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«BLUEPRINT SERIES 25 EUROPEAN BANKING SUPERVISION: THE FIRST EIGHTEEN MONTHS Dirk Schoenmaker and Nicolas Véron, editors Thomas Gehrig, Marcello Messori, ...»

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bank with a significant footprint outside Portugal – it owns banks in Brazil, South Africa, Macao, East Timor and all former Portuguese colonies in Africa with the exception of Guinea-Bissau. Millennium BCP is the largest private-sector group, with significant operations in Poland and also in Mozambique and Angola. By end-2015, Angola’s Grupo Sonangol was its main shareholder with 18 percent, followed by Spain’s Banco Sabadell with 5.1 percent. Novo Banco is the ‘good bank’ that emerged from the resolution of Banco Espírito Santo (BES) in August 2014. Banco Português de Investimento (BPI) is the smallest of the four. As of April 2016, BPI’s main shareholders were Spain’s CaixaBank (44 percent) and Angola’s Isabel dos Santos (close to 20 percent)105, and it in turn owned a controlling position (51 percent) in Angola’s largest and most profitable bank (Banco de Fomento de Angola). In addition, Spain’s Santander Group has a significant presence in Portugal through its wholly owned subsidiary Santander Totta, which also in late December 2015 bought the performing operation of Banco Internacional de Funchal (Banif ), a smaller bank that had gone through a resolution process106.

The Portuguese supervisory authority is the national central bank, the Bank of Portugal, which now also has resolution authority.

The 2011-14 assistance programme In April 2011, the Republic of Portugal sought assistance and obtained a three-year assistance programme from the European Union, the ECB and the IMF. The package was agreed in May 2011 and included a €78 billion loan, split equally between the European Financial Stabilisation Mechanism, the European Financial Stability Facility and the IMF. Of these funds, €12 billion was to be reserved for the country’s 105 On 18 April 2016, Caixa Bank announced a preliminary offer to take full control of the bank. It was the second announcement in less than a year.

106 In addition to this sale, a vehicle (Oitante) for non-performing assets (mostly NPLs, secured and unsecured) and a residual bad bank, which retained the name Banif, were created.

140 | BRUEGEL BLUEPRINT banks, which had to raise their CET1 ratios to 9 percent in 2011 and to 10 percent by the end of 2012107. The programme also included a fully-funded capital backstop facility of €35 billion, as well as “safeguards to support adequate banking system liquidity and for strengthening the supervisory and regulatory framework”108. The backstop facility was independent from the aforementioned €12 billion capital facility and was meant to facilitate the wholesale financing of Portuguese banks in the presence of the downgrading of their respective ratings below investment grade. These measures were intended to create the conditions for an orderly deleveraging of private-sector balance sheets while preserving financial sector stability.

The banks’ dependence on ECB funding had increased sharply in the months before the programme. As a result, the programme required all major banks to produce quarterly updates of their funding and capital plans.

The Portuguese economy had accumulated imbalances in the decade prior to 2011. During this period, the economy became ever more dependent on bank credit, posting substantial accumulated deficits on the part of both the government and non-financial corporations. The adjustment initiated in 2011 noticeably changed this trend, with the total financing needs of the economy decreasing by 13 percent of GDP in the six years ending in December 2015109.

As a result of the accumulated borrowing prior to 2011, which was mostly bank lending, private corporations started a significant deleveraging process which led to a decline in their accumulated debt in excess of 20 percent of GDP between the start of the programme and December 2015110. However, at the end of 2015, the debt of 107 Only half the amount, ie €6 billion, was used to recapitalise Portuguese banks during the three-year bailout programme.

108 Portugal’s Letter of Intent to the IMF, May 2011.

109 Source: Statistics Portugal and IGCP (Portugal’s Debt Management Agency).

110 Source: Bank of Portugal.

141 | EUROPEAN BANKING SUPERVISION: THE FIRST EIGHTEEN MONTHS

non-financial corporations still represented more than 145 percent of GDP, the same level as in December 2008111. Because most of the financing of corporate debt had been done through bank lending, this trend was followed by the very substantial deleveraging of the balance sheets of banks operating in Portugal.

The adjustment of Portugal’s economy after 2011 had a significant impact on banks. This, together with increased capital requirements and a new institutional framework for regulation and supervision, led to a major overhaul of the competitive landscape in Portugal’s banking sector, leading to its greatest transformation in decades112. The deleveraging process after the beginning of the adjustment programme led to a 19 percent reduction in total banking assets between May 2011 and June 2015. The equivalent figure for the euro area was a mere 2.8 percent decrease113.

