Executive summary

Risks to financial stability arise, to a large degree, from the potential fallout that geopolitical tensions and protracted tight monetary conditions may have on economic activity. In the last half of the year, vulnerabilities have decreased on the back of improved economic conditions. Inflation is expected to continue its downward path and economic growth in Portugal should remain positive and above that of the euro area. According to the most recent projections of the European Central Bank and the Banco de Portugal, inflation is expected to decline to 2.3% in the euro area and 2.4% in Portugal in 2024, reaching 2% in 2025. The economy is projected to grow at around 2% in Portugal and 0.6% in the euro area in 2024, with more favourable projections for the following two years, with Portugal growing above 2.2% per year, at a pace higher than the 1.5% and 1.6% projected for the euro area.

At international level, the tense geopolitical context, with ongoing military conflicts in Ukraine and the Middle East, weighs on international trade flows and has an impact on economic activity. The strategic security considerations that can support the economic and financial fragmentation of the global economy and jeopardise a more inclusive re-globalisation process are particularly noteworthy. In addition, there is a risk that the ongoing adjustment in the Chinese real estate market could have a more pronounced negative impact on its economy, with repercussions for the global economy.

Maintaining monetary conditions tight for longer and/or with longer than anticipated effects impacts economic and financial conditions. The conduct of monetary policy should consider the synergies achieved through a global coordinated response, but it should also take into account the underlying reality in each economic area, which may require differentiated responses to reduce the risks of excessive tightening.

At national level, a scenario of heightened policymaking uncertainty stands out, within the framework of a new model for European budgetary rules, which will pose new challenges to fiscal policy.

A possible deterioration in macroeconomic conditions triggering abrupt corrections in financial asset prices could exacerbate risks to financial stability. Deteriorating economic conditions lead to a reduction in the value of assets and a worsening of the debt service of resident sectors, although mitigating factors, such as the reduction of indebtedness, have been consolidated in recent years.

Risks associated with the financial position of the general government have been decreasing, driven by fiscal consolidation and the resulting downward trend in the public debt-to-GDP ratio, only interrupted by the pandemic crisis, when the ratio peaked at 138% but then immediately resumed, with the ratio standing at 112% at the end of 2022 and falling to 99% in 2023. This deleveraging path was reflected in corresponding upgrades in the Republic’s rating. However, debt is still high. In this way, general government is exposed to persistently higher interest rates and volatility in international financial markets, which may spill over to other resident sectors by contagion in their risk assessments.

Firms have continued to improve their capital ratio and to reduce indebtedness. The average leverage ratio, measuring the share of debt in total equity and financial debt, decreased to 41.3% in 2023 (42.2% in 2022). In a year of economic growth, the indebtedness ratios as a percentage of GDP, gross and net of deposits, narrowed to 82% (89% in 2022) and 56% (59% in 2022) respectively. Corporate profitability has withstood the increase in debt servicing. EBITDA accounted on average for 9% of assets, down by only 0.2 percentage points (p.p.) from 2022, the highest level since the financial crisis. In the past year, there has been no material increase in insolvencies and the quality of credit granted to firms has not deteriorated, which is reflected in the decline in the ratio of non-performing loans (NPLs) to 5.0% (6.5% in 2022). In any event, the cumulative effect of maintaining high interest rates on economic activity and financing costs, together with possible increases in production costs and supply chain disruptions, could trigger the materialisation of credit risk, particularly for the most vulnerable firms.

Households also saw a decline in their indebtedness ratio, following a trend that started in 2010, reaching 85% at the end of the year (91% in 2022). The improvement in the risk profile of loans to households has benefited from the macroprudential Recommendation introduced in 2018, which includes limits to the debt service-to-income (DSTI) ratio as one of the criteria for approving new loans. Amid rising interest rates, household default mitigation has also benefited from a strong labour market and higher real disposable income. Owing to a contained increase of 0.2 p.p. in NPLs in loans for house purchase, the household segment had a 2.4% NPL ratio, higher by 0.1 p.p. than in 2022.

A scenario of protracted tight monetary policy and worsening economic conditions may also lead to lower real estate market prices through their impact on demand. However, the effects on the Portuguese banking system should be contained. Only 5% of banks’ housing loan portfolios have loan-to-value (LTV) ratios of more than 80%, lessening the impact of a potential drop in house prices. In the commercial segment, the banking sector’s exposure is contained.

The international non-banking financial sector is exposed to risks inherent in its business model, where there are fewer liquidity instruments and backstops in stress situations. In Portugal, vulnerabilities did not build up in the sector.

The situation in the Portuguese banking sector has improved further, characterised by higher levels of capital, liquidity and profitability. It has been a source of stability, helping to ensure the regular financing of the economy. The profitability of the sector increased to 1.28% of assets (0.69% in 2022), with a positive impact on capital ratios. The total capital ratio and the Common Equity Tier 1 (CET1) ratio increased by 1.5 and 1.7 p.p., respectively, to stand at 19.6% and 17.1% respectively. Liquidity indicators remained high and above 2022 levels, with the liquidity coverage ratio (LCR) reaching 255% and the net stable funding ratio (NSFR) 151%.

Should adverse conditions materialise, including in economic activity, with implications for unemployment, credit quality may deteriorate. While the total NPL ratio continued to narrow in 2023, from 3.0% to 2.7%, there was an increase in loans showing a significant increase in credit risk (stage 2 loans). The ratio of stage 2 loans to households increased by 2.2 p.p. to 10.4%, with a contribution from housing loans – mostly at a variable rate – reflecting an increase in credit risk associated with the higher debt service burden in the income of the most vulnerable households.

Preserving banks’ net interest income is key to sustaining organic capital generation, being the preferred means when setting capital buffers. In a context of lower interest rates and subsequent tightening of net interest income, Portuguese banks will need to be able to find mitigants due to its importance to the profit/loss structure.

Financial Stability outlook

Vulnerabilities, risks and macroprudential policy

Main risks and vulnerabilities

Risks to financial stability largely arise from the potential consequences that geopolitical tensions and protracted tight monetary conditions may have on economic activity. In the last half of the year, there was a reduction in vulnerabilities as a result of improved economic conditions. Inflation is expected to continue its downward path and economic growth in Portugal should remain positive and above that of the euro area.

At international level, the tense geopolitical context, with ongoing military conflicts in Ukraine and the Middle East, weighs on international trade flows and has an impact on economic activity. The strategic security considerations that can support the economic and financial fragmentation of the global economy and jeopardise a more inclusive re-globalisation process are particularly noteworthy. In addition, there is a risk that the ongoing adjustment in the Chinese real estate market could have a more pronounced negative impact on its economy, with repercussions for the global economy.

Maintaining monetary conditions tight for longer and/or longer than anticipated effects impacts economic and financial conditions. The conduct of monetary policy should consider the synergies achieved through a global coordinated response, but it should also take into account the underlying reality in each economic area, which may require differentiated responses to reduce the risks of excessive tightening.

At national level, a scenario of heightened policymaking uncertainty stands out, within the framework of a new model for European budgetary rules, which will pose new challenges to fiscal policy.

A possible deterioration in macroeconomic conditions triggering abrupt corrections in financial asset prices could exacerbate risks to financial stability. Deteriorating economic conditions lead to a reduction in the value of assets and a worsening of the debt service of resident sectors, although mitigating factors, such as the reduction of indebtedness, have been consolidated in recent years.

Risks associated with the general government’s financial position of have been decreasing, driven by fiscal consolidation and the downward trend of the public debt-to-GDP ratio, as reflected in the Republic’s ratings upgrades. However, debt is still high. In this way, general government is exposed to persistently higher interest rates and volatility in international financial markets, which may spill over to other resident sectors by contagion in their risk assessments.

Firms have continued to improve their capital ratio and to reduce indebtedness. Corporate profitability has withstood the increase in debt servicing. In the past year, there has been no material increase in insolvencies and the quality of credit granted to firms has not deteriorated. In any event, the cumulative effect of maintaining high interest rates on economic activity and financing costs, together with possible increases in production costs and supply chain disruptions, could trigger the materialisation of credit risk, particularly for the most vulnerable firms.

Households also saw a decline in their indebtedness ratio, following a trend that started in 2010. The improvement in the risk profile of loans to households has benefited from the macroprudential Recommendation introduced in 2018, including limits to the debt service-to-income (DSTI) ratio as one of the criteria for approving new loans. Amid rising interest rates, household default mitigation has also benefited from a strong labour market and higher real disposable income.

A scenario of protracted tight monetary policy and worsening economic conditions may also lead to lower real estate market prices through their impact on demand. However, the effects on the Portuguese banking system should be contained. The share of banks’ housing loan portfolios with high loan-to-value (LTV) ratios is small, lessening the impact of a potential drop in house prices. In the commercial segment, the banking sector’s exposure is contained.

The international non-banking financial sector is exposed to risks inherent in its business model, where there are fewer liquidity instruments and backstops in stress situations. In Portugal, vulnerabilities did not build up in the sector.

The situation in the Portuguese banking sector has improved further, characterised by higher levels of capital, liquidity and profitability. It has been a source of stability, helping to ensure the regular financing of the economy.

Should adverse conditions materialise, including in economic activity, with implications for unemployment, credit quality may deteriorate. While the total non-performing loans (NPL) ratio continued to narrow in 2023, there was an increase in loans showing a significant increase in credit risk (stage 2 loans), notably in housing loans – mostly at a variable rate – reflecting an increase in credit risk associated with the higher debt service burden in the income of the most vulnerable households.

Preserving net interest income is key to sustaining organic capital generation, being the preferred means when setting capital buffers. In a context of lower interest rates and subsequent tightening of net interest income, Portuguese banks will need to be able to find mitigants due to its importance to the profit/loss structure.

Macroeconomic and market environment

In 2023 the Portuguese economy grew by 2.3% in real terms (9.6% in nominal terms) and the labour market remained resilient. After two quarters of stagnation, the Portuguese economy recovered in the fourth quarter, based on private consumption, which benefited from real wage growth, and exports, in a context of improved external demand and additional market share gains. The dynamics in the last quarter of the year largely justified the upward revision of the economic activity forecasts for 2024 from December 2023. The labour market remained resilient, with employment increasing and the unemployment rate remaining low at 6.5%, 0.4 p.p. higher than in 2022. Economic growth maintained a positive differential compared with the euro area, 1.8 p.p., reinforcing the convergence of the Portuguese economy (Table I.1.1).

The inflation rate declined over the course of 2023, reaching 1.9% in December (2.9% in the euro area) and resulting in annual inflation standing at 5.3% (-0.1 p.p. than the euro area). These developments largely reflected the strong increase in energy and food prices recorded in the previous two years fading-out. In early 2024, as expected considering the base events, inflation temporarily interrupted the downward trend, standing at 2.6% by the end of the first quarter, 2.4% in the euro area. Excluding food and energy, the HICP in Portugal reached a year-on-year rate of change of 3.2% in March (3.3% at the end of 2023), 0.2 p.p. higher than the corresponding rate for the euro area (a -0.1 p.p. difference in December 2023). Prices have been growing more significantly in recent months for the services component, in Portugal and in the euro area.

In Portugal, annual economic growth is expected to stand at 2.0% in 2024, 2.3% in 2025 and 2.2% in 2026, revised upwards from the end-2023 projections, mainly for 2024 (+ 0.8 p.p.). The Portuguese economy will continue to grow more than the euro area and close to potential. The projection incorporates the positive effects of lower inflation, the expansionary impact of the measures approved in the State Budget for 2024 and the projected acceleration in external demand. The financial implementation of the Recovery and Resilience Plan (RRP) and other European funds, as well as the gradual easing of monetary and financial conditions will also benefit economic activity. Against this background, the labour market is expected to maintain a favourable position, with increases in employment projected, after peaking in 2023, real wage increases and stable unemployment.

These developments should take place against a background of continuous fundamental macroeconomic equilibria, in terms of public and external accounts. The economy is expected to have an average lending capacity of 3.9% of GDP in 2024–26, the highest since the beginning of the euro area, reflecting the further reduction in resident sectors’ indebtedness.

Inflation is expected to continue to decline in Portugal to 2.4% in 2024 (revised downwards by 0.5 p.p. compared with the December projections), 2% in 2025 and 1.9% in 2026. In the euro area, the gradual reduction of cost pressures and the impact of the ECB’s monetary policy are anticipated to translate into additional reductions in inflation to 2.3% in 2024, 2.0% in 2025 and 1.9% in 2026, in line with the ECB’s medium-term price stability objective.

Risks to economic activity and inflation at international level are associated with persisting tight monetary conditions, with effects exceeding those anticipated by the authorities. Such tightening is conditioned by the greater than expected resilience of the US economy, which postpones the US Federal Reserve’s reduction of official interest rates, with an impact on exchange rates and international financing conditions. An increased differential between interest rates in the euro area and in the United States may facilitate the expansion of economic activity in the euro area but could lead to imported inflation via the exchange rate effect.

The persistence and the possibility of geopolitical tensions escalating, coupled with elections taking place throughout the year in several countries that are significant for the global economy, are another source of macroeconomic risk. In the short term, there may be an impact on international trade flows, also penalised by changes in the confidence of economic agents, and in the longer term, reinforce a trend of global economic and financial fragmentation. The shocks that may arise in this dominion could potentially constrain commodity prices and disrupt supply chains. They can give rise to inflationary pressures and affect economic activity at international level, making the conduct of monetary policy in major economies more complex and uncertain.

Conversely, confirmation of moderating wage growth and lower unit profits, as global demand slows down – for example with the possibility of a negative shock if China’s ongoing housing market adjustment has a greater impact on its economy as a whole – are expected to contain inflationary pressures.

At national level, there are risks associated with possible delays in implementing European funds and a scenario of greater uncertainty in the conduct of economic policy in the context of new European fiscal rules.

At its meeting on 11 April, the Governing Council kept key ECB interest rates unchanged and confirmed that they would stay at sufficiently restrictive levels for as long as necessary. The latest increase in key ECB interest rates took place in September 2023. The ECB will continue to follow a data-dependent approach to monetary policy decisions. Over the past few months, financial markets have been updating the expected future path of short-term interest rates, notably by lowering the expected rate cut. Investors’ expectations about interbank market interest rates, as implied by three-month EURIBOR futures, point to a reduction of approximately 60 b.p. between 15 May (the cut-off date for this report) and December 2024 (Chart I.1.1).

After a reduction in the last quarter of 2023, market financing costs for sovereigns and the private sector have increased slightly since the beginning of the year, while the spread vis-à-vis Germany narrowed somewhat (Chart I.1.2). Over the same period, yields on euro area non-financial corporate and bank bonds increased by 30 and 10 b.p. to 3.6% and 3.8% respectively.

Interest rate implied in three-month EURIBOR futures contracts | Per cent	Yields on 10-year sovereign debt (Portugal and Germany) and corporate and bank bonds in the euro area | Per cent
Source: Refinitiv (Banco de Portugal calculations). | Note: latest observation: 15 May 2024.	Source: Refinitiv. | Note: latest observation: 15 May 2024.

The expectation of an easing in global monetary policy contributes to an increase in investor confidence and a boost in risk appetite. The faster than expected gradual reduction in inflation has created expectations about benchmark interest rates beginning to decline. These developments contributed to an increase in investors’ risk appetite and consequently, to the recent better performance of riskier assets (Chart I.1.3). In the United States, the strong stock market performance in recent months has led to higher market concentration, with larger companies accounting for a historically high share of stock market capitalisation, raising concerns about the potential overvaluation of assets, in particular those related to artificial intelligence.

Low implied equity market volatility may be underestimating vulnerabilities and leading to excessive risk-taking. Since the beginning of 2023, US and European equity market volatility indices have remained slightly below their long-term averages, which may indicate a benign risk assessment by investors (Chart I.1.4). The low levels of volatility can be explained inter alia by: (i) the better protection that shares offer against inflation, (ii) the absence of economic contraction during the process of reducing inflation, and (iii) the assumption that central banks now have more scope to ease monetary policy in case of need (Financial Stability Review, May 2024, ECB). In bond markets, volatility has remained above the historical average, in line with investors’ reaction to developments in expectations regarding inflation paths and policy interest rates.

The possibility of abrupt corrections in the value of financial assets remains high, especially if there is a deterioration in macroeconomic conditions or a less predictable disinflation process. The price of some commodities, such as energy and oil, has been increasing since the beginning of 2024 reflecting tensions in the Middle East. These developments may lead to sharper repricing of financial assets, notably if market expectations change about monetary policy easing.

Yields by asset class        | 16-11-2023 – 15-05-2024	Equity and debt market volatility | Deviations from long-term averages (points)
Source: Refinitiv. | Notes: BTC and ETH refer to cryptocurrencies Bitcoin and Ethereum, S&P500, STOXX EUROPE 600 and FTSE All World to US, European and global stock market indices, High yield bond to index iBoxx EUR Liquid High Yield.	Source: Refinitiv. | Notes: Option-implied volatility. “VSTOXX” refers to Euro Stoxx 50, “VIX” to S&P500, “MOVE” to the US Treasury curve. Latest observation: 15 May 2024.

Sectoral risk analysis

General government

In 2023 public debt reached 99.1% of GDP, having fallen by 13 p.p. since 2022. This stemmed from a combination of a reduction in public debt (-4 p.p.) and, as in the two preceding years, a positive change in GDP (Chart I.1.5). Considering public debt net of deposits, it decreased by 12 p.p. from 2022 to 95% of GDP. At the end of 2023, government deposits reached 4.3% of GDP, similar to the level seen prior to the international financial crisis, accounting for a 1.4 p.p. decrease from the end of 2022.

The public debt ratio is expected to decline further in the coming years, helping to reduce the country’s vulnerability to adverse shocks and to improve external financing conditions. In its April 2024 projections, the International Monetary Fund (IMF) anticipated further reductions in the ratio over the coming years, dropping to levels below the euro area average from 2026 onwards (Chart I.1.6).

Portuguese public debt ratio	IMF projections for public debt developments | As a percentage of GDP
Sources: Banco de Portugal and Statistics Portugal.	Source: IMF. | Note: April 2024 projections.

The cost of new public debt issuance has doubled since 2022, reaching 3.5% in 2023 (Chart  I.1.7). The cost increase was broadly based across the main instruments issued, notably Treasury bills and Treasury bonds. However, the pass-through of rising interest rates on new issuances to total interest expenditure was contained, with the cost of debt stock edging up from 1.7% to 2.1%. This reflected the large amount of stock issued at fixed rates and the average maturity of debt, which remained slightly above seven years. Medium and long-term debt issuances had an original maturity of more than 15 years. At the end of March 2024, debt redemptions still scheduled for 2024 represented 2.5% of total debt stock. For 2025 and 2026, scheduled medium and long-term debt redemptions amount to around 8% of the stock (€18 billion) each year and remain in line with previous years. This profile reflects the Portuguese Treasury and Debt Management Agency’s efforts to smooth the time profile of maturities by avoiding excessive concentrations and, therefore, minimising refinancing risk. This becomes increasingly important at a time when a growing share of debt is expected to be placed in international markets, as the reduction of the Eurosystem’s balance sheet proceeds. At the end of 2023, the Eurosystem maintained 32.1% of the national sovereign debt stock (Chart I.1.8), as a result of non-standard monetary policy operations, intensified with the pandemic emergency purchase programme (PEPP).

