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Portuguese bank collapse and rescue revives questions about eurozone stability

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LISBON, Portugal - A new Portuguese bank appeared Monday, born from the ruins of a collapsed business empire, and declared on its website that it was now "stronger and safer."

Investors rattled by the eurozone's latest financial drama will, however, need more reassurances.

Portugal's biggest banking scandal, which compelled authorities Sunday to put up 4.9 billion euros ($6.6 billion) to prevent the collapse of ailing Banco Espirito Santo, raised questions about how regulators were apparently hoodwinked. It will also focus minds on the European Union's year-long health check on the banking sector, whose results are due in October.

The debt crisis that in recent years battered countries sharing the euro currency, forcing countries such as Greece, Ireland and Portugal to request bailouts, has ebbed in recent months. Investors remain wary, though. They fear more nasty surprises could be around the corner, and the scandal surrounding Banco Espirito Santo's huge unreported debts is fueling those concerns.

Barclays analysts predicted investors will "remain guarded about risks which could stem from latent problems in the (Portuguese) financial system." Lisbon's difficulties demonstrated "the major surgery that Europe still has to undergo with respect to its economic and banking problems," said a note from CMC Markets UK.

The European Central Bank, the eurozone's main regulator, is currently examining the books of more than 100 of the bloc's top banks. The goal is to weed out the lame ones, helping ensure financial markets have faith in the banking system. The Banco Espirito Santo case could undermine that effort.

Portuguese authorities sought late Sunday to extinguish the Espirito Santo wildfire by splitting it into two banks: a new one, called Novo Banco, which keeps the company's healthy businesses and will later be sold, and a so-called "bad bank" that will hold toxic assets and retain the Banco Espirito Santo name. The bad bank will be put into liquidation, meaning it will cease to exist once the bad investments are dealt with.

Officials had last month attempted to halt the bank's collapsing share price by insisting the bank had sound finances and that private investors were ready to take it over. That was until the true picture emerged last week: the bank reported a record half-year loss of 3.58 billion euros, trading in its shares was suspended, and the Espirito Santo family's three main holding companies asked for bankruptcy protection.

Bank of Portugal governor Carlos Costa conceded in a televised statement close to midnight Sunday that officials had been duped by a type of Ponzi scheme whereby cash and debts were shifted around the Espirito Santo family's tourism-to-health care business empire on four continents.

Costa said the bank's activities "were in clear violation of Bank of Portugal rules" and used "fraudulent schemes." Police suspect former Chief Executive Ricardo Espirito Santo Salgado, who stepped down last month, of fraud, forgery and money-laundering at the bank, whose business dates from the 19th century and has been one of Portugal's most venerable financial institutions, as well as for years its biggest private bank.

"International experience shows that schemes of this kind are very hard to detect before they collapse, especially when it takes place in different countries," Costa said.

Just as worryingly, Costa said an audit by the central bank of Banco Espirito Santo had detected problems 11 months ago. He said the central bank had attempted to ring-fence the problems, without elaborating.

It remains unclear why action to shore up the bank was not taken back then. Some Portuguese politicians are demanding an inquiry into how Banco Espirito Santo slipped through the net of supervision. Costa did not take reporters' questions after his statement.

European stress tests of banks in 2009, 2010 and 2011 — conducted not by the ECB but another EU office with fewer powers — fell short of convincing markets. Some banks passed the tests on paper but needed bailouts soon afterward. Banco Espirito Santo passed them all and was the only major Portuguese bank to not require any public aid during the country's bailout program.

Simon O'Connor, a spokesman for the EU's economic and monetary affairs commissioner, argued that Banco Espirito Santo was a special case. Its woes shouldn't be taken as a sign of systemic weakness, neither for the eurozone as a whole nor for Portugal, he said.

The rescue money will come from a special fund set up during the eurozone crisis and designed to help financial institutions in difficulty. That means Portugal doesn't have to raise new taxes to get the money or apply for more help from the EU.

Shareholders and junior bondholders, including some major companies such as Portugal Telecom which held the bank's commercial paper, will bear the brunt of the losses. The cash injection is a loan and will be repaid with interest, with no cost to taxpayers, Costa said.

Still, almost 5 billion euros is a big number in Portugal, one of the eurozone's smaller economies. The aid is roughly equivalent to the annual budget for the country's schools and universities.


Juergen Baetz contributed from Brussels.

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