1. The environment in which the Portuguese banking system has been operating remained highly unfavourable. The sovereign debt crisis in the euro area and the interaction between market players’ perception of the risk attached to Government debt and to the banks of the respective jurisdiction continue to be a major source of uncertainty and vulnerability for Portuguese banks. In addition, the uncertain recovery of global economic activity is a constraining factor on the future evolution of the Portuguese economy. The downside risks to the growth of the international economy are not only the result of the uncertainty surrounding the resolution of the sovereign debt crisis but also the need for the adjustment of the imbalances of the private sector in several advanced economies. In such a context, together with the demanding adjustment underpinning the economic and financial assistance programme, the Portuguese economy is going through a prolonged recessionary period, with a strong adverse impact on banks’ operating conditions.
    
2. In the first half of 2012, Portuguese banks continued to promote a gradual deleveraging of their balance sheets, which occurred in a context of lower credit granted and, simultaneously, high resilience of households deposits. The profitability of the banking system has deteriorated over the first half of 2011, reflecting the increase in provisions and impairments associated with banks’ loan portfolio and the evolution of net interest income. Nevertheless, there was an improvement over the results presented for the second half of 2011, though these have been strongly penalized by extraordinary events.
    
3. Households and non-financial corporations continued to adjust their balance sheets. The two sectors together registered a net lending position, that is, saving is higher than investment, which happens for the first time since the inception of the euro area. The reduction in disposable income arising from higher unemployment, lower wages and higher tax burden led to an increase in the materialization of households’ credit risk. This increase was particularly pronounced in the consumption and other purposes segment and relatively mitigated in the case of loans for house purchase. The observed reduction in housing prices, which is related with the slowdown in demand, may involve some risk of losses for credit institutions in those cases where default results in payments in kind and mortgage foreclosures, despite an overvaluation of prices in this market before the crisis has not been observed.
    
4. The sharp contraction in domestic demand had a strong impact on non-financial corporations’ performance, limiting their ability to finance themselves through internally generated funds. This has been aggravated by a significant tightening of bank credit standards, which happened in a context of high uncertainty and increased perception of risk by banks. The tightening of credit standards has been more pronounced in the case of smaller firms, more opaque and less profitable and in those sectors more dependent on domestic demand. These are also the sectors that have contributed the most for the materialization of credit risk. The high level of bank exposure, both direct and indirect, to the construction and real estate activity sectors, coupled with the sharp deterioration in the financial situation of companies in these sectors, led Banco de Portugal to conduct a cross-inspection on the credit quality of these loans.
    
5. The ongoing adjustment of the Portuguese economy will tend to persist in the future with direct implications on credit risk materialization prospects. Households and non-financial corporations’ default should thus continue to increase in the coming quarters. It is important to ensure that this process is consistent with the ongoing restructuring of the Portuguese economy, ensuring that the dynamics of the economic recovery in the medium term is not postponed. The financial position of the corporate sector and households will, thus, continue to be monitored in order to identify possible measures to mitigate the effects of the high debt of these sectors on their financing capacity and on credit risk of the banking system. In parallel, the national authorities, including Banco de Portugal, are identifying measures aimed at diversifying financing sources and supporting the financing of the most dynamic and productive segments of the economy.
    
6. In the course of 2012, the liquidity position of the Portuguese banking system improved, following the measures announced by the ECB and the European Union to mitigate tensions in financial markets stemming from the euro area sovereign debt crisis. These measures have helped stabilize banks Eurosystem funding and thus substantially reduce banks' short term refinancing needs. The latter led to an improvement in banks' liquidity gaps in all maturities, thus, helping to increase the resilience of the banking system to potential negative shocks on its financing capacity. More recently, two Portuguese banks issued debt securities in international financial markets. Despite the positive trend observed recently in international investors risk assessment of the Portuguese banking system, Portuguese banks' access to international financial markets remains conditioned. Therefore, and given the persistence of tensions in international financial markets, banks should continue to further strengthen their pool of available assets for use as collateral in monetary policy operations. Furthermore, the adoption of more stringent rules under the future European regulation on liquidity requirements is an additional challenge for banks internationally, including the Portuguese ones. In this context, the ongoing gradual adjustment of Portuguese banks balance sheets, translated into a gradual reduction of the ratio between loans and deposits, will allow banks to converge over time to a more sustainable funding structure, less sensitive to changes in risk perception by international investors.
    
7. The profitability of Portuguese banks is expected to remain under pressure in sight of expectations of deterioration in bank credit quality, combined with the persistence of very low levels of interbank interest rates. In this context, the maintenance of adequate capitalization levels remains crucial to preserve the soundness and strength of the banking system when faced with adverse shocks. Moreover, it is essential that the strategy behind the restructure of banks commercial networks and, more generally, the rationalization of banks costs, continue in the near future, allowing banks to adapt their installed capacity to the structural decrease in demand for banking services. This should occur simultaneously with the entry into force of the new European regulatory framework. The latter largely reflects the precepts of Basel III, which translates in gradually more demanding solvency and liquidity requirements. Recent evolution of Portuguese banks solvency and liquidity is consistent with planned goals and timeframe.
    
8. Banks financing conditions continue to be heavily influenced by the financial situation of their states. Thus, it is crucial that the commitments assumed at the euro area level over the past few months, aiming at the creation of a Banking Union, are met. The implementation of the latter should ensure greater integration both at the financial and fiscal level creating the necessary mechanisms to stop the interaction effects between sovereign risk and financial stability.

Authored articles

As usual, this Financial Stability Report includes three articles authored by economists of Banco de Portugal. The articles, which are the sole responsibility of the authors, are:

• “Systemic liquidity risk”, Diana Bonfim and Moshe Kim;
• “Households´ default probability: an analysis based on the results of the HFCS”, Sónia Costa;
• “A scoring model for Portuguese firms”, Ricardo Martinho and António Antunes.

 
Lisbon, 29 November 2012