Situation and challenges of the Portuguese Banks

I start to thank for the invitation of Diário Económico and add that it is an honour to intervene at the Banking Forum. 

Presentation - Banking, Supervision and Funding of the Economy


Today I will assign three main aspects: the present situation of banks, the financing of economy and the main challenges that the banking sector is facing.


 I will characterise the current banking sector situation based on four indicators:

Total assets, liquidity, solvency and profitability

(Slide 3) – (see presentation above)
In the framework of the deleveraging process started last year, the total assets of banks decreased 1.5% in the first half of 2012 comparing with December 2011. Part of this decrease was due to financial investments, being the marketable assets portfolio the major contribute for the behaviour of this item.

(Slide 4)
Regarding to liquidity, the situation has improved considerably mainly due to the excellent performance of deposits and the BCE’s policy.

The customers funds and other loans, slightly decreased in the first half of the year (-0.8%) due to deposits reduction and others resources (-7.5% and -4.5%), once time deposits, although in slowdown, showed an increase of 1.7%.

(Slide 5)
The ECB demand registered a substantially increased of approximately 30% comparing with December 2011, essentially as a result of a three-year monetary policy operation subscription that greatly promoted the liquidity and contributed to bridge the offset of net resources from the other lending institutions, that still results from the inactivity of the interbank market.

About this subject, I would like to highlight the remarkable performance of Mário Draghi at the head of the ECB. He is playing a fundamental role in combating the debt crisis, carrying out two injections of three-year liquidity (LTROs – long-term financial operations) and more recently the OMT debt purchase programme.

In June of this year, the Portuguese bank's exposure to the ECB was 60.5 billion Euros, which represents 4.3% of the euro area.

(Slide 6)
The funding structure of the financial institutions is made up of customer’s funds and others loans, central banks borrowing, wholesale operations, capital and other liabilities.

Customer’s funds in total funding rose 1.5% against June 2011 while ECB funds increased 3.3%, representing each one of these items 41.6% and 12.3%, respectively, of the total in June 2012.

Debt securities issued and other equity tolls, which represented 14.2% of funding in June 2012, had a positive evolution comparing with December 2011, due to capitalisation requirements for the sector.

In the first half of the year, three financial institutions issued hybrid equity instruments totalling 5.4 billion Euros, which were fully subscribed by the state. Of this, 4.3 billion Euros were part of the recapitalisation scheme.

The state guarantee scheme for funding agreements was used for five bond issues totalling 4.7 billion Euros in the first half of 2012.

(Slide 7) (Slide 8)
The solvency of the financial institutions has been substantially reinforced.

Their aggregate core Tier 1 capital ratio in June 2012 was 11.4%, against 9.5% at the end of 2011, showing record figures that were well above regulatory requirements and favourably compares the institutions with their peers in euro area.

(Slide 9)
Regarding profitability of associated financial institutions, the aggregated net income before taxes at the end of the first half of 2012 was -431 million Euros, 515 million less than in the same period in 2011.

These results were caused by:

a) The impacts of the economic situation

- Impairments were increased by 3.144 billion Euros (77% more than in the first quarter of 2011). Credit impairments went up 1.259 billion Euros and financial assets 98 million due to devaluation of securities.

- Aggregate net interest income decreased by 8.6% year on year, mainly due to the weight of the mortgage portfolio and long-term loans in stock, at a time when the indexer and spreads are very low (to such an extent that mortgage repayments are at an all-time low). The banks with the highest proportion of mortgages and long-term loans in their portfolios are naturally the most affected. Therefore makes sense try to render the Banco de Portugal projects viable or of the others vehicle banks creation to securitize bank loans supported by real assets and remove these assets from the bank's balance sheets.

- However, there is an issue to be resolved: these debt securities issued by the vehicle should have a supranational guarantee (European Stability Mechanism). This guarantee would ensure that potential losses incurred in the process would be manageable by the banks and at same time would be also attractive to investors.

