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Comprehensive report on Portugal by Banco de Portugal - Financial Stability Report November 2010

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The Portuguese financial system is facing several serious challenges, arising from the international financial instability, particularly marked in Europe during 2010, and worsened, in the Portuguese case, by the need of adjustment of structural imbalances, which are becoming more severe.



The strong deterioration of the prospects of international financial markets players on the sustainability of the public finances situation in Portugal has been reflected in a strong increase in the risk premium on sovereign debt, which has had negative repercussions on the Portuguese banking system’s access and funding costs in the international wholesale debt markets. This increase in risk premium occurred against a background of a significant differentiation in sovereign risk assessment in the euro area. The imbalances of the Portuguese economy are not only associated with a worsening fiscal situation but also with a persistent and significant deterioration of the economy’s external position, against a background of high levels of private and public indebtedness and low economic growth over the course of the last decade.

As the Portuguese economy’s external indebtedness has been almost fully intermediated by the public sector and the banking system, these sectors’ difficulties in access to financing in the international debt markets force the intensification and acceleration of the adjustment between the Portuguese economy’s savings and investment, involving all institutional sectors. This adjustment will require a significant deleverage both in the public and private sectors, including the banks, and will have inevitable negative effects on the Portuguese economy’s growth prospects over the short and medium term, translating, in turn, into a more intense materialisation of credit and market risk. Indeed, the need for deleverage also includes the Portuguese banking system which has, over the course of the last decade, been obtaining financing from the international wholesale debt markets, in euros and in very favourable terms, to support its lending to the Portuguese economy. The difficulties in access to these financing sources, which were aggravated over the course of this year, imply a reinforcement of regulatory capital and a contraction of the banks’ activity, which should, in turn, imply an acceleration of the private sector’s deleverage process. Further, this banks’ capital reinforcement will be consentaneous with the implementation of the new Basel III international regulatory package. It should be noted that in a context of the necessary deleverage of the Portuguese banks, the increased restrictiveness of credit supply will, in turn, tend to reinforce the recessionary pressures on economic activity.

During the course of 2010 the magnitude of this adjustment and deleverage process was not very significant. Lending to non-financial corporations and households by the Portuguese banks only decelerated gradually and the indebtedness of the public sector continued to increase. This evolution was, to a large extent, sustained by the support measures adopted on a supranational level within the framework of the international financial crisis. In particular, the unconventional monetary policy measures implemented by the European Central Bank (ECB) with the objective of ensuring the regular functioning of the monetary transmission mechanism, while also contributing to the financial stability in the euro area, were essential for ensuring continued access to financing by the Portuguese banks. These measures avoided significant falls in private and public sector financing flows. In addition, ECB interventions in the public debt securities markets in the euro area (i.e. Securities Market Programme) were also relevant in such a framework. However, the continued use of such measures will be unsustainable, owing to their temporary nature and purposes. These unconventional measures should be suspended as soon as the functioning of the financial markets in the euro area as a whole permits the adequate transmission of the ECB’s monetary policy. Over the course of the last few months there was some decrease in the use of ECB financing by the Portuguese banks. Banks should, however, continue to promote balance sheet adjustment policies and secure alternative financial resources, namely by seeking to broaden their customer base and offering attractive saving products. As already mentioned, notwithstanding the difficulties in access to financing in the international wholesale debt markets faced by the Portuguese banks, there has, to-date, been no contraction of their balance sheets. In the first half of 2010, the Portuguese banking system on a consolidated basis posted growth of 4.3 per cent vis-à-vis the end of the preceding year. However, this expansion of activity was not fundamentally based on lending to the non-financial private sector, as opposed to what is usually the case. Indeed, the annual rates of change in bank loans to the non-financial private sector remained globally stable over the course of 2010, after having decelerated significantly over the preceding two years. Growth of credit to the non-financial private sector was essentially geared to loans for house purchase, with a less significant change in lending to non-financial corporations having been noted over the course of 2010. However, the fact that several Portuguese companies succeeded in obtaining financing from non-resident financial institutions, through loans and the issue of short term securities, made it possible to attenuate the effects of the disruptions in the sovereign debt markets.

