Uncertainty about the Espírito Santo group leaves the Portuguese banking system vulnerable to declining confidence even though the immediate fall-out from troubles appears contained, Fitch said yesterday (Monday), as Moody’s downgraded BES covered bonds by two notches to Ba1.

Moody’s downgraded Banco Espírito Santo (BES) covered bonds from Baa2 to Ba1 yesterday after it downgraded the deposit and debt ratings of the issuer from Ba3 to B2 and B3, respectively, on Friday. The covered bonds remain on review for downgrade, as do the issuer ratings.

The downgrade of the covered bonds is due to a downgrade of BES’s deposit rating, which is the covered bond anchor point for BES’s mortgage backed issuance and was lowered from Ba3 to B2 on Friday.

Moody’s assigns BES covered bonds a Timely Payment Indicator (TPI) of “improbable”, which does not provide for any TPI leeway.

A covered bond analyst said that the covered bonds could have been cut to Ba2 rather than Ba1 had Moody’s used BES’s debt rating as the covered bond anchor point instead of the bank’s deposit rating.

BES has one obrigações hipotecarias benchmark outstanding, a 2015 issue, according to analysts.

Fitch said that it believes that the Portuguese banks it rates – Banco BPI, Santander Totta, Millennium bcp and Caixa Geral Depósitos – have limited exposure to the Espírito Santo Group. As a result, it believes the risk for each bank in the short term is likely to be manageable relative to its Fitch Core Capital.

The rating agency’s comments reflect uncertainties about the financial position of entities within the Espirito Santo Group, which led to considerable spread widening in peripheral markets at the tail-end of last week.

Fitch said that within the Portuguese banking system there are interbank positions with BES, but noted that these will at least be partly collateralised or short term and should also be manageable.

However, Fitch said that funding cost volatility for the country’s banks will remain until the Espírito Santo Group situation is clarified and resolved.

“We expected a reduction in deposit costs to be a key driver for improved Portuguese bank profitability this year, but to the extent that the BES uncertainty puts pressure on funding costs, earnings improvement will be deferred,” Fitch said. “The funding gap for Portuguese banks has steadily decreased as a result of deleveraging.”

According to Fitch, the banks rated by Fitch have combined unsecured debt maturities for 2014 of an estimated Eu2bn. It said that this does not look onerous in relation to their liquidity, and the banks also benefit from continued access to the European Central Bank.

It said that the impact on banks in the wider periphery should only be temporary, but noted that the situation highlights the fragility of investor sentiment for the region and could raise funding costs.

“Continued uncertainty might dampen investor sentiment for peripheral banks’ equity issuance, many of which are committed to building up buffers in anticipation of the AQR and stress tests,” Fitch said.