(Slide 10)
- Effects of deleveraging processes

- Cost of capital, especially that obtained from the banks recapitalization line and considered state aid

b) Costs resulting from new regulatory requirements (such as costs of reinforcement or creation of structures and changes or acquisition of information systems) and new actions derivates related with the reinforcement of prudential and behavioural supervision

c) Tax burden, namely the extraordinary levy on the banking sector

d) On the other hand, contributing for positive results, I would like to highlight the efficiency improvement with a operational costs reduction of almost 10%, that enable a cost-to-income favourable evolution of 12bps comparing with the first half of the year.

e) The profits obtained with the alienation of marketable assets portfolio (mainly of public debt) and the results of repurchasing liabilities issued and included in assets and liabilities at fair value through profit or loss

f) International activity
Cross-border activity of the financial institutions contributed in a highly positive way for the consolidated balance sheets results.

(Slide 11)
I would like to make a brief comment about the actual banks profits and the capital market conditions (highlight that are very different situations from one bank to another, as the results for the third quarter shows). A shareholder who invested 1 million Euros in shares in the three largest banks at the end of October 2002 today would have 266,000 Euros.


(Slide 12)
Total credit improved with a remarkable growth between 2001 and 2008, at a rate of 6.6% (7% for companies). During the 2008-2010 financial crisis it still grew by 0.5%, when the average in the euro area was a 0.8% decrease.

(Slide 13)
The total credit fell 3.6% between 1 January 2011 and June 2012 (-2.6% in companies) due to sovereign debt crisis pressure and strict deleveraging programmes, while the euro area growth at an average of 3.3%.

The transformation ratio fell from 163% to 137.7% in June 2012.

(Slide 14)
Concerning to companies loans, the defaults increased from 2.2% in 2008 to 6.3% in 2011 and 8.3% in June 1012.

It is important to point out:

Economic agents, politicians and the public expect the banks to make a definitive contribution towards overcoming the crisis by being the main source of funding for the economy (while in the USA more than 70% of the funding of the economy comes from the capital market, in Europe 2/3 of companies' funding comes from bank loans).

(Slide 15)
However the European banking system suffered serious effects of the 2008-2010 financial crisis requiring substantial state aid (Portugal was one of the countries that required for least aid in that period – 0 % in recapitalisation measures, 3% GDP in guarantees against a total in the euro area of 13.11% of GDP (2.35% in recapitalisation, 9% in guarantees). Meanwhile, in response to a need, new substantial restrictions in terms of regulation and competition were imposed along with a natural increase in supervision.

This context, plus the development of the sovereign debt crisis and the resulting Economic Adjustment Programme involving the deleveraging of the banks, naturally had a violent impact on banking.

(Slide 16)
Loans to companies

The constraints that led to a reduction in loans to companies are due to three factors:

- Structural limitations:

- The need to deleverage the banks, a stricter capital ratio than other European banks, dependence on the ECB, restrictions on the generation of income to replace the capital base (impairments, cost of customer funding and strict pricing of mortgages)

- Economic crisis (recession) – adverse circumstances (expectations)

- Low demand for loans

- The weakness of companies balance sheets and the difficulty in providing guarantees and less favourable perception of risks to which companies are exposed

It is often said that credit does not reach the economy. What happens in most cases is that companies have weak balance sheets, unsatisfactory levels of self-financing, insufficient capital and an inability to offer adequate guarantees. This is why they are not able to pass the risk assessment and this assessment in order to a correct management must be strict and (slightly) more restrictive in view of the requirements of supervision and regulation, mainly at long term.

Just like the banks, Portuguese companies, whose borrowing reached 138% of PIB, have to try to reduce it by recapitalization. How can this recapitalisation be done?

There are a number of alternatives when the shareholders are unable to do it:

- New shareholders

- Partnerships with other companies that may be able to consolidate them

- Different types of venture capital

- Use of innovative instruments and unusual forms of capital increase (such as recapitalisation and restructuring funds)

- Restructuring of loans with the possible conversion of part of the loan into capital, also reinforcing their governance

- Greater use of the capital market

Portuguese banks will be at first line of the economical growth support and also will be it their driving force, supporting the current exploitation of companies, the investments for their modernization and new investments, especially in the tradable goods sector. The credit grant to companies with healthy balance sheets, which are competitive, innovative and with good projects is one of the bank’s main responsibilities. But also their contribution to the creation of company recapitalisation instruments, venture capital (seed, mezzanine or development capital), encouragement to access and use the capital market (e.g. issuing bonds) and particularly financial restructuring mechanisms will be extremely important in developing a new, healthy economic growth model. This depends on business capacity, innovation and efficiency leading to greater competitiveness and of course on the economy's financial capacity.