In this framework of moderate growth in lending to the non-financial private sector, the expansion of Portuguese banks’ balance sheets in the first half of the year essentially reflected the financing of general government. On the one hand, lending to the public sector has been accelerating since mid 2009, having intensified in the second quarter of 2010, notwithstanding the contraction of credit flows to this sector over the most recent period, as discussed in “Box 4.3 Financial situation of the six major banking groups in the Portuguese banking system in the third quarter of 2010”. On the other hand, banks increased their portfolio of Portuguese public debt securities, which made a relevant contribution to the growth of banks’ assets in 2010. Notwithstanding the fact that Portuguese banks continued to be less exposed to these securities than most European banks, 2010 witnessed a significant increase in the banking system’s exposure to the public sector. Although the public debt securities of the advanced economies are usually characterised by a reduced level of risk, the significant increase in sovereign risk in several European countries (including Portugal) over the last few months has implied significant drops in the price of such assets. However, as most of these securities are classified in the available for sale assets or assets held to maturity portfolios, the impact of this loss of value on profitability and banks’ regulatory capital is relatively limited and restricted to the realisation of losses in the event of a sale of such financial assets or the recognition of impairment, namely in the case of default by a sovereign state. Reference should be made to the fact that these securities may be used as collateral for the Eurosystem’s monetary policy operations. In addition, changes to the international financial regulation on liquidity risk under the Basel III regulatory package tend to create incentives for the reinforcement of public debt securities portfolios.

The stress test exercise carried out in mid 2010 by the Committee of European Banking Supervisors (CEBS), in cooperation with the ECB, demonstrated that the magnitude of the direct impact on regulatory capital of changes in value associated with sovereign exposures in the Portuguese banks’ portfolios considered in the exercise was very low owing to this prudential rule, as discussed in “Box 4.1 Main results of the stress test exercises in the European Union in the sample of Portuguese banks” of this Report. It should be stated that, even based on the highly implausible case of the realisation of latent losses on the sale of the whole sovereign debt portfolio, Portuguese banks would still continue to enjoy a relatively comfortable financial situation under the criteria used in the exercise.

In short, notwithstanding the fact that the restrictions faced by the banks in access to market financing tend to contribute towards a contraction of the banking system’s balance sheet, reinforced by lower demand-side pressure for credit from the private sector, this contraction has not, to-date, significantly taken place. This was mainly due to the possibility of access to Eurosystem financing, which has enabled the banks to finance a significant part of the public sector’s borrowing requirements over the last year. However, in the third quarter there was a slight contraction of the consolidated balance sheet of the six largest banking groups.

There was a marked increase in the use of Eurosystem monetary policy operations starting in May 2010, when there was a strong increase in sovereign risk differentiation. The significant increase in the risk premium associated with Portuguese sovereign debt was reflected in a marked increase in risk premiums on Portuguese banks in the wholesale debt markets starting from the end of April and comprising strong quantitative restrictions in access to these financing markets. It should be noted that the difficulties being faced by Portuguese banks in accessing the international wholesale debt markets essentially reflect the increase in the sovereign risk premium, in a context of greater risk differentiation in the euro area, as well as the Portuguese economy’s structural imbalances, but not any intrinsic profitability or solvency problems of the Portuguese financial system. The implementation of measures on a European level, the disclosure of some information on the implementation of the Basel III regulatory package and the results of the European stress test exercise enabled some reduction in the differentiation between risk premiums in the euro area in the summer. In this respect, the results for the Portuguese banks are analysed in “Box 4.1 Main results of the stress test exercises in the European Union in the sample of Portuguese banks” of this Report. In accordance with the results of the exercise, the four Portuguese banking groups analysed displayed a high level of resilience to a further materialisation of risks on a global and national level. Notwithstanding the positive developments noted at the start of the summer, new tensions emerged at the end of August, associated with the situation of the Irish banks and the announcement of worse than expected economic and fiscal data in several euro area economies.

In this context, Portuguese banks faced quantitative restrictions on access to interbank money market financing. In turn, net bond issues over the first three quarters of the year were negative, i.e. the amounts issued were insufficient to offset the bonds maturing in the same period. Portuguese banks failed to place debt issues in international financial markets after the first quarter. Most of the bonds issued since then were placed with institutions belonging to the perimeter of the respective banking groups. The changes noted in the Portuguese banks’ financing structure translated into an across-the-board deterioration of their global liquidity situation. Banco de Portugal has accordingly endeavoured to encourage banking groups to look for alternative financing sources over the last few months. The realisation of several repo operations in the market, in conjunction with a slight growth of customer resources and some improvement in access conditions to the short term wholesale debt markets, permitted a recent decrease in the use of the Eurosystem’s monetary policy operations, the magnitude of which, notwithstanding, continues to be highly significant. This evolution was also favoured by a major operation involving the sale of assets abroad.

