Prudential rules
Institutions subject to supervision by Banco de Portugal shall comply with the prudential rules aimed at controlling risks inherent in their activities. On the one hand, these rules aim to ensure the solvency and creditworthiness of institutions and, therefore, to maintain the stability of the financial system (and trust in such stability). On the other hand, they aim to protect users (depositors, investors) against losses stemming from bad management, fraud or bankruptcy of financial service suppliers/providers.
The Legal Framework of Credit Institutions and Financial Companies plays a central role in the Portuguese prudential regulation, largely mirroring the European Community directives on financial activity. It is, hence, a set of a harmonised regulation covering a wide range of subjects such as the capital adequacy regime, the limits on risk concentration or rules on the supervision on a consolidated basis. It also includes prudential rules or limits pertaining to certain non-harmonised areas which fall under the responsibility of national authorities, for example, the provisioning framework, internal control requirements or limits to holdings of fixed assets.
Most limits established in the context of prudential rules rely on the concept of own funds. In addition to the shareholders’ equity net of some assets with no autonomous value and of some holdings in financial institutions, own funds include other aggregates (such as subordinated loans). Due to their features, these aggregates may act as buffers able to absorb certain volume of losses, giving institutions time to react (for example, by increasing equity capital or issuing other instruments eligible for own funds), thus allowing them to pursue or even strengthen their activities. Own funds shall never be lower than minimum equity capital, and at least 10% of net profits in each fiscal year shall be allocated to the building-up of legal reserves up to the amount of equity capital.
One of the main prudential rules imposes minimum own funds requirements, according to risks associated with the institutions’ activity, namely credit, market (including minimum capital requirements pertaining to foreign-exchange and commodity risks) and operational risks. The current prudential framework establishing these prudential rules, known as "Basel II", was laid down in Decree-Law No 103/2007 and Decree-Law No 104/2007, as well as other related legislation.
Another important principle in controlling an institution’s exposures consists in imposing limits on the concentration of exposures to a single client or group of connected clients (i.e. a group of clients so interconnected that, if one of them were to experience financial problems, the other or all of the others would be likely to encounter repayment difficulties). Specifically, the range of exposures to one client (or group of connected clients) shall not exceed a given percentage of the institution’s own funds.
Under the scope of prudential rules, there are also limits on holdings in other companies. In addition, in order to avoid conflicts of interest, there are limits on loans to shareholders with qualifying holdings, and loans to members of the management or supervisory bodies are prohibited (unless when granted with purposes specified in the law).
Credit institutions shall also maintain an appropriate balance between financial flows associated to their balance sheet items, thereby ensuring adequate net funding, under reasonable conditions, to meet their financial obligations as they mature (liquidity risk).
These preventive prudential rules are complemented by other rules with corrective nature, for example requiring minimum provisioning of credit overdue (i.e. loans that were not paid by the obligor at maturity), which represents the recognition of a reduction in the recoverable value of those loans in the institution’s accounts.
Other prudential rules stipulate that, for example, institutions shall only have real estate essential to their establishment and functioning. Furthermore, there are limits on institutions indirectly carrying on non-financial activities (long-standing holdings in non-financial companies shall not exceed 25% of the capital of the participated undertaking), in addition to the limits on holdings in financial and non-financial fixed assets, which in total cannot exceed the amount of own funds.
In addition to the aforementioned objectives, minimum prudential requirements are established with a view to setting up a uniform prudential framework regarding the market performance of the institutions. These requirements are simplified preventive instruments, which should be considered complementary to sound and prudent management, and should never replace effective systems for risk assessment, management and internal control. These systems shall be developed by credit institutions and financial corporations taking into account their responsibilities to shareholders, depositors and other creditors.
Notice of Banco de Portugal No 5/2008 defines a wide set of internal control requirements to be observed by institutions subject to its supervision. Appropriate and effective internal control systems in institutions are important to ensure compliance with their legal obligations and duties and to the proper management of risks inherent in their activities.
In order to monitor compliance with prudential rules, Banco de Portugal analyses information reported on a systematic basis by institutions subject to its supervision. This mandatory reporting is defined in Instructions and Notices.
The process of financial liberalisation and innovation and the developments in the regulatory framework have introduced profound changes in banking institutions strategies, leading to the establishment of financial groups that include several types of institutions and aim at increasing their size and market share and at integrating complementary activities.
As a result, supervision is carried out on an individual and consolidated basis in order to monitor activities not only by individual institutions, but also by the whole group as an economic and financial unit with centralised management.
Furthermore, financial systems have evolved toward the establishment of groups supplying services and goods to different sectors. These groups, usually known as “financial conglomerates”, comprise credit institutions, insurance undertakings and investment firms. With the implementation of Decree-Law No 145/2006, which transposes into national law Directive 2002/87/EC of the European Parliament and of the Council, financial conglomerates are subject to supplementary supervision as regards capital adequacy requirements, risk concentration, intra-group transactions, internal risk management processes, and fit and proper character of the management. This supervision is carried out in cooperation with other supervisory and regulatory authorities of the financial sector (see National Council of Financial Supervisors).