(Slide 17)
The financial crisis braked the financial integration process in Europe and there are risks of additional fragmentation with the deepening of the sovereign debt crisis.

Regarding to financial integration, it should be noted that the interest rates charged by the banks went down by an average of around 70% in Europe compared to 1990.

Although it is hard to quantify, the low interest rates charged to companies helped to increase investment, employment and growth, thereby benefiting all European economic agents.

In a Monetary Union is supposed have homogeneous and uniform monetary conditions in all state members. But reality has shown that MU is fragmented and each Member State is subject to its own monetary conditions – liquidity, interest rates, credit conditions, which are much tougher in the country’s most affected by the sovereign debt crisis.

There has been also a decline or even reversal of cross-border credit flows. The banks have focused more on their domestic markets and looking to meet domestic funding needs.
There are growing differences in wholesale funding costs and retail interest rates between Member States.

This process is at some extent aggravated by the supervisors focus in the financial stability of they own countries.

There is the awareness that there is a risk of an upward trend to the reduction of banks exposure in another’s state members, to encourage the banks to invest their liquidity in domestic debt and for their regulators to increase their discretionary intervention at national level.

The financial crisis showed up the insufficiencies of the EMU and there are more and more political, legislative, regulatory and structural initiatives to try to correct the obstacles to the proper functioning and goals that dictated its creation. Banking union, tax union, political union and a central bank that is lender of last resort are essential in standardising the situation.

But the interests are often not the same, neither from a political nor a business point of view.

The process is complex and difficult and has been slower than required.

It is in this framework, that European financial system is experiencing a time of profound changes leading to a new paradigm for the sector.

This is characterised by a true regulatory, technological and behavioural “revolution” and significant changes in business models.

Changes in regulation and accounting rules

I will only mention the most important directives, regulations and decisions that are being prepared at European and international level.

First of all it is necessary refer the upcoming entry of Basel 3 and its transposition into European law in the new Capital Requirements Directive and Capital Requirements Regulation (CRD 4 and CRR), which should be approved at the end of the year. This new regulation will bring new challenges for the banking sector in terms of capital and liquidity ratios and leverage.

The most important European Union initiatives, with different origins and participants, are:

- The Single Rule Book, i.e. the institutionalisation guidelines and standards for all EU Member States in terms of implementation of the CRR and CRD 4

- Banking union, initially with the introduction of a single supervision mechanism and single prudential supervisor (ECB) and later a European insurance scheme and common resolution mechanism and the

- Banks' capitalisation fund

- The Crisis Management dossier, including plans for the recovery and resolution of financial institutions and bail-in mechanisms

- The Liikanen Report, the European replica of the Volker and Vickers Reports, which seeks to identify the need for and ways to go about an in-depth restructuring of the European financial system

The approval timelines are very tight, with the exception of the Liikanen Report, as some measures are supposed to come into force on 1 January 2013.

In Portugal, new binding guidelines have come from the regulator along with legislation to protect defaulting customers, which penalise the banks considerably.

Technological changes

We are all aware of the extraordinary importance that IT had in the modernisation of the banks, involving platforms and new applications that often resulted in differentiation in the market and innovative services to the benefit of their customers. There was also sharing and collaboration between institutions offering substantial synergies and economies of scale.

This use of information and telecommunications technology is going to intensify considerably in terms of means of payments, bank reporting and product development.

The banks will try to achieve important competitive advantages by means of innovation, anticipation and collaborative investments.

Changes in business model

The banks' business model will undergo significant adjustments as a result of adaptation to the new circumstances in the market.

The banks will focus first on funding, quality of assets, control of impairments and capital consumption.

They will seek to develop “operational excellence” to increase earnings and reduce costs.

Their management will have five main concerns: high management, high touch (customer relations), high tech, high service and risk control.

Training and retraining will necessarily be stepped up as many professionals will be changing their specialisation (e.g. from personal loans to company loans).

