The impact of interest rate fluctuations on the net interest margin depends on the respective duration of banking assets and liabilities. Theoretically, the net interest margin rises during phases of falling interest rates because bank funding can be replaced more rapidly by other less costly resources than assets can be replaced by lower-yielding ones. This phenomenon is naturally linked to the traditional activity of maturity transformation. The cost of funding for Portugal’s major banks has adjusted more rapidly to the decline in interest rates than the return on assets, even though the preponderance of variable-rate loans means that returns fall more rapidly than if they were fixed-rate instruments.
Lastly, the positive impact of a higher net interest margin on net interest income neutralised the negative effect arising from the decline in the outstanding amounts of bank loans. Net interest income for the major Portuguese banks grew at an average annual rate of 6.5% between 2014 and 2018, from EUR 3.4 billion to EUR 4.4 billion. In Q3 2019, the year-on-year increase in net interest income was 8.8%. In comparison, net interest income for the euro area’s 183 biggest banks rose only 0.4% over the same period.
Portuguese banks have increased their dependence on net interest income
Net interest income as a share of operating income for the major Portuguese banks has increased steadily since 2005. In 2018, this proportion reached an all-time high of 67% (compared to 51% in 2005). The breakdown of the different types of revenues (interest, commissions, gains or losses on financial instruments, etc.) is generally better balanced for the larger banks compared to their smaller competitors. Although the increasing share of net interest income can be largely explained by the decline in other revenues, less diversity in terms of the types of revenue increases the major Portuguese banks’ dependency on interest income, which has been declining over the past several years.
Nonetheless, net commissions collected by the major Portuguese banks continued to increase in 2018 (+3.6% year-on-year, vs +4.4% in 2017). Yet this positive trend is not yet strong enough to serve as a new source of growth to replace net interest income. At an annualised EUR 2.1 billion in 2019, net commissions still fell short of the 2010 peak of EUR 2.8 billion.
Hit by a bout of weakness in 2018, other income amounted to only EUR 63 million, down from EUR 2.6 billion in 2005. This sharp drop is mainly due to the decline in income generated by market activities. Between 31 December 2017 and 31 December 2018, for example, CGD reported an 85% decline in net trading income[19]. Similarly, in 2018 Novo Banco reported a net trading loss of EUR 242 million after a net gain of EUR 179 million in 2017. These losses can be attributed to the Nata project, under which Novo Banco sold some of its assets to a consortium of funds managed by the American KKR and the Luxembourg-based LX Investment Partners[20].
Tight cost controls
Net banking income for the major Portuguese banks has levelled off thanks to cutbacks in the cost of funding. Yet net income increased is due to cutbacks in total operating expenses and the cost of risk.
The major Portuguese banks cut total operating expenses by 31% in 10 years
Portuguese banks were forced to make major adjustments in the wake of the troubles experienced during a series of crises in 2007-2008 and then in 2010-2011. As a result, total operating expenses were reduced by 31% on average between 2006-2008 and 2016-2018 (see chart 6). Cutbacks in personnel costs and other operating expenses contributed to this decline, with cuts averaging 34% and 27%, respectively, between 2006-2008 and 2016-2018. Tight cost controls offset the decline in operating income. As a result, the major Portuguese banks have managed to maintain their cost-to-income ratio at an average of about 60% since 2005, although small improvements can be seen in 2018 and so far in 2019 as well.
Personnel expenses continued to fall in 2018
Like most of the other euro area countries, the Portuguese banking system has scaled back capacity over the past ten years. Bank staff in Portugal was reduced by 19% between 2008 and 2018, compared to 17% for the euro area banks as a whole.
Personnel expenses for the major Portuguese banks continued to decline to EUR 2 billion in 2018, from a 2009 peak of EUR 3.2 billion. Most of these cutbacks occurred between 2011 and 2014, although they continued at a slower pace between 2015 and 2018.
The decline in other operating expenses helped keep total operating expenses under control
Other operating expenses, including rent, advertising expenses and costs pertaining to information and communications technology, did not decline quite as fast as personnel expenses. Even so, the number of Portuguese bank branches was reduced by 35% between 2008 and 2018, compared to a euro area average of 27% for the same period. As the Bank of Portugal points out[21], the intensification of digitalisation plans and investments by Portuguese banks undoubtedly helped drive up other operating expenses. Novo Banco, for example, set up a “digitalisation circle” to transform the group by focusing more on customers, streamlining procedures and reducing risks[22]. The bank also pooled together its main digital sector skills and expertise within an internal entity called “Novo Banco Digital” in 2018. On 4 December 2019, Caixa Geral de Depósitos director Maria João Carioca announced that the group intended to invest EUR 200 million over 5 years to accelerate the bank’s digital transformation.
