A turning point as Portugese banks seek growth

Amid the gloom of a deep recession, and after a year of record losses for his bank, Nuno Amado, chief executive of Millennium BCP – Portugal’s second largest lender by assets – has found a reason for cautious optimism. Almost every day, he says, he meets company managers who want to talk about loans. He is equally encouraged that most of them are also visiting his competitors.

“Today, when we meet a firm with a medium to good risk profile, we usually find there are three or four other banks competing for their business,” he says. “This is an encouraging sign that the demand for credit is gradually returning.”

Even more positive, says Mr Amado, is the fact that many of these companies are seeking funds to expand their businesses overseas – such as the winemaker he spoke to recently, who sells 75% of his goods outside of Portugal. “These are exactly the kind of companies Portugal needs to drive the economy forward,” says Mr Amado, who in 2006 succeeded António Horta-Osório – now head of Lloyds Banking Group – as CEO of Santander Totta, the Spanish bank’s Portuguese subsidiary, before taking the helm at BCP in February 2012.

If, as Mr Amado believes, “BCP is very much a mirror of Portugal”, for better and for worse, these early indications of emerging credit demand, fuelled by manufacturers turning away from a depressed domestic economy to fast-growing markets outside Europe, will be warmly welcomed by a country and a banking sector badly in need of good news.

As Portugal's centre-right government of prime minister Pedro Passos Coelho tightens an already tough austerity programme to reach fiscal targets agreed with the EU and the International Monetary Fund as part of a €78bn bailout programme, the economy is expected to contract by 2% in 2013, the country’s third consecutive year of recession. In a country used to low levels of unemployment, the jobless rate is forecast to reach a record 17.3% this year – and more than 40% among under-25s. Public debt is projected to peak at 122% of national output over the next two years.

Elusive profits

A sharp fall in average return on equity (ROE) to much less than 5%, excluding one-off items, illustrates the impact of the crisis on banks (the official ROE level was -0.3% in September 2012). Before the previous government was forced to request a bailout in May 2011, average ROE levels were more than 12%.

“It was normal to see 15% [ROE], although this was based on huge risk-taking,” says a Lisbon-based banking analyst. Of the country’s five largest banks, only unlisted Santander Totta posted a profit in 2011, joined by Banco BPI and Banco Espírito Santo in 2012. Along with Portugal itself, all the country's leading lenders have seen their credit ratings cut to below investment grade.

While the coalition government is under pressure to cut the budget deficit and lower public debt, Portugal’s banks are required by the European Banking Authority (EBA) to lift their core Tier 1 capital ratios to 9%, and to 10% under Bank of Portugal rules aimed at ensuring they can weather a substantial rise in loans losses. They are also under orders to reduce their loan-to-deposit ratios to less than 120% by the end of 2014, a target requiring massive deleveraging.

Banks have invested great efforts in doing this 'heavy lifting' over the past 18 months and – at great cost – have largely succeeded in resolving their underlying capital and liquidity issues. The goal now is to build sustainable profitability in a domestic market that has not yet begun to emerge from its worst economic crisis in more than half a century.

“Profitability and asset quality is the main challenge for the banking sector as a whole and for BPI,” says Fernando Ulrich, chief executive of BPI, the country’s third largest listed bank and, just behind unlisted Santander Totta, the listed lender that posted the largest net profit in 2012 at €249m. “BPI's main objectives in 2012 had to be, first, liquidity and, second, recapitalisation,” says Mr Amado of BCP, which recorded a record loss of €1.2bn last year. “Now the bank can focus on the third phase, profitability and sustainable growth.”

Flashes of optimism

Despite grim economic figures and grinding austerity measures, there are, according to both Mr Amado and Mr Ulrich, some reasons for bankers to be, if not cheerful, then at least prudently hopeful. Faced with a collapse in domestic demand, Portuguese companies have increasingly turned to overseas markets. Exports rose by 5.8% in 2012, the third consecutive year of strong growth, with shipments to fast-growing markets outside Europe surging by almost 20%.

Together with falling imports, this trend has seen the current account deficit drop from 10% to 2.5% of gross domestic product in three years, while the trade deficit fell by €5.6bn in 2012 alone, to €10.7bn. Competitiveness, in terms of unit labour costs measured against the eurozone average, has improved significantly over the past three years. Portugal has recently seen one of the fastest growths in innovation in the EU, helping it to move steadily closer to the EU average.

Bankers are hoping that exporters and companies working to replace imports, together with tourism and agriculture, two other sectors of healthy growth during the crisis, will lead a return to credit growth. They also believe that economic recovery, forecast to begin gradually by the end of this year, will bring with it a marked change in the composition of their credit portfolios.

