratio from 6.5 to 10 per cent, and the Core Tier 1 ratio from 5.3 to 10.3 per cent.

With regard to asset quality review exercises, which repeatedly inspected the group’s perimeter of supervision, Banco Espírito Santo was forced to reinforce impairment levels – to a total amount of €621 million for all three initial horizontal inspections (SIP, OIP and ETRICC) – to amounts proportionally higher than those seen for the banking system on average, partly explained by the credit portfolio’s greater exposure to enterprises and also by greater exposure to the non-residential real estate sector.

With regard to stress tests, in the exercises concluded up to mid 2013, Espirito Santo Financial Group presented satisfactory results overall, compatible with the minimum thresholds defined by Banco de Portugal. The Espirito Santo Financial Group was also subject to stress tests by the European Banking Authority in 2010 and 2011, and presented values higher than the minimum thresholds defined by the authority.

In this context, one must remember the capital recommendation of the European Banking Authority of December 2011, which effectively penalised the Portuguese banking system by requiring it to set up a buffer for sovereign risk. This recommendation required a further increase in the Portuguese banking system’s capital, in addition to the determinations and recommendations of Banco de Portugal already mentioned. This exercise gave rise to additional capital needs for the four largest Portuguese banking institutions that in three cases were chiefly met by access to public funds. In the case of Banco Espírito Santo, they were met exclusively through private funds. It is very important to keep in mind that in this context it was precisely the sovereign risk buffer mentioned above that contributed the most to set Portuguese institutions apart in this exercise, amounting to between €1.1 billion and €1.4 billion for three of the institutions and virtually nil for Banco Espírito Santo (only about €100 million).

Reviews of international investment banks – a very important element in financial market perception of banking institutions – often considered Banco Espírito Santo to have a positive well-grounded history for those intending to invest in the Portuguese banking sector, not only for having high-quality shareholders, but also for not needing public capital.

In parallel with the capital increases carried out by Espírito Santo Financial Group in response to new regulatory requirements, Banco de Portugal kept this banking group under strong surveillance, and identified a series of weaknesses that became more evident in the course of 2013. Hence, following regular supervisory actions by Banco de Portugal, in July 2013 ESFG received a summary of the main issues causing particular concern from the prudential viewpoint: group complexity, associated with wide international activity in various jurisdictions; high concentration risk, both via exposure to Grupo Espírito Santo’s (GES) non-financial activity and at the level of the real estate sector; liquidity situation characterised by a high credit/deposit ratio; and finally reputational risk associated with the trading of debt securities issued by the non-financial arm of the group. Within this framework, and as a reflection of a material risk profile assessment, in July 2013 Banco de Portugal determined the establishment of a minimum capital buffer of 50 basis points by the end of the year, through reinforcement of the Core Tier 1 ratio vis-à-vis the minimum ratio in force.

In sum, in a framework of ongoing increases in the institution’s capital and an overall favourable perception of the group in financial markets, Banco de Portugal’s supervision has made it possible to identify – through permanent and intrusive monitoring – risk elements outside the perimeter of banking supervision.

This leads us to the third and final part of my address: Banco Espírito Santo’s ring-fencing, carried out in the wake of new supervisory actions by Banco de Portugal.

3. Banco Espírito Santo’s ring-fencing


As a result of the findings of the three supervisory inspection exercises conducted since 2011, Banco de Portugal decided to deepen its assessment of a set of 12 economic groups, since banks capacity to recover their debt and inherent impairment were analysed through the generation of financial flows. For that purpose, a new horizontal inspection exercise was carried out, in early September 2013, called ETRICC2. One of the 12 selected economic groups was the non-financial arm of GES.

The quality of credit granted to several entities of GES’s non-financial arm – either by BES or other banking groups – had already been assessed in prior horizontal supervisory inspections, in the course of which it was not found that impairment in these exposures needed reinforcement. As such, the previous close-to-zero impairments were validated.

This means, and this is very important, that the four main auditors – both as external auditors and as independent auditors responsible for conducting the horizontal inspection exercises launched by Banco de Portugal – validated zero or close-to-zero impairment, naturally on the basis of accounting information for each firm. This implies that, by mid-2013, no material credit risk to entities in GES’s non-financial arm had been identified.

Thus, as a result of this supervisory exercise, conducted in accordance with the markedly intrusive supervisory model adopted by Banco de Portugal, it was detected at the end of November that the accounts publicly disclosed by Espírito Santo International (ESI) did not reflect their true financial position.