Lastly, the cost-income ratio of Portuguese banks improved slightly in 2018 and has continued to improve so far in 2019 (see chart 7) after fluctuating around an average of 60% since 2005. It is now lower than the average cost-to-income ratio for the EU banking system as a whole. In this respect, the major Portuguese banks stand apart from the average of the major EU banks as a whole, whose cost-to-income ratio has tended to erode since 2017. Yet the divergent trajectories between banking systems must be kept in perspective: the decline in income from corporate and investment banking activities probably contributed to the deterioration in the cost-to-income ratios of banking systems that rely more heavily on these activities to generate a their income.
In 2018, international activities made a large contribution to the net income of the major Portuguese banks
Thanks to the lower bank funding costs and tight cost controls, the major Portuguese banks swung into positive territory in 2018 for the first time since 2010, with net income of EUR 375 million. This is still far short of the 2005-2007 average of EUR 2.6 billion. In the first three quarters of 2019, net income for the five major Portuguese banks remained positive thanks to the reduction in Novo Banco losses.
International activities made a big contribution to the consolidated net income of the major Portuguese banks (see chart 8). The main international markets are Spain and France, where Caixa Geral de Depósitos and Novo Banco are very active. Millennium BCP has a bigger foothold in Poland and Mozambique. BPI has a major subsidiary in Angola, where Caixa Geral de Depósitos and Novo Banco also have operations. Though a Portuguese-speaking country, Brazil is not a significant market for Portuguese banks. Although international activities make a positive contribution to the consolidated net income of Portuguese banks, this contribution is bound to diminish if they go ahead with plans to sell-off non-strategic assets. In 2018, Novo Banco sold off its activities in Venezuela, Italy, and Cape Verde, and Caixa Geral de Depósitos has put several subsidiaries up for sale, including in Brazil and Spain.
The return on equity improved in 2019 but remains low
The return on equity for the major Portuguese banks was naturally positive in 2018, although it remains low. The weighted average return on equity was 1.5% during the year (see chart 9), whereas it surpassed 15% prior to 2008. It was also much lower than the average return for the other large EU banks in 2018. In 2019, in contrast, the big Portuguese banks began to approach the euro area average.
In the short term, however, the adjustments that had to be made during the crisis years should continue to strain the returns of the major Portuguese banks. In the longer term, these cost adjustments should help increase returns, although their impact could be delayed by slower growth and a persistently accommodating monetary policy for many more quarters.
Lower interest rates helped reduce risks
All things being equal, low interest rates have reduced the cost of risk for the major Portuguese banks and helped clean up their balance sheets. The reduction in the cost of risk helped limit the erosion of equity capital, but it still declined. The regulatory solvency ratios of the major Portuguese banks improved essentially because risk-weighted assets declined faster than equity capital.
Non-performing loan ratios and outstanding amounts continue to decline
The cost of risk[23] for the major Portuguese banks dropped from a peak of EUR 5.6 billion in 2011 to EUR 1 billion in 2018 (see chart 10). It has now fallen below the 2007 level of EUR 1.1 billion. The temporary upturn in 2016 can be largely attributed to Caixa Geral de Depósitos’ plan to clean up its balance sheet. Excluding CGD, the cost of risk for the major Portuguese banks would have declined continuously between 2012 and 2018. Changes in the cost of risk at Novo Banco (formerly BES) largely determined the dynamics for all of the major Portuguese banks. Novo Banco was largely responsible for the general downward trend in 2016, but also for the upturn in the first three quarters of 2019.
Along with the decline in the cost of risk, the non-performing loan ratio was halved for the major Portuguese banks, from a peak of 20.1% in Q2 2016 to 8.9% in Q2 2019. Even so, the NPL ratio is still nearly three times higher than the average for the main EU banks (see chart 11).
According to Bank of Portugal figures[24], the decline in the NPL ratio is mainly due to a reduction in the outstanding amount of non-performing loans (the ratio’s numerator). The outstanding amount of NPL was halved, from EUR 50 billion in Q2 2016 to approximately EUR 25 billion in Q1 2019. Over the same period, the outstanding amount of total bank loans (the ratio’s denominator) contracted by 8%. This means that the decline in the NPL ratio was not due to dilution but to the clean-up of bank balance sheets.
The tightening of bank lending conditions in 2011/2012[25], which were maintained thereafter, helped reduce the cost of risk for Portuguese banks. Lower interest rates also eased the solvency requirement that weighed on borrowers in the repayment process.