Cost and maturity of Portuguese public debt	Structure of Portuguese public debt holders | Per cent
Sources: Banco de Portugal, Portuguese Treasury and Debt Management Agency and Statistics Portugal. | Notes: The implicit average cost of the debt stock corresponds to the ratio of interest expenditure to average debt stock. The cost of debt issued in each period is weighted by amount and maturity and includes Treasury bills, Treasury bonds, floating rate Treasury bonds and medium-term notes issued in the corresponding year. The average maturity of issued medium and long-term debt domain includes Treasury bonds and medium-term notes issued in the corresponding year.	Sources: ECB, Banco de Portugal and Portuguese Treasury and Debt Management Agency . | Note: End-of-period data.

Notably, the Portuguese Republic’s credit rating was upgraded by all major international rating agencies. In early March 2024, S&P Global Ratings raised its long-term credit ratings from ‘BBB+’ to ‘A-’.

Risks associated with the performance and financial position of the general government have been receding. However, debt remains high and is comparable to 2010 levels despite a very different fiscal balance landscape. As such, despite the public debt adjustment observed over the last decade, only disrupted by the budgetary and economic consequences of the COVID-19 pandemic, its high level exposes governments to fluctuations in the international financial market sentiment. However, there are some mitigating factors, such as the longer maturity of the debt securities portfolio, as well as the stabilising role of the ECB, in particular via its new Transmission Protection Instrument.

The possibility of a more adverse macroeconomic environment associated, for instance, with maintaining a tight monetary policy for longer than currently anticipated, would amplify servicing debt costs. Risks associated with developments in economic activity and possible increases in public expenditure are a source of additional pressure. Managing these aspects should follow an intertemporal sustainability approach and consider the recently revised EU fiscal rules. Reducing public debt further is therefore important for economic growth dynamics and its resilience, in a context where interest rates are expected to exceed those prevailing before the pandemic. The other resident sectors of the economy are subject to spillover effects from the Republic’s risk on their risk assessments.

Households

Household disposable income grew further, supported by a strong labour market. Nominal disposable income rose by 6.5% (8.2% in 2022), reflecting the contribution from the compensation of employees (Chart I.1.9). Continued employment and real wage growth has contributed to an improvement in households’ financial situation, with increases in real disposable income over the past three years (1.9% in 2023).

Changes in household nominal disposable income and contributions | Per cent and percentage points
Sources: Banco de Portugal and Statistics Portugal. | Note: (a) Net of transfers in kind.

In 2024 household income is expected to continue to evolve favourably. In particular, against the background of a decline in inflation, real disposable income is estimated to grow by 4%, reflecting wage growth and contained unemployment.

The saving rate has remained at historically and internationally low levels, standing at 6.3% of disposable income (Table I.1.2). Households have continued to prefer to invest in real assets, largely in housing, with this investment amounting to 5.3% of disposable income (5.8% in 2022). The purchase of financial assets decreased to 1.4% of disposable income (4.4% in 2022) and was based on a significant reallocation of investment in deposits towards savings certificates, concentrated in the first two quarters. Investment in savings certificates totalled €10.2 billion and accounted for 5.8% of disposable income (compared with 2.7% in 2022, concentrated in the fourth quarter). Household net lending amounted to 1.5% of disposable income (0.9% in 2022) and the saving rate was below the peak observed during the pandemic and is still below that observed in the pre-pandemic period.

The household indebtedness ratio narrowed further. In the fourth quarter of 2023, household indebtedness was 85% of disposable income (Chart I.1.10). These developments reflected an increase in nominal disposable income and a slowdown in lending to households (Section 2.2). The household indebtedness ratio has declined considerably since 2010, falling below the euro area average since 2019 and now standing close to 2001 levels. This reduction was broadly based across all income brackets, but more marked for lower-income households. In Portugal, the share of loans for house purchase in household disposable income is below the euro area average (58% in Portugal and 62% in the euro area in the third quarter of 2023) (Chart I.1.11).

Household indebtedness ratio | As a percentage of disposable income	Ratio of the stock of loans for house purchase to disposable income | Per cent
Sources: Banco de Portugal and Eurostat (Banco de Portugal calculations). | Notes: Non-consolidated figures for total debt. The shaded area corresponds to the range between the third and the first quartiles of the distribution for a set of euro area countries (Belgium, Germany, Ireland, Spain, France, Italy, Netherlands, Austria, Portugal, Slovenia and Finland).

Developments in interest rates resulted in a relevant rise in the debt service burden of loans for house purchase for the majority of indebted households, with an increase in the loan-service-to-income (LSTI) ratio, which measures the value of the instalment as a percentage of income. The average interest rate on the stock of loans for house purchase has increased significantly since 2022, reaching 4.7% at the end of 2023, a peak since 2009 (Chart I.1.12). In this context, there was an increase in the share of agreements with an LSTI of over 50%, which was sizeable in the case of lower-income households, at which exceptional government support measures were specifically targeted. It is worth noting that the share of lower-income households in the stock of loans for house purchase is currently low, in line with other euro area countries. In August 2023, agreements in the 1^st income quintile accounted for only 9% of the stock of loans for house purchase in Portugal. Nearly 70% of agreements are likely to have continued to have an LSTI of 30% or less (Table I.1.4, Financial Stability Report, November 2023).

Household credit risk did not entirely materialise. Rapid interest rate rises notwithstanding, the NPL ratio in loans to households was relatively stable, despite an increase in the ratio of stage 2 loans by 2.2 p.p. in 2023, helped by resilient employment and real disposable income, renegotiations and government support measures (Chapter 2). The improvement in the risk profile of new borrowers, as a result of the macroprudential Recommendation introduced in 2018 relating to new credit for house purchase and consumer credit, has also helped mitigate households’ default.

The reduction in short-term interest rates and in the inflation rate, combined with a strong labour market, will contribute to keeping households’ default contained. Prospects of a gradual reduction in Euribor rates over 2024 and 2025, following 4.6/4.7 p.p. increases across maturities between the end of 2021 and October/November 2023 (Chart I.1.13), anticipates an improvement in households’ ability to service debt. The share of new loans with interest rate fixation increased from 17% in 2022 to 47% in 2023, thereby reducing uncertainty around the value of debt servicing. The concentration of loans for house purchases and, to a lesser extent, consumer credit in higher-income households, which can more easily accommodate higher loan instalments, helps mitigate the risk of households defaulting. However, the potential materialisation of a more adverse economic scenario, particularly on the back of rising unemployment, and the maintenance of high interest rates for longer than currently anticipated may reduce households’ ability to service their debt, thereby enhancing a greater materialisation of credit risk.

Developments in the average interest rate on the stock of loans for house purchase | Per cent	Market expectations for developments in Euribor rates | Per cent
Source: ECB (Banco de Portugal calculations). | Notes: The shaded area corresponds to the range between the 10th and 90th percentiles of the distribution for a set of euro area countries (Belgium, Germany, Ireland, Spain, France, Italy, Netherlands, Austria, Portugal, Slovenia and Finland). Latest observation: December 2023.	Source: Refinitiv (Banco de Portugal calculations). | Notes: Information up to April 2024 refers to hard data. From May 2024 onwards, the series refer to market agents’ expectations as at 15 May 2024.

Non-financial corporations

The financial indicators of non-financial corporations (NFCs) have continuously improved since the sovereign debt crisis, with a notable increase in their capital ratio (i.e. share of assets financed by equity). This trend is common to all sectors of activity (Chart I.1.14). Particularly noteworthy are developments in the capital ratio of small and medium-sized enterprises, increasing by 19 p.p. since 2012, compared with the relative stability of large enterprises, whose ratio grew by 3.8 p.p. in the last quarter of 2023.

NFCs’ capital ratio in Portugal | Per cent
By sector of activity	By enterprise size
Source: Banco de Portugal. | Notes: The capital ratio measures the percentage of firms’ assets financed by equity. A higher capital ratio hints at an increase in corporate capitalisation. The dotted line corresponds to total NFCs. Quarterly economic and financial indicators of firms in the Central Balance Sheet Database are used. The quarterly ratio corresponds to the value obtained for the year ending in the quarter. Latest observation: December 2023.

Firms’ return on assets remained high, despite interrupting the upward path followed since 2012 and only disrupted by the pandemic crisis in 2020. Return measured by EBITDA amounted to 9% of assets, down by 0.2 p.p. from 2022 (Chart I.1.15).

Return and financing costs: by sector of activity | Per cent
NFCs’ return on assets (a)	Cost of obtained funding (b)
Source: Banco de Portugal. | Notes: (a) Average return on assets defined as the ratio of EBITDA to average assets for the period. EBITDA is an acronym for earnings before interest, taxes, depreciation and amortisation. (b) The costs of obtained funding include costs associated with bank loans, debt securities and other loans. Quarterly economic and financial indicators of firms in the Central Balance Sheet Database are used. The quarterly ratio corresponds to the value obtained for the year ending in the quarter.

These developments come amid a slowdown in economic activity in Portugal and mainly in its trading partners. The turnover of industry index decreased by 3.3% in 2023. However, in line with the momentum in tourism, this index increased by 9.9% in services. Across sectors of activity, the 6.6% increase in unit labour costs in 2023 (0.5% in 2022) contributed to a decrease in NFC’s return on assets. Nevertheless, developments in production costs were heterogeneous across sectors, with the industrial producer price index remaining stable and the construction cost index increasing by 3.9% on average in 2023.

The increase in market interest rates was almost fully passed through to firms’ financing costs, which rose from a low of 2.7% in the year ending in March 2022 to 4.0% in December 2023. The predominance of variable rate loans and refinancing fostered the pass-through of rising market interest rates to financing costs. Any future replacement of fixed rate loans taken out in the period prior to the first increase in interest rates will lead to an additional impact on firms’ financing costs (Chart I.1.16).

Characterisation of the stock of loans to NFCs | Per cent
By benchmark rate (Dec. 23)	By residual maturity and type of rate
Source: Banco de Portugal. | Notes: Exposure to loans to NFCs according to the Central Credit Register. In some breakdowns, the total may not add up due to rounding.

The financing expenses coverage ratio (FECR) fell, but to levels still above pre-pandemic levels. On average, the EBITDA covered eight times the firms’ financing expenses (compared to ten times in 2022). Despite this decrease, the FECR broadly remained higher than in 2019, except in industry and trade, where the decline was most marked (-5). The only sector where this ratio increased was electricity, gas and water (+3), where profitability gains more than offset the rising cost of obtained funding.

The 1.3% increase in total debt in 2023 reflected lending by non-residents. As in previous years, external credit was concentrated in a small number of firms with access to this type of financing. The change in loans obtained from the resident financial sector was virtually nil (Chart I.1.17).

The indebtedness ratios, gross and net of deposits, narrowed respectively by 6.7 p.p. and 3.0 p.p. from 2022, to stand at 82.3% and 55.5%. Given the rise in debt, nominal GDP growth made the largest contribution to this. Firms’ deposits decreased by 3.8%. Nevertheless, the amount of deposits held by NFCs remained higher than in 2019 (+43%) (Chart I.1.17).

Developments in total debt and indebtedness ratios, gross and net of deposits
Contributions to the change in total debt (a)	Developments in the ratio of indebtedness net of deposits (b)
Source: Banco de Portugal. | Notes: Consolidated figures. (a) The NFCs’ debt-to-GDP ratio is shown at the top of each bar. (b) The ratio of indebtedness net of deposits corresponds to the ratio of NFC total debt less deposits to GDP. (c) External credit includes liabilities on account of loans and debt securities held by non-residents. (d) Includes debt securities held by residents, credit written off from assets in the balance sheet of resident monetary financial institutions, loans from households, trade credits and advances and other changes in volume and value.

The average leverage ratio, measuring the share of debt in total equity and financial debt, decreased in 2023 to 41.3% (42.2% in 2022), thereby confirming the positive developments in the position in relation to the euro area. There was also a convergence in terms of developments in the indebtedness ratio, measured as a percentage of GDP, which dropped from 89% in 2022 to 82% in 2023 (Chart I.1.18).

Developments in the financing structure in Portugal and in the euro area (a)
Leverage ratio (b)| Per cent	Indebtedness ratio (c)| As a percentage of GDP
Sources: Banco de Portugal and Eurostat. | Notes: (a) Consolidated figures. Latest observation for Portugal: December 2023. The euro area series is released annually. Latest observation for the euro area series: December 2022. The shaded area represents the interquartile range, calculated based on the distribution of leverage ratios of NFCs in euro area countries, i.e. it corresponds to the area defined by the value of the country identified as in the 75th percentile and the value of the country identified as in the 25th percentile. (b) Leverage ratio defined as the ratio of financial debt to the sum of equity and financial debt. The value of financial debt corresponds to the stock of loans and debt securities, while the value of equity corresponds to the stock of shares and other equity (liabilities) of NFCs. (c) The indebtedness ratio corresponds to the ratio of the country’s total debt to GDP. Figures are calculated on the basis of the National Financial Accounts. Quoted financial instruments, according to the National Account methodology, are measured at market value.

The reduction in structural vulnerabilities of Portuguese NFCs has resulted in greater resilience to the shocks to which economies have been subject in recent years, and systemically relevant risks to the Portuguese financial system have not materialised. In particular, there was no material increase in the number of insolvencies declared by NFCs (+73, totalling 473), remaining below the average in 2018-19 (558). Similarly, the quality of bank lending to firms has not deteriorated (Section 2.3).

Nevertheless, firms’ activity and their financial situation may be affected by the cumulative effect of maintaining high interest rates on economic activity and financing costs, together with possible increases in production costs and/or supply chain disruptions. For firms that are most vulnerable or more exposed to specific shocks, these developments may lead to the materialisation of defaults. The share of financially vulnerable firms (with a FECR below 2) is estimated to have increased in 2023 and to stabilise at around 18% in 2024, albeit to below sovereign debt crisis levels (around 29%). Sectoral heterogeneity in the share of vulnerable firms, higher in construction and real estate activities (Box 2), as well as within each sector, warrants close monitoring of these firms’ financial situation by credit institutions.

Residential and commercial real estate market

Residential real estate market

House prices have started to fall in the euro area. Residential real estate prices fell by 1.1% in the euro area in 2023, the first price correction since 2013. Some countries saw sizeable corrections, such as Germany and Finland, where the prices of dwellings fell by 8.4% and 5.6% respectively. In other countries, like Croatia and Portugal, house prices continued to rise by 11.9% and 8.2% respectively. The reduction in the number of transactions in dwellings was broadly based across countries (Chart I.1.19). While house prices and the number of transactions grew across the majority of countries in 2021, most countries saw a reduction in the quantity of dwellings traded already in 2022, despite the continued increase in prices. In 2023, there was a market adjustment and the fall in the number of transactions in dwellings was accompanied by a correction in prices (Charts I.1.20 and I.1.21).

Price index and number of transactions in dwellings in the euro area | Per cent
Source: Eurostat. | Notes: The chart includes only euro area countries for which comparable information on house prices and transactions is available (Belgium, Denmark, Ireland, Spain, France, Luxembourg, Netherlands, Austria, Slovenia and Finland). Each point in the chart corresponds to one country.

House prices grew by 8.2% in Portugal, 4.4 p.p. less than in 2022. Following quarterly growth of 3.1% in the second quarter of 2023, prices decelerated in the second half of the year (quarter-on-quarter rate of change of 1.8% and 1.3% in the third and fourth quarters). The price of existing dwellings rose by 8.7%, above that for new dwellings (6.6%).

136,499 dwellings were traded, totalling €28 billion and accounting for decreases of 18.7% and 11.9% respectively compared to 2022. The fall in the number of transactions was more marked for existing dwellings, at 21.4% (down by 16.5% in value) than for new dwellings (6.1%, up by 2.6% in value). Transactions in existing dwellings accounted for 80% of total transactions in dwellings. Typically, the price and quantity traded in that market change more sharply than those of new dwellings.

Price index and number of transactions in new and existing dwellings | Per cent	Changes in prices and in transactions in dwellings – total | Per cent
Source: Statistics Portugal.	Source: Statistics Portugal.

The median value of transactions in dwellings increased further. In the fourth quarter of 2023, the median value per square metre rose by 7.9% year on year in Portugal, 7.5% in the Lisboa Metropolitan Area (LMA) and 7.7% in the Algarve. The LMA and Algarve regions have the highest median housing value, exceeding that associated with the 3^rd quartile of sales at national level. The median value of bank appraisals on housing also increased further, by 5.3% at the end of 2023.

The average time it takes to sell real estate properties stabilised at around six months. New dwellings, often placed on the market early in construction or at the design stage, have longer absorption time than existing dwellings (in 2023, 11 months compared with five months), albeit decreasing slightly in recent quarters (Chart I.1.22). Up to 2021, the number of available-for-sale dwellings followed a downward trend, most notably used dwellings. In 2022 and 2023, there was an increase in the number of listed dwellings (around 5,000 dwellings per year), helped by a reduction in residential real estate transactions (Chart I.1.23).

Absorption time | In months	Number of listed dwellings | Thousands
Source: Confidencial Imobiliário (Banco de Portugal calculations). | Notes: This data includes only transactions carried out through real estate agents. Absorption time is the average number of months between placing on the market and trading.	Source: Confidencial Imobiliário (Banco de Portugal calculations). | Note: This data includes only real estate placed on the market through real estate agents.

Supply developments were constrained by low construction activity during the years following the great financial crisis, restricting housing stock growth. After the sharp decline during the financial crisis and the sovereign debt crisis, the number of household dwellings built per year has been slowly increasing. 277 thousand new dwellings were built between 2007 and 2014, amid a marked loss in momentum in licensing and construction. Between 2015 and 2023, despite the gradual recovery in market activity, 125 thousand new dwellings were constructed. The licensing and construction of new household dwellings accelerated in 2023, increasing by 6% and 7% respectively (after 3% in licensing and construction in 2022) (Chart I.1.24). However, the rebound in construction activity has been slow and the number of new completed dwellings is still limited, despite the growth path followed since 2016.

Real estate market prices also reflect the still high construction costs. Between December 2019 and December 2023, the cost of construction materials and labour rose by 26% and 25% respectively. However, the construction materials cost index started a downward trend in mid-2022, decreasing by 2.2% in 2023 (Chart I.1.25). In turn, labour costs rose further, by 7.3, % in 2023, in line with the increase observed in previous years.

Licensed and concluded dwellings | Thousands	Index and year-on-year change in construction costs | As an index 2021=100 and per cent
Source: Statistics Portugal. | Note: Household dwellings in new buildings.	Source: Statistics Portugal.

In recent years, construction activity has been constrained by labour shortages. According to the survey of obstacles to construction activity, half of the responding construction firms reported obstacles to activity and 30% of firms reported difficulties in recruiting staff. Construction activity is still constrained by a lack of materials, dampened in 2023. The share of firms that report difficulties in obtaining credit and dealing interest rate levels has remained contained. Finally, firms in the sector report a slight increase in difficulties in obtaining construction permits.

Over the past years, the increase in the participation of non-resident buyers has driven the residential real estate market in Portugal. Portugal’s geographical location and its safety and stability support demand from non-residents and foreign citizens residing in Portugal. The growth of the foreign population residing in Portugal, which increased from approximately 400 thousand people in 2016 to nearly 800 thousand in 2022, has had an impact on house prices.

In 2023, non-resident residential real estate buyers accounted for 8% of the number of transactions and 13% of their amount. The number of transactions by non-residents dropped by 3%, with a decrease in buyers from other EU countries (-14%) and an increase in buyers from outside the European Union (Chart I.1.26). In 2023, the average transaction value for non-resident buyers was €343 thousand, 77% higher than that for resident buyers (€194 thousand). The average transaction value of buyers from outside the European Union was €405 thousand, significantly higher than the €277 thousand spent by buyers from other EU countries.

