IMF: Banking Sector Needs to Provision More for Credit Risk

15 September 2017

Portuguese banks have made efforts in recent months to improve their balance sheets. But more remains to be done, including raising provisions for credit risk.

Over the last six months, Portuguese banks have made progress in attracting new capital into the banking system. And, in addition to having liquidity, they continue to reform and reduce their balance sheets. The International Monetary Fund (IMF) praised Portugal’s recent progress in its article IV report, published this Friday. But the institution warns: the banking sector still faces several challenges, namely the weight that distressed debt continues to have on profitability. For the fund led by Christine Lagarde, financial institutions need even more provisions for credit at risk of defaulting.

“The coverage ratio increased slightly to 45.5% of the NPLs by the end of March this year, at a time when provisions are much lower for overdue loans (> than 90 days) than for non-performing loans,” reads Subir Lall’s last report as the head of the IMF’s mission in Portugal. This is in a context in which “total capital in the banking system still seems low, considering the weight of distressed debt and approaching regulatory obstacles [Basel III will require further reinforcements to ratios], highlighting the need to generate domestic capital to maintain sufficient resilience.”

While acknowledging the efforts made by various Portuguese banks – pointing to the recapitalisation of Caixa Geral de Depósitos, the sale of Novo Banco, injecting capital into BCP and buying BPI from CaixaBank – the fund continues to point to weaknesses and state what remains to be done, particularly regarding the reduction of non-performing loans. This is in a context of weak asset quality, low profitability, limited capital cushions and still high costs, the fund says.

There has been a modest drop in the outstanding balance of NPL since the end of 2015, supported by the recovery in growth. But it remains high, standing at 16.4% of total loans at the end of March 2017.

International Monetary Fund

“There has been a modest drop in the outstanding balance of NPLs since the end of 2015, supported by the recovery in growth. But it remains high, standing at 16.4% of total loans at the end of March 2017,” the entity announced. The amount of non-performing loans held by the national bank fell to a minimum of almost five years, according to data released by the Bank of Portugal. Unprovisioned distressed debt amounted to 15.392 billion euros.

But the banking sector has another problem: costs remain high. According to the IMF, banks must try to reduce this burden further. “Banks have cut operational costs, but this is insufficient to offset the low profitability caused by low-interest rates and high impairments related to NPLs,” it said. This, in a period where various banks have shuttered branches and dismissed employees. “The challenge remains to break the vicious cycle between weak banks, elevated exposure to NPLs and anaemic investment that continues to constrain medium-term growth,” reads the report.

Three Pieces of Advice from the IMF to the Portuguese Banking Sector

The IMF states several times in its report that more needs to be done. “It will take ambitious effort on the part of the banks to strengthen their balance sheets, which will improve financial intermediation and boost potential growth,” said the entity led by Christine Lagarde. Therefore, the fund leaves some advice for the Portuguese authorities, such as cutting costs, creating a platform to manage distressed debt, but also preparing for the new capital rules, known as Basel III, which require stronger ratios.

The creation of a platform that will allow coordination between the creditors of a company in difficulties should be encouraged.

International Monetary Fund

  1. Increase internal capital generation: the IMF says banks will need to cut costs and increase profits to make this happen. “Reducing costs has already begun, but financial institutions have to reduce domestic and international networks further [i.e. closing more branches and laying off more employees], to sell non-strategic assets and reduce the burden of NPLs,” the fund says. They also must “diversify their incomes” so that there is an increase in profits;
  2. Remove obstacles to the resolution of distressed debt: measures should be implemented to improve legal frameworks, says the fund. This will help small and medium businesses that are in financial stress, but that are still feasible, to facilitate the insolvency process, remove fiscal disincentives and develop a market to sell the NPLs. In this context, the IMF supports the creation of a common management platform, which should start at the beginning of next year. “The creation of a platform that will allow coordination among the creditors of a company in difficulty should be encouraged,” reads the report;
  3. Overcoming the next regulatory challenges: the most urgent challenge for the IMF will be to adopt the new rules, which will require banks to put money aside based on potential losses rather than losses incurred. Consequently, the implementation of Basel III should lead to the issue of new shares to compensate for the fall in capital ratios.

Original Story: Economia Online – Rita Atalaia

Translation: Richard Turner