Bank balance sheets were largely cleaned up through sales and securitisations
Sales and securitisations of non-performing loans were one of the main channels for cleaning up the balance sheets of Portuguese banks in 2018. These operations reduced the NPL ratio by 1.7 percentage points during the year[26]. Their cumulative total reduced the NPL ratio by 2.9 percentage points from the Q2 2016 peak. As part of Project Sertorius, for example, Novo Banco sold off EUR 488 million in non-performing real-estate loans to Cerberus Capital Management at 33% of its gross book value in August 2018. The price is comparable to the ones paid for other sales in Spain and Italy, although it naturally depends on the quality of the loan portfolio being sold. Novo Banco is also conducting Nata 2, which should lead to the sale of another non-performing loan portfolio by the end of 2019[27]. Given the planned amount of the disposal (EUR 3.3 billion initially), this operation should have a significant impact on Novo Banco’s non-performing loan ratio, and to a lesser extent, on the NPL ratio of the entire Portuguese banking system.
Write-offs have reduced the non-performing loan ratio of Portuguese banks by 3 percentage points since the 2016 peak, including 1 point during the year 2018. At 31 December 2018, the total reduction in the NPL ratio was 8.5 points, which means that write-offs have been the main channel so far for cleaning up the balance sheets of Portuguese banks, ahead of sales and securitisations. Yet the relative contribution of write-offs to the decline in the NPL ratio has gradually decreased while that of sales and securitisations has increased. These trends suggest that Portuguese banks initially cleaned up their balance sheets by selling their most deteriorated exposures with the highest provision ratios and lowest valuations. Thereafter, they sold and/or securitised their less deteriorated non-performing exposures with higher valuations. The breakdown may have been determined in part by the time it takes to set up sales and securitisation operations. In addition, low interest rates may have influenced the growing use of sales and securitisations, because all things being equal, a reduction in the discount rate increases asset value.
The net flow of non-performing loans, i.e. the difference between new non-performing loans and non-performing loans reclassified as performing, plus impairment and repossessions, contributed to 1.8 percentage points of the total decline in the NPL ratio. Lastly, dilution arising from the flow of performing loans made only a small, 0.8-point contribution to the decline in the NPL ratio of Portuguese banks.
Portuguese banks are expected to continue cleaning up their balance sheets in the quarters ahead, notably because some have been required to submit NPL reduction plans to the Bank of Portugal. Moreover, the introduction of accounting standard IFRS 9 on 1 January 2018 could increase the cost of risk when a cyclical slowdown is expected. This accounting standard recognises expected credit losses (and not only incurred credit losses as was the case under the previous IAS 39 standard), as well as minimum coverage requirements for non-performing exposures imposed by the European Commission and the ECB’s “supervisory expectations for prudential provisioning”[28]. As a result, the Portuguese banks’ situation may seem to have deteriorated even without an intrinsic deterioration in the quality of their portfolio.
Better loss absorbing capacity
The major Portuguese banks have strengthened their capital adequacy ratios despite low profitability and the clean-up of balance sheets. Ongoing clean-up efforts, however, are likely to further strain bank equity. Moreover, under certain conditions, the fiscal treatment of deferred tax assets (DTA) provides the major Portuguese banks with additional loss absorbing capacity equivalent to 15% of their CET1, without it counting as equity capital.
Despite low profitability, Portuguese banks have nearly doubled their capital ratios over the past 5 years
Regulatory capital ratios for the major Portuguese banks have increased since 2014. They had a fully-loaded Common Equity Tier 1 (CET1) ratio of 13.2% in Q2 2019, up from 7.9% in Q3 2014. Despite this significant improvement in the solvency of the major Portuguese banks, it still falls short of the weighted average CET1 ratio for the major EU banks as a whole, which came to 14.4% and 11.3%, respectively, at the same dates (see chart 12).
None of the Portuguese banks made it on the list of Global Systemically Important Banks (G-SIBs) established by the Financial Stability Board (FSB). Consequently, they are not subject to additional regulatory requirements.
Risk-weighted assets decline faster than equity
The process of cleaning up the balance sheets of Portuguese banks and to a lesser extent the introduction of IFRS 9 on 1 January 2018 hampered the improvement in capital adequacy ratios. The outstanding amount of CET1 of the major Portuguese banks rose by 105% between 2007 and 2012, from EUR 13 billion to EUR 27 billion, before contracting by 24% to EUR 21 billion in 2018. Capital adequacy ratios continued to improve in the recent period because risk-weighted assets declined faster than equity capital. Risk-weighted assets declined by 31% between 2012 and 2018, from EUR 226 billion to EUR 157 billion[29].
