By Andrei Khalip and Robert-Jan Bartunek
LISBON/BRUSSELS (Reuters) - The European Commission and Portugal have agreed in principle on the recapitalization, on market terms, of ailing state-owned bank CGD, envisaging an injection of up to 2.7 billion euros ($3 billion) in state funds and nearly as much in debt and equity.
Portugal is still reeling from two bank rescues in 2014 and 2015 that have undermined investor confidence. Caixa Geral de Depositos, or CGD, its largest bank by assets, needs to bolster its capital because of massive bad loans on its books.
The government has been negotiating with Brussels for months so that any injection is not considered state aid and does not count towards the budget deficit, which Lisbon has promised to cut to 2.5 percent of GDP in 2016 from last year's 4.5 percent.
"This is an innovative deal in Europe...This is good news not only for CGD but for the whole Portuguese banking system," Finance Minister Mario Centeno told a news conference, adding that he expected that there would be no impact on the deficit.
A spokeswoman for the European Commission said the planned recapitalization would have sufficiently high expected returns for the state to mean it would not be considered state aid.
The plan, agreed in principle late on Tuesday between Centeno and European Union Competition Commissioner Margrethe Vestager is aimed at returning the bank to long-term health through cost cuts, improved efficiency and de-risking measures.
The plan is yet to be formalized and approved by the College of Commissioners.
Under the terms of the deal, Portugal will inject up to 2.7 billion euros of capital into CGD, transfer 500 million euros worth of its ParCaixa shares to CGD and convert 960 million euros of contingent convertible (CoCo) bonds into equity.
CGD has also committed to raise 1 billion euros of capital through subordinated debt, which means private investors can help to increase the bank's equity without becoming shareholders.
CGD last received state funds in 2012 when 1.65 billion euros were injected via CoCo bonds. Other Portuguese banks that also received state help via CoCos then have repaid most of the loans to the government.
The bank posted a net loss of 205 million euros in the first half of the year due to provisions for bad loans. The government in June ordered an independent audit of CGD, after allegations of irregularities in granting loans.
($1 = 0.8881 euros)