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Financial Stability Report - May 2011

Banco de Portugal publishes today the Financial Stability Report. Its main conclusions are summarised in the following paragraphs.

Portuguese banks are facing a highly challenging period, requiring a significant effort of adaptation and resistance. The Portuguese economy will undergo a prolonged adjustment period of its imbalances and structural vulnerabilities and, notwithstanding the globally positive prospects for the international macroeconomic and financial environment, risks associated with this external environment cannot be ignored.

Over the last few months, there has been a significant deterioration of the environment in which Portuguese banks have been performing their domestic operations. The tensions associated with the sovereign debt crisis since the spring of 2011 have not only brought strong pressure to bear on the Portuguese state’s borrowing costs but have also severely constrained Portuguese banks’ access to the international wholesale debt markets, forcing them to make intensive use of financing from the Eurosystem.

More recently, in March 2011, the economy’s external financing conditions worsened significantly in a context of political instability and uncertainties regarding temporary and permanent financial assistance mechanisms in the European Union. The rating agencies successively downgraded their ratings on the Portuguese Republic, as well as those of the banks and several non-financial corporations. At the beginning of April, heightening pressures on Portuguese public and private debt made the Portuguese government’s request for international financial assistance inevitable.

The economic and financial adjustment programme defined under the scope of this request for financial assistance is a fundamental instrument to ensure the undelayable correction of the Portuguese economy’s structural imbalances and vulnerabilities, with the aim of achieving more balanced and sustained growth over the medium and long term. In such a context, there are two complementary dimensions to the challenges to be faced by the Portuguese economy which have been included in this programme: on the one hand, it is necessary to correct the imbalances in the public finances; on the other hand, it is fundamental to tackle the structural vulnerabilities of the economy with the aim of promoting its potential growth.

Financial stability is also an essential dimension of the adjustment programme. Banco de Portugal has taken several measures since the summer of 2010 to reinforce the stability of and trust in the Portuguese banking system, advising the banks to gradually deleverage their balance sheets in order to reduce their funding from the ECB, to adopt prudent earnings distribution policies, to increase their regulatory capital, and to improve their operational efficiency.

At the beginning of April 2011, with the objective of increasing the solvency of the Portuguese banking system, Banco de Portugal, in its publication of Official Notice 1/2011, announced that all banking groups were required to have a minimum Core Tier 1 ratio of 8 per cent from the end of 2011, on a consolidated basis.

These measures were reinforced in the economic and financial adjustment programme defined under the Portugal’s request for financial assistance. Within the context of the programme, a gradual financial system deleveraging process will be implemented, which will be consistent with the non-financial private sector’s adjustment and will consolidate the trend initiated in the second half of 2010.

The programme includes measures designed to ensure the liquidity of the financial system, including an increase in the level of collateral buffers and the possibility of issuing up to EUR 35 billion in government guaranteed debt. The programme also reinforces solvency ratio requirements, imposing a minimum Core Tier 1 ratio of 9 per cent starting from the end of 2011 and 10 per cent by the end of the following year at the latest (this new regulatory requirement was already implemented through Official Notice 3/2011 of Banco de Portugal). Banks are recommended to comply with the new capital requirements by using private market solutions, notwithstanding the fact that the programme includes a recapitalisation support fund involving an overall amount of EUR 12 billion to enable the banks to comply with this requirement. Lastly, the programme also provides for improved monitoring, regulation and supervision of the banking system, in line with work already being developed in Banco de Portugal.

The specific financing and deleveraging plans under the scope of the programme, at the individual bank level, should be able to reconcile the tension, at the aggregate level, between the need for a gradual reduction in the banking system leverage and the importance of maintaining a sufficient flow of credit to meet the economy’s borrowing requirements, so as not to put the gradual economic recovery at risk.

Therefore, banks should prefer strategies based on the strengthening of their regulatory capital, on sales of credit and of non-strategic private and public sector assets, and on reinforcing stable financing sources, mainly in the form of deposit-taking from customers. These strategies should allow for the implementation of a gradual and orderly deleveraging process of the financial system and the Portuguese economy as whole, against a background of fiscal consolidation and profound structural reforms.

It must be acknowledged that the economic and social impact of the adjustments to be made will be substantial in the short term and that there are risks including, in particular, those deriving from international economic and financial developments. Notwithstanding this, full compliance with the programme is, in all that depends on the national commitment, a crucial imperative.  A further postponement of the correction of the Portuguese economy’s profound fiscal and structural imbalances would imply a substantial worsening of the already high economic and social costs.

Lisbon, 7 June 2011