Notwithstanding the fact that market fi nancing is relatively important for Portuguese banks, their main financing source continues to be resources taken from customers. The first quarter of 2010 witnessed a decrease of such resources, which was latterly reversed in the following two quarters. The acceleration of non-monetary sector deposits in the third quarter essentially reflects the evolution of the deposits of non-financial corporations (partly related to the above mentioned sale of assets operation abroad), non-monetary financial institutions and central government, as there was a deceleration of household deposits in the most recent period. Deposits taken from the international activity of Portuguese banks were also highly relevant in this positive evolution. It should be noted that, notwithstanding the strategic importance of resources taken from customers in the current context, bank interest rates on deposits remain at historically low levels, although they have recently recorded some increase. Accordingly, in the first half of 2010, savers continued to prefer alternative financial investments with higher yields (albeit with lower liquidity and/or greater risk), notably life insurance investments.

The moderate acceleration of deposits by households in the fi rst half of 2010 occurred in the context of a slight increase in households’ financing capacity. This period witnessed a positive change in labour remuneration and current net transfers to households (including social payments), enabling households’ disposable income to record a positive evolution even against a background of contraction of employment. Notwithstanding the strong growth noted in private consumption, the households’ savings rate was on a level close to that of the previous year, in a context of high levels of uncertainty and a deterioration of consumer confidence. A signifi cant increase in households’ financing capacity had already been noted in 2009, reflecting the start of an adjustment process. In turn, there was a positive change in the savings rate of non-financial corporations in the first half of 2010, reflecting a reduction of funding costs and a recovery in corporate profitability. The improved profitability indicators of Portuguese companies represents an inversion of the negative trend noted since 2007. However, a significant heterogeneity in the business sector is underlying this aggregate evolution: whereas many companies recorded a recovery in sales (particularly in external markets), there was also a large number of corporate bankruptcies. In global terms, the balance sheet adjustment needs of households and companies over the next few years will tend to imply a contraction of expenditure. The said adjustment, however, will be differentiated and tend to be of a greater magnitude for companies predominantly geared to the domestic market, as the recovery in external demand should allow exporting companies to remain globally viable.

In such a framework, 2010 continued to be marked by a signifi cant materialisation of credit risk. The increase in default ratios was more expressive in loans to non-fi nancial corporations and loans to households for consumption and other purposes, with a relative stabilisation of this indicator in loans to households for house purchase. The stabilisation of the default ratio in this latter segment at historically high, albeit contained, levels is associated with relatively low debt servicing levels (reflecting the continuation of low interest rates and prevalence of long maturities), in addition to the fact that the involvement of lower income families in this market remains low. This was offset by the significant materialisation of credit risk in loans to households for consumption and other purposes, which could be associated with the intensification of access to this market by lower income households in the years preceding the onset of the financial crisis. The greater vulnerability of these borrowers to the more recent developments in terms of unemployment contributed towards the referred to evolution, which trend is expected to continue in the near future. As regards non-financial corporations, notwithstanding the strong growth in default ratios, there was a decrease in flows of new loans in default which, nevertheless, have remained at historically very high levels. In global terms, the magnitude of default ratios has continued to be lower in the largest companies, to which the Portuguese banks are more heavily exposed (a detailed description of companies in default situations is given in “Box 4.2. Financial situation of non-financial corporations and the evolution of default in 2009” of this Report). There has also been differentiation in the evolution of loans according to the size of companies, with a growth in exposures to major companies and a contraction of lending to smaller companies having been noted at the same time. Notwithstanding the global worsening of default indicators, reference should be made to some slowdown in the materialisation of credit risk. However, the profound adjustment process to which the Portuguese economy will be subject over the next few years will take the form of additional increases in default levels, suggesting the need for the banks to reinforce the booking of impairments for losses in their credit portfolio, particularly in loans to non-financial corporations and to households for consumption and other purposes.