The weight of non-resident buyers is very significant in the Algarve, the Norte region and the LMA. House purchases by non-resident buyers were mostly in Algarve (29.9% of the total), followed by the Norte region (17.5%) and the LMA (15.6%), contributing to higher price growth in these regions and to a higher median housing value.

Foreign direct investment (FDI) in (residential and commercial) real estate totalled €3.9 billion, up by 22% from 2022 (up by 49% between 2021 and 2022), with the most notable investors coming from the United Kingdom (12%), the United States (10%), China (9%) and France (9%). In the case of residential real estate, non-resident buyers in the Lisbon urban rehabilitation area accounted for 33% of the number of transactions in dwellings and 41% of the amount invested. Notable from outside the European Union are US (16% of real estate purchases by foreign citizens), UK (9%), Chinese (8%) and Brazilian buyers (6%) and, from within the European Union, French (13%) and German buyers (5%). UK and US buyers increased their investment compared to 2022; the other nationalities mentioned reduced the number and value of transactions, particularly Chinese buyers, who reduced the amount invested in house purchases by 46%.

Total transactions in dwellings in Portugal and share of non-residents
Source: Statistics Portugal. | Notes: Including transactions by natural and legal persons. The term “non-residents” refers to citizens having their tax domicile outside Portugal. In the case of natural persons, the tax domicile is the place of habitual residence. In the case of legal persons, the tax domicile is the place of the head office or effective management or, in the absence thereof, their permanent place of establishment in Portugal.

There are signs of overvaluation in the Portuguese residential market. Statistical indicators remained above the values taken as a benchmark to signal potential episodes of overvaluation. The ratio of the house price index to household income was, in the third quarter of 2023, 23% above its long-term average while the price-to-rent ratio stood 29% above that average (Chart I.1.27). The real house price index is also above its long-term trend: 16% higher at the end of 2023 (Chart I.1.28). Likewise, two models based on macroeconomic determinants point to some overvaluation in the residential real estate market (Chart I.1.29).

However, these estimates should be interpreted with special care due to methodological limitations and consequent uncertainty associated with the results. In particular, they might not appropriately capture the participation of non-residents in the market and the role played by tourism in determining housing supply and demand. Both have been key factors to price developments in this market over the past few years. The Google search-based housing demand indicator presented in Box 1 can be used as an additional house price assessment tool.

The share of transactions financed with recourse to credit stood at 46% in 2023, similar to the average in 2018-23 (Chart I.1.30). This indicator stood at 76% in the period before the sovereign debt crisis. In 2023, there was a substantial volume of credit transfers between institutions (Section 2.2), accounted for as new loans for house purchase by home credit institutions. This increase in transfers is the result of legislative measures that facilitated early repayments of loans for house purchase amid rising interest rates. The impact of these loans transferred from one institution to another is estimated at 13 p.p., i.e. excluding renegotiations and transfers, the share of new transactions financed with recourse to credit is estimated to have stood at 33%.

Transactions in dwellings financed with recourse to credit | Per cent
Sources: Banco de Portugal and Statistics Portugal. | Notes: Information available up to December 2014 does not make it possible to isolate new loans associated with renegotiations. However, these loans are estimated to account for a residual share of the total volume of new business and therefore have no impact on the historical comparison presented. In turn, neither is it possible to isolate the impact of credit transfers between banks up to 2022. Latest observation: 2023 Q4.

Since 2016, house prices have almost doubled, while the stock of loans for house purchase has grown moderately, by 5%. Marked house price growth makes the banking system and the economy more vulnerable to a price correction in this market. In Portugal, however, the effect is mitigated by more moderate growth in the stock of loans for house purchase.

The limited supply of new dwellings and the likewise limited accumulated stock of available dwellings mitigate the impact on prices if demand wanes. The banking sector’s exposure to the construction sector is also limited. In 2023, the stock of loans to construction accounted for 9% of total loans to NFCs, in contrast with a share of 23% in 2009.

According to the survey of residential real estate agents and promoters,¹ expectations regarding house sales and demand recovered in 2024, after a compression trend in 2023. The expectation of a rebound in sales is accompanied by an expectation that residential real estate prices will continue to rise throughout 2024.

Commercial real estate market

In 2023, global commercial real estate prices were adjusted downwards, in response to rising financing costs and new remote working models. In the euro area, the prices of these assets decreased by 8.2% (after 1.5% in 2022), even falling by around 11% in France, Ireland as well as the United States. These developments were broadly based, with the exception of Portugal (Chart I.1.31).

Changes in the Commercial Property Price Index | Per cent
Source: Morgan Stanley Capital International (MSCI).

In contrast to the euro area, commercial real estate prices in Portugal remained resilient across segments, growing by 1.2% in 2023 in aggregate terms (2.5% in 2022). The shortage of quality supply has been identified by market participants as the main factor supporting increase in value in Portugal. In the euro area, by contrast, supply shortages are less severe and all market segments have experienced a devaluation (Chart I.1.32). The retail segment grew by 1.9% in Portugal and contracted by 5.2% in the euro area. Despite rising interest rates, private consumption growth has helped support the momentum in this segment. The latter has remained attractive to investors and its yields have risen. In the office segment, devaluation reached 11% in the euro area, while in Portugal the valuation of assets accompanied by a slowdown in activity in terms of transactions was maintained due to a mismatch between supply and demand, the latter targeting high-quality assets in prime areas. Also in the industrial and logistics segment, prices remained robust owing to supply shortages, while in the euro area they decreased markedly, by 5.9%. Finally, in the accommodation segment, growth remained strong, at 4.6%, linked to the momentum of and favourable outlook for the tourism sector.

Changes in the Commercial Property Price Index by segment | Per cent
Source: Morgan Stanley Capital International (MSCI).

In 2023, the share of investors assessing commercial real estate in Portugal as expensive or very expensive increased.² There was, however, a recovery in confidence for investment in this sector, with fewer investors considering that the commercial real estate market in Portugal is in a contractionary stage (Chart I.1.33). In some euro area countries, reflecting the price correction in 2023, the share of investors assessing commercial real estate as being expensive or very expensive has declined, with the share of investors assessing that the market is contracting also decreasing.

Views from market participants as to commercial real estate prices | Per cent
Sources: Global Commercial Property Monitor, Royal Institution of Chartered Surveyors – RICS. | Notes: Data for the fourth quarter of 2023. For Portugal, the figures for the fourth quarter of 2022 are also included.

Investment in the commercial real estate market totalled €1.7 billion, the lowest figure since 2016 and a 50% reduction from 2022. Investment in the Portuguese commercial real estate market is dominated by non-resident investors, mostly institutional investors, which accounted for 70% of the total amount invested (80% in previous years). This renders the market more sensitive to international developments. The market is also characterised by a concentration of amounts invested in a relatively limited number of very high-value real estate assets.

The banking sector’s exposure to commercial real estate is limited, both in comparison to other countries and with the exposure of the residential real estate sector. Loans to firms secured by commercial real estate are concentrated in SMEs and spread across sectors of activity. In many cases, the property securing the loan is a property owned by the firm to carry out its business and not as a real estate asset held from an investment perspective to generate income from rental or sale (Box 2). In addition, capital requirements for this type of credit are higher than those for credit secured by residential real estate, which will tend to mitigate the impact of any adverse market developments on banks. In September 2023, loans to NFCs secured by real estate accounted for 30% of total loans to NFCs on a consolidated basis, the fourth lowest figure for known data in the euro area (Chart I.1.34).

Loans to NFCs secured by real estate in Portugal and in the euro area – September 2023 | As a percentage of total loans to NFCs
Sources: ECB and Banco de Portugal. | Notes: Consolidated data. Ratio obtained from figures net of impairments. Includes loans to NFCs secured by (commercial or other) real estate. Data not available for Spain or Ireland.

Total assets of real estate investment funds (REIFs) accounted for 7.3% of GDP at the end of 2023, below the euro area, at 8.9%, with 68% of the shares issued by REIFs relating to closed-ended funds, with lower liquidity risk. Risks related to REIF exposure to the commercial real estate market are assessed as low (Box 2, Financial Stability Report, November 2023).

The evidence does not indicate an increase in risks and vulnerabilities in the commercial real estate market in Portugal. Given the banking sector’s limited exposure to commercial real estate, adverse developments in this sector have a small impact on the stability of the financial system.

Non-banking financial sector

The downward trend in the share of non-bank financial sector assets and in interlinkages between sub-sectors of the financial sector continued (Chart I.1.35). Investment funds and insurance corporations and pension funds (ICPFs) stand out in terms of interlinkages, as deposits and debt and equity securities issued by banks account for a sizeable share of these entities’ assets. As institutional investors pooling and channelling funds from savers, they reduce risk by diversifying investments. This is how exposures to the banking sector come to be predominant among interlinkages between sub-sectors of the financial system.

The relative importance of the ICPF sector has decreased over time, due to the reduction in assets under management associated with life insurance products and, to a lesser extent, with pension funds, only partially offset by the increase in non-life insurance business. From the onset of the pandemic crisis in 2020 onwards, exceptional regimes have lifted the loss of tax benefits associated with the early redemption of specific retirement savings plans (PPR, in the Portuguese acronym), with an impact on this activity. In 2023, developments in the assets of ICPFs were strongly influenced by the extinction of the Caixa Geral de Depósitos Employees’ Pension Fund, whose assets and liabilities were absorbed by social security funds.

Relative size and interlinkages in the financial system, in Portugal and in the euro area
Sources: ECB and Banco de Portugal. | Notes: Non-consolidated figures. The following were considered in the calculation of financial assets: deposits, debt securities, loans, shares and other investment fund units and listed shares. In the case of banks, the latest figure for financial assets as a percentage of GDP available for the euro area refers to December 2022.

In the euro area, during the period of very low interest rates, vulnerabilities to adverse shocks in the non-bank financial sector built up. Until 2022, the very sharp growth of this sector, in particular investment funds, was accompanied by higher risk-taking in terms of asset quality and investment maturity. In some cases, leveraging has also increased, either directly or via the derivatives market, while liquidity buffers have not been strengthened.

In this context, high interest rates have reduced incentives for excessive risk-taking, associated with lower risks and vulnerabilities to financial stability, despite transition risks. However, keeping rates unchanged for longer than expected and an unanticipated pace of withdrawal of non-standard monetary policy measures can lead to higher financial market volatility and to credit risk materialisation, affecting the asset portfolios of these intermediaries. The key risk drivers for the euro area also include a growing concentration of exposures to equity securities by increasingly fewer issuers. This will make it more possible for episodes of idiosyncratic weakness to become systemic.

In Portugal, there is no evidence of a build-up in vulnerabilities. Also, the balance sheet has not grown exponentially nor have asset maturity or leveraging increased. Nevertheless, the Portuguese non-bank financial sector is exposed to contagion risks should risks in this sector materialise in the euro area.

In the longer term, the activity and intermediation capacity of these sub-sectors may decrease somewhat, if the remuneration of savings in investment funds, pension funds or life insurance products fails to be attractive. Changing circumstances, among other aspects, in terms of taxes or funding of reforms may contribute to these investments becoming less attractive. In addition, the currently low household saving rate tends to limit new subscriptions, which may pose challenges to liquidity management.

Investment funds

The stock of shares/units issued by investment funds rose by €3.9 billion in 2023, totalling €40 billion (15% of GDP) in December. This change was mainly due to the increase in the value of existing shares/units (€2.1 billion) and the reclassification of NFCs in the real estate sector into REIFs, with an impact of €1.9 billion. As regards securities investment funds (SIFs), value losses recovered somewhat.

The amortisation and redemption of shares/units issued by investment funds were close to the amount of subscriptions. Securities investment funds (bond, equity, mixed and other) remained fairly buoyant, with positive net subscriptions, while REIFs had negative net subscriptions but continued to be the most prominent investment policy (36% of the total shares/units issued in December 2023) (Chart I.1.36). The increase in the stock of shares/units in 2023 contrasts with the reduction seen in 2022, when there were sizeable negative transactions, most notably for REIFs and bond funds.

Total shares/units issued by investment funds: stocks, transactions and other changes, by type of fund | EUR billions
End-of-period positions	Transactions and other changes in value and price
Source: Banco de Portugal. | Note: ‘OCVP’ refers to other changes in value and price; including appreciation/depreciation, reclassifications and other changes in volume not explained by transactions.

Households continue to be the main investor sector in investment funds. Households held 50% of the value managed by REIFs and 92% of that managed by SIFs. By contrast, the financial sector’s exposure to these assets has been declining, to stand at 14%.

Commercial real estate is the main asset in REIF portfolios. Assets in this segment totalled €9.5 billion of investment (or 75% of real estate assets in the funds). Unlike in the euro area, this real estate segment has not depreciated (Real Estate Section). The occupancy rate of real estate in the funds’ portfolio remained above 85% in December 2023.

Any price corrections in the real estate market, particularly in the commercial market segment, could put pressure on the liquidity of REIFs. Nevertheless, in the Portuguese market some factors mitigate liquidity risk materialisation among REIFs. Closed-ended funds, which are less exposed to this risk, account for more than 60% of shares/units issued. The liquidity ratio of open-ended REIFs has been increasing, standing slightly below the euro area average, with residual debt financing. In addition, existing redemption fees discourage a massive withdrawal of capital (Box 2, Financial Stability Report, November 2023).

Insurance corporations and pension funds (ICPFs)

Liabilities of insurance corporations and pension funds in the form of technical reserves decreased by 3.7%.³ In the insurance sector, gross written premiums declined by 1.9% compared to 2022, while amounts paid rose by 12.1%. Written premiums in life insurance decreased by 14.3% and contributions to pension funds fell by 32%. In turn, written premiums in non-life insurance rose by 10.4%, reflecting the increase in economic activity and prices.

Developments in life insurance and pension funds were largely driven by the dynamics of the PPR market. Early redemptions increased by 57.2% in 2023, benefiting from the measure that lifted the tax burden levied on the early redemption of these instruments if the funds withdrawn were used to repay loans for house purchase. Subscriptions fell by 5.3%, which may be explained by the higher return on alternatives for investing savings (Section 1.3.2).

The asset portfolio of insurance corporations decreased by 0.7%, while that of pension funds fell by 11.2%, according to the Insurance and Pension Funds Supervisory Authority. Had the Caixa Geral de Depósitos Employees’ Pension Fund not been terminated, it would have increased by 5%.

Insurance corporation and pension fund assets are highly exposed to sovereign and private debt markets and to investment fund shares. In December 2023 the share of private and public debt in the investment portfolios of insurance corporations and pension funds accounted for 62% and 50% respectively (Chart I.1.37). As of 2021, insurance corporations’ exposure to sovereign debt securities has decreased in absolute terms and as a share of the portfolio, having been replaced by an increase in the stock of shares/units. In 2023, exposure to investment funds accounted for 21% and 36% of the portfolios of insurance corporations and pension funds respectively. Given their exposure, these sectors are exposed to credit and market risks, albeit differently. In the case of insurance corporations, exposure to interest rate risk is mitigated by the short duration of assets in the portfolio, but the creditworthiness of the securities issuers is at the lower end of the investment grade category. For pension funds, the credit quality of securities is higher, but exposure to market risk is also higher.

Assets of insurance corporations and pension funds | As a percentage of the total portfolio
Source: Insurance and Pension Funds Supervisory Authority.

In 2024, taking into account the expected developments in interest rates, some unwinding of the positive net impact in 2022 and 2023 on the financial position of life insurance and pension funds is expected. Given that in these sectors the duration of liabilities is longer than that of assets in the portfolio, all else being equal, and for the same increase in interest rates, the reduction in liabilities exceeds the devaluation of assets. Due to the “discount effect”, the increase (decrease) in market interest rates tends to be favourable (unfavourable) to these financial intermediaries.

However, the maintenance of high interest rates tends to increase the credit risk of households and firms across the financial sector. Together with possible episodes of liquidity risk materialisation, credit risk materialisation could lead to losses for ICPFs, should the financial situation of the issuers of the securities in the portfolios deteriorate.

For some non-life business segments, the negative impact of rising inflation on the profitability of these business lines tends to dissipate. In particular, this affects those with liabilities with a shorter duration and/or higher costs for settling claims (e.g. motor vehicle insurance, due to increased repair costs of insured vehicles and/or medical expenses associated with personal injury).

The Insurance and Pension Funds Supervisory Authority considers that the solvency levels of the insurance sector make it resilient and create room to absorb adverse developments.⁴ In addition, the Portuguese insurance sector has a contained liquidity risk, stemming in particular from the share of liquid assets in investment portfolios.

Other financial sub-sectors

Other financial intermediaries (OFIs) and captive financial auxiliary institutions and lenders are a very mixed group of financial intermediaries that are not allowed to take deposits. Financial auxiliaries are entities whose business is to facilitate financial intermediation; however, they do not handle the intermediation themselves. These three types of entities correspond to other financial intermediaries and financial auxiliaries (OFIFA).

At the end of 2023, captive financial auxiliary institutions and lenders accounted for 72% of OFIFA’s total assets. These include holding companies, money lenders (granting credit secured by pledge over assets) and special purpose vehicles (SPVs) that raise open market funds to fund firms within the group. The assets of these entities decreased by 4.6% from 2022, with a notable impact of the relocation of a relevant holding company to another country. Other financial intermediaries other than ICPFs are a residual and diversified category, which includes credit securitisation companies.

Macroprudential policy

The strategy and instruments of the Banco de Portugal as the national authority responsible for implementing macroprudential policy were defined in 2014. The implementation of macroprudential policy has been characterised by a preventive attitude, anticipating and responding to factors that may indicate the build-up of sources of systemic risk. This approach requires a systematic adaptation of methodologies for signalling risk and estimating the impact of measures.

Macroprudential policy has adapted to the various phases of the financial cycle (Special issue “Macroprudential policy at different phases of the financial cycle: the Portuguese case”). In a context where uncertainty about the materialisation of risks to financial stability remains elevated – driven by high interest rates and a potential deceleration in economic growth – macroprudential measures have been instrumental in ensuring that the financial system has sufficient capital buffers to absorb unexpected losses, thereby continuing to finance economic activity.

In 2023, developments in the financial cycle were not indicative of a build-up of systemic risk in Portugal. This was due to the narrowing of the current account deficit, the reduction in credit to firms and households and the increase in GDP. House price developments pointed to the opposite direction (Chart I.1.38).

The potential impact on GDP of an extremely negative event stemming from a build-up of cyclical systemic risk or a period of financial stress remained relatively low in the last quarter of 2023. According to the Growth-at-Risk (GaR) model, the year-on-year rate of change in GDP one year ahead in the case of an extreme negative event, with a 10% likelihood of materialising, is -1.6% (compared with -1.7% in the previous quarter and -4.1% in the first quarter). The slight worsening compared to the second quarter (-1.1%) was due to the financial stress indicator (Country-Level Index of Financial Stress – CLIFS), while the contribution of GDP was less negative (Chart I.1.39).

