UPDATE: Banco Espirito Santo S.A. Cut to B+ from BB- by S&P

(Updated - July 11, 2014 2:00 PM EDT)

Standard & Poor's Ratings Services said today that it lowered its long-term counterparty credit rating on Portugal-based Banco Espirito Santo S.A. (BES) and its core subsidiary Banco Espirito Santo de Investimento S.A. (BESI) to 'B+' from 'BB-'. At the same time, we placed the 'B+/B' long- and short-term ratings on CreditWatch with negative implications. We lowered to 'CCC+' from 'B' our issue rating on BES' non-deferrable subordinated debt and placed it on CreditWatch with negative implications.

We also lowered to 'CCC' from 'B-' our issue rating on the bank's hybrid instruments and placed it on CreditWatch with negative implications.

The lowering of the rating on BES reflects our view of the increased risks that the bank faces owing to current management instability and the reportedly weak financial position of several entities within the Grupo Espirito Santo (GES)--the holding and operating companies group that includes Espirito Santo Financial Group, S.A. (ESFG; not rated), which has a 25% direct stake in BES. In our view, a weak financial position of several group entities is compounding challenges to the bank's franchise and poses increased risks to BES' financial position. We are placing the long- and short-term rating on BES on CreditWatch with negative implications to reflect that we could lower the ratings on BES if we believed that there are further negative implications for BES' business or financial profiles resulting from the current management and corporate governance changes or from the developments at GES.

In our view, current management instability is having a negative effect on the bank's business position. We have therefore revised our assessment to "moderate" from "adequate", as our criteria define the terms. On July 5, 2014, ESFG unexpectedly made its second proposal for a new management team, to be considered at BES' shareholder meeting scheduled for July 31, 2014. At the same time, it withdrew its first proposal for the management team, which included managers with a long track record at the bank, after it was, according to press reports, challenged by European and Portuguese banking regulators. We therefore believe that attempts to improve corporate governance at the bank are not progressing smoothly. We understand this process has led to the resignation of five members of the board of directors on June 20, 2014, following the dilution of ESFG during the bank's recent capital increase.

We also believe that the reportedly fragile and possibly deteriorating financial position of several entities within GES, which is becoming increasingly evident to us, is compounding challenges for the bank's franchise amid what we view as a disruptive management and corporate governance change process. Ongoing new public information about the financial position of several GES companies included media reports on July 8, 2014 of delayed payments on commercial paper issued by Espirito Santo International (ESI, one of the ultimate holding companies in GES), which had been placed with clients of BES' sister private banking operation in Switzerland, which BES shares its brand name with. We note that BES confirmed on July 11, 2014 that €0.9 billion and €2.0 billion of debt instruments issued by ESI and other GES companies had also been distributed to BES' retail and institutional clients, respectively.

Similarly, we believe that the reportedly weak financial position of several entities within GES poses risks to BES' financial profile. We cannot, at this point, fully capture this in our forecast of the bank's solvency, and therefore believe that it constrains our assessment of BES' risk position. This is because BES has direct exposure to GES entities and because ESFG (BES' immediate holding company within GES, for which we understand BES is its main asset and revenue source) has provided a guarantee on at least some debt issued by GES and sold to at least some of BES' clients. In our view, the uncertain operating position of BES' subsidiary in Angola also adds to potential financial risks that we cannot currently fully capture in our assessment of the bank's solvency. As a result of the combination of these factors, we are revising our assessment of its risk position to "moderate" from "adequate".

The revision of our assessments of the bank's business and risk position has led us to revise down BES' stand-alone credit profile (SACP) to 'b' from 'bb-'. We have maintained unchanged our assessment of other stand-alone rating factors of the bank. BES' SACP thus continues to incorporate the 'bb' anchor that we apply to financial institutions operating primarily in Portugal, our "moderate" assessment of BES' capital and earnings and liquidity position, and our view of its funding as "average".

We now also incorporate into our long-term ratings on BES one notch of uplift to reflect our view of the potential for extraordinary government support, according to our criteria. This reflects our view of the likelihood of extraordinary government support, given the combination of BES' 'b' SACP and the 'BB' long-term sovereign credit rating on the Republic of Portugal, and our view of BES' high systemic importance within the Portuguese banking sector and Portugal's supportive stance toward its banking system.

The lowering of our long-term ratings on Banco Espirito Santo de Investimento S.A. to 'B+' from 'BB-', and subsequent negative CreditWatch placement, mainly reflects the rating actions on its parent, BES, given that we consider BESI to be a "core" subsidiary of BES.

The negative CreditWatch placement reflects the possibility that we could lower the ratings on BES if we believed that there are further negative implications for BES' business or financial profiles from changes to the bank's current management and corporate governance or from developments at GES.

We will monitor any further developments regarding BES' potential new management team. We will also seek to understand what the bank's strategic direction, which we currently have little visibility on, will look like once shareholders appoint a new board of directors and management team at their meeting on July 31, 2014. We could lower the ratings if we perceive that developments in this process further debilitate the bank's franchise or business stability, including access to affordable funding. We could also consider a downgrade if we anticipate that the process would result in the bank losing its strategic focus or cause the bank to take on greater risk, particularly in the context of the bank seeking to mitigate the impact of risks we see to its financial profile.

We will also monitor any developments at GES, including any implications of the restructuring plan for some of its entities, which GES reported will be announced by the group in the short term. Given the limited information available about developments in parts of the GES, we currently have limited visibility on some of the potential developments in the group, and, therefore, the ensuing potential consequences for BES. We currently take into account the Portuguese regulatory environment and the regulator's supervisory track record and efforts to contain the potential financial impact on BES of developments at the GES level. To some extent, we believe that this limits the risk of a significant negative financial impact on BES from the reportedly fragile financial position of some of the entities belonging to GES. Nevertheless, it does not, in our view, entirely eliminate the possibility of some negative financial impact on BES at some point given its direct exposure to and ties with GES companies. Despite the regulatory efforts to contain the impact on BES of developments at the GES level, we also believe that such developments could potentially harm the bank's franchise. This, in turn, could also have a knock-on financial effect on, among other things, the bank's cost of funding.

The CreditWatch negative placement of the ratings on BESI reflects that on its parent, BES, as well as the possibility that, consistent with our criteria, we might lower the degree of parent support that we currently incorporate into our ratings on BESI if, in contrast to our current belief, BESI's strategic importance within the BES group were to diminish. We believe this could be the case if there were changes to BESI's shareholder structure and strategic focus or significant financial pressures. We could affirm the ratings and remove them from CreditWatch if we conclude that BES has successfully undergone changes to its management and corporate governance while protecting its franchise and maintaining its strategic focus without engaging in higher risk-taking practices. An affirmation of the ratings would also depend on the developments at GES not having further negative effects on the bank's business and financial profiles, in our view.

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