Address by the Governor of Banco de Portugal at the 3rd Reuters-TSF Conference
Portugal Post-Troika: Risks and Opportunities - The role of banking in financing the economy
I would like to start by thanking you for the invitation to take part in the opening of this 3rd Conference promoted by Reuters and TSF.
Around two and a half years ago I had the chance to take part in the 2nd of these conferences. At that time, with the euro area's sovereign debt crisis in full progress, we watched the wholesale capital markets close to Portugal's banks.
Today our banking system is more robust and in a better position to finance a sustained recovery of the Portuguese economy. It is worth remembering the steps taken since then and to outline the challenges - no less demanding - that we now face. This is the purpose of my address.
I. THE STEPS TAKEN
Thus I would like to start with the steps taken so far.
We now have more capitalised, more transparent banks, in a more comfortable liquidity position. We benefit from increased supervision and a stronger regulatory framework.
Solvency levels in the Portuguese banking institutions have been strengthened and now compare well with those of the main European banking institutions quoted on the stock markets.
At the end of 2010, the Portuguese banking system had a core Tier 1 ratio of 8.1%. By the end of 2012, it reached 11.5%, clearly above the lower limit of 10% set in the Economic and Financial Assistance Programme to Portugal (EFAP). The recapitalisation operations undertaken by the main banking institutions in 2012 - financed largely by the facility proposed in the EFAP - made a key contribution to boosting solvency in the system.
Besides solvency, the liquidity position of the main banking institutions has improved considerably.
The loan-to-deposit ratio of the eight major banks fell from around 150% at the end of 2010 to around 120% in 2012. Thus there was a gradual convergence towards a more sustainable financing structure that was less sensitive to changes in risk perception among international investors. This positive trend in the loan-to-deposit ratio on the one hand reflects the behaviour of private individuals' deposits - which, after growing sharply in 2011, was very stable in 2012 - and on the other hand, a fall in credit granted by banks.
Two large Portuguese banking institutions have returned to the bond markets in the interim. This is also an encouraging sign, although the cost and volume of bond issues held do not yet allow these operations to be seen as a relevant alternative to financing.
With a more comfortable liquidity situation, the banks have managed to reduce their dependence on Eurosystem financing. Furthermore, the non-standard monetary policy measures adopted by the European Central Bank have led to significant increases in assets eligible for use in monetary policy operations, bringing available collateral to levels that are now comfortable.
To encourage the distribution of liquidity among the Portuguese banks, Banco de Portugal has also launched a new platform for processing secured and unsecured interbank money market operations.
The improvement in the banks' solvency and liquidity levels coincided with a very large boost in banking system supervision.
In 2011, Banco de Portugal launched a wide-ranging inspection programme under the EFAP, which came to be known as the SIP (Special Inspections Programme). This involved an external assessment of the banks' credit portfolios, verification of the risk assessment methods used by the institutions and assessment of the methodologies used in the stress tests.
The SIP provided a snapshot of the quality of the banks' assets. As the situation is dynamic, Banco de Portugal included cross-cutting periodic monitoring of the overall credit portfolio as part of regular banking system supervision, or of specific asset classes which were particularly exposed to macroeconomic or market developments. Thus the goal is to ensure that at any given moment the balance sheets of the banks accurately reflect the reality of their assets.
Thus, in 2012, Banco de Portugal ran a detailed assessment of the building and real estate sectors' credit portfolios. In 2013, two special audits will be carried out to confirm the prudence level used for the credit portfolio impairments among the main banking groups. There will also be two audits on the institutions' credit risk management procedures, including the processes for restructuring problematic credit.
Banco de Portugal also intensified its macro-supervision of the financial system. The traditional monitoring of banking institutions, which was by nature fundamentally static and case-by-case, is now complemented by a forward-looking, systemic approach, based on financing and capital plans submitted by the banks each quarter, and stress-testing.
The legal and regulatory instruments available to the authorities to maintain financial system stability have also been greatly reinforced over the last two years.
In this area I would like to refer to the following:
- The change to the banks' access to capitalisation through public investment;
- The new framework for preventive, early intervention and resolution mechanisms;
- The changes to the deposit guarantee system;
- And the initiatives relating to prevention and management of arrears situations.