Domestic cyclical systemic risk indicator | Standard deviations from the median	Contributions of explanatory variables to Growth-at-Risk | Per cent and percentage points
Sources: ECB and BIS (Banco de Portugal calculations). | Notes: The domestic systemic risk indicator (d-SRI), developed by Lang et al. (2019), is an aggregate indicator aimed at identifying the accumulation of cyclical imbalances created in the domestic non-financial private sector. For a detailed description of the d-SRI for Portugal, see Financial Stability Report, June 2019.	Sources: ECB, Banco de Portugal and Statistics Portugal (Banco de Portugal calculations). | Notes: Growth-at-Risk is the estimate of the 10th percentile of the distribution of the year-on-year rate of change in GDP for Portugal over a one-year projection horizon, based on information available from the first quarter of 1991 to the quarter of the projection. The template includes GDP, CLIFS and the d-SRI as explanatory variables. Contributions are presented in percentage points.

The Banco de Portugal identified seven banking groups as other systemically important institutions (O-SIIs). For each O-SII, the Banco de Portugal has also set the corresponding capital buffer requirements, as a percentage of the total risk exposure amount. In the case of the LSF Nani group, the buffer was also applied to Novo Banco.

The Banco de Portugal introduced a sectoral systemic risk buffer (sSyRB) of 4% with effect from October 2024 on the risk-weighted exposure amount of households’ portfolio secured by residential real estate for banks using the internal ratings-based (IRB) approach. This preventive buffer aims to increase the resilience of institutions in view of possible future systemic risk materialisation in the residential real estate market in Portugal, stemming from a potential reversal of the economic cycle and/or an unexpected significant correction in residential real estate prices. It thus complements the macroprudential Recommendation as regards the conditions for credit agreements. In addition, the sectoral capital buffer may also contribute to discourage the excessive exposure of the banking sector to real estate by changing the relative cost in terms of capital requirements associated with different asset classes.

With a view to increasing the banking system’s resilience to a sector-specific systemic risk, the sSyRB is considered a more effective tool than the CCyB (Box 3).

The interest rate hike that took place from the second quarter of 2022 led the Banco de Portugal to review its macroprudential Recommendation for lending for house purchase in 2023. The interest rate shock considered in the debt service-to-income (DSTI) ratio decreased from 3 p.p. to 1.5 p.p. This revision was applied to agreements with a variable or mixed rate and with a maturity of more than 10 years, with the decrease being proportional for the other maturities.

Overall, institutions continued to comply with the guidance set out in the macroprudential Recommendation relating to new loans for house purchase and consumer credit. The risk profile of borrowers of new loans for house purchase continued to improve, with the share of credit granted to high-risk borrowers declining. Of the total amount associated with new loans for house purchase and consumer credit, 91% was granted to borrowers with a DSTI ratio of 50% or less. Regarding the loan-to-value (LTV) ratio, almost all new credit recorded a value of 90% or less, with the LTV ratio for 68% of new agreements being less than or equal to 80%. The average LTV ratio of new loans for the purchase of own and permanent residence fell by almost 10 p.p. from the third quarter of 2018 and by 6 p.p. from 2022, standing at 69% (Macroprudential Recommendation on new credit agreements for consumers – progress report, March 2024). Note that banks apply the criteria of the macroprudential Recommendation to all new credit granted, which may include that from borrowers transferring their loans from another institution.

So far, the European Systemic Risk Board (ESRB) has classified Portugal’s macroprudential policy as adequate and sufficient to mitigate the systemic risks and vulnerabilities identified in the residential real estate market. The Banco de Portugal, as macroprudential authority, has not been the subject of any specific warning or recommendation by the ESRB. In 2023, Portugal continued to be assessed as medium risk, as in the previous 2019 and 2021 assessments.

The review of the EU operational framework for macroprudential policy is ongoing (Report from the European Commission COM/2024/21) and is currently at the stage of assessment and stakeholder consultation. This review aims at ensuring the effectiveness of macroprudential policy, as well as equipping authorities with macroprudential tools targeting sectors other than banking and other sources of systemic risk, such as climate and cyberspace. Particular emphasis was placed on three main areas: (i) use and release of capital buffers; (ii) consistency in the use of the macroprudential toolkit for banks by national authorities and (iii) ability of the macroprudential toolkit to address conventional risks and new sources of risk, notably cyber, climate change and commercial real estate-related risks. Regarding the non-banking sector, the aim is to mitigate the build-up of systemic risk, manage the impact of systemic events caused by liquidity imbalances, excessive leverage, interconnectedness among non-bank financial institutions (NBFIs) and between them and banks, and address the lack of consistency and coordination among national macroprudential frameworks across the EU.

Banking system

In 2023, the situation in the Portuguese banking sector improved further, characterised by higher levels of capital, liquidity and profitability.⁵ The increase in the return on assets to 1.28% had a positive impact on capital ratios, and it maintained a robust liquidity situation and stable asset quality. This outcome was achieved against a background of disinflation and slowdown in economic activity, but with monetary policy and market interest rates above those of 2022.

Improved profitability was based on the increase in net interest income, from 1.65% to 2.80% of assets, reflecting the rapid pass-through of the rise in key interest rates to interest rates on bank loans, and only then passed through to deposit interest rates. The resulting increase in total operating income made it possible to accommodate the increase in impairment costs and provisions, which nevertheless remained contained.

The total gross NPL ratio decreased further in 2023, by 0.3 p.p., despite a slight increase, of 0.2 p.p., in the ratio for loans to households for house purchase. Similarly, the ratio of stage 2 loans increased by 2.2 p.p. in the household segment, most notably loans for house purchase, contributing to the increase in the ratio for the total portfolio.

Against the background of an increase in the burden on the stock of loans for house purchase, mostly for variable rate agreements, labour market resilience and recovery in real household income made a contribution to containing default, as did the low weight of lower-income borrowers in the total portfolio. The specific government support measures and the proactivity of borrowers are also relevant to mitigate the rise in monthly instalments, through a timely renegotiation of the original contractual conditions with the creditor institution (trade renegotiations) or the transfer of the credit to another institution. The increase in these operations, amid lower demand for new loans for house purchase, was boosted by increased competition among institutions and the temporary suspension of payment of the early repayment fee for variable-rate loans for house purchase. In many situations, the new conditions resulted in a fixed interest rate, typically for a period of between 2 and 5 years, reducing the uncertainty in the debt service for the debtor and stabilising the interest income for the bank during that period.

The balance sheet of the Portuguese banking system maintained a concentration of exposure to real estate assets and sovereign debt securities. Exposure to real estate includes loans to households secured by residential real estate, where the collateral risk, if it falls below the amount of credit, is mitigated by the small share of loans with LTV above 80%. In the sovereign debt securities portfolio, in addition to increasing geographical diversification, the share of the portfolio valued at amortised cost, which is expected to be held to maturity, increased and its average duration was reduced for the major banking groups.

The various liquidity indicators continue to signal a robust position and thus the sector's lower sensitivity to disturbances in international financial markets. Similarly, banks’ capital was strengthened to a level similar to that of the euro area, enhancing the ability of institutions to absorb adverse shocks and to continue funding the economy in the less favourable stages of economic cycles.

Profitability

Return on assets (ROA) increased by 59 b.p. compared to 2022, standing at 1.28% (Chart I.2.1), representing a peak over the last decade. These developments were broadly based across the Portuguese and euro area banking systems, although more marked in Portugal, with a ratio of 0.57 p.p. higher than that of the euro area in September 2023. The dispersion among institutions in the banking system remained broadly unchanged, with increases both in the 10^th and 90^th percentiles (Table I.2.1).

Developments in ROA were marked by a rise in net interest income (1.15 p.p. contribution), which accounted for 2.8% of average assets in 2023. The increase in provisions and credit impairments and, to a lesser extent, in operating costs contributed to mitigating that rise. Recurring operating income, which includes the typically most stable components of income (net interest income and net fees minus operating costs), increased by 1.07 p.p. of average assets to 2.14%. It was the largest contribution of net interest income to ROA growth in Portugal that led this ratio to be higher than that of the euro area.

ROA and contributions to change | Per cent and percentage points of average assets
Source: Banco de Portugal. | Notes: Return on assets (ROA) consists of the net result as a percentage of average assets. ‘Other results’ includes other operating results, negative goodwill, appropriation of income from subsidiaries, joint ventures and associates, income from non-current assets held for sale and not qualifying as discontinued operations, increase or decrease in the fund for general banking risks, results from contractual changes/renegotiations of cash flows, profit or loss of discontinued operations before tax and tax on profit for the year.

The significant increase in net interest income was largely the result of a rise in interest received exceeding the rise in interest paid. This increase stemmed mainly from interest received on variable-rate loans and the positive contributions of the debt securities portfolio, in particular the increase in interest received on securities issued by general government and NFCs. Interest on deposits also increased, especially for households, which dampened the positive effect observed on the assets side. The rise in interest rates was accompanied by a transfer from demand deposits to time deposits.

In 2023 the difference between lending and deposit rates on agreements with the non-financial private sector (NFPS) increased for both the stock and new business. The increase was more significant for the stock, surpassing that of the new business in the last two years. These developments result from an average rate on new loans lower than that observed in stocks (Section 2.2) given the prevalence of variable-rate loans. The difference between the interest rates on stocks of loans and time deposits is higher in Portugal than in the euro area (Chart I.2.2), which explains the net interest income in the first three quarters of 2023 in Portugal (2.73%, compared with 1.39% in the euro area).

As mentioned above, recent developments in net interest income benefited from the context of rising interest rates. In a central scenario of future interest rate reduction, the adjustment by a large part of banks’ interest rate risk management strategies, which are also influenced by the higher share of fixed or mixed-rate loans for house purchase, will have a positive impact on future results. The use of hedging interest rate risk through financial derivatives and the higher share of the mixed interest rate in the loan portfolio contribute to smaller reductions in net interest income (as a percentage of Tier 1) in a scenario of a parallel decline in the interest rate curve. These developments are particularly relevant given the importance of net interest income in Portuguese banks’ income structure, a key element in sustaining organic capital generation, being the preferred means when setting management capital buffers.

Despite the increase in operating costs, operational efficiency in view of the cost-to-core income ratio improved in 2023. Importantly, lower values of this ratio are associated with higher efficiency, ceteris paribus. Portugal has one of the lowest ratios at European level, with operating costs, as a percentage of total assets, similar to those in the euro area and higher operating income (Box 4). This ratio decreased to 39.4% (-15.3 p.p.) due to the aforementioned increase in net interest income (Chart I.2.3). The increase in operating costs, by 3.3% year on year, stemmed from administrative expenses, of which IT costs are noteworthy, and, to a lesser extent, staff costs. Most institutions justified these developments with the general increase in prices and, in addition, with digital transformation spending.

The loan loss charge rose by 0.16 p.p., to stand at 0.45%. The increase in this ratio occurred following the increased flow of credit impairments, which may indicate an increased risk perception by institutions in a context of higher interest rates. This change corresponds to a reversal of the downward trend that began in 2021, with a similar figure as in 2018 (Chart I.2.3).

Difference between interest rates on loans and deposits of the NFPS         | Percentage points	Cost-to-core-income and loan loss charge | Per cent
Sources: ECB and Banco de Portugal. | Notes: The non-financial private sector includes NFCs and households. The series refers to the reporting on an individual basis of the other monetary financial institutions resident in Portugal. New business include average annual rates weighted by their respective amounts. (a) Difference between the interest rates on loans and on time deposits.	Source: Banco de Portugal. | Notes: Cost-to-core-income consists of the ratio between operating costs and the sum of net interest income and net commissions. The loan loss charge consists of the flow of credit impairments as a percentage of total average gross loans to customers.

Credit standards

Loans to households

In 2023 the stock of bank loans to households remained relatively stable. In December, the annual rate of change (ARC) adjusted for securitisation and loan transfers was -0.4%, the lowest since 2017. This reflects a decline in the rate adjusted for the housing loans stock to -1.4% in December 2023, amid subdued growth in the stock of consumer loans. In the first quarter of 2024, there was a slight acceleration in both segments (Chart I.2.4). In the housing segment, the rate not adjusted for securitisation and loan transfers stood at -0.6% in March 2024, below that of the euro area (-0.3%).

Annual rate of change adjusted for the stock of loans to households | Per cent
Source: Banco de Portugal. | Notes: Annual rates of change are calculated on the basis of end-of-month stock changes in bank loans, adjusted for changes not defined as transactions, namely, reclassifications, write-offs and exchange rate and price revaluations. ARCs are also adjusted for securitisation and loan transfers. March 2024.

New loans for house purchase contracted by 11.8%, a less sharp fall than in the euro area, where new loans (excluding renegotiations) fell by 33%. These developments were broadly based across most countries, with declines of around 50% in some (Charts I.2.5 and I.2.6). In Portugal in the year ending in September, new loans for house purchase (excluding renegotiations) recorded a year-on-year fall of 18.9%, showing some recovery in the last quarter of the year.

New loans for house purchase excluding renegotiations (12-month cumulative figures) | € thousands and per cent	Annual rate of change in the stock and year-on-year rate of change in new loans for house purchase in 2023 | Per cent
Source: Banco de Portugal. | Note: The red bars highlight the values of the year-on-year rate of change in the stock of loans for house purchase in 2023 in Portugal and the euro area.

Early repayments of loans for house purchase totalled €11.2 billion – 69% more than in 2022 – and accounted for 11% of the year-end stock of loans for house purchase. Partial early repayments gained relevance, but total early repayments continued to account for the most significant share, corresponding to 83% of total repayments (91% in 2022). Early repayment reduces borrowers’ debt level and service and, consequently, the impact that future adverse changes in interest rates may have on debt service, as well as life insurance costs, helping to reduce households’ financial vulnerability. Total early repayments include house exchanges and transfers of loans to other institutions, so the impact on household vulnerability is more limited within that component.

2023 was marked by an increase in transfers of loans for house purchase between banks. The government measure suspending the early repayment fee in the case of variable-rate loans for the purchase of own and permanent residence, introduced at the end of 2022, encouraged these transactions. According to the information given by institutions, these transfers were also stimulated by the actions of credit intermediaries, which are likely to have made a contribution to reducing the costs associated with the search for information. The increase in transfers started at the end of 2022 and intensified throughout 2023. A preliminary analysis indicates that the weight of transfers in total new loans for house purchase granted by institutions (excluding renegotiations) is likely to have been 8% in 2022 and 27% in 2023.⁶ New loans for house purchase, excluding renegotiations and transfers, are likely to have declined by around 30% in 2023.

Those borrowers that transferred loans sought more advantageous pricing conditions (narrowing of spreads) and increased medium-term predictability of monthly credit-related expenses through a fixed interest rate for a longer period. With reference to the stock of loans for house purchase, more recent agreements accounted for a larger relative share in credit transfers, the instalments of which are very significantly impacted by the increase in interest rates. In terms of amount, around 75% of the transfers are loan agreements that had originally been entered into between 2018 and 2022, compared with 50% of their share in the stock. Loans granted under transfers show a higher share of mixed rate (63%) than the remaining new loans (39%). In the case of a mixed and variable rate, the most common reference rate was the 6M Euribor, and there were no significant differences in the relative weights of the three most usual reference rates. In cases where old and new loans were granted at variable or mixed rates, the average spread reduction is estimated to have been around 0.4 p.p. Although to a lesser extent in terms of volume, the decline was more pronounced for loan agreements that had originally been entered into between 2011 and 2016, a period of tightening of credit standards by banks and pricing conditions/spread less in line with business practices associated with the higher interest rate cycle. In addition, on average, there was no increase in the residual maturity of loans with the transfer.

The borrowers’ proactivity to mitigate the rise in monthly instalments, which was also reflected in a large volume of changes in the original contractual terms (trade renegotiations), benefited from increased competition among institutions amid lower demand for new loans for house purchase. In both trade renegotiations and credit transfers, it is particularly important for the system’s stability that banks conduct a thorough assessment of borrowers’ credit risk considering the suitability of the new contractual terms to their ability to pay and the risk they pose.

The average interest rate (annualised agreed rate – AAR) on new loans for house purchase increased from 0.8% in December 2021 to 3.2% in December 2022 and to 4.1% in December 2023. The annual percentage rate of charge (APRC), which includes charges other than interest, has also increased in recent years, standing at 6.3% in December 2023. According to the April Bank Lending Survey (BLS), competition between institutions, in the first quarter of 2024, promoted the narrowing of the spread applied to medium-risk loans for house purchase.

New loans for house purchase with a fixed or mixed interest rate increased in 2023, accounting for 47% of the amount of new loans. These developments intensified in the second half of the year, with these agreements accounting for 75% of lending in December 2023. Lending for house purchase with a fixed or mixed interest rate ranges between 16% and 79% across the largest credit institutions. Regarding mixed interest rates, about 57% of the amount of new loans has an initial rate fixation period of up to and including 2 years and 27% between 2 and 5 years. However, despite the stock of variable-rate loans for house purchase still being predominant, the increase in new loans with a fixed or mixed interest rate throughout 2023 made a contribution to the decrease in the share of variable-rate loans in the stock from 89% in December 2022 to 80% in December 2023 (Chart I.2.7).

Monthly flow of new loans and stock of loans for house purchase by type of rate | Per cent
Source: Banco de Portugal. | Notes: The 'mixed rate’ classification is based on the date the agreement is signed, from which a fixed rate period is in force that differs from one agreement to another. The share of the mixed rate stock may include agreements that are already within the variable rate period or close to the end of the fixed rate period.

New consumer loans decreased by 2% in 2023. The annual rate of change adjusted for the stock of consumer credit was 5.1% in December 2023 (5.9% in March 2024) (Chart I.2.4). The average interest rate and APRC for this segment increased by 1.1 p.p. and 1 p.p. in 2023, standing at 9.1% and 11.3% in December respectively (9.5% and 11.8% in March 2024). In March, both rates are higher than those of the euro area, standing at 7.8% and 8.6% respectively. In contrast to loans for house purchase, most of these agreements have a fixed interest rate. As at March 2024, variable rate contracts accounted for only 13.7% of consumer credit stock.

According to the January Bank Lending Survey (BLS), credit standards for loans for house purchase to households remained broadly unchanged in the fourth quarter of 2023 (Chart I.2.8). Institutions also reported a slight decline in demand for loans for house purchase in the fourth quarter of 2023 owing to the level of interest rates and consumer confidence (similar profile for the consumption and other purposes segment). For the first time since 2021, banks in the euro area reported an easing of credit standards for loans for house purchase in the first quarter of 2024, together with a slight decline in demand for loans for house purchase.

Supply and demand for housing loans | Diffusion index
Supply	Demand
Sources: ECB and Banco de Portugal. | Notes: Credit supply corresponds to credit standards reported by banks. An increase (decrease) in the diffusion index means an increase (decrease) in restrictiveness by institutions and an increase (decrease) in demand in the credit segment. The last observation for each variable corresponds to the expectations of the institutions for the second quarter of 2024 (dashed part).

Lending to non-financial corporations

The annual rate of change in the stock of loans granted by resident banks to non-financial corporations was -0.7% in December 2023, compared with a change of -0.1% in the euro area. Developments by sector of activity showed differentiated patterns, being positive in construction and real estate activities (1.2% and 2.2% respectively) and negative in other sectors, particularly industry (-8.9%) and accommodation and food services (-4.1%). By size, microenterprises maintained positive year-on-year rates of change in 2023 (3.8% in December), while the remaining types showed negative annual rates of change, notably medium-sized enterprises (-5.8% in December 2023) (Table I.2.2). The reduction in the stock of loans to NFCs stems from the decrease in the amount of new loan agreements in 2023, which, together with an increase in loan renegotiations, resulted in a similar volume of new business between 2022 and 2023. Adding to this effect is the increase in repayments by firms whose liquidity positions were enhanced during the pandemic through the moratoria and State-guaranteed loans (Box 3 – March Economic Bulletin). This contrasted with developments in financing from non-residents, which showed a positive flow in 2023, accounting for around 1% of GDP (Section I.1.3.3).