Credit-to-deposit ratios for the system had been rising steadily since 2000, when the ratio was 115 percent, reaching a maximum of

161.5 percent at the end of 2009114. With the implementation of the adjustment programme and following the troika’s instructions, the Bank of Portugal recommended that the (then) eight largest banking groups reduce their loan-to-deposit ratios to 120 percent by the end of





2014. The credit-to-deposit ratio decreased steadily, from 158 percent at end-2010 to 140 percent at end-2011, and 104.2 percent at the end of September 2015. Even so, the downgrading of Portugal by the three main credit rating agencies, which occurred during 2010 and 2011, 111 Deleveraging of non-financial corporations continued throughout 2015 at a slightly slower pace than in the previous years.

112 In March 1975, all Portuguese-owned banks were nationalised, while foreign banks then operating in Portugal were left untouched. Everything else was kept unchanged. This time, there was a smaller change in the ownership structure of banks but the change in the sector’s structure was much more pronounced, and likewise the regulatory framework faced by banking institutions.

113 Source: ECB.

114 Credit net of impairments, including securitised and non-derecognised loans.

Source: Bank of Portugal.

142 | BRUEGEL BLUEPRINT adversely affected the ratings of Portuguese banks115 and led to a substantial increase in the amount they borrowed from the ECB, from €10 billion in December 2008 to €60.5 billion in June 2012116. This amount started to decrease in mid-2012, and was €25.1 billion in September

2015. Correspondingly, the share of Portuguese banks in total funding granted by the ECB fell from 8.1 percent in April 2011 to 3 percent in June 2015117.

The rise in credit risk led to a substantial increase in the impairments recorded by banks, which rose from €3.56 billion in 2010 to €6.6 billion in 2011, €7.2 billion in 2012, €6 billion in 2013, €8.2 billion in 2014 and €8.5 billion in 2015118. The simultaneous decrease in net interest income, from €7.9 billion in 2011 to €5.6 billion in 2014, affected the profitability of banks119. As a result, in recent years the return on Portugal’s banking assets fell sharply. In aggregate, Portuguese banks only returned to profit in the first half of 2015. In December 2015, NPLs represented 12 percent of total loans. In spite of this significant deleveraging, however, households and non-financial corporations have remained more dependent on bank loans than the euro-area average: in December 2014, loans to private customers were 72 percent of GDP in Portugal versus 51.7 percent for the euro area, while loans to non-financial firms were 50.4 percent in Portugal and

42.4 percent in the euro area120.

Portuguese deposits have remained more stable than in some other countries facing economic and financial adjustment. Deposits from 115 Among major banking groups, only Santander Totta retained investment-grade status.

116 Source: Bank of Portugal.

117 Source: Bank of Portugal, ECB.

118 Source: Bank of Portugal.

119 At the time of writing there is no equivalent figure for 2015.

120 Source: AMECO, ECB. It includes only loans and not debt-issued securities.

Although there are no more-recent figures for Portugal it is clear that the relative assessment did not change meaningfully in 2015.

143 | EUROPEAN BANKING SUPERVISION: THE FIRST EIGHTEEN MONTHS

the non-monetary sector were €208 billion in May 2010, reached a peak of close to €240 billion in early 2012, and stood at €219 billion in June 2015121.

Efforts to ensure the capitalisation of most banks led to an improvement in the quality of banks’ own funds. Core Tier 1 (CET1) ratios were

8.7 percent in December 2011, 11.5 percent in December 2012, 12.3 percent in December 2013, 11.3 percent in December 2014 and 11.6 percent in September 2015122, 123.

In accordance with the programme, from 2011 the Bank of Portugal conducted several inspections of the largest Portuguese banking groups to assess whether the accounted impairments were adequate.

The first exercise occurred in the second half of 2011 and was intended to perform an assessment of credit portfolios, the validation of credit risk capital requirements and the assessment of parameters and methods used in stress testing. It concluded that there was a need to reinforce impairments by €596 million124. The second exercise took place in the second half of 2012 and assessed credit exposure to real estate, leading to the need to reinforce impairments by €474 million. The third inspection, in June and July 2013, assessed €93 billion of credits and led to a need to reinforce impairments by €1.1 billion. The fourth and final inspection occurred between October 2013 and March 2014 and centred on 12 large clients across the system, producing a further need to reinforce impairments by €1 billion.

From the beginning of the programme until mid-2015, six banks used €16.53 billion of the €35 billion state guarantee facility, totalling 121 Source: ECB.

122 Source: ECB, using data from bank groups and domestic banks on a consolidat ed basis, excluding the insurance business, when applicable.

123 Since the beginning of 2014, Portuguese banks have had to follow the new CRDIV/CRR transitional arrangements for the adequacy of own funds (CET1 ratio of 7 percent). The Bank of Portugal obliged Portuguese banks to meet a minimum CET1 ratio of 10 percent by December 2013.

