Amid recession and difficult trading conditions, the sector is delivering “an impressive performance”, says Citigroup Smith Barney, lifting operating profit by an average of 8% last year without suffering any significant deterioration in asset quality.
“The Portuguese banking system has adapted well to changing conditions, including the recent downturn,” says António Guerreiro, chairman and chief executive of Banco Finantia, an independent investment bank that achieved record profits in 2003. “Restructuring programmes have taken them to new levels of productivity and efficiency, to a point where they enjoy some of the best banking ratios in the world.”
Outperforming peers
Portuguese banks outperform most of their European peers in terms of average return on assets, cost/income ratios, asset quality and productivity. Indeed, the Portuguese economy, where overall productivity is the lowest in the EU, would benefit enormously if more industries were to emulate the country’s financial services sector.
Productivity in terms of the number of banks per 1000 inhabitants and the number of employees per branch is among the highest levels in Europe, says the European Central Bank. So too is average pay in the banking sector: currently E28,600 per employee a year. “This shows that Portuguese companies can be internationally competitive without having to rely on low wages,” says Luís Bento dos Santos, a board member of Totta, one of the country’s five biggest banks, which was acquired by Spain’s Santander Central Hispano in 2000.
A fall in interest rates to historically low levels and increasingly tough competition have eroded financial margins in recent years. But Miguel Namorado Rosa, chief economist at Millennium BCP, the country’s biggest listed bank, points out that, at about 1.8%, the average margin for Portuguese banks is still higher than in most mature European markets and is exceeded only by the UK, Italy, Spain and Greece.
As pressure on margins increases, banks have diversified their income structures and increased the relative importance of other income, particularly fees and commissions. The financial margin accounted for about 61% of total banking income last year, down from 65% in 2002, while commissions rose from 19% to about 20% of the total.
Banco Espírito Santo (BES), another of the top five banks, lifted income from fees and commissions by 15.3% last year to E470m, while net interest income fell 4.7% to E750m. Commissions as a share of total commercial banking income rose to 33%, compared with 28% for the banking sector as a whole.
In common with other Portuguese banks, net interest income at BES has been hit hardest by the reduction in market lending rates, which fell 125 basis points last year. Increasing spreads on credit, particularly in the corporate segment, was not enough to offset the overall decline in interest income as the retail sector came under pressure from falling rates and aggressive competition.
Cross-selling trend
To lift commission revenue, banks have been phasing out special commission-free offers, introducing new charges and boosting the cross-selling of financial products. “The name of the game today is not acquiring new customers, but gaining a bigger share of the wallet of existing customers,” says Christopher de Beck, deputy chairman of Millennium BCP, Portugal’s biggest listed bank.
BCP sees cross-selling as one of the most vital banking skills and is a champion of the art. The group is selling an average of more than five products to each of its customers and still sees “enormous potential” for growth, says Mr de Beck.
In 2003, BCP posted a 60% increase in net profit to E438m, also beating market expectations by a wide margin. Operating revenue rose 4%, reflecting stable net interest income at E1.37bn, a 9% increase in fee revenue to E544m and an 18% improvement in other income to E345m. This helped to compensate for a 36% drop in financial trading income to E28m.
Ricardo Espírito Santo Salgado, chairman of BES, which has an average of 4.1 products per customer, sees a big future for cross-selling to the 650,000 customers of the group’s insurance company, Tranquilidade. So far only about 175,000 of these customers are among the bank’s 1.6m customers. “Between the bank and insurance company, we cover 20% of the Portuguese population,” says Mr Salgado. “More than 900 insurance agents are now actively engaged in marketing mortgage and consumer loans, credit cards, current accounts and other BES products to Tranquilidade customers. The untapped potential is huge.”
Organic growth
Cross-selling to the group’s insurance arm is the basis for BES’s ambitious growth strategy. Having lifted its share of the total Portuguese banking market from 9% in 1992 to 17.1% in 2003, purely by organic growth, it has set a target of gaining a 20% share in the next three years. This means increasing its share-of-wallet of existing customers and attracting 130,000 new ones, of which 30,000 are expected to come from a pool of 100,000 affluent Tranquilidade customers that BES is targeting.
BES lifted net consolidated profit by 14% to E250.2m in 2003, substantially higher than market forecasts. It particularly impressed analysts with a 54.1% gain in income from financial trading to E213.4m.
For a rough indication of the financial value of market share, Portuguese bankers look to the purchase of Banco Nacional de Crédito Imobiliário (BNC) by Spain’s Banco Popular in January 2003. Popular paid E520m for BNC, which then had a market share of 1%. This provides a benchmark, for example, for the 1% in market share that Totta gained since its acquisition by Santander, rising from 10% to 11% of the total Portuguese market. António Horta Osório, Totta chairman, aims to grab a further 1% of the market until 2005.
Totta, named by The Banker as Best Bank in Portugal in 2003, is underpinning growth with a comprehensive cost-cutting programme. The bank has cut its cost/income ratio, excluding depreciation, by almost 10 percentage points in the past three years to 43.7%, the second lowest level in the Portuguese market after BES at 40.8%. Including depreciation, Totta has the lowest cost/income ratio in Portugal at 49.8%.
“Cost-cutting has focused on integrating the computer systems, central services and back offices of the group’s main networks (Totta, Crédit Predial Português and Banco Santander Portugal), renegotiating supply and outsourcing contracts, joint advertising campaigns for our main brands and efficiency gains made by specialised product creation units,” says Mr Bento dos Santos.