According to the BLS, banks reported that credit supply conditions remained stable from the second half of 2023 onwards, following a tightening in the first half of the year, and were expected to continue stable (Chart I.2.9). Following the beginning of the interest rate increase, the dynamics observed in Portugal and the euro area are very similar in terms of supply, while demand decreased more sharply in Portugal. The decline in credit demand was more moderate from mid-2023 onwards, a trend expected to continue.

Supply and demand for loans to NFCs | Diffusion index
Supply	Demand
Sources: ECB and Banco de Portugal. | Notes: Credit supply corresponds to credit standards reported by banks. An increase (decrease) in the diffusion index means an increase (decrease) in restrictiveness by institutions and an increase (decrease) in demand in the credit segment. The last observation for each variable corresponds to the expectations of the institutions for the second quarter of 2024 (dashed part).

The general level of interest rates and, to a lesser extent, lower financing needs for investment are likely to have played a role in the reduction in credit demand by firms observed from the third quarter of 2022, albeit decreasingly (Chart I.2.10). In 2023, rising interest rates affected business investment, which presented an annual rate of change of 1.5% that is estimated to rise to 3% in 2024, driven by the implementation of European funds. As of the first quarter of 2023, financing through internal financing also contributed to lower demand. From the third quarter of 2023 onwards only debt refinancing, restructuring or trading made a positive net contribution.

Determinants of firms’ demand for credit | Diffusion index
Sources: ECB and Banco de Portugal. | Note: A positive (negative) figure in the diffusion index means an increase (decrease) in demand by firms.

New loans to firms rated in the lowest credit risk class continued to account for around half of new loans. In turn, the share of loans granted to firms in the higher-risk class remained constant at 16% of loans to NFCs granted in the respective period (Table I.2.3).

The share of the stock of loans granted to firms in the highest credit risk class has been declining sustainedly since 2019, despite the shocks which the economy and firms have been subject to in recent years. The share of loans to lower-risk firms continued to increase, to half of the total, to the detriment of loans to higher-risk firms. These developments are consistent with the persistent improvement in firms’ financial indicators in recent years (Subsection I.1.3.3).

The average interest rates on new loans granted in 2023 amounted to 5.5%, notably reflecting the developments in the Euribor rates. The average interest rate on the stock of loans to NFCs was 5.7% in December 2023, the highest since the sovereign debt crisis. In the euro area, an average rate of 5.2% was observed in December 2023.

Spreads on new variable-rate loans narrowed somewhat in 2023, with the differential between firms in the higher and lower risk classes remaining broadly the same. In 2023, average spreads across all risk classes were lower than those observed in 2021 and 2022, which, notably, may have been driven by increased competition between institutions, as also reported in the BLS.

Loan pricing by banks takes several factors into account, including the institutions’ and borrowers’ characteristics, as well as the macroeconomic and financial environment. Banks should be able to identify borrowers’ vulnerabilities and, all things being equal, higher interest rates are expected to be offered to riskier borrowers. The results of an analysis based on individual information by loan and borrower show that the interest rate charged on new loans tends to be higher for more indebted firms and lower for firms with higher liquidity and profitability. In the period under review, despite some heterogeneity over time, loan pricing appears to have responded more significantly to changes in firms’ liquidity than to changes in their leverage or profitability (Special issue: “The importance role of firms’ characteristics on setting bank interest rates”).

Credit quality of assets

The total gross NPL ratio continued its downward path, decreasing by -0.3 p.p. in 2023, to stand at 2.7% in December (Table I.2.5). This development was accompanied by the NPL ratio net of impairments, which dropped to 1.2%. The decrease in non-performing loans (“unlikely to pay or less than 90 days past due” and “more than 90 days past due”) led to a numerator effect that contributed -0.3 p.p. to the change in the total gross ratio compared with 2022. This ratio would have narrowed further but for the decrease in NFCs and cash balances at central banks (denominator effect, 0.1 p.p.).

Owing to the increase in NPLs in loans for house purchase, the household segment had a higher NPL ratio than in 2022 by 0.1 p.p., standing at 2.4%, still significantly below pre-pandemic figures (3.7% in 2019). The slight increase in the household ratio was due to a higher flow of new NPLs than of cures, albeit partly mitigated by the amount of write-offs and NPL sales. For loans for house purchase, the increase in NPLs was due to the “unlikely to pay or less than 90 days past due” component. The rise in key interest rates in 2023 is likely to have contributed to the increase in this component, given the predominance of variable rate loans in the stock of loans for house purchase.

In loans to NFCs, the gross NPL ratio stood at 5.0%, a 1.5 p.p. decrease. In this segment, the decrease in NPLs more than offset the reduction in performing loans. The lower flow of NPLs compared to cures was the main factor behind the reduction in NPLs, but there were also contributions from write-offs and NPL sales (Table I.2.6). The decrease in the gross NPL ratio was broadly based across sectors of activity.

The heterogeneity of the gross NPL ratio among institutions, assessed through the difference between the 90^th and 10^th percentiles, decreased by 0.6 p.p. This was particularly due to the reduction in the ratio of institutions with higher amounts compared with the other institutions. The NFC segment was behind these developments, as there was an increase in heterogeneity in the household segment due to the increase in the 90^th percentile.

The NPL impairment coverage ratio remained at 55.5%, with different developments for firms and households. In NFCs, despite the reduction in impairments, the decrease in NPLs led the coverage ratio to increase by 4.9 p.p. to 60.9%. In households, the impairment coverage ratio decreased by -4.5 p.p. to 50.6%, mainly due to a reduction in impairments in the segment of consumption and other purposes, but also due to an increase in NPLs in the housing segment.

Across the main institutions, the ratio of stage 2 loans to households increased by 2.2 p.p. to 10.4%, bringing to the fore the vulnerability of lower-income households to tighter monetary conditions. These dynamics reflected a net transfer of loans to higher credit risk categories, namely stage 1 to stage 2 transitions, which contributed to a 12.6% increase in the gross value of stage 2 loans to households. This includes a notable contribution from loans for house purchase (10.1 p.p.), with the ratio of stage 2 loans rising by 2.3 p.p. to 9.8% in this segment. For the consumption and other purposes segment, the ratio increased to 12.4% (+1.6 p.p.) (Chart I.2.12). The potential for credit risk materialisation means that coverage is important to meet losses. The impairment coverage ratio of stage 2 loans to households increased to 7.2% (+2.0 p.p.) as a result of increased impairments in housing and in consumption and other purposes.

In 2023, the forborne loan ratio for households increased to 2.5% as a result of the increase in performing forborne loans in the housing segment. Coupled with rising interest rates, the increase in the debt servicing burden in variable-rate agreements is likely to have contributed to the increase in forborne loans for house purchase, where this type of rate is more frequent. Government measures to mitigate the impact of rising interest rates on the financial management of households created better conditions to forebear agreements where borrowers faced financial difficulties. In loans for consumption and other purposes, the reduction in forborne NPLs helped to narrow the ratio of forborne loans.

In NFCs, the reduction in the gross value of loans was more than offset by the reduction in stage 2 loans, resulting in a decrease in the ratio of stage 2 loans to 13.5%, which was broadly based across main institutions (Chart I.2.11). This was due to a positive net transfer of stage 2 loans to stage 1. The reduction in stage 2 loans led to the coverage ratio remaining broadly unchanged (8.2%), despite a decrease in impairments. Forborne loans decreased by 24% compared with 2022, with a stronger contribution from the NPL component (-18 p.p.) and an impact on the forborne loan ratio, which decreased by 1.1 p.p. to 4.4%.

Ratios of stage 2 and forborne loans | Per cent
Source: Banco de Portugal. | Notes: The ratio of stage 2 loans corresponds to the ratio of total gross stage 2 loans to total gross loans. The ratio of forborne loans corresponds to the ratio of total gross forborne loans to total gross loans.

Concentration of exposures

Although the banking system’s assets stabilised (Table I.2.7), the debt securities component increased and now accounts for 23% of assets, of which 15.7% are sovereign debt. There was a reduction in assets with central banks (-0.7 p.p.), loans to customers (-0.3 p.p.) and investments in the interbank market (‑0.5 p.p.). In particular, these developments reflected less buoyant lending, which, given the liquidity situation, translated into increased investment in debt securities. In addition, in the context of non-standard monetary policy instruments, the targeted longer-term refinancing operations (TLTRO III) were reimbursed, with an impact on central bank assets.

An analysis by counterparty sector shows exposure to the sovereign and NFCs via the securitised component increased by 1.2 and 0.5 p.p. respectively, accounting at the end of 2023 for 16% and 4% of assets respectively (Chart I.2.12). However, at the same time, loans to NFCs decreased (-4%) to stand at around 19% of total assets in 2023 (Section 2.2). Loans to households increased by 1% and still accounted for 34% of total assets.

Loans and debt securities by counterparty sector | EUR billions				Exposure to real estate and current LTV of housing loans stock | As a percentage of assets
					Dec 21	Dec 22	Dec 23
				Exposure to real estate	34.0	34.7	34.6
				Loans to households collateralised by RE	25.1	25.9	25.5
				Loans to NFCs of construction and RE activities(a)	4.0	4.2	4.2
				Loans to NFCs collateralised by RE(b)	3.4	3.2	3.7
				Real estate funds(c)	0.9	0.9	0.9
				Real estate assetsd)	0.6	0.5	0.3
				Loans with LTV above 80 (e)	8	7	5
Source: Banco de Portugal. | Notes: (a) not excluding loans granted to projects unrelated to the real estate sector, such as public works; (b) excluding loans to NFCs in the construction and real estate activities sectors; There was a change in methodology in one of the main institutions when reporting loans to NFCs secured by real estate as of 2023, which led to a break in the series; (c) including loans and mutual funds shares; (d) gross values; (e) indicator based on granular data at loan level from the Central Credit Register, as a percentage of the portfolio. Whenever the date of the last valuation of the property is prior to 2023 Q3, its current value is estimated using Statistics Portugal Housing Price Index.

The Portuguese banking sector’s consolidated exposure to real estate through housing loans was 27.4% at the end of 2023. However, exposure to the real estate market may take other forms. In domestic activity, total exposure, both direct and indirect, remained at around 35% of assets (Table I.2.8). Loans to households secured by real estate continued to account for the largest share in assets (25.5%), exposing banks to developments in the residential real estate market. In this context, the low share of high current LTV housing loans in the portfolio mitigates the impact of a potential reduction in residential real estate prices, with only 5% of loans having LTVs above 80%.

The increase in the share of the sovereign debt securities portfolio has been followed by a greater share of the portfolio valued at amortised cost, expected to be held to maturity. In recent years, the increase in the sovereign debt component accounted for at amortised cost, currently standing for 80% of the total securities portfolio, and the reduction in the average duration of this portfolio, mitigated the impact of market changes to the balance sheet value of securities, making it less sensitive to interest rate changes. The average residual maturity of sovereign debt securities of the banking system’s main institutions decreased from 5.0 years in 2022 to 4.7 years in 2023.

The risk of interconnectedness between the sovereign and the banking system through direct exposure to domestic public debt has been decreasing. This is due to the diversification of the sovereign debt securities portfolio by geographical counterparty, in particular with the increase in the share of Italian, German and European Commission sovereign debt (Table I.2.9).

In recent years, the possibility of transmitting and amplifying adverse shocks via interconnectedness in the financial sector has been reducing (Section 1.3.5). In December 2023, the banking sector’s exposure to other financial sector entities (excluding Central Bank) stood at around 16% of assets in terms of domestic activity. In the last 10 years, this exposure decreased by 8 p.p., initially due to the reduction in exposure between banks (-2 p.p.) and, later, lower exposure to investment funds and other financial intermediaries (-1 p.p. and -4 p.p. respectively). Exposure to resident banks remains relevant, at 11% of assets.

Financing and liquidity

The liquidity framework of the banking system remained robust. At the end of the year, the loan-to-deposit ratio stood at 78%, similar to that of 2022, but much lower than before the financial crisis (Table I.2.10). Liquidity coverage and net stable funding ratios (LCR and NSFR respectively) remained high, above the regulatory minimum of 100%. The increase in the LCR ratio to 255% was mainly due to the liquidity buffer (numerator), which remained mostly composed of government securities (51%) and central bank reserves (41%), representing 34% of customer deposits. The main banks in the system recorded similar values and no relevant dispersion was observed.

The share of funding obtained from the Eurosystem has been declining rapidly since 2021 as a result of the repayment of targeted longer-term refinancing operations (TLTRO III). At the same time, central bank reserves remain high, warranting negative net lending. These developments were reflected in the reduction of the asset encumbrance ratio to historically low levels.

On 13 March 2024, the Governing Council concluded the process of reviewing the operational framework for implementing monetary policy. The characteristics of the chosen framework foster secure access to liquidity, promoting financial stability (Box 5).

On the liability side, customer deposits remain the main source of funding. At the end of 2023, customer deposits represented 80% of the banking system’s total liabilities, mostly belonging to households and non-financial corporations. Given the increase in interest rates over the past year, there has been a reallocation from overnight deposits (typically non-interest-bearing) to time deposits, by both households and corporations. In aggregate terms, the share of overnight and time deposits became similar (Chart I.2.13).

The main banks of the Portuguese banking system issued, outside the banking group to which they belong, eligible instruments for compliance with the minimum requirement for own funds and eligible liabilities (MREL) totalling €1.5 billion. At the end of the year, all institutions whose transitional period to comply with MREL ended on 1 January 2024 met the final requirement. However, there are institutions for which a longer transitional period has been set, which continue to build their MREL capacity to meet their final targets. The stock of MREL eligible instruments consists mainly of own funds, namely Common Equity Tier 1 (CET1) capital (Chart I.2.14). Most MREL-eligible instruments represented by securities have a residual maturity of 2 to 5 years, with only 5% having a maturity of less than 2 years, mitigating short-term refinancing needs.

Customer deposits | Per cent	Instruments eligible for MREL (outside the group) – Composition and maturity (years) | 2023, per cent
Source: Banco de Portugal.	Source: Banco de Portugal.

Capital

The increase in income, as well as in other comprehensive income, allowed for an increase in own funds across virtually all large institutions in the banking system, making them less heterogeneous (Chart I.2.15). Recorded profitability is particularly relevant for sustaining the organic generation of capital, promoting an increase in management buffers and thus equipping institutions with the ability to accommodate future shocks, notably in less favourable stages of the economic cycle.

Total capital ratio – level and contributions to changes | Per cent and percentage points	Risk-weighted assets by risk type | Dec 2023
Source: Banco de Portugal. | Note: The total capital ratio is the ratio of total capital to risk-weighted assets.	Source: Banco de Portugal.

The total capital ratio and the Common Equity Tier 1 (CET1) ratio increased by 1.5 and 1.7 p.p. respectively, to stand at 19.6% and 17.1% respectively. The performance of the total capital ratio is also determined by the reduction of Tier 2 capital, as explained by the early repayment of Tier 2 instruments by Caixa Geral de Depósitos, to fully pay off the funding obtained from private investors under the Recapitalisation Plan agreed between the Portuguese State and the European Commission.

With reference to September 2023, there was convergence for euro area capital ratios, with the total capital ratio 0.5 p.p. below the euro area average, while the CET1 ratio was 0.5 p.p. higher.

In addition, there is also a strengthening of the leverage ratio, which increased by 0.6 p.p. due to a rise in Tier 1 capital to 7.3% and remaining above the minimum requirement of 3%.

The reduction in the average risk weight is mainly explained by the decrease in risk-weighted assets, -0.3 p.p. (the numerator effect). Specifically, RWAs associated with credit risk exposure and market risk decreased, both by -0.3 p.p., which were partially offset by RWAs associated with operational risk exposure (0.4 p.p.). Developments in RWAs for credit risk and operational risk were broadly based across most of the system’s largest banks, while in the case of market risk, the reduction observed is explained by the exercise of a regulatory option by a large institution to calculate RWAs for foreign exchange risk.

The main component of risk-weighted assets is credit risk, 85%, with exposures to firms and retail operations becoming more relevant, accounting for 34% and 19% respectively (Chart I.2.16). While exposure to credit risk decreased, developments in its different components performed very heterogeneously across banks, reflecting different combinations of asset classes. In addition, there are differences in the risk assessment approaches, for example as a result of the use of the standardised approach or the internal ratings-based (IRB) models.

While the remaining components of risk-weighted assets are less material, operational risk, representing 11% of risk-weighted assets, is noteworthy, and is associated with potential losses in regular activity stemming from failures in external processes, people, systems and/or events. The change in this risk component correlates with developments in total operating income, helping to explain the impact of operational risk on developments in the average risk weight in 2023.

1. Housing Search Index for Portugal

Motivation and data

House price volatility has an impact on households’ welfare, financial stability, and ultimately the broader economy. According to Statistics Portugal data, in nominal terms house prices more than doubled over the last 10 years. Almost 80% of the Portuguese population owns its own home, of which 38% pays a mortgage loan, according to the latest Census data from 2021. According to the Household Finance and Consumption Survey, the main residence constitutes the largest share of wealth for most households in Portugal. Mortgages and loans to the construction and real estate sector represent 26% and 4% of total assets in the banking system’s balance sheet in December 2023 respectively. For these reasons, monitoring and forecasting house price developments is of crucial importance.

Building on work by Møller et al. (2023) for the US, this box presents a Housing Search Index (HSI) for Portugal using Google Trends data. The main goal is to assess whether it is a leading indicator of house-price dynamics in the short-term. Google Trends measures online search activity, serving as a proxy for housing demand that can therefore be used to construct a demand-based indicator for the housing market. Today, most prospective house buyers in Portugal start with an online search, according to data from a 2023 survey⁷ by the Portuguese consumers’ association, DECO PROteste. Therefore, an uptick in the total search volume within a country, as registered by Google Trends, is a candidate to be a leading indicator for future house price increases.

To construct the HSI, search volumes for the query "comprar casa" (“buy a home”) and the respective top 25 related searches were collected from Google Trends, considering only searches made within Portugal. Search volumes over time are easily accessible on the Google Trends website from 2004 onwards (Figure B1.1). Six of the related searches refer to the rental market or to specific city-level housing markets (e.g. “comprar casa Porto”). and were therefore removed. Finally, the search queries for the two most frequently used online platforms for housing searches in Portugal were added.

Google Trends search volume index for the term “comprar casa”
Source: Google. | Note: The search volume index considers searches made within Portugal between January 2004 and April 2023.

Given the set of 22 monthly search volumes resulting from the procedure described above , the starting point was defining the 10 most relevant search volumes, done by following a Machine Learning algorithm.⁸ The HSI is then obtained as the first principal component of these 10 search volumes.⁹ When looking at the monthly HSI plotted against the monthly house price growth from January 2004 to August 2023 (Chart B1.2), we can immediately see a strong correlation between the HSI and price changes in the housing market.

Housing Search Index and house price growth in Portugal
Sources: Banco de Portugal and Confidencial Imobiliário.

Prediction performance

This model was estimated for different prediction horizons $h$, where $h$ ranges from 1 month to 60 months. In the equation above, $p_{t + h} - p_{t}$ represents house price growth $h$-months ahead of month $t$; ${HSI}_{t}$the Housing Search Index in month t; and $\varepsilon_{t + h}$the residual term.