Notwithstanding the unfavourable prospects for the Portuguese economy, there was some dynamism in lending to the non-financial private sector over the course of 2010. As regards households, demand for loans was stimulated by the continuation of relatively low interest rates and by the acceleration of private consumption. In the case of companies, demand remained relatively stable, deriving essentially from liquidity difficulties associated with the need for debt restructuring and inventory and working capital financing. This evolution in the demand for credit was accompanied by a more restrictive approach in terms of supply, owing to Portuguese banks’ difficulties in obtaining access to financing. These restrictions particularly affected loans with greater risk, revealing a higher risk aversion by Portuguese banks. This more prudent approach by the banks in their appraisal of credit risk in periods involving a greater materialisation of such risk is a stylised fact at this stage of the credit cycle.

Notwithstanding the markedly unfavourable setting over the last few years, Portuguese banks have succeeded in ensuring the funding of the economy and maintaining globally adequate solvency levels, although they have faced substantial falls in their profitability. In the first half of 2010, the profitability of the Portuguese banks decreased in year-on-year terms but recorded a slightly positive evolution vis-à-vis the end of the preceding year. This slight increase was essentially the result of the positive effects associated with other provisions and impairment losses (not related to credit to customers), in addition to the containment of operating costs. The results generated by international activity continue to make an increasingly more expressive contribution to the profitability of the Portuguese banks, representing around one third of the results generated in the first half of 2010 (notwithstanding the fact that their proportion of banking system activity was slightly more than 10 per cent). In turn, own funds adequacy ratios were significantly above the recent minimums observed at the end of 2008. In the first half of 2010 there was a slight deterioration of the overall own funds adequacy ratio vis-à-vis the end of the previous year and, in contrast, an increase of the original own funds (Tier I) ratio.


Reference should be made to the fact that the need for the adjustment of the Portuguese banking system will be reinforced, over the medium and long term, by the implementation of new regulatory requirements on capital and liquidity ratios under Basel lII. Although these adjustments, when considered globally, could have negative impacts on banking system profitability, they will help to reinforce the stability of the financial system, ensuring the necessary conditions for improving the capacity to resist future shocks. Convergence to the new regulatory requirements on an international level will also imply significant adjustment endeavours by Portuguese banks which, as a whole, will have to reinforce their regulatory capital base, increase the proportion of liquid assets in their balance sheets and endeavour to secure more stable financing sources. As regards capital ratios, the impacts on Portuguese banks will be mainly associated to changes to several positive own funds elements (notably minority interests), in addition to several deductions and prudential filters to be applied (namely, the recognition of defined benefit pension plans actuarial deviations and the deduction of holdings in banks, other financial institutions and insurance companies). The magnitude of the impacts on the Portuguese banking system may be very heterogeneous and will be conditioned by the point of departure of each banking group and the relative importance of the referred adjustments, as discussed in “Box 2.1. Main Basel III proposals” of this Report. It should, however, be stated that the Basel Committee has defined a very gradual implementation timetable.

In addition, the Portuguese economy’s necessary deleverage process will imply changes in the size and composition of the balance sheet of the Portuguese banking system, in a context of more diffi cult fi nancing conditions in the international wholesale markets. The Portuguese economy’s prospects over the next few years will tend to condition the evolution of the banks’ profitability (making it more difficult for them to reinforce their capital base), and will also imply an expectable intensification of the materialisation of credit and market risk. In addition, the unsustainability of the permanent large scale use of Eurosystem financing will require a redefinition of Portuguese banks’ financing strategy, particularly in a framework of persisting major restrictions on access to financing in the wholesale debt markets. This being the case, the adoption of strategies for taking resources from customers is essential in order to mitigate the liquidity risk of the Portuguese banking system. Reference should be made to the fact that Portuguese banks, notwithstanding the highly adverse setting in which they have been operating since the start of the international financial crisis, have displayed a remarkable capacity to resist and adapt themselves. However, given the prospects for the Portuguese economy, the reinforcement of banking system capital is considered to be indispensable for ensuring the continuity of their capacity to resist additional adverse shocks. The new regulatory demands in the context of Basel III will also require the reinforcement of Portuguese banks’ regulatory capital base. In addition, the furthering of a credible fiscal consolidation process is essential for facilitating the reopening of the international financial markets to Portuguese banks, thus allowing for a more gradual adjustment of the Portuguese economy.


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