Banco de Portugal publishes the December 2018 issue of the Financial Stability Report.

In 2018 the Portuguese economy saw a range of favourable developments from a financial stability standpoint. The indebtedness ratios of the non-financial private sector (households and non-financial corporations – NFCs) narrowed further, while the level of NFC capitalisation continued to increase. Public debt, net of general government deposits, continued to move along the downward path that started in mid-2017. The combined current and capital account is set to maintain a surplus in the year as a whole.

The Portuguese banking system also evolved favourably in the first half of the year. Profitability continued along a recovery path, while non-performing loans (NPLs) declined further at a fast pace, impairment coverage ratios continued to grow, the liquidity position remained within comfortable levels and the total capital ratio was enhanced.

Thus, vulnerabilities in the Portuguese economy and banking system decreased further, bolstering their resilience to adverse shocks.

This improvement trend needs to be continued and indeed reinforced in view of the persistence of major constraints, such as continued low potential growth of the Portuguese economy. This is particularly noteworthy given the still significant sources of systemic risk, most notably those stemming from the current international environment.

Vulnerabilities and risks

As of 2016 good progress has been made in reducing the stock of NPLs and in increasing their coverage by impairments. In June 2018 the NPL ratio declined by 3.6 p.p., to 11.7%, and the impairment coverage ratio rose by 7.1 p.p., to 52.9%, from one year earlier. The greater solvency of major banks, improvements in economic activity and changes in real estate prices have created a favourable environment supportive of the reduction in non-performing assets. 

Another vulnerability is the high concentration of the Portuguese banking system’s exposure to specific asset classes, in particular, exposure to government bonds, chiefly those issued by the domestic sovereign (approximately 9% of total assets). In the case of the insurance sector, exposure to the domestic sovereign has decreased in recent years, but its weight in total assets remains far above that of the banking sector.

At the end of the first half of 2018, Portuguese banks continued to be highly exposed to real estate assets (38.9% of total assets, 1.5 p.p. down from the end of 2016). This exposure is mostly indirect, particularly via residential assets used as collateral in the mortgage market (approximately 28% of total assets). 

The current economic environment, characterised in particular by low interest rates and competitive pressure in the mortgage market, is conducive to a loosening in credit standards. The purpose of the Recommendation issued by Banco de Portugal for new credit agreements for consumers (more specifically, credit related to residential immovable property, credit secured by a mortgage or equivalent guarantee and consumer credit agreements) is to contribute to a more resilient Portuguese banking system and the sustainability of household financing.

The main risk to financial stability in Portugal continues to be significant and abrupt reassessments of risk premia. This risk has intensified compared to the assessment presented in previous issue of the Financial Stability Report. Increased geopolitical and economic uncertainty, both at global and European level, the partial materialisation of some risks stemming from trade tensions and the normalisation of the US monetary policy, and a background of expected deceleration in world economic growth may lead to risk-aversion behaviour and risk premia reassessments. Uncertainty as to the outcome of Brexit or financial instability episodes associated with the political situation in euro area countries have the potential to exacerbate this risk in the near future. Should such a scenario be confirmed, it would certainly impact on the Portuguese economy and the financial sector, associated, in particular, to funding costs and the negative effects on external demand for Portuguese goods and services.

The prospect of normalising monetary policy by the ECB indicates a very gradual increase in market interest rates. The low interest rate environment has led investors to seek higher profitability from riskier assets, thus increasing their exposure to this type of assets. In turn, the excessive narrowing of risk premia renders international financial markets more sensitive to the materialised risk of an abrupt reassessment of such premia. 

Although the correction in macrofinancial imbalances continued to advance, in a number of major components of the Portuguese economy, it is key that the vulnerabilities discussed here are further addressed, particularly given the prevailing systemic risks. Turning to the general government, structural fiscal adjustment efforts must continue. As regards the non-financial private sector, the financial position of excessively leveraged agents must be adjusted further. Steps should be taken to promote an increase in the household savings rate and firm capitalisation levels, to bolster their resilience against less favourable developments in the economic and financial environment.

In the most recent quarters, there are some signals, albeit limited, that aggregate residential real estate has been overpriced, with possibly more marked overvaluation episodes at regional/local level. This has been linked to the strong momentum in tourism and direct investment by non-residents. Given that the banking system is highly exposed to the residential real estate market, a sudden price adjustment in this market poses risks to the sector. 

Fintech may also be a source of risk or an amplifier of systemic risks. However, to date, there is no evidence of risk materialisation at European level.

The Portuguese banking system must still overcome a range of significant challenges, stemming from the low short-term interest rate environment in the euro area and the need to proceed with the reduction of non-performing assets (particularly NPLs), to invest in technological infrastructure, to address potential competition from specialised firms (Fintech), to cut operating costs (without jeopardising the appropriate allocation of resources to control duties), and to issue debt instruments eligible as regulatory capital, for the purposes of complying with the MREL. These challenges warrant a prudent allocation of profit, particularly as regards the distribution of dividends.

Macroprudential policy

As the national macroprudential authority, Banco de Portugal has chiefly focused on the development of the conceptual framework of macroprudential policy and the activation of instruments it deems, ex ante, suited to address the build-up of systemic risk. Examples include the capital conservation buffer, the Other Systemically Important Institution buffer and the Recommendation of Banco de Portugal within the legal framework of new credit agreements for consumers.

With the purpose of assessing the implementation of the aforementioned Recommendation, Banco de Portugal contacted major institutions in the Portuguese financial system and institutions specialising in consumer credit. Compiled information suggests that as at 31 July all institutions operated within the limits established in the Recommendation in the retail distribution channels. The implementation of limits in the digital channels of a number of institutions was more incipient, but institutions seem to have adapted their offer in these channels in accordance with the limits established in the Recommendation. 

Overall, the implementation of the Recommendation seems to have improved the creditworthiness assessment of borrowers by institutions, given that it has set harmonised minimum criteria for credit agreements. 

Banco de Portugal kept the countercyclical capital buffer at 0% for the last quarter of 2018.

The phase-in of the capital conservation buffer has remained unchanged and is nearing completion. On 1 January 2019 the capital conservation buffer will become fully effective and correspond to 2.5% of a bank’s total exposures. The purpose of this buffer is to absorb losses experienced in a potentially adverse macroeconomic and financial scenario, thus enhancing the financial system’s resilience and helping maintain stable financing flows to the real economy.

The phase-in of capital buffers for other systemically important institutions remained unchanged. This buffer, whose purpose is to mitigate the build-up of systemic risks stemming from misaligned incentives and moral hazard associated with institutions that are too big to fail, should be fully completed on 1 January 2021.

Special Issues

• 'Investment funds as a source of systemic risk'; 
• 'Revision of the CRD IV-CRR: what’s new?'.

Caixas 

• 'Real estate investment funds resident in Portugal';
• 'Fintech – financial stability perspective';
• 'Implementation of countercyclical capital buffers in the European Union'.