The respective estimates of β coefficients (left panel of Chart B1.3) represent the sensitivity of house price changes to the HSI on different time horizons, whereas the respective R² values (right panel of Chart B1.3) reflect the percentage of house price dynamics that can be explained by the HSI.

Model estimates at different prediction horizons
$\beta$ coefficients and 90% confidence intervals	R2 values
Sources: Banco de Portugal and Confidencial Imobiliário.

The R2 estimates (Chart B1.3) indicate that the HSI has a strong prediction performance, peaking within the horizon of 1 to 2 years. At the 12-month prediction horizon, the HSI alone predicts 70% of the variation in house prices. The HSI performs well, in particular when comparing the results to other predictors commonly used in the literature¹⁰, as well as when adding all these predictors to the base model.

Model extensions

On top of the base model, two separate extensions were considered. The first proposes measuring the relevance of supply indicators to predicting house prices, compared to the demand indicator HSI, by adding the log changes of dwellings on offer as an additional predictor to the model. This addition does not affect the original coefficient estimates for the HSI significantly and, more importantly, it does not add any significant predictive power to the model: for instance, at the 12- month prediction horizon, only around 7 additional percentage points of house price dynamics are explained by adding the supply indicator, beyond the 70% already explained by the HSI. On the other hand, if the supply indicator is considered to be a single predictor, it only explains about 12% of house prices. These data sustain the claim that the HSI continues to be a leading indicator for house prices in Portugal, even when supply as an indicator is also being considered.

The second extension looks at the importance of foreign demand, measured by searches performed outside Portugal. In a market where foreign demand has been increasingly present in recent years, it is interesting to determine the relevance of this component in shaping house price dynamics, in comparison to domestic demand. If the HSI is a good proxy for domestic demand, it should be possible to make a comparison by constructing foreign demand indicators in a similar fashion.

Bearing this objective in mind, foreign HSIs for the following countries were computed: USA, France, UK, Italy, Brazil, Germany, South Africa, Israel and India. According to data from Confidencial Imobiliário, these are the countries with the largest weights in housing transactions in the Lisbon urban rehabilitation area in 2023, ordered by weight of the underlying transactions, with the exception of China, for which there is no sufficient Google Trends data. For each of these nine countries, an individual foreign HSI was constructed using a method equivalent to the national HSI but considering only Google searches restricted to each country’s territory instead whilst still associated with searching for housing in Portugal. For illustrative purposes, the foreign HSIs for the two countries with the greatest representation of home ownership in the Lisbon area (USA and France) are plotted against the series of house price changes in Portugal (Chart B1.4). These indices are strongly correlated with the house price growth series in Portugal, with correlations of 66% and 54% respectively for the USA and France.

Foreign Housing Search Indices
United States HSI and House price growth	France HSI and House price growth
Sources: Banco de Portugal and Confidencial Imobiliário.

By adding these nine indicators to the base model, one by one, we found that the addition of foreign demand indicators is relevant to explain house price dynamics, beyond what is already accounted for by the national HSI. This relevance is heterogenous across indicators, with the one for France adding the most information out of the nine countries considered, with an addition of 5 p.p. to the R² of the base model at the 12-month prediction horizon.

Conclusion

Creating a Housing Search Index is beneficial to assess housing market dynamics in Portugal, in particular as a leading indicator for house price changes in the horizons between 1 and 2 years. At the 12-month prediction horizon, the HSI outperforms most other variables commonly used in the literature.

The methodology used to construct the indicator is versatile and can be adapted to examine additional dimensions of interest, such as indicators of foreign demand. Additionally, the model suggests that the HSI, a demand indicator, proved to be more suitable than the supply indicator as a leading house price indicator in the period under study, and that foreign demand is relevant to define house price dynamics in Portugal.

Based on the results presented, the HSI can complement the conventional models that are commonly used in the literature and can therefore be used as an additional tool in the house price assessment by policymakers.

References

Møller, S.V., Pedersen, T.Q., Montes Schütte, E.C. and Timmermann, A. (2023). “Search and Predictability of Prices in the Housing Market.” Management Science, 70(1), 415-438.

Zou, H. and Hastie, T. (2005). “Regularization and Variable Selection via the Elastic Net.” Journal of the Royal Statistical Society. Series B (Statistical Methodology), 67(2), 301–320.

2. The exposure of Portuguese banks to the commercial real estate market and the financial position of firms in the construction and real estate sectors

In Portugal, commercial real estate (CRE) market risks are assessed as low. The market has been characterised by dominant foreign investors, typically from large economic groups with diverse portfolios. The role of Portuguese banks in financing construction and CRE investment has been less relevant than in the past. Among other factors, supply shortages in some segments, such as offices and logistics, and buoyant tourism have contributed to sustaining prices (Section I.1.3.4).

The limited exposure of Portuguese banks to the CRE market is mainly indirect, through loans. In December 2023, loans to firms collateralised by commercial real estate (hereinafter CRE loans) totalled €21.6 billion, 5% of the banking system’s total assets on a consolidated basis. This compares with €113 billion of loans to households collateralised by real estate, mainly residential property (26% of total assets). The exposure is also limited, compared to other euro area countries (Section I.1.3.4).

CRE loans are concentrated in small and medium-sized enterprises (80%) and spread across various sectors of activity. Despite a greater concentration in the real estate sector (31%, firms mainly engaged in buying, selling and renting real estate, of which real estate brokerage represents only a small portion), accommodation and food services (19%), manufacturing (11%) and trade (9%) also have a significant share, and higher than those of firms whose core business is the development of building projects and the construction of buildings (8%, Table B.2.1). The business nature of firms with loans collateralised by commercial real estate is diverse, which helps to mitigate credit risk. In many cases, the property used to collateralise the loan may be a property held by the firm for its own use/development of its business, and not a real estate asset held from an investment perspective to generate income by renting or selling, which is particularly relevant from a risk assessment perspective.

Firms in the construction and real estate sectors will be the most potentially affected by risk materialisation in the CRE market. These firms have undergone a very significant adjustment in the aftermath of the sovereign debt crisis, reflected in an improvement in their key financial indicators. Profitability levels are at an all-time high, the capital ratio has increased, the reliance on banks for funding dropped and the debt servicing capacity improved significantly (Chart B2.1). In particular, in the domestic activity, the stock of bank credit (including a residual component of debt securities) decreased from €45 billion in 2009 to between €16 billion and €17 billion over the last four years. Despite an improved financial situation, pockets of vulnerability remain in these two sectors, which maintain higher financial risk indicators compared with total firms.

Firms in the construction and real estate sectors are sensitive to rising interest rates. In addition to the immediate cost pass-through to the new loan, the predominance of floating-rate loans (75% of the stock in December 2023) resulted in a rapid increase in the cost of the stock of loans, from 2.5% in construction and 2.2% in real estate activities in June 2022, to 5.9% and 5.6% respectively, in December 2023.

Economic and financial indicators | Per cent and number of times
Return on assets	Capital ratio
Financing expenses coverage ratio	Bank loans as % of funding obtained
Source: Banco de Portugal. | Notes: Bank loans as a % of funding obtained only available up to 2022. Data for the real estate sector not available (separately) for the 3 indicators with information up to 2023. The financing expenses coverage ratio is the number of times the EBITDA generated by firms exceeds financing expenses. A higher financing expenses coverage ratio means less financial pressure. Financing expenses include interest and other costs incurred by the firm in connection with funding obtained.

The percentage of financially vulnerable firms in the construction and real estate sectors (with a financing expenses coverage ratio below 2) is estimated to have increased in 2023 and stabilised in 2024, at around 30%. The increase is expected to be more pronounced in the real estate sector (from 25% to 36%), compared to the other firms considered in the analysis (Chart B2.2). Moreover, the increase in financial vulnerability is estimated to occur mainly as a result of an increase in the percentage of relatively less vulnerable firms, i.e. with a financing expenses coverage ratio above 1. Estimated values are below those observed before the international financial crisis, especially in 2007, a year characterised by interest rates closer to those expected in 2024. Throughout that year, the share of financially vulnerable firms was 24% for all firms, 55% in the property development and construction of buildings sector and 47% in real estate activities, reflecting the high leverage of these sectors.

Breakdown of firms according to the financing expenses coverage ratio, by sector of activity | Per cent
Source: Banco de Portugal. | Notes: Percentages correspond to the share of firms in each financing expenses coverage ratio class, weighted by total assets. The financing expenses coverage ratio projection is based on a firm-level financial statements simulation exercise, as presented in Augusto, F. et al, (2022). “Modelling the financial situation of Portuguese firms using micro-data: a simulation for the COVID-19 pandemic”, Banco de Portugal, Occasional Paper 2022. Individual information on firms for 2023 is projected, given that complete data are not yet available on financial statements for this year. The simulation exercise is based on the economic scenario described in the March 2024 issue of the Economic Bulletin. For a breakdown of the construction and real estate sectors see note to table B2.1. The aggregate “Other sectors | with CRE collateral” comprises firms in other sectors of activity with at least one loan collateralised by real estate, regardless of its value.

Credit risk in CRE loans has recently materialised on the international scene, concentrated in smaller or specialised banks. The issue has been particularly acute in the US, especially in the office space segment, with an oversupply as a result of the post-pandemic increase in remote working and an excessive concentration of exposures in a limited number of banks. In the euro area, the risk is lower, but there has been a slight increase in defaults on CRE loans and a tightening in lending standards for this type of loan (Financial Stability Review, European Central Bank, May 2024).

In Portugal, there was no evidence of any significant materialisation of risk in CRE loans or in loans to the construction and real estate sectors. In 2023 the stock of NPLs decreased by around 30 % in both cases. In particular, the stock of NPL inflows for CRE loans in 2023 was lower than between 2020 and 2022, and the NPL impairment coverage ratio increased by 6.3 p.p. to 53.2%. Developments in stage 2 loans were also favourable: a 10% reduction in 2023, which in a context of reduced exposure translated into a relative stabilisation of the stage 2 loan ratio at around 16%. Against this background, the downward trend in gross and net NPL ratios in recent years was observed in the case of CRE loans and, even more so, in the case of loans to firms in the construction and real estate sectors (Table B2.2). Despite heterogeneity across banks, CRE loans are distributed among the largest institutions, in most cases accounting for between 22% and 33% of loans to firms, and between 4% and 7% of the institution’s total assets.

Credit standards for loans to firms have been tightened in recent years, with higher collateral and/or equity requirements for bank financing. The share of loans granted to higher-risk firms in the construction and real estate sectors fell from 49% in 2016 to close to 30% in recent years (Chart B2.3). Consequently, banks are currently less exposed and less vulnerable to shocks in the commercial real estate market. Despite favourable developments in financial stability, it is crucial that banks continue to assess the risks of exposure to this market in a forward-looking manner.

New loans to firms in the construction and real estate sector by risk class | Per cent
Source: Banco de Portugal | Notes: Loans granted by resident monetary financial institutions to non-financial corporations resident in Portugal. Credit risk, as measured by probability of default, is based on credit ratings available in the Banco de Portugal’s Internal Credit Assessment System (ICAS). Only new operations from firms with risk information available were considered. The lowest risk class (risk class 1) corresponds to firms with an estimated one-year probability of default (PD) of less than or equal to 1%; risk class 2 corresponds to firms with a one-year PD of more than 1% and less than or equal to 5% and the highest risk class (risk class 3) corresponds to firms with a one-year PD of more than 5%.

3. Broad or sectoral? Unveiling the impacts of the CCyB and the sSyRB

The countercyclical capital buffer (CCyB) and the sectoral systemic risk buffer (sSyRB) are two of the tools available in the European Union prudential regulatory framework. The CCyB corresponds to a capital buffer that should be built up to protect the banking sector in periods when systemic cyclical risks or vulnerabilities to financial stability are growing due to excessive credit growth. The sSyRB is a capital buffer that can be applied to the total risk exposures’ amount of a subset of exposures and aims to increase the financial system’s resilience to the possible materialization of sector/geographic or exposure-specific systemic risk. Both CCyB and sSyRB ensure that banks are better equipped to absorb unexpected losses while continuing to provide credit to the economy.

A comparison of the short- and long-term impact of the sSyRB and CCyB on financial stability and economic activity is important. In the European Economic Area (EEA), ten countries announced the activation of a systemic risk buffer (SyRB) (Malta, Finland, France, Portugal, and Italy), changed the level of an existing SyRB (Romania, Belgium, Slovenia), or reaffirmed the level of an existing SyRB (Liechtenstein and Bulgaria) between January 2023 and March 2024. Six of these ten SyRB are sectoral, targeting either exposures to the real estate sector (Malta, Portugal, Belgium, Slovenia, Liechtenstein) or to non-financial corporations (France). In November 2023, the Banco de Portugal announced, a sSyRB for exposures secured by residential real estate, which will apply from October 1, 2024. The preventive application of this macroprudential tool is justified by the need to increase the resilience of financial institutions to the materialization of potential systemic risk in the residential real estate market in Portugal. Use of the CCyB is more widespread and has been adopted by 21 countries in the EEA.¹¹

To assess the effects of implementing the CCyB and the sSyRB, the macroeconomic model with three layers of default (hereinafter 3D model) by Clerc et al. (2015) is used, calibrated for the Portuguese economy as described in Lima et al. (2023). This model introduces financial intermediation and default among agents into an otherwise standard Dynamic Stochastic General Equilibrium (DSGE) model. The represented economy comprises households, entrepreneurs, and banks. “Patient” households save and deposit their savings in banks, while “impatient” households borrow from banks to finance investments in residential real estate. Both types of households consume, invest in housing and work in the production sector. Entrepreneurs use capital, inherited net worth, and bank credit for investments. In the production sector, perfectly competitive firms produce the final good, new physical capital and housing. Specialized banks in the model grant credit to impatient households for investment in housing (mortgage loans) and to entrepreneurs (corporate loans). Banks finance themselves through deposits and equity. Banks are subject to regulatory capital constraints and operate with limited liability. All agents, including households, entrepreneurs, and banks, can default. Deposits are guaranteed by a deposit guarantee system which is financed through a tax levied on households.

The 3D model provides a rationale for capital regulation, stemming from two types of distortions: i) banks’ limited liability due to the existence of a deposit insurance scheme and ii) bank funding cost externality in which the deposit rate does not fully depend on the risk of default of each individual bank but on the system-wide bank default risk. Both distortions encourage banks to expand their leverage and extend excessive credit to the economy, providing grounds to impose regulatory capital requirements. The model also incorporates a third distortion related to economic agents’ default, causing external financing frictions in the form of bankruptcy costs and restricted access to credit, resulting in suboptimal credit allocation.

The 3D model is appropriate for the analysis of the impact of broad and sectoral capital requirements as it distinguishes between mortgage and corporate credit segments, and the associated capital requirements, using a stylized representation of the economy. Firstly, the presence of representative banks that offer loans to either impatient households (mortgage loans) or entrepreneurs (corporate loans) is assumed. The heterogeneity of institutions' financial and business models is not considered. Secondly, the management buffer of banks remains fixed and does not change endogenously in the model, implying a compulsory increase of capital ratios for banks in tandem with the implementation of capital buffers. This feature of the model is a significant simplification of reality, as banks often possess a management buffer that allows them to comply with the new capital requirements, thus avoiding deleveraging to comply with the requirement. The impact of increasing capital buffers, especially in the short term, is influenced by this feature, as described in more detail below.

To assess the impact of the CCyB, a permanent 0.25 p.p. increase is introduced in the capital requirements for both mortgage and corporate loans, which is equivalent to a sSyRB of 4%, as announced by the Banco de Portugal in 2023. It also represents the minimum CCyB buffer rate a national authority can apply, serving as a baseline to evaluate its impact. The permanent nature implies a transition from one equilibrium position to another. A phase-in period of one year from the announcement date to build the additional capital buffer, with uniform increases over that period is assumed.

To gauge the impact of the sSyRB, targeting the real estate sector, the amount of equity raised to comply with the CCyB increase is factored in. Subsequently, a sSyRB is calibrated to align, ex-ante, with that amount. This procedure results in a permanent 0.62 p.p. increase in the capital requirements for mortgage banks. For the implementation, the same assumptions as made for the CCyB are used, involving a linear increase spread over a one-year phasing-in period.

In the model, the CCyB and the sSyRB contribute to enhancing the resilience of the banking system, despite the differences in their transmission mechanisms (Chart B3.1). The CCyB improves the resilience of both types of specialized banks, i.e. banks granting loans to "impatient" households (mortgage credit) and banks granting loans to entrepreneurs (corporate credit), exerting a widespread negative effect in both credit segments. This results in an average one-year reduction of 0.5% in mortgage credit and 0.7% in corporate credit. However, it leads to a milder reduction of the default rate of banks, with a one-year average decrease of 7.6% and of 15.2% in the long-run. Being more targeted, the sSyRB contributes to a higher reduction in default rates for banks specialized in mortgages, which results in short run and long run decreases of 11.1% and 21.9%, respectively, in the default rate of banks. This improvement in resilience occurs even though it does not directly impact the corporate segment.

The impact of the CCyB and the sSyRB | Percentage per Quarter
Capital ratio of corporate banks	Capital ratio of mortgage banks	Average banks’ default rate
Mortgage loans	Corporate loans	Total loans
GDP	Consumption	Investment
Source: Banco de Portugal. | Note: Dynamics of variables after the implementation of the CCyB and the sSyRB. S.S. stands for steady state, i.e., the initial equilibrium position of the economy.

In contrast to the sSyRB, the CCyB entails a lower short-term contraction in mortgage (0.5%) and total loans (0.6%), with a smaller long-term impact on total loans (a 0.04% increase). The contraction in mortgage loans is more pronounced when implementing the sSyRB, (one-year average contraction of 1.6%), which is also reflected in total loans (0.9% for the one-year average). Nevertheless, the short-term decline in corporate loans is milder with such a tool (0.004% for the one-year average). Credit reduction during the phase-in period is related to the model assumption of a fixed management buffer. However, it should be noted that, in practice, macroprudential authorities consider the availability of capital headroom to comply with the additional capital requirements when introducing a capital measure, to avoid disruptions in lending in the short-term.

While the long-term effect of the sSyRB is positive for both types of loans, the positive long-term impact of the CCyB on mortgage loans comes at the expense of a negative impact for corporate loans, owing to resource reallocation. This resource reallocation is explained by the interplay between the banks’ balance sheet and capital constraints in the model, coupled with the lower risk weight attributed to mortgage loans, motivating a shift from corporate to mortgage loans in the long-term.

Both the CCyB and the sSyRB exhibit a short-term negative impact on GDP due to investment contraction (around 0.05% in the first quarter). However, there is an increase in the GDP level in the new equilibrium, with an increase of 0.05% with the introduction of the CCyB and of 0.1% with the introduction of the sSyRB. This increase is driven by aggregate consumption and investment improvement over the longer term. As the default rate of banks falls more with the sSyRB than with the CCyB, the fiscal cost of default for the economy decreases, leaving households with an income surplus. They use this surplus to increase consumption. The higher demand for aggregate consumption of final goods triggered by the sSyRB, compared to the CCyB, explains the greater increase in investment in physical capital, supported by the positive long-term effect on corporate loans.

