1. In 2011, the Portuguese banking system activity was performed in a particularly adverse and demanding environment, deriving from the scarcity of market funding, intensification of the sovereign debt crisis in the euro area and increased materialisation of credit risk in domestic activity. The evolution of Portuguese banks’ activity in this period is also set against the ongoing deleveraging process and the reinforcement of solvency levels. The profitability of the banking system deteriorated significantly, reflecting higher levels of impairments on credit and the financial assets portfolio, in which several non-recurring events played an important role. Excluding these effects, profitability was virtually zero.
    
2. Portuguese banks made major efforts to reinforce their solvency levels in 2011, to ensure compliance with the minimum Core Tier 1 ratio of 9 per cent, defined by the Economic and Financial Assistance Programme for the end of the year. In December, the Portuguese banking system’s average Core Tier 1 ratio was 9.6 per cent (8.7 per cent including the BPN bank), representing an increase of 0.9 and 1.5 p.p. over June 2011 and December 2010, respectively. This improvement is explained both by the decline of risk-weighted assets, a natural outcome in the context of the current deleveraging process, and by the increase in core own funds.
    
   The reinforcement of solvency levels remains a priority for Portuguese banks, which will have to comply with highly ambitious objectives, on a domestic and international level, in 2012. At the end of June, the four major Portuguese banking groups should ensure their compliance with the prudential requirements defined at the European Council meeting of 26 October, as proposed by the European Banking Authority (EBA). In addition to the EBA’s assessment of the needs to establish the temporary capital buffer (sovereign buffer) and capital needs deriving from the difference between the Portuguese and EBA definitions of the Core Tier 1 ratio, these banks must recognise in their regulatory capital the impact of the partial transfer of the banks’ pension funds to the Portuguese Social Security System and the impact of the results of the special inspections on the quality of banks’ assets (Special Inspections Programme - SIP). In the context of the capitalisation needs deriving from these four challenges, reference should be made to the major contribution of the sovereign buffer, estimated at EUR 3.7 billion.
    
3. The significant increase in customer resources in the form of deposits has enabled the structural liquidity position of the Portuguese banking system to be improved. This was particularly the case of domestic institutions, in a context of virtual absence of access to the international wholesale debt markets. In parallel, the ECB Governing Council decisions of 8 December 2011, namely the two long-term refinancing operations (3 years) at a fixed-rate with full allotment, in addition to the widening of the set of assets available as collateral for monetary policy operations, also contributed favourably to mitigating liquidity risk in the Portuguese banking system. These measures translated into a significant improvement of liquidity gaps, particularly over 1 year maturities. There continues, however, to be substantial risks to Portuguese banks’ liquidity management. On the one hand, in a context of persistent tensions in the international financial markets, any additional rating downgrades on domestic issuers could have a negative impact on the value of asset pools guaranteeing the lending operations in the sphere of monetary policy execution. In any event, the reinforcement of eligible assets pools through bank lending portfolios is a risk mitigating factor, given that such assets are not sensitive to rating changes. On the other hand, the persistence of doubts regarding the capacity to resolve the sovereign debt crisis in the euro area and, in particular, the possible intensification of contagion to other countries may translate into a reinforcement of capital outflows associated with non-residents’ deposits. Lastly, it should be remembered that the adoption of more demanding liquidity management rules, in the sphere of future Community regulations on liquidity requirements, represents an additional medium term challenge for the banks in general, including Portuguese banks.
    
4. The recessionary environment which marked 2011 and the start of 2012 translated into an increase in the materialisation of credit risk, reflecting the deterioration of the financial situation of the non-financial private sector. As a result, the default ratio and the annual flow of new loans in default reached their highest level since the inception of the euro area, with expectations that the situation will tend to intensify over the course of 2012. Reference should also be made to the fact that while the non-performing loans ratio to households for house purchases has been growing relatively gradually, there were major increases in non-performing loans to households for consumption and other purposes and loans to non-financial corporations. As regards non-financial corporations, the deterioration of credit quality indicators was transversal to all sectors of activity. This increase also generalised by corporate dimension and exposure level, with defaults continuing to be more frequent and significant in the case of loans for smaller amounts and in the case of smaller firms.
    
5. Given the systemic nature of this financial crisis, risk assessment has necessarily increased in complexity. In addition to the idiosyncratic factors conditioning the banking sector and the Portuguese economy in general, there is also a very major risk of contagion of adverse developments on an international level, with highly significant potential effects on the materialisation of market and liquidity risk. These risks are still at very high levels and were exacerbated in the recent past by the reinforcement of the connections between the banking system and sovereign risk in a growing number of countries in the euro area. In such a context, euro area Member States have already declared they stand ready to support Portugal until market access is regained provided the authorities persevere with strict programme implementation.

Signed Articles

This Financial Stability Report includes, as usual, three articles written by Banco de Portugal economists. These articles, of the sole responsibility of the authors, are the following:

“The households’ indebtedness: a microeconomic analysis based on the results of the Inquérito à Situação Financeira das Famílias”, by Sónia Costa and Luísa Farinha;

“Access to credit by non-financial corporations”, by António Antunes and Ricardo Martinho;

“Systemic risk analysis and option-based theory and information”, by Martim Saldías.

Banco de Portugal, 29 May 2012