September 15, 2017

IMF publishes its staff report and selected issues report in the context of the 2017 Article IV consultation with Portugal. The staff report highlights that stability and confidence in the Portuguese banking system have improved, following successful efforts to raise capital. However, the IMF Directors cautioned that the large stock of nonperforming loans (NPLs) could limit banks’ ability to finance productive investment.

In the staff report, the staff recommends boosting internal capital generation, removing the impediments to NPL resolution, and addressing the forthcoming regulatory challenges in the form of IFRS 9. There has been a modest decline in the outstanding stock of NPLs since end-2015, supported by the pickup in growth, but they remain elevated at 16.4% of total loans at end-March 2017. This weakness in asset quality remains particularly concentrated in the corporate sector, with corporate NPLs at 29.0% at end-March 2017, compared with 6.7% NPLs on household loans for house purchase and 10.0% for consumer and other loans. The Portuguese authorities emphasized that the long phasing-in of Basel III and the transition period envisaged for IFRS 9 will allow banks to meet their capital requirements smoothly as ongoing cost-cutting efforts will boost banks’ profitability and internal capital generation. Basel III will likely necessitate new equity issuance to offset the reduction in capital ratios, while the setting of Minimum Requirement for Own Funds and Eligible Facilities (MREL) targets will also likely require Portuguese banks—predominantly deposit-funded—to tap wholesale markets to comply with the minimum required level of liabilities that can absorb losses in the event of resolution. Both the Portuguese and European authorities remain cautious about the pace of NPL resolution, warning against NPL fire sales that would destroy bank capital.

 

The selected issues report examines the challenges (including poor asset quality and weak capital adequacy) facing the banking system in Portugal. A tightening of capital requirements has already begun with the Supervisory Review and Evaluation Process (SREP) conducted by the European authorities on the largest banks in recent years; this tightening would continue with the imposition of a capital conservation buffer and additional systemic capital buffers by the Bank of Portugal. Nevertheless, against the background of stressed asset quality, Portugal has one of the lowest common equity tier 1 (CET1) ratios in the EU—12.6% of risk-weighted assets as of end-March 2017. The macro-prudential toolkit includes requirements for all banks to implement a capital conservation buffer of up to 2.5 percentage points of CET1 and for other systemically important institutions (O-SII) to hold a capital reserve of up to one percentage point of CET1. Given the challenges they are facing, Portuguese banks, as virtually all European banks, have thus been required to hold significant capital above the minimum regulatory level.

 

In the context of the recovery and resolution planning cycle, banks are expected to adjust their capital and funding structure to the risks inherent in their business models. Pursuant to the Bank Recovery and Resolution Directive (BRRD), banks’ recovery plans are required to ensure that the restoration of banks’ financial conditions, following any significant deterioration, will not have a negative effect on financial markets, other institutions, or funding conditions. To this end, banks must identify the key steps to maintain the proper functioning of their core business lines and critical functions in a situation of financial stress, and thus may have to adjust their business models accordingly. Furthermore, EBA has stressed that the calibration of the MREL target should be closely linked to the bank’s resolution strategy and business models. The impact of these clean-up efforts will be amplified by the move from the current incurred-loss model to the expected credit-loss model, in relation with the implementation of new IFRS 9 provisioning rules, from January 2018. However, the impact of this change will depend not only on the level of existing provisions under IAS 39 and current capital, but also on the method used for calculating regulatory capital. Therefore, the impact will differ for banks using standardized approach and for the few banks using internal models-based approach, or IRB, the latter being already required to deduct any shortfall of loan -oss provisions over regulatory expected losses from their CET1 ratios.

 

Related Links

Staff Report on Portugal (PDF)

Selected Issues Report on Portugal (PDF)

Keywords: Europe, Portugal, Banking, Article IV, Basel III, IFRS 9, MREL, BRRD, IMF

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