Portugal’s bank rescue plan has one hole

By Hugo Dixon
May 4, 2011

By Hugo Dixon and Neil Unmack
The authors are Reuters Breakingviews columnists. The opinions expressed are their own.

LONDON — Portugal’s bank rescue scheme has one big hole. The European Union and International Monetary Fund have come up with a punchy blueprint to restore confidence in the financial system, as part of the country’s 78 billion euro bailout. The plan includes recapitalisations, stress tests and privatisations. But there’s one weakness: funding. Allowing banks to issue state-guaranteed bonds, as envisaged by the plan, is only a partial solution so long as the government’s credit is still weak.

First, look at the good part of the blueprint. Banks will have to boost their core Tier 1 capital ratio to 9 percent by the end of 2011 and 10 percent by end-2012. That’s above the 7 percent agreed under the new global banking rules. If the banks can’t raise this capital on their own, the state will provide up to 12 billion euros.

What’s more, there will be quarterly stress tests. If a bank’s core Tier 1 ratio threatens to fall below 6 percent under a stress scenario, it will have to raise more capital. This is tougher than the EU’s upcoming stress tests, which use a 5 percent threshold. And while the 6 percent figure is in line with Ireland, the idea of quarterly tests seems an innovation.

The bailout plan also envisages Portuguese banks issuing up to 35 billion euros of state-guaranteed bonds to maintain their liquidity. Funding is clearly the sector’s biggest problem. Wholesale markets are largely shut to the banks, with the result that, as of March, they had borrowed 39.1 billion euros from the European Central Bank.

The snag is that state-guaranteed bonds won’t, in themselves, reopen the markets. That won’t happen until and unless investors believe the government itself won’t need to restructure its debts. And issuing such bonds will, in itself, increase the state’s contingent liabilities. In the meantime, the best that the banks may be able to do is issue the bonds to themselves and then pledge them as collateral to the ECB or the Portuguese central bank in return for cash. The latter is similar to what some Irish banks have done.

Such an elaborate money-go-round is not to be sniffed at. It would allow the banks to raise cash if their supplies of high-grade collateral run low. As such, it would buy the sector time until either confidence in the government returns or a longer-term solution is found.

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