1. After two years since the beginning of the economic and financial assistance program, an adjustment of the banking system’s balance sheet was observed, with a significant improvement of the liquidity situation, a strengthening of solvency and a reduction of leverage, although there are still major challenges regarding the prospective evolution of profitability.
    
2. Tensions in the international financial markets have been easing since mid 2012, as a result of the accommodative monetary policy in the main advanced economies, including the euro area (Chart 1.2). In the latter case, ECB’s non-conventional monetary policy measures had a significant impact on the conditions in the public debt markets of countries under pressure, although fragmentation of credit markets still persists.
    
3. In this context, in conjunction with international investors’ acknowledgement of the results of ficcal consolidation already achieved, the perception of risk attached to Portuguese sovereign debt among market operators improved throughout 2012. This is visible in the very substantial reduction of yields in the Portuguese secondary public debt market. This situation culminated, already in 2013, in the first issues of public debt by the Portuguese Republic with 5 and 10 years’ maturity, since the inception of the economic and financial adjustment programme. These developments had also been punctuated by Portuguese banks’ issues of debt starting from the last quarter of 2012, an indication of improved risk perception of the sector by international investors. However, as the issues in question involved small amounts and still at a relatively high cost, access to the international markets, both by the banks and the Portuguese state cannot as yet be considered normalised.
    
4. In 2012, for the first time since the inception of the euro area, the private non-financial sector showed lending capacity. This evolution resulted from a rise in savings and decline in investment, in both households and non-financial corporations’ sectors and took place alongside persistently low corporate profitability.
    
5. Aggregate indebtedness levels remain high, especially in the non-financial corporations’ sector. In this regard, it is worth highlighting the construction, real estate development and trade sectors, which present more fragile operational conditions and higher credit delinquency levels than the remaining economic sectors. Against this background, firms in the construction sector face very restrictive bank financing conditions. In the remaining sectors, it is possible that the easing of international markets’ risk perceptions vis-à-vis the Portuguese sovereign and bank debt, which has been observed since mid 2012, is being progressively translated in less tight conditions to access to credit.
    
6. The rise in delinquency in banks’ credit portfolio, which is reaching successively higher levels, with a focus in loans to firms and to households for purposes other than housing, results from the protracted recession the Portuguese economy is going through. In the case of residential mortgages, the reduction of the short term market interest rates that led mortgage interest rates to very low levels is mitigating the deterioration of the capacity of households to serve their debts. In the same vein, the available information concerning the stock of restructured loans provides some evidence that restructuring is reaching relevant proportions and that, despite that, important vulnerabilities in the private non-financial sector, with an emphasis on non-financial corporations, persist.
    
7. Net interest income is also under downward pressure as a result of several factors, namely the low profitability of the residential mortgages portfolio, contracted in the past, when put into perspective against the current funding costs; the persistence of high funding costs, namely in the deposit base and in hybrid instruments; and the low level of short term interest rates, which compresses the margin associated to sight deposits.  Bank profitability is also conditioned by the need to readjust commercial structures, which have to deal with lower demand for financial services over the medium term. In turn, international activity, which in past years more than compensated the downward pressure on the profitability of domestic operations, has been making a progressively smaller contribution to the banks’ profits.
    
8. Against the background of increasingly sustained signs that there will be a prolongation to 2013 of the  ongoing recession in the euro area, the renewed reduction of activity in the Portuguese economy expected to take place in 2013, accompanied by a contraction of demand for Portuguese companies’ goods and services and a deterioration of conditions in the labour market, suggest that credit risk will continue to materialise and that banks will need to maintain a prudent policy to recognise the ensuing losses. In addition, the reduction of the contribution of international activity and the downward pressures to net interest income are particularly demanding in term of banks’ balance sheet management.

Lisbon, 28 May 2013.