The strategy, says Mr Osório, is based on creating a low-cost structure to provide a margin for price competition. This enables the bank to gain market share in strategic products, such as mortgage lending, investment funds and insurance, by offering low rates and commissions. The increased volume more than compensates for the reduced earnings on individual transactions.
During the past three years, this has helped Totta gain a market share of 16.5%, 37.4% and 10% in the new production of mortgage lending, investment funds and insurance respectively, expanding its overall market share by 1%.
Net operating profit has increased 35% in the past three years and net income by 63%, by far the biggest gains in Portuguese banking.
Staff reduction
Portuguese banks’ cost-cutting has focused on reducing staff levels. Banco BPI, for example, has reduced its workforce in Portugal by 27% since 1996 from 8800 employees to 6400. At the same time, it has expanded its branch network, created a new call centre and extended internet services.
Staff reductions are seen as the natural consequence of a wave of mergers and acquisitions in the late 1990s that placed 85% of Portuguese banking assets in the hands of five banks. BPI, for example, acquired Banco Fomento de Exterior and Banco Fonsecas e Burnay and has since invested more than E100m in reducing its workforce. “Personnel represents somewhere between 50% and 60% of the total costs of a bank. If you really want to cut costs you have to act at that level,” says Fernando Ulrich, who has recently moved from being vice-president to chief executive of BPI.
Lower cost-structures helped BPI to achieve its best annual result to date in 2003, increasing net profit by 17% to E163.8m. The group’s cost/income ratio fell from 58.7% in 2002 to 57.5% last year. Its efficiency ratio – operating costs as a percentage of loan and deposit earnings – dropped from 67.1% to 66.7%.
Strain on capital
This effort to reduce staff has proved a strain on capital. Portuguese bank workers are covered by pension funds run by their employers, not the state social security system. “When an employee retires early the liabilities of our pension fund increase substantially and that increase has to be deducted from our equity,” says Mr Ulrich.
This negative cycle, which has been draining bank capital since the late 1990s, is now drawing to a close as early retirement programmes reach completion. “From the point of view of generating capital, the next five years will be much better than the previous five years,” says Mr Ulrich. “From next year, all the capital we generate will stay in the bank or be used to pay dividends.”
Despite these constraints, Portuguese banks remains well capitalised. Solvency ratios were negatively affected in 2002 by the unfavourable performance of capital markets and changes in Portugal’s regulatory framework. But banks have proved successful at restrengthening their capital bases. The average solvency ratio for the sector is stable at 9.8% and 7.2% for Tier 1 capital. Portuguese banks’ exposure to emerging market risks and capital markets is low.
An important contribution to the banks’ resilience during the past two years of recession has been their ability to maintain a high standard of asset quality despite the deterioration in the economic climate. The level of non-performing loans is one of the lowest in Europe at about 2% of total lending.
“Banks have been more rigorous in their loan granting, monitoring and recovery procedures,” says Mr Namorado Rosa. “In comparison with previous recessions, the exchange rate stability with Portugal’s main trading partners brought by the euro and low interest rates have also helped to avert loan delinquency.”
Risk assessment
Doubts had been raised about whether Portuguese banks were assessing risk adequately when credit growth was booming at an average annual rate of 18% between 1998 and 2002. But the concerns proved groundless. Citigroup Smith Barney says net losses on loans and advances – the difference between bad debt and recoveries as a percentage of total credit – fell in 2003. For the three listed Portuguese-owned banks, BCP, BES and BPI, the ratio of doubtful debt fell 15bp in 2003 to 1.56% of total loans while coverage increased 11bp to 147%.
“We adapted as the situation evolved and became more and more selective both in lending to companies and individuals,” says Mr Ulrich. “The fact that interest rates are so low is helping borrowers maintain the capacity to service their debt.”
Provisioning for Portuguese banks accounts for a significant proportion of gross operating income – 41% in 2003, says Citigroup Smith Barney, the highest level in Europe after Germany. It is forecast to improve to 38% by 2005 compared with a forecast EU average of 22% in 2004 and 20% in 2005. Provisions represented 28% of the gross earnings of Portuguese banks between 1999 and 2001.
Buoyant mortgage market
Domestic lending growth has inevitably decelerated amid the economic downturn, slowing to about 6.5% in 2003 for the banking sector as a whole, down from 9.8% in 2002. Mortgage lending, however, has remained buoyant, increasing 13% last year and continuing to account for the lion’s share of lending to individuals.
The good news for banks is that soaring household indebtedness, which rocketed from 38% of disposable income in 1995 to 103% in 2002, has not been accompanied by a real estate bubble. Although mortgage loans account for 79% of total household loans – above the EU average of 64% – growth in mortgage lending has been underpinned by a sharp decrease in interest rates and the lack of a properly functioning rental market. Property prices have been supported by economic fundamentals and bankers expect a recent downturn in prices, arising from a slowdown in demand, to be moderate and temporary.
State-owned Caixa Geral de Depósitos (CGD), Portugal’s biggest bank, is the Portuguese champion of mortgage lending, which accounts for more than 50% of its total loan portfolio. “We have lent our customers more money to buy homes in the past five years than in the previous century,” says António de Sousa, until recently chairman and chief executive of CGD. In another boardroom change, Luís Miral Amaral, a former industry minister, is vacating the vice-presidency of CGD to become its chief executive. Mr de Sousa stays on as chairman.
Portugal’s banks have proved resilient in a challenging economic environment, protecting the quality of their assets from deterioration and maintaining a buoyant level of profitability. Their track record of diversifying businesses areas, cutting costs and keeping credit provisions under control can be expected to pay even higher dividends as the economic climate improves.