Mortgage lending, which together with loans to construction companies and real estate promoters, used to account for more than 60% of total credit, has effectively collapsed. Mr Ulrich says that new mortgage lending at BPI, for example, has fallen by about 80% over the past five years, while the drop in corporate loans has been only marginal. BCP amortised about €850m in mortgage credit in 2012, while new production was at historically low levels.

“We are beginning to see a turnaround,” says Mr Amado. “Banks are competing for corporate customers in a way that did not happen last year.” He is hopeful that trends in the economy will substantially alter the credit mix as lenders allocate more resources to industry, especially export companies, and other foreign revenue-generating sectors such as tourism and farming. “This won’t affect BCP's balance sheets this year,” he says. “It takes years to alter the mix. But the beginnings of a change in the cycle has been noticeable since the last quarter of 2012.”

More capital needed

Portugal’s banks still face intense pressures before they can hope to return to sustained profitability in their home market, however. To meet the EBA requirements, the sector has had to make capital injections totalling €8.2bn. Out of this, €4.3bn has been in the form of state aid, allocated from €12bn set aside from Portugal’s €78bn bailout loan to ensure the stability of the financial sector.

BES, the largest bank by market value, is the only locally owned lender to have met the new capital levels without using public funds, opting instead for a successful €1bn capital increase in May 2012. The state directly injected €1.65bn into state-owned Caixa Geral de Depósitos (CGD), Portugal’s largest bank by assets, while Santander Totta, supported by its parent group, required no extra capital.

The approach adopted for BCP and BPI was to inject state capital through contingent convertible bonds, or CoCos, which convert into equity if a trigger such as a bank’s core capital ratio breaches a predestined floor. Through this channel, BCP took €3bn in state aid and BPI €1.3bn. BCP also raised €500m from private investors and BPI €200m.

Using CoCos enabled the two banks to comply with their capital requirements without involving any direct state ownership. But the solution carries with it a heavy cost. The CoCos have to be paid back within five years – otherwise they convert into equity – at an initial interest rate of 8.5%, which will steadily increase to 10% by the fifth year. 

Making good

BCP has outlined a plan for repaying the CoCos that implies generating €2bn in net profit from 2014 to 2016, a level considerably above some analysts’ estimates for organic profit growth over that period. Another of the repercussions of accepting state aid is that European authorities could require BCP to dispose of assets to ensure public funds are not being used to distort competition.

BCP is expected to dispose of its loss-making subsidiary in Greece to Piraeus Bank and, in return, the Portuguese lender will acquire capital in Piraeus, which would help the Greek bank avoid full nationalisation. However, Mr Amado says the group is strongly committed to holding onto its Polish operation – a key profit-making centre, along with Mozambique and Angola – that one analyst describes as “the jewel in BCP’s crown”. Talks with EU competition officials on potential asset sales are expected to end by May.

BPI has already repaid €300m of the CoCos it received in June 2012 and expects to pay off another €200m by April this year. Mr Ulrich says the bank could repay almost all the outstanding amount if the calculations the EBA made in 2011 were recalibrated to take into account the considerable improvement in Portugal’s sovereign debt yields over the intervening period. This is because of the so-called 'sovereign buffer' – additional reserves to protect against potential falls in the value of eurozone sovereign debt holdings.

If these were marked to market at today’s yields, or according to the Basel III regulations due to be implemented next year, BPI would quickly be able to reimburse all its CoCos, says Mr Ulrich. “We think BPI is in a very unfair situation because, based on sovereign debt yields that no longer apply, it is being forced to hold capital that is not necessary.”

Shrinking balance sheets

Portuguese banks are comfortably on track to meet the loans-to-deposits target of 120% by the end of 2014, having undergone extensive deleveraging. From 166% in mid-2010, the average ratio for the sector had fallen to 133% by June 2012. CGD and BPI have already met the target and BCP and BES are close, meaning that at least 75% of the sector has effectively dealt with the issue. Over the three years to December 2012, lending to the private sector fell by 6.4%. Part of this has been achieved by sales of overseas loan portfolios and disposing of poorly performing corporate credit, at a loss, to loan recovery funds.

During the first 18 months of Portugal’s adjustment programme, deleveraging was largely achieved through better-than-expected deposit growth. Unlike Greece and Ireland, Portugal has seen deposits hold up well throughout the crisis, with household deposits increasing 10% over the three years to December 2012. Frozen out of interbank markets since May 2010, banks have had to compete intensely for funds, offering rates of about 4% on one-year deposits in early 2012. This has since fallen to an average of 2.4% following intervention by the Bank of Portugal to regulate deposit remuneration.

In an environment of historically low interest rates, banks see high deposit rates as one of the biggest threats to sustained profitability. Now that cheap European Central Bank funding has eased their liquidity problems, they are working to ease the impact of funding costs and impairment charges on net interest margins.

“This year is going to be very difficult,” says Mr Amado. “But I believe it will also be a turning point, a year in which we will see negative trends inverting and paving the way for more robust growth in 2014 and 2015.”