Immediately after this situation had been identified, Banco de Portugal defined and implemented a supervisory strategy based on three pillars: (1) confirmation of ESI’s actual financial position and identification of flaws that had led to this situation; (2) strengthening of the financial group’s internal governance mechanisms; (3) and, finally, protection of the financial group from risks stemming from GES’s non-financial arm.

Let’s start with the latter aspect. With the purpose of ring-fencing risks stemming from the non-financial arm, Banco de Portugal held a meeting with ESI’s Board members at Banco de Portugal’s head office on 3 December and determined that ESFG should (i) remove ESFG’s direct and indirect exposure to ESI that was not covered by legally enforceable and prudently assessed guarantees, and (ii) open an escrow account supported by resources other than ESFG’s, with an amount equal to the debt issued by ESI and placed with BES’s retail customers; also, this account should be exclusively used to repay that debt.

Banco de Portugal’s determination also established that failure to implement these measures would lead to the compulsory constitution of a provision with reference to 31 December 2013, reflecting the conclusions of the assessment of ESI’s financial position, to be conducted by KPMG, i.e. the group’s external auditor. Indeed, although a deleveraging plan for GES had been launched, liquidity-generating measures envisaged in that plan were not implemented within the specified timeframe, rendering it necessary to constitute a provision in ESFG’s accounts, with reference to 31 December 2013, to cover risks associated with ESI’s financial position.

KPMG calculated that provision, at EUR 700 million, as reported to Banco de Portugal on 7 February. The amount of this provision was considered to be sufficient over time to guarantee that risks associated with ESFG’s direct and indirect exposure to ESI would be covered, as confirmed by the external auditor on 17 April and, subsequently, on 21 May (with reference to 24 April 2014).

The measures aimed at segregating the financial group from the risks stemming from GES were successively strengthened by Banco de Portugal, which established monitoring mechanisms to guarantee compliance with ring-fencing instruments. In particular, Banco de Portugal promoted a series of initiatives to guarantee that an active and reinforced role would be played by the three lines of defense of a banking institution’s financial strength prior to the intervention of the supervisory authority, i.e. the management board, the audit board and, finally, the external auditor.

As such, Banco de Portugal – either by means of correspondence or in the course of several meetings – signalled the decisive importance of monitoring and vigilance obligations of members of the executive boards and management boards, audit committees and the external auditor, on the basis of the tasks entrusted to them by Law. In particular, (1) a declaration was requested confirming that no financial assistance had been received from ESFG (and, consequently, BES) to implement the deleveraging plan, (2) it was established that replies to Banco de Portugal’s determinations should be prepared and approved during management board meetings and, finally, (3) on 17 March, BES appointed an internal committee to monitor all credit operations or commercial relations with associated parties, with the approval of any operation now hinging on a non-opposition opinion by this committee.

The constitution of a EUR 700 million provision would lead, with reference to 31 December 2013, to non-compliance with ESFG’s Core Tier 1 ratio. Therefore, and in full compliance with its legal obligations, Banco de Portugal determined, on 14 February, that measures should be adopted to strengthen the group’s solvency levels. Following that decision, BES’s Board of Directors decided – undoubtedly after assessing possible ways to comply with Banco de Portugal’s determination – to increase its capital to the amount of EUR 1,045 million, which was concluded on 16 June 2014. It should be noted that, in the context of this capital increase, BES provided all correspondence with Banco de Portugal to the syndicate of investment banks that led this operation.

In early July, Banco de Portugal decided that a special forensic audit should be conducted to assess actual compliance with the above-mentioned determinations, as well as to assess whether the boards had acted in a sound and prudent manner in the performance of their tasks, at a moment where there was strong evidence of non-compliance. At that time, the management practices that were severely harmful to BES’s interests were not yet known, only to be identified during the second part of July and, as is well known, resulted in additional losses to the amount of EUR 1,500 million in the accounts with reference to 30 June 2014. These additional losses implied a reduction in own funds to levels markedly lower than the minimum thresholds, which, due to the institution’s inability to repay them, led to the resolution of Banco Espírito Santo.

To sum up, to address a severe financial imbalance identified outside its banking supervisory perimeter, Banco de Portugal – consistently and determinedly – adopted a strategy aimed at protecting BES, which also relied on the monitoring and vigilance obligations of the first three lines of defence: management boards, audit boards and external auditors. Unfortunately, the management practices that were severely harmful to BES’s interests resulted in unforeseeable losses and eventually caused the institution’s resolution.

I shall conclude by saying that Banco de Portugal is fully aware that, in the course of the ring-fencing process, it acted in a straightforward and rigorous manner at all times, on the basis of available information, with the main purpose of protecting the interests entrusted to it by Law: the financial system’s stability, the safety of deposits and the safeguarding of public confidence.

Thank you very much.