The legislative framework will be strengthened in the near future, through the approval of the EU Directive on bank recovery and resolution and the corresponding transposition into domestic law. In this regard, please allow me a brief aside to emphasise that despite what is commonly believed, deposits that are not covered by the guarantee funds are now more protected than in the past.
Deposits are protected through: the requirement to have adequate capital ratios; the stress-testing, that allows the resilience of the banks' balance sheets in specific scenarios to be assessed; and the creation of forcible capitalisation mechanisms for the use of institutions' shareholders, where deemed necessary.
This means that Banco de Portugal's activity in increasing equity capital requirements and running stress-tests and cross-cutting audits of banks' balance sheets aims not only to strengthen financial system stability, but also to boost confidence among depositors and Treasury bond-holders. Financial stability and confidence go hand-in-hand in other words.
The results I have just mentioned are encouraging and reveal that significant progress has already been made in tackling the crisis; however this does not mean that the difficulties are behind us, or that the challenges that we face are less tough.
Domestically the main challenge to the banking system is profitability.
As we know, the banks' profitability has been under great pressure. This is due to a variety of factors.
Firstly, default in the credit portfolio has been increasing, because of the recession we are facing.
Secondly, spreads have narrowed due to various circumstances, of which I would like to pick out five:
- The low level of short-term interest rates, which reduces spreads on demand deposits;
- High financing costs, as a result of the deposit base and hybrid instruments;
- Decreasing activity in the credit market;
- Increasing defaults in the credit portfolio;
- The low profitability of the mortgage credit granted in the past.
Thirdly, despite the adjustment made to-date, the banks currently bear operating costs that are out of step with the "new normal", in which the economy will have much lower leverage levels than those of before the international financial crisis.
This low profitability, coupled with the increasing application of Basel III rules, will continue to force institutions to manage their capital levels with particular care and pro-activity.
To respond to these challenges, the institutions must take action on various fronts.
On the one hand, they need to find ways to reduce the proportion of mortgage credit agreed in the past with low spreads, thereby freeing liquidity for new activity.
On the other hand, they need to execute their resource rationalisation plans with determination, in order to bring about structural cost reduction.
Lastly, they need to actively seek out strategic investors that can bring new capital to the institutions.
At European level, the negative interaction between the financing of the sovereigns and that of the banking system must be broken credibly and effectively, and the normal functioning of the money and debt markets in the euro area must be re-established. The creation of the Banking Union is the key to this process.
With the Banking Union, the European Central Bank becomes responsible for the prudential supervision of euro area credit institutions, doing so through the so-called Single Supervisory Mechanism, which brings together the ECB and the national supervisory authorities.
From the middle of 2014, the ECB will take on responsibility for the functioning of the integrated supervision system, through the Single Supervisory Mechanism. The ECB will be responsible for direct supervision of the most important credit institutions and the national supervisory authorities will directly supervise all the other institutions, always following a common framework.
Over the past few months, detailed preparatory work has been undertaken to put the Single Supervisory Mechanism into operation. Banco de Portugal has taken an active role in this process.
In this regard, I would like to make an important point: the technical work is being carried out with complete commitment and rigour to ensure that the transition of the Portuguese systems to the new European system goes smoothly, with the aim of building a solid, effective and homogeneous supervisory model for European banking.
I have no doubt that the Single Supervisory Mechanism will allow a common set of norms to be applied to banking and will result in standardised supervisory procedures and practices aligned with demanding benchmarks. It will thereby contribute to increasing the solidity of the euro area banks, promoting depositor confidence and stability in the European financial system as a whole.
However, the Banking Union structure will only be complete with two additional pillars. I of course refer to the need within Europe to have common instruments to resolve institutions and a deposit guarantee mechanism, that can act as a safety net for the whole integrated supervisory system. This is the only way to ensure confidence levels are identical across the Banking Union.
We are aware of the challenges and obstacles we face in this process. We know that building a common safety net that on the one hand minimises losses to taxpayers and on the other hand conserves investor and depositor confidence in the banking system and institutions is a complex exercise that is not free of risk. In this regard I would like to leave you with three messages.
Firstly, I want to give you a message of determination. Banco de Portugal will not give up the fight for a European solution for these safety instruments for the system and will contribute proposals and arguments so that the solution may be introduced quickly, ensuring an appropriate balance between the considerations at stake.