For the major Portuguese banks, a lasting return to profitability would boost improvements in capital adequacy ratios, this time through an increase in equity. The major Portuguese banks have also strengthened their loss absorbing capacity thanks to issues of subordinated debt eligible as Tier 2 capital. In 2018, for example, Novo Banco and Caixa Geral de Depósitos issued EUR 400 million and EUR 500 million, respectively, in Tier 2 capital. Additional requirements for Total Loss Absorbing Capacity (TLAC) and the Minimum Requirement for Own Funds and Eligible Liabilities (MREL) should continue to support debt securities issues eligible as Tier 2 capital.
DTA eligible for a special tax regime represent additional loss absorbing capacity equivalent to 15% of CET1
Like in the Spanish and Italian banking systems, deferred tax assets (DTA) comprise a major part of the regulatory capital of the Portuguese banking system according to European Commission calculations[30]. After the introduction of the Capital Requirements Regulation (CRR)[31] in 2013, banks were required, as of 1 January 2018, to deduct all of their deferred tax assets that rely on future profitability, and some of those that did not, from their regulatory capital. At 31 December 2018, DTA eligible as equity capital comprised roughly 4% of CET1 outstanding amount for the major Portuguese banks, after peaking at 9% in 2016, which reflects the losses reported during this period. On average, DTA eligible as equity capital accounted for less than 10% of all the DTA of the major Portuguese banks between 2014 and 2018.
Since 2014, Portugal’s tax code stipulates that under certain conditions part of bank DTAs can be converted into a tax credit to cover losses[32]. Since the latter is payable by the Treasury, it can be used to preserve capital adequacy ratios. In return for the conversion of DTA into tax credits, a special reserve is created with an amount equivalent to 110% of the converted DTAs, and securities convertible into ordinary shares are issued for the same amount to the Portuguese state. Based on data published by the major Portuguese banks, about 50% of their deferred tax assets were eligible for this special regime in 2018. This increased their loss absorbing capacity by about EUR 3 billion, or nearly 15% of CET1 in 2018.
In 2016, for example, Novo Banco converted deferred tax assets into a tax credit for a definitive amount of EUR 154 million after the bank reported a loss in 2015. In return, a special reserve was created amounting to EUR 169 million, i.e. the amount of DTA converted into a tax credit plus 10%[33]. Similar operations were conducted for an end tax credit of EUR 99 million in 2017 and an estimated EUR 152 million in 2018, pending validation by the tax authorities in 2019. All in all, through the conversion of DTA into tax credits, the Portuguese government will hold convertible debt amounting to 6.5% of Novo Banco’s equity capital at 31 December 2018 (the tax credit is postponed by a year from the year under consideration) and 10.3% according to the H1 2019 financial statement. To a certain extent, the special tax regime applied to the DTA of Portuguese banks shelters their capital adequacy ratios from any book losses.
Risks associated with “low for long” interest rates
Although lower interest rates seem to have had a rather positive impact so far on the major Portuguese banks, the levelling off of interest rates at low levels for a prolonged period, also known as “low for long”, is likely to be less favourable for them in the future.
The continuation of an accommodating monetary policy combined with greater competitive pressures, notably from entities in other sectors with more flexible prudential regulations, should continue to exert downward pressure on lending rates. Yet rates are likely to fall at a slower pace as they converge on the zero lower bound. In Portugal, where lower rates have not yet stimulate growth in loan outstanding amounts, the Bank of Portugal’s recommendations are likely to curb the growth of loans to households. All things being equal, “low for long” rates should also support bank lending to NFC, but the upcoming slowdown in growth is likely to hamper demand. Under these conditions, interest income is might continue to decline for the major Portuguese banks.
With interest rates already at such low levels, it seems reasonable to assume that most of the decline in bank funding costs has already occurred. The ban on applying negative rates to customer deposits serves as a floor for the funding costs of Portuguese banks. Moreover, as long as the opportunity cost for households to hold sight deposits remains so low, the structure of liabilities for the major Portuguese banks is likely to remain relatively akin. As a result, interest expense should continue to decline very moderately.
“Low for long” interest rates could end up reversing recent trends: interest income might begin to fall more rapidly than interest expense. This would squeeze the net interest margin while the positive volume effect necessary to offset its erosion would become hypothetical at best. Lastly, the outlook for operating income growth for the major Portuguese banks continues to be hampered by GDP growth forecasts (1.9% in 2019 and 1.4% in 2020 according to our scenario, compared to 3.5% in 2017 and 2.4% in 2018). Without sufficient new sources of growth, the major Portuguese banks will have little choice but to pursue their cost-cutting strategies.