In summary, the results suggest that the sSyRB is more suitable than the CCyB when macroprudential regulators are concerned about a specific sectoral source of systemic risk. The CCyB is preferable when the sources of risk are broader, i.e., related to both credit segments. The choice between these instruments depends on the specific objective of policymakers and is tied to their transmission mechanism. The broader scope of the CCyB aids in enhancing the resilience of the banking sector and addresses the systemic risks and vulnerabilities accumulated during the expansion phase of the financial and macroeconomic cycle. In this scenario, the transmission channel operates across all credit segments. Conversely, the sSyRB, a targeted tool, is better equipped to address specific systemic risks, whether cyclical or structural, with minimal repercussions on other credit sectors, according to these results.

Regarding credit and economic activity, both the CCyB and the sSyRB point to an intertemporal trade-off, with mild contraction in the short term being the cost of creating conditions conducive to beneficial long-term effects. However, such a temporary and short-lived contraction should be strongly downplayed or even disregarded in reality, considering banks' ability to use their management buffers for compliance, a factor that was not considered in the present analysis due to model assumptions. Nevertheless, for both instruments, there is a positive long-term impact on credit and economic activity, driven by enhanced banking system resilience, which reduces the likelihood of a financial crisis and promotes financial stability.

References

Clerc, L., A. Derviz, C. Mendicino, S. Moyen, K. Nikolov, L. Stracca, J. Suarez, and A. P. Vardoulakis (2015). “Capital Regulation in a Macroeconomic Model with Three Layers of Default.” International Journal of Central Banking, 11(3), 9–63.

Lima, D., D. Maia and A. Pereira (2023). “Structural and cyclical capital instruments in the 3D model: a simulation for Portugal.” Working Papers 2023/15, Banco de Portugal.

4. The efficiency of the Portuguese banking system from a cost-to-core-income ratio perspective

The cost-to-income ratio is one of the accounting and financial indicators used to assess banks’ operational efficiency. This metric measures the share of structural costs incurred in the course of regular bank operations (i.e. operating costs, including staff costs, other administrative expenses and depreciation) in operating income generated (i.e. net operating income, including net interest income, net fees, results of financial operations and other operating profits). All other things being equal, lower ratio values are associated with higher operational efficiency and lower operating leverage, contributing to mitigating the sensitivity of profitability to reductions in revenues. The business model and the degree of competition in the market may affect this indicator. For instance, the evidence points to an improved performance of commercial banks with predominantly deposit-based funding (Roengpitya et al, 2017). A variant of the cost-to-core-income ratio includes only the operating income deriving from the core business of retail banks (net financial income and net fees).

The operational efficiency of the Portuguese banking system as measured by the cost-to-core-income ratio has improved over the last decade and is currently at one of the lowest levels in Europe (Chart B4.1). Between 2009 and 2014 Portugal had an average cost-to-core-income ratio of 73%, higher than the 70% in the euro area (EA). As of 2013 this indicator fell consistently, leading to a cumulative reduction of 41 p.p. by 2023. As of 2015 had fallen below the euro area average, with the differential peaking in 2023 (21 p.p).

Cost-to-income ratio | Per cent
Sources: The ECB and the Banco de Portugal. | Notes: Values between 2009 and 2013 for the euro area were estimated using series that consider only domestic banking groups in each country. The difference between the 90th and 10th percentiles was calculated based on data from euro area countries. (a) Euro area data for 2023 refer to September (annualised values).

The improvement in Portuguese banks’ operational efficiency was due to the reduction in operational costs in the aftermath of the international financial crisis, and more recently to the increase in net interest income (Chart B4.2). Between 2009 and 2021, operational costs decreased by 30% (-€2,350 million). During this period, the number of bank branches and employees in Portugal fell by 44% and 23% respectively, a development that closely followed the euro area median. These dynamics reflected the need for the banking sector to adjust in the wake of the international financial crisis, a scenario that was exacerbated by the sovereign debt crisis and the implementation of restructuring plans stemming from the public recapitalisation of some major institutions. By contrast, operational costs rose by 11% in the euro area over the same period. Over the last two years, operational costs increased by 13% in Portugal (8% in the euro area), only partially reversing the decline observed since 2009 and reflecting the pass-through of inflation to staff costs, notably salaries and other administrative expenses. In terms of operating income, net interest income fell more sharply in Portugal between 2009 and 2021 and increased in the last two years with the cycle of rising interest rates. This increase was significantly stronger in Portugal than in the euro area, reflecting the large share of floating rate loans on banks’ balance sheets, which quickly passed on monetary policy decisions to the economy. In a scenario of lower interest rates in the future, net interest income is expected to fall, an impact that will be mitigated by banks adjusting their interest rate risk management strategies. In turn, fees have remained stable in Portugal since 2009, while they have increased by 40% in the euro area.

Recurring operating income, operational costs and cost-to-core-income ratio EUR | Billion (left-hand scale) and percentage (right-hand scale)
Portugal	Euro area
Sources: The ECB and the Banco de Portugal. | Notes: 2009-13 values for the euro area have been estimated using series that consider only domestic banking groups in each country. (a) Euro area data for 2023 refer to September (annualised values).

In 2023 the Portuguese banking system recorded operational costs, as a percentage of total assets, similar to those in the euro area, and higher recurring operating income (Chart B4.3). Staff costs and other administrative expenses, which include, among other things, salaries, social security contributions and IT, consultancy and advertising costs, account for the bulk of the banking systems’ operational costs in the euro area. In Portugal, these items together account for -1.2% of total assets (-1.1% in the euro area). In turn, net interest income is the most important component of profitability, despite heterogeneity across euro area countries. In Portugal, net interest income stood at 2.7% of total assets, above the euro area (1.4%). Commissions account for a smaller share, with Portugal and the euro area very close (0.7% and 0.6% respectively).

Operating income and costs and cost-to-core-income ratio, 2023 (a)
Sources: The ECB and the Banco de Portugal. | Note: (a) Euro area data for 2023 refer to September (annualised values).

In Portugal, the downsizing of the banking system has contributed to cutting operational costs and enabled increased investment in digitalisation in recent years. Between 2009 and 2023, the share of the banking system in the overall economy, as measured by the ratio of total assets to GDP, fell by 121 p.p. to 166%. Reducing structural costs is relevant for the competitiveness of Portuguese banks, given the need to strengthen investment in technological innovation and digitalisation to enable them to keep pace with progress at international level, whether by banks or by new entities developing financial activity. The growing digitalisation of financial services also entails greater care and investment in critical risk management areas such as cybersecurity. Between 2021 and 2023, IT expenditure increased on average by 13% per year. This investment in digital transformation enhances cost cuts by rationalising resources and processes. According to the Financial Access Survey (IMF), between 2018 and 2022 the number of banking transactions through digital channels per thousand adults in Portugal increased by 30% per year on average (up from 16% in a subset of euro area countries for which this information is available). However, the number of transactions remains low compared to that observed in Europe (44 vs. 100,000 in 2022).

References

Huljak, I. (2015). “Cost Efficiency of Banks in Croatia”. Croatian Review of Economic, Business and Social Statistics. 1. 12-26. 10.1515/ -2016-0002.

Huljak, I., Martin, R. and Moccero, D. (2019). “The Cost-Efficiency and Productivity Growth of Euro Area Banks.” Working paper, European Central Bank.

Roengpitya, R., Tarashev, N., Tsatsaronis, K. and Villegas, A. (2017), “Bank business models: popularity and performance”, No 682, BIS Working Papers, Bank for International Settlements.

5. Review of the operational framework for monetary policy implementation of the European Central Bank – Financial stability perspective

On 13 March 2024 the Governing Council concluded the review of the operational framework for monetary policy implementation, which had been launched at the end of 2022.¹² The choice of the operational framework for monetary policy implementation is not indifferent and may have effects on financial stability, in the short and long term. Its design could affect the functioning of markets and the behaviour of financial intermediaries, the amount of central bank liquidity available to the system and thus its ability to counter liquidity stress in the financial markets. Defining its characteristics therefore requires a careful assessment of the associated risks, which largely reflect the incentives that are created for the behaviour of the various economic agents.

In order to achieve its primary objective of maintaining price stability, the ECB Governing Council must decide, building on both economic analysis and monetary and financial analysis, on the short-term interest rate level needed to ensure price stability over the medium term, while seeking to influence prevailing money market conditions and hence the interest rates commercial banks apply to loans and deposits of other economic agents. The Eurosystem has a set of instruments at its disposal to provide or absorb the liquidity of the financial system, with an impact on short-term interest rates, and operates under a set of rules which together form the operational framework for monetary policy implementation. This framework is based on three main elements: (i) instruments, (ii) collateral (marketable and non-marketable) and (iii) counterparties. Instruments comprise monetary policy operations, standing facilities, minimum reserve requirements and forward guidance.

The Governing Council signals the monetary policy stance through the interest rates on the main refinancing operations, the marginal lending facility and the deposit facility. To fulfil its mandate, the ECB can also determine and implement non-standard monetary policy measures, such as the asset purchase programmes. This has occurred significantly over the last decade and a half, resulting in a framework of ample liquidity, which is expected to prevail for some time ahead.

In the ECB’s original operational framework, commonly referred to as the classical corridor system, which prevailed until around mid-2014, the central bank aimed to keep money market interest rates between the marginal lending facility rate (the upper limit of the corridor) and the deposit facility rate (the lower limit of the corridor) via the regular conduct of market liquidity management operations (typically lending) (Figure B5.1). This system was also usually characterised by a structural liquidity shortage in the money market, which caused money market interest rates to fluctuate around the rates on the main refinancing operations (MROs). However, in view of the various challenges facing the euro area, the past few years have been marked by ample liquidity conditions, with longer-term credit operations and financial asset purchases, which has led the key interest rate corridor, formally in place, to gradually become a de facto floor (minimum rate) system. The money market interest rate came to be in the vicinity of the deposit facility rate (DFR) (more details on this process can be found in Box 2 of the 2022 Report on Monetary Policy Implementation, Banco de Portugal). Normalisation of the Eurosystem’s balance sheet, i.e. the gradual decline in excess liquidity, has prompted reflection on the most appropriate way to steer short-term interest rates.

Monetary policy implementation in the euro area - systems
Corridor system	Floor system

Analysis from a financial stability perspective

The reflection on the operational framework to be adopted was assessed within the defined range of possibilities, generally considering two types of systems: the corridor system described above and the floor system, characterised by high liquidity, with money market interest rates in the vicinity of the deposit facility rate. This system is usually associated with an outright structural bond portfolio, in market operations that are executed by the Eurosystem to adjust its structural position vis-à-vis the financial sector. Therefore, with the floor system, there may exist regular market operations with a view to renewing this portfolio, which in general requires a larger central bank balance sheet than a corridor system, where liquidity provision takes place by means of operations against collateral.

A larger central bank balance sheet can promote financial stability: (i) by mitigating banks’ liquidity risks by having ample buffers available, typically in the form of liquid assets, (ii) by contributing to the transfer of duration and credit risks from financial intermediaries to the public sector and (iii) by curtailing the risk of disorderly market dynamics and the associated fragmentation risks.

However, the response in securities markets tends to be a compression of credit and term risk premia, leading to a flatter yield curve, with potentially adverse effects on financial stability. These effects, which tend to build up gradually over the medium to long term, include incentives for financial intermediaries to take additional risks (e.g. credit and/or liquidity risks) stemming from potentially adverse effects on profitability, namely for banks, insurance corporations and pension funds (with assets that typically have longer maturities). Having a regulatory regime and regular supervisory review in place to counter those incentives for banks is essential, in particular as regards the prudent management of liquidity by banks, which is more complex to achieve in the floor system. Indeed, the incentives associated with the current liquidity regulation (introduced after the global financial crisis) are mitigated, especially as far as compliance with the liquidity coverage ratio (LCR) is concerned.

In a floor system, liquidity management is also impacted by lower activity in the interbank money market, due to ample central bank reserves. An active money market is important for financial stability, as it supports banks’ liquidity management and provides market discipline and peer monitoring.

A dimension for which the floor system appears to be comparatively more appropriate is the role of lender of last resort played by central banks, which is essential for financial stability in times of stress. In fact, a floor system is more appropriate, not only for acting as lender of last resort to address banks’ liquidity pressures of a more specific scope, but also for the function of market-maker of last resort, avoiding systemic market dysfunctions. This dimension has become particularly relevant given the increasing importance of non-bank financial intermediaries in the financial system, which do not have access to central bank liquidity. Thus, in situations of financial stress, it may be necessary to inject large amounts of liquidity very quickly that encompass a wide number of participants to stabilise the market. In addition, unlike the corridor system, the floor system limits the direct repercussions of the assistance of the lender of last resort (or of the interventions to stabilise the functioning of the market) on the monetary policy stance. However, it may provide less leeway to intervene due to the increased risk of collateral scarcity and asset encumbrance, given the relatively larger balance sheet of the central bank.

The choice of system also has an impact on the financing conditions of the non-financial sector. Indeed, to the extent that providing liquidity also envisages purchasing debt instruments, thus fostering lower medium and long-term interest rates, the floor system may lead to higher levels of (public and private) debt. It may also have potential distributional effects across countries/sectors, because for a broad set of countries the financing costs of mortgage loans in general are closely linked to long-term interest rates, while non-financial corporations, to a large extent, take on loans at variable rates, indexed to short-term reference rates.

The arguments presented suggest that robustness (i.e. the ability to implement monetary policy in different financial and liquidity circumstances) and flexibility (i.e. ability to meet banks’ liquidity needs in an elastic manner by channelling liquidity effectively across the banking system) are key dimensions of the operational framework for monetary policy implementation and reveal that each system has advantages and disadvantages in the short to medium term under normal circumstances or in the case of stress in the financial markets.

New operational framework

The operational framework for monetary policy implementation announced by the ECB on 13 March is hybrid and flexible, with short-term credit operations (MROs) and three-month longer-term refinancing operations (LTROs) being conducted through fixed-rate tender procedures with full allotment (FRFAs) and a broad collateral framework comprising assets with high quality and market liquidity, such as government debt instruments, as well as assets without these attributes, such as claims that meet eligibility requirements.

By providing certainty in access to liquidity, these features promote financial stability. Liquidity will be provided in a flexible manner, based on banks’ funding needs, through a broad mix of instruments which, in addition to regular operations, will also include structural credit operations and a structural portfolio of securities. This operational framework is compatible with rapid switching between normal and stress periods without implying the central bank becoming the lender of first resort (or the market maker of first resort), which, from a financial stability perspective, should be avoided given the set of perverse incentives associated with that function.

Some of the above disadvantages can be mitigated by appropriately calibrating certain aspects of monetary policy implementation (e.g. structural portfolio size, combination of liquidity-providing operations with varying maturity and frequency, features of the collateral framework), or possibly by prudential authorities taking effective action.

Uncertainty about behavioural and structural changes in the financial system, some reflecting the regulatory reform that ensued after the global financial crisis, others constituting an endogenous response to the ample liquidity environment that prevailed for an extended period of time, calls for regular market monitoring. In this respect, it should be noted that on 13 March the Governing Council also announced that it intends to reassess key parameters of the operational framework for monetary policy implementation in 2026, based on the experience gained in the intervening period, standing ready to adjust earlier, if necessary, to ensure that monetary policy implementation remains in line with the established principles.

Special issue

Macroprudential policy at different phases of the financial cycle: the Portuguese case¹

1 Macroprudential policy – Objectives, instruments and implementation

Macroprudential policy aims to preserve financial stability. It does so by pursuing two objectives: increasing resilience and diminishing the build-up of risks and vulnerabilities in the financial system. In recent years, macroprudential authorities have implemented, on their own or together with others, two types of macroprudential instruments: capital measures and borrower-based measures (BBMs).

Capital measures increase institutions’ resilience immediately and directly. These measures can be applied to all or only a subset of institutions’ risk-weighted exposures, raising capital requirements, which makes the financial system more resilient and reduces the likelihood of financial crises (Birn et al., 2020). This makes it possible to absorb adverse shocks to the economy, maintaining an adequate flow of credit and thus preventing excessive deleveraging stemming from a lower flow of credit in times of systemic risk materialisation.

These measures may be cyclical or structural and may be partially or entirely reduced when the source of risk they are aimed at materialises or ceases to be considered systemic. An example of a cyclical capital instrument is the countercyclical capital buffer (CCyB), while instruments such as the capital conservation buffer and buffers that apply to other systemically important institutions (O-SIIs) are of a more structural nature. The systemic risk buffer (SyRB) is used to prevent and/or reduce systemic risk not covered by another capital measure and may be of a structural or cyclical nature (Table 1).

Turning to borrower-based measures (BBMs), their main objective is to foster the adoption by the banking system of prudent credit standards, improving the borrower profile and thus reducing the probability of default in the institutions’ portfolio. These measures set caps on the amount of credit that borrowers can obtain according to their risk profile, notably in what concerns the value of the property or the value of their income, and affect new loans, meaning that the impact on the financial system’s resilience is gradual. Accordingly, these measures reduce the magnitude of potential losses for institutions resulting from shocks to borrowers’ income and/or collateral value. This increases the shock-absorbing capacity of the financial system (Gross and Población, 2017; Neugebauer et al., 2021). In most countries where they have been implemented, they are of a structural nature and are therefore not expected to change over the financial cycle. As a result, these instruments often include some flexibility in their design, for instance by setting exemption clauses or adjustments in the calibration of some parameters.

The design and calibration of macroprudential policy measures should maximise the benefits to financial stability, while minimising the costs to economic activity. Empirical evidence indicates that the costs of macroprudential policy stemming from the decline/deceleration in economic activity are low and emerge mainly in the short term (Araujo et al., 2020; Birn et al., 2020; Richter et al., 2019). In turn, the benefits of increasing the resilience of the financial system are positive and emerge in the medium term (Araujo et al., 2020; Mendicino et al., 2020).

The assessment of certain factors by macroprudential authorities allows them to reduce policy costs in the short term. Examples include the amount of each institution’s management buffers and their willingness to use these buffers when systemic risk materialises. If an institution does not have sufficient management buffers, there may be a reduction or recomposition of the credit portfolio or even a contraction in new lending, with a negative impact on economic activity in the short term.

Moreover, the adequacy of the period granted by the macroprudential authority to implement the measure is key to reducing short-term costs and increasing net benefits. Mendicino et al. (2020) and Buratta et al. (2023) consider that longer transition periods allow for the build-up of further resilience without incurring significant costs, thereby preserving stable credit flows.

The phase of the financial cycle shapes the selection of instruments and the timing of their activation and release. In the upward phase of the financial cycle – when sources of cyclical risk and vulnerabilities accumulate in the financial system – macroprudential policy should implement capital measures to increase the financial system’s resilience against unexpected losses stemming from the materialisation of risks and mitigate the build-up of financial imbalances. The pace for building up capital measures depends on credit institutions’ internal capital generation capacity, which cannot be decoupled from interest rate levels and thus from monetary policy, particularly in countries whose banking systems have a credit portfolio with predominantly variable interest rates.

In the downturn of the financial cycle – when sources of systemic risk materialise or are reduced – macroprudential policy should fully or partially release cyclical capital measures. Under these circumstances, it is important to consider the timing and extent of such release. A premature release of capital buffers may reduce the level of resilience needed to absorb unexpected shocks in the future, while a late release, amid acute materialisation of risk, may limit the banking system’s ability to absorb losses while maintaining credit levels in the economy. Overall, when banks are more capitalised, unanticipated shocks are less amplified or actually absorbed by the financial system, with less impact on credit provision to the economy (Clerc et al., 2015; Mendicino et al., 2020; Faria-e-Castro, 2021).