The tendency to innovate and simplify financial products will continue in this area and in services. But also in response to market needs there will be banks that specialise in complex products.

There will very likely be changes in the branch network. Branches will decrease in number, which will result in an increase in multi-channel distribution with more and more use of the internet, mobile phones and electronic payments. There will be more demand for call-centres.

Institutions' organisation will be improved and polished and motivational leadership is thought to be the main trump card for increasing efficiency.

Banks' governance will be more closely scrutinised by regulators, shareholders, employees and other stakeholders and even greater importance will be given to codes of conduct and good practices. The banks will show even greater concern for supporting and protecting their customers.


(Slide 18)
The Portuguese banks' performance in two successive crises as serious as the international crisis in 2008-2010 and the sovereign debt crisis clearly shows the soundness that they achieved in the 2000s.

The Portuguese banks have been working in a highly adverse context with significant competitive disadvantages compared to the banks in most euro area countries:

- Their rating has been severely penalised by the sovereign debt crisis.

- They don't have access to the IMM.

- In spite of recourse to the ECB, which accounts for 12.3% of funding, the overall cost of funding is much higher than that of banks in other countries.

- Net interest income is under serious pressure, given the weight of loans at very low interest rates.

- The economic recession and the EAP austerity measures resulted in a substantial rise in the default rate and a need to record impairments and increase provisions.

- In this context, the new capital requirements imposed by the EAP obliged the banks to use stricter, more selective criteria when granting loans, meaning they bore the burden of seeming not to provide the economy with credit.

- The performance of the capital market, which resulted mainly from the sovereign debt crisis, has severely penalised shareholders and does not encourage new ones to invest, thereby standing in the way of their participation in share capital increases.

- The state levied an extraordinary tax on the banks and may levy a tax on financial transactions that may not be imposed in other Member States.

- The Portuguese banks had to take the place of international banks in funding state undertakings.

- The compensation planned for the transfer of pension funds to the state has not yet materialised.

- Legislation seeking to protect consumers defaulting on mortgages for extraordinary reasons is not found in almost any other European country.

Due to a blind interpretation of the rules on competition by DGCom, the cost paid by the banks that used the line of recapitalisation set out in the Economic Adjustment Programme is very high (the interest rate on CoCos is at least 8.5%).

On the subject, I would like to quote a passage from another excellent article by Vítor Bento, which was published in Diário Económico on 25 September:

“Look at state aid for the banks' capitalisation for example. The intention underlying this support is to ensure that the banks continue to fund the economy, which is currently the main constraint on the process. Well, to prevent this aid from “distorting competition between banks in Europe”, it was based on such conditions, e.g. interest rates of around 9%, that it will be practically useless for its intended purpose, as the banks will want to get rid of it as quickly as possible and will curb their business activity to levels that can be supported by their own capital.

"All this is based on the fiction that the single market is operating normally, when reality shows that, in the case of the banks, there is not a single foreign bank that wants to lend to Portuguese companies and that making decisions on the basis of this fiction only hurts the Portuguese economy and the European economy with it, without benefiting anyone."

"This is just one example of overzealous regulation that is adding competitive disadvantages to an economy that is already in serious difficulty".

In spite of all these problems, the Portuguese banks are sounder, better provisioned and doing their essential job of intermediation. The banks' primary responsibility is to manage their customers' deposits well, pay them proper interest and use the resources obtained efficiently to fund households, companies and institutions in the service of the economy, growth and the population's wellbeing.

The Portuguese banks have fulfilled their responsibilities scrupulously. In recent decades they have showed a remarkable capacity for modernisation and outstanding resilience in the face of very difficult circumstances moving into their fifth consecutive year.

The Portuguese banks are now in a more comfortable liquidity situation with the highest ever levels of solvency and soundness and will continue to be the fundamental instruments in a strong financial system, where they fulfil their irreplaceable mission of funding the economy.

The international markets recognise the remarkable resilience shown by the Portuguese banks. An excellent example of this is the success of last week's 750 million euro, three-year senior debt issue by BES, in which demand was five times greater than supply, bringing forward entry into the medium- and long-term market by one year.

Fernando Faria de Oliveira

APB's President

Lisbon, 6 November 2012