Secondly, I want to issue a warning. We cannot lose our way on the journey towards the new model. Today, Portugal is still more vulnerable than other countries to facts or developments that lead to a deterioration of risk perceptions over the banking system, even where these are unfounded. This situation warrants redoubled prudence and good sense in managing the transition process towards full banking union.
And it is on this basis that I want to leave you with a final message on the Banking Union, a message of confidence. As a result of the assessment exercises on banks' assets, the recapitalisation of the institutions and the enhancing of the regulatory instruments and supervisory tools, which began in 2011, we are now better prepared to face the challenges of the Banking Union. I am sure that the good practices that we have developed since the end of 2010 will facilitate the integration of our supervision and our institutions into the Single Supervisory Mechanism.
Thus we may have legitimate hope and a reasonable expectation that in the medium term the Banking Union will bring effective and material benefits to our institutions and citizens.
III. FINAL NOTES: FINANCING THE ECONOMY
I would like to turn now to the "other side of the mirror", the manufacturing base and the companies that make it up.
Financing the economy does not only depend on the solvency and liquidity of the banks; it also depends on a large set of factors that affect the perception and appetite for risk among banking institutions.
In other words, credit to firms does not only depend on there being demand for financing, but also on that demand for financing being interesting to the banks, meaning that there is a high chance of recovering the credit granted.
Factors such as firms’ demand prospects or their leverage greatly influence the banks’ decision to grant credit.
Demand prospects have deteriorated considerably with the recession, which leads to increased risk aversion, both for investors and for banks. Worsening demand prospects are also related to the structural adjustment of the Portuguese economy. This adjustment involves:
- On the one hand, a structural reduction in domestic spending, with the consequent downsizing of the non-tradable sector and thus falling credit to this sector due to a lack of solvent demand;
- On the other hand, better prospects for the sectors working with the external market, which will tend to increase their demand for credit both for working capital and for investment. These circumstances have therefore influenced not only the cost of credit, but also its distribution across the sectors; the construction, real estate and trade sectors, more exposed to domestic demand fluctuations, are those registering a sharper fall in credit; in contrast, credit to exporters is behaving more positively.
These trends should not change greatly in the near future, as high levels of indebtedness of both firms and households imply that the stimulus to economic growth will have to come from external demand.
Even so, it is possible to reduce risk perception among banks and improve the supply conditions of credit to the economy. We may adopt measures to reduce the asymmetry of information and make firms’ financial situation (in particular SMEs) more transparent. We may also consider creating risk-sharing mechanisms and promoting the increase of firms’ capital.
Portuguese firms’ low levels of equity s when compared to firms in most mainland European countries imply a double fragility in our case: financial fragility, as companies are particularly vulnerable to changes in financing conditions, both in terms of volumes and interest rates; and strategic fragility, given that high leverage is inconsistent with safeguarding the ability to respond to changes in the environment, and thus jeopardises the company's sustained growth.
This situation is the result of a careless attitude on the part of many companies, which bet on a short-sighted strategy of maximum leverage and profit distribution. It is also the result of a tax system that favours debt financing over capital. Lastly, it results from the general complacency that typifies the period before the financial crisis and which led to an expansion in credit, not always after a suitable consideration of the risk involved.
To give an idea of the order of magnitude involved, over a third of Portuguese companies showed profits in 2010 and 2011, and - I emphasise that I am only referring to companies that presented profits - they had a capital adequacy ratio below 30%. The capital needed to boost capital adequacy up to that 30% level would be in the order of €18.4 billion, equivalent to 11% of GDP. To bring capital adequacy levels among profitable companies to 50% would require capitalisation of €55.6 billion, 32% of GDP.
Thus we need to find solutions to boost capital levels in the Portuguese manufacturing base significantly. Different options should be considered and combined:
- To recalibrate taxation to ensure neutrality between debt and equity financing;
- To consider subordinated capital increase mechanisms as part of the new European multiannual financial framework in conjunction with a reduction in indebtedness of the companies in the financial system;
- To open up companies' equity to new investors.
Of course, these matters do not belong within the remit of Banco de Portugal. For our part, we will continue to strengthen supervision, with the goal of ensuring sufficient capital and liquidity in the banks and to promote sound management practices. This is the best contribution that Banco de Portugal can make to maintain confidence, safeguard savings and ensure that the banking system continues to finance the economy based on a prudent assessment of the risks.
Thank you very much.
Lisbon, 30 May 2013