Finally, in the case of borrower-based measures, costs to economic activity also depend on the tightening implemented in the face of market practices. The higher the share of borrowers whose decision to borrow is constrained by the measure, the higher the costs may be in the short term.

The protracted period of low interest rates between 2013 and 2021, followed by the recent phase of marked interest rate hikes to address inflation, has posed significant challenges to the conduct of macroprudential policy. Against this background, it is vital to understand macroprudential policy action throughout the different financial cycle phases, bearing in mind how it interacts with other policies, such as monetary policy (Banco de Portugal, 2015).

2 Interaction between monetary policy and macroprudential policy

While the main goal of monetary policy is to ensure price stability, macroprudential policy aims to increase resilience and mitigate the build-up of risks and vulnerabilities in the financial system and, to that end, to maintain financial stability (Fahr and Fell, 2017).

By containing the excessive build-up of cyclical systemic risk sources associated with periods of excessive credit and/or financial asset price growth, cyclical macroprudential instruments complement monetary policy. Financial stability is seen as a precondition for price stability, as recognised in the ECB’s 2021 monetary policy strategy review (European Central Bank, 2021). At the same time, monetary policy complements macroprudential policy, as price stability also contributes to financial stability by anchoring inflation expectations, removing inflationary distortions in financial markets and mitigating the procyclicality of the economy. As such, both policies interact in pursuing their respective objectives and reinforce each other.

This complementarity mainly emerges when business and financial cycles are synchronised, which makes it possible for both policies to move in the same direction. During the upward phase of the business cycle characterised by economic expansion and above-target inflation, monetary policy is expected to tighten. When this phase of the business cycle coincides with a financial cycle phase in which risks and vulnerabilities are building up, macroprudential policy is expected to move in tandem. The increase in the benchmark interest rate and the application of higher capital requirements affect the economy via lending, reinforcing its impact on costs incurred.

However, the two policies can originate negative spillovers in the short term (Laeven et al., 2022; Van der Ghote, 2021). By sharing transmission mechanisms, both policies impact on credit supply, thereby influencing the amplitude of the financial cycle, institutions’ profitability and economic activity. The effectiveness of each policy is thus conditioned by the other’s direction. In the event that the economy is at an early stage of economic recovery, the impact of an accommodative monetary policy may be counteracted by the adoption of overly tight macroprudential measures with procyclical effects resulting in an excessive slowdown in lending. In turn, protracted low interest rate environments may fuel riskier lending dynamics and higher prices of other assets (e.g. real estate), leading to the build-up of financial stability risks and, consequently, the need to adopt tighter macroprudential measures.

On this interaction, empirical evidence shows that periods of rapid monetary policy tightening after a protracted period of low interest rates tend to increase the likelihood of cyclical systemic risk materialisation, with a potential negative impact on economic activity (Boissay et al., 2023). This may affect the pursuit of monetary policy’s price stability objective (particularly in systems with a dual mandate), as it may lead to monetary policy possibly having to react and take extraordinary liquidity-providing measures, or to reduce the level of interest rates. The fact is that preventive macroprudential policy action can increase the resilience of the financial system, making it less vulnerable to unanticipated shocks and allowing monetary policy to focus more on its main objective.

In addition to the specific phase of financial and business cycles, their degree of synchronisation and the banking system’s capital position, the interaction between macroprudential and monetary policies also depends on the characteristics of the financial system, namely the weight of fixed or variable rate loans and the importance of the non-banking financial sector, as they may lead to lagged effects on the economy. Finally, the completeness of the institutional framework is also important to ensure the effectiveness of macroprudential policy.

3 Macroprudential policy at a time when financial cycle vulnerabilities and risks build up

In 2013, the Banco de Portugal was entrusted with setting and conducting macroprudential policy. The designation of the national macroprudential authority was set against a scenario where the Portuguese economy was significantly constrained by (i) the process of correcting the macroeconomic imbalances accumulated during the 2008 financial crisis and the euro area sovereign debt crises, (ii) the high uncertainty associated with them and (iii) financial market fragmentation. Simultaneously, vulnerabilities related to private and public sector over-indebtedness remained.

At the time, the macrofinancial environment was characterised by a backdrop of low nominal and real interest rates that intensified from 2013 up to 2021 and prompted reflection on its effects on financial stability. It was concluded that the protracted low interest rate environment could benefit financial stability but could also lead to the build-up of vulnerabilities and risks (Borio and Zhu, 2012; CGFS, 2018).

Low interest rates affect economic agents’ risk-taking decisions, bringing benefits to the economy by boosting investment and, consequently, economic activity. However, low interest rates can give rise to dynamics that lead to the build-up of vulnerabilities and risks to financial stability, encouraging search-for-yield behaviours, and thus higher associated risk. Against this background, there may also be a widely held perception that risk is low, as credit standards are looser and funds are channelled to borrowers with a higher risk profile. This makes the banking system more vulnerable to shocks, adding to the aforementioned effect.

While this search-for-yield and excessive risk-taking behaviour may affect various asset classes, the effects on the real estate market are particularly substantial. Some research (Claessens et al., 2013 and Jordà et al., 2015) indicates that financial crises stemming from house price overvaluation, particularly when fuelled by credit expansion, are characterised by longer recession periods and greater losses to the economy. The procyclical relationship between house price growth and credit, where rising house prices are reflected in the value of the collateral, may lead to an increase in the availability of credit. This could trigger rising housing demand, which might consequently lead to a further rise in house prices. This procyclical relationship tends to intensify in low interest rate environments and is closely linked to the emergence of financial crises associated with the real estate market (Claessens et al., 2008 and Jordà et al., 2015). Macroprudential policy can play an important role in countering this build-up in systemic risk.

In 2018, taking into account the protracted low interest rate cycle and the potential build-up of risks and vulnerabilities going forward, the Banco de Portugal introduced two macroprudential measures targeting the Portuguese banking system.

3.1 BBMs implemented in Portugal and in Europe

In view of the importance of housing credit for the Portuguese banking system and the predominance of variable rates, the Banco de Portugal adopted the Recommendation on new credit agreements for consumers in July 2018. This Recommendation² set limits to the loan-to-value (LTV) and debt service-to-income (DSTI) ratios, and to maturity, as well as regular principal and interest payments requirements, aiming to prevent excessive risk-taking by the financial sector and households. The Recommendation was driven by evidence of an easing of credit standards by the Portuguese banking sector, a trend which was expected to intensify owing to the protracted low interest rate environment and competition between institutions.

In designing and calibrating the Recommendation, the Bank took into account, among other things, the risks to financial stability stemming from the low interest rate environment. Such an environment could provide an incentive for risk-taking and increased indebtedness, leading to the emergence of asset price bubbles. Particularly, in Portugal most housing loans were then granted at a variable interest rate, with agreements indexed-linked to the Euribor rate, leading to a faster transmission of monetary policy. With this in mind, the design and calibration of the DSTI ratio limit contemplated an upward cycle in European Central Bank (ECB) benchmark rates, by including an interest rate shock of up to 3 p.p. in their calculation to reduce the risk of possible defaults on new loans.

Between 2014 and 2019, 21 countries also implemented BBMs, including limits to the LTV, DSTI, loan-to-income (L/DTI) ratios and maturity (Table 2). Limits to the LTV ratio were those most commonly adopted by European macroprudential authorities (19 countries, up to the end of 2019). As in Portugal, these measures aimed to promote the adoption of more prudent credit standards, limiting excessive indebtedness and protecting the banking system from exuberant developments in real estate markets. Most countries, including Portugal, combined different instruments.

3.2 Capital measures implemented in Portugal and in Europe

In addition, the Banco de Portugal also implemented a capital measure in 2018. As required by European legislation, an O-SII buffer has been introduced. As a structural measure, the purpose of this capital buffer is to offset the higher systemic risk posed to the Portuguese financial system by systemic institutions, to restrict possible incentives for excessive risk-taking and to increase the resilience of the financial system as a whole. In accordance with the methodology established by the Banco de Portugal, six systemically important institutions were then identified, which were required to hold capital buffers. As in Portugal, the relevant European macroprudential authorities have established methodologies for the identification of O-SIIs and the calibration of this buffer.

This O-SII buffer was also adopted during the phase of the financial cycle characterised by low interest rates with an impact on internal capital generation and resulting low profitability of the banking system. At that time, the effects of the 2008 financial crisis were also felt, as mirrored by the high level of non-performing loans (NPLs). The Banco de Portugal introduced a phase-in period over four years, starting in 2018, so as not to halt credit recovery, the NPL reduction process and sustained economic growth over the medium term (Table 3).

Notable among capital measures implemented in EU countries was the activation and reinforcement of the countercyclical capital buffer (CCyB) by an increasing number of countries between 2013 and mid-2019 (Chart 1). This buffer aims to protect the banking sector during periods when cyclical systemic risk increases due to excessive credit growth. When risks materialise or decrease, this additional capital buffer may be released by macroprudential authorities. The main goals of the measures that have been implemented and, in some cases, reinforced during this period were to mitigate the build-up of cyclical systemic risk, in particular that associated with excessive credit secured by real estate, amid signs of overvaluation in residential real estate prices in several European countries. The CCyB rates introduced ranged from 0.25% to 2.5% of the total risk exposures’ amount. During the COVID-19 crisis, several European macroprudential authorities released this buffer, partially or fully, in order to support the flow of credit to the economy. In the case of Portugal, the CCyB buffer has stood at 0%, given the quarterly risk assessment following the Banco de Portugal’s methodology³ and taking into account other macroprudential measures already taken.

CCyBs applied in Europe (since December 2013) | Per cent
Source: ESRB. l Notes: The value in the vertical axis corresponds to the cumulative percentage of the CCyB rate applied by jurisdictions in the European Economic Area that activated or maintained this instrument in each quarter. Section 3 covers the period from December 2013 to January 2020 and Section 4 covers the period from January 2020 to December 2023.

4 Macroprudential policy during a reversal in the financial cycle

Following a long upswing in the financial cycle, characterised by a build-up of vulnerabilities and risks that macroprudential authorities sought to mitigate, over the past two years the international economy has come under the effect of exogenous shocks at a global level. The Russian Federation’s invasion of Ukraine has particularly affected energy and commodity markets as well as supply chains, leading to increased uncertainty for economic agents, constraining the recovery in economic activity and exacerbating inflationary pressures already stemming from the pandemic. Against this background, the ECB raised its official interest rates at a pace unparalleled in recent euro area history.

In 2023 concerns over financial stability shifted focus to the implications of higher interest rates and the risks of a slowdown in economic growth. Tighter financial conditions drove a continued downturn in the financial cycle, although systemic risk sources have not materialised.

Portuguese banks’ profitability and capital management buffers remained at comfortable, albeit heterogenous, levels across institutions. Looking ahead, higher debt servicing costs and a deteriorating macroeconomic environment could challenge the debt servicing capacity of the non-financial sectors and gradually impair banks’ asset quality. In addition, there are lower lending volumes and rising funding costs, which may predict a future negative impact on banks’ profitability and resilience.

4.1 BBMs implemented in Portugal and in Europe

After 2020, the Banco de Portugal reviewed the calibration of its macroprudential policy instruments. Regarding the Recommendation, in January 2022 the Banco de Portugal recommended new limits to the maximum maturity of new loans for house purchase according to the borrower’s age. In 2023, as the Bank recognised that the interest rate shock considered when calculating the DSTI ratio was too restrictive an approach to assessing borrowers’ creditworthiness, it halved it. The 1.5 p.p. shock now considered for new credit with a maturity of over ten years and a variable or mixed interest rate means that Euribor rates may reach similar levels to the historical peaks observed in the euro area. Also, by design, the Recommendation has always contained exemption clauses from the limit applied to the DSTI ratio to prevent the Recommendation from being too restrictive on households’ access to credit in periods of rising interest rates.

Amid rapidly and significantly increasing interest rates, 15 countries maintained BBMs in place to prevent banks from taking excessive risks when lending to households (Table 2). In addition to Portugal, other European macroprudential authorities have eased some of the limits when granting credit, particularly with regard to the DSTI ratio. In Czechia, the upper limit of the DSTI ratio was abolished, while by contrast limits to the LTV and DTI ratios remained unchanged. In Norway, the interest rate shock used for calculating the DSTI ratio was reduced, as credit standards were assessed by the national macroprudential authority as being tighter than in 2017, when the measure was implemented.

4.2 Capital measures implemented in Portugal and in Europe

In November 2023, the Banco de Portugal introduced a 4% sectoral SyRB buffer on the risk-weighted exposure amount of the households’ portfolio secured by residential real estate located in Portugal applicable to banks using the internal ratings-based (IRB) approach. This preventive measure will enter into force on 1 October 2024, aiming to increase the resilience of institutions to potential systemic risk materialisation in the residential real estate market in Portugal. As such, this buffer enhances resilience against a potential reversal of the business cycle and/or a significant unexpected correction in residential real estate prices.

Capital buffers like the SyRB can be released when risk materialises or to reduce systemic risk. The current and future high levels of banks’ management buffers mitigate potential negative effects that the introduction of a new buffer could have on their ability to supply credit. The sectoral SyRB is also not expected to hinder compliance with the other requirements and guidelines.

In addition, this sectoral buffer is a further strengthening factor for banks and complements the Recommendation, eased in 2023. Through different transmission channels and time horizons, the two instruments contribute to (i) promoting the adoption of prudent credit criteria throughout the financial cycle, (ii) improving the borrowers’ risk profile by increasing their resilience against potential shocks to income, interest rates and real estate prices and (iii) enhancing the resilience of the banking system by making it possible to absorb unanticipated losses without jeopardising its financial intermediation function.

On 30 April 2024, 16 European countries had SyRB buffers in place, nine of which were general buffers (Chart 2) and seven of which were sectoral buffers (Chart 3).

The Bank conducted its annual review of the O-SII buffer, with ensuing value updates according to the assessment of the systemic importance of Portuguese institutions. The Banco de Portugal identified seven systemic banking groups in 2023 and applied the buffer to one of these groups at two consolidation levels (Table 3).

Over the past year, European national macroprudential authorities continued to tighten macroprudential policy in order to boost the resilience of banks, which was facilitated by banks’ high average profitability levels and management buffers. Several authorities activated the countercyclical buffer (CCyB) to address vulnerabilities linked to the build-up of excessive credit risk or to create more macroprudential space in the form of releasable capital buffers. In the case of Portugal, this buffer was maintained at 0%, as per the methodology. In 2023, eight countries introduced or tightened this buffer, bringing the total number of countries that implemented or announced a positive CCyB to 14 by the end of the year (Chart 1).

5 Conclusion

Lessons can be drawn for the design of a macroprudential policy strategy from conducting macroprudential policy in Portugal and the European Union over a decade throughout different financial cycle phases.

The first lesson is that macroprudential policy decisions should be based on an analysis of intertemporal costs and benefits. Empirical evidence suggests that costs in terms of a slowdown in economic activity are small and mainly in the short term. In contrast, the benefits of implementing a macroprudential measure, substantiated in greater resilience of the financial system, materialise over the medium term. The costs will be more or less substantial depending on the financial system’s management buffer levels and institutions’ internal capital generation capacity, or the share of borrowers whose decision to borrow is constrained. These costs are reduced when a transition period is established for the gradual implementation of the measure.

The second lesson is that monetary and macroprudential policies are complementary, although in the short run they may generate negative spillovers from sharing transmission mechanisms, which can affect the amplitude of financial and business cycles and the level of risks and vulnerabilities in the financial system. In pursuing their objectives, the two policies should then seek to identify potential trade-offs and find ways to minimise them, without undermining the primary objective of monetary policy.

The third lesson relates to how macroprudential policy acts across different phases of the financial cycle, depending on the instruments used and how they are combined. Overall, during the upward phase of the financial cycle, macroprudential authorities should implement capital measures to increase the financial system’s resilience against losses stemming from the materialisation of risks and/or mitigate the build-up of such financial imbalances. In turn, during a downturn in the financial cycle, macroprudential policy should (fully or partially) cut back on cyclical capital measures. However, this course of action may need to be adjusted where certain factors come into play. For instance, in the case of banking systems where credit is mostly granted at a variable rate, periods of low interest rates constrain the profitability of the financial system. In this case, it is beneficial for the macroprudential authority to opt for longer periods of capital build-up as opposed to periods of high interest rates. In turn, capital buffers are expected to be implemented or reinforced in times of persistent sources of systemic risk and vulnerabilities in the financial system that have not yet been effectively mitigated by the existing macroprudential instruments, or in times of a marked reversal of the financial cycle and greater likelihood of systemic risk materialisation.

As regards BBMs, which are structural in nature, their structure is not expected to be dependent on the position of the financial cycle, unlike what generally happens in the case of capital measures. Measures targeting credit conditions should be designed to ensure that prudent criteria are applied at all phases of the financial cycle. As such, the specific design features or incorporation of exemption clauses of such measures should be defined in such a way as to allow some flexibility so that, for instance, in periods of rapidly rising interest rates, particularly in countries with predominantly variable rate credit, they should not become too restrictive for households to access credit. Those flexibility elements are also a macroprudential policy tool.

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The role of firm characteristics on bank loans’ interest rates¹

From July 2022, following the rapid and significant rise in inflation, the European Central Bank (ECB) responded with the fastest increase in policy rates since the creation of the Euro Area. A consistent increase in both the 3-month and 1-year Euribor rates (interest rates in the interbank lending market) was observed, as illustrated in Chart 1.

One of the key channels of the ECB monetary policy is through the credit market to firms, due to the predominance of variable rate loans and the rollover risk of fixed rate loans. Banks passed on the increase in their funding costs to the interest rates on loans to firms. Between June 2022 and July 2023, the average interest rate on new loans to firms in Portugal jumped from 3% to 6.6%, with the 1-year Euribor climbing from 0.85% to 4.14%. Despite this sharp rise, current interest rates on new loans to firms remain lower than those observed during the sovereign debt crisis.

Interest rates on new loans to firms and 1-year/3-months Euribor | Per cent
Notes: The red line represents the simple average of interest rates on new loans to Portuguese firms, while the blue line shows the median interest rate on these loans. The grey shaded area indicates the range between the 20th and 80th percentiles of the interest rates distribution.

Previous studies, such as Santos (2013) and Bonfim et al. (2021), analysed the determinants of bank loan interest rates for firms in Portugal. Santos (2013), using information from June 2012 to February 2013, found that banks establish price conditions on the basis of borrowers' characteristics, such as firm risk (proxied by the probability of default) or size. Firms with more fragile financial conditions are charged a higher interest rate. Bonfim et al. (2021) showed the importance of banks' characteristics in loan pricing, with a special focus on the role of banks' capital. For the period from 2012 to 2019, they found that better capitalized banks are more conservative in their loan pricing.

This study builds upon previous research by incorporating more detailed information on firms. Specifically, it focuses on three key financial aspects of firms: indebtedness, liquidity, and profitability. These financial soundness indicators are important in determining the observed dispersion of interest rates in Figure 1. In periods of overall changes in borrowing costs, such as due to monetary policy tightening, the impact on firms' financing conditions can be intensified or mitigated depending on their financial standing. These changes in borrowing costs can also magnify effects in the real economy; for example, Durante et al. (2022) demonstrate that investments by highly leveraged firms are more responsive to monetary policy shocks. From a financial stability perspective, how banks price different firms’ financial characteristics is relevant for their own stability. Banks should be able to identify borrower vulnerabilities and price them accordingly.

1 Data sources and descriptive statistics