124 Source: Bank of Portugal.

144 | BRUEGEL BLUEPRINT 16 new operations125. This line was created to mitigate banks’ financing pressures and to support collateral buffers. That is, the government extended guarantees on bank bonds to be used as temporary collateral for Eurosystem financing126. In addition, to strengthen the capital position of specific banks, between 2012 and 2014 public injections of new capital through issuance of new shares were made into CGD (€750m) and Banif (€700m). State-sponsored convertible bonds (CoCos) were allocated to Banif (€400m), Millennium BCP (€3 billion), BPI (€1.5 billion) and CGD (€900m). Of these, only €3.75 billion has been repaid127.

In 2014, the newly-established Portuguese Resolution Fund injected €3.9 billion into Novo Banco in the process of resolving BES.

Supervision during the programme and beyond: the Bank of Portugal and European banking supervision Problems in the Portuguese banking sector started to emerge before the 2011 programme. In 2008, a small bank (BPP, Banco Privado Português) was liquidated, but the government nationalised ailing BPN (Banco Português de Negócios) for fear of destabilising the sector.

This near-bankruptcy and subsequent nationalisation prompted a parliamentary inquiry and several criminal cases, which uncovered several episodes of apparent excessive leniency (maybe naiveté) towards BPN by the supervising authorities in the years prior to nationalisation. These events and subsequent losses at BPN post-nationalisation generated unprecedented pressure on the Bank of Portugal, which was seen as lacking initiative and demonstrating excessive caution prior to action: for close to ten years BPN had been seen by the market as a non-compliant institution although it benefited from apparent complacency on the part of the supervisor, who followed the old-time 125 Source: Portuguese Ministry of Finance, Directorate General of Treasury and Finance.

126 Similar schemes have been implemented in several other euro-area countries.

127 In any event, a substantial part of the recapitalisation facility was left unused.

145 | EUROPEAN BANKING SUPERVISION: THE FIRST EIGHTEEN MONTHS

common practice of ‘trusting a banker’s word’ In spite of this, and.

before the case was made public, the supervisor was already taking steps to increase its ability to effectively regulate the Portuguese banking sector. After years of preparation and study, the Bank of Portugal had promoted internal changes, separating solvency and capital adequacy supervision from behavioural supervision, reinforced the supervision area with new specialists and, after 2008, started supervising in situ all major banks, with permanently embedded teams monitoring their day-to-day activity. In other words, the Bank of Portugal’s supervisory approach was to a great extent proactive, even though the effectiveness of the changes in terms of the daily supervisory and regulatory practice fell below everybody’s expectations.

In spite of this reinforcement and of the collaboration with the troika’s experts during the programme, the Portuguese authorities were unable to avoid the failure of BES, then the third-largest bank operating in Portugal, in July 2014. This event, occurring after years of allegedly tight scrutiny and examination involving the Bank of Portugal, the ECB (as part of the troika even before the start of European banking supervision in 2014), the European Commission and the IMF, was clearly detrimental to the public perception of the effectiveness of bank supervision and regulation128. The negative public perception in Portugal of the effectiveness of banking regulation concerns all relevant players, although local politicians (especially members of parliament) have singled out the Bank of Portugal as the source of the lack of effectiveness and inadequate pre-emptive measures that these cases arguably illustrate.

The ECB’s comprehensive assessment of euro-area banks happened at the same time as the BES debacle. The assessment initially included CGD, BPI, Millennium BCP and Espírito Santo Financial Group, but the BES resolution led to the latter being removed from 128 In spite of this lack of confidence expressed in the media and via opinion polls, total deposits in Portugal were not affected, with most of the deposits departing BES/Novo Banco going to other Portuguese banks, notably state-owned CGD.

146 | BRUEGEL BLUEPRINT the list. CGD and BPI passed the test, while Millenium BCP failed the stress test under the adverse scenario129. The asset quality review of 2014 strengthened confidence in the Portuguese banks’ balance sheets. Nevertheless, some evidence indicates that, though it was demanding and fairly rigorous, the examination failed to take into account the fact that some of the banks’ assets are parked at above-market prices in so-called ‘restructuring funds’ From 2011.

onwards, some of the major banks, notably BES and Millenium BCP (and to a lesser extent Montepio, a smaller bank, and only residually CGD), transferred NPLs and other soon-to-be-troubled loans to nominally independent funds at close to book value, in exchange for participating units in these funds, becoming the sole participants of each of these funds. It seems that, as of the time of writing, these units are still valued above market prices, in spite of recent adjustments.



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