Bank of Portugal Report Minimises Risk of a Real Estate Bubble Bursting the Banks’ Balance Sheets

6 December 2017

The Bank of Portugal (BdP) has just released its Financial Stability Report, a document in which the central bank points out potential vulnerabilities and risks to the Portuguese banking sector. The report emphasises the critical importance of continuing efforts to reduce the level of public debt by strengthening the structural character of fiscal consolidation, while bolstering efforts to deleverage by households and companies, taking advantage of the favourable macroeconomic and financial environment.

The Bank of Portugal has just published its Financial Stability Report for December 2017. The highlight of the report is that the economy’s indebtedness is an obstacle to investment since heavily indebted companies tend to invest less. Therefore, the central bank points to the need to overcome the challenge of corporate capitalisation.

“In recent years, corporate savings have contributed significantly to financing business investment,” the introduction to the report noted. Regarding companies with financial debt, the highest investment growth between 2013 and 2015 occurred in companies with the lowest levels of indebtedness.

Another highlight of the report is the central bank’s contention that the risks of a real estate bubble bursting and negatively affecting the banks’ balance sheets is minimal. “Housing price growth is not synchronised with the credit cycle,” the report said. Not only because real estate prices have not yet exceeded pre-crisis levels, but more importantly because there has been no link between the rise in real estate and the corresponding bank financing. Thus, it can be understood that easy bank credit is not the underlying cause of the boom in real estate, and for that reason, the central bank has not yet sounded any alarms regarding the rapid rise in asset prices. But the regulator is still vigilant and is considering requiring banks to include the possibility of an abrupt rise in interest rates in their calculations of the implicit effort rate in housing lending.

“This analysis leads us to conclude that housing prices in Portugal are not overvalued,” the Banco de Portugal’s report stated.

“The current credit and economic dynamics do not compromise the reduction of the still high personal debt ratio and do not promote the accumulation of excessive risk on the banks’ balance sheets and the excessive allocation of resources to the real estate sector,” the document read.

Between the end of 2013 and the first half of 2017, residential real estate prices grew by about 20% in real terms, at a national level, returning to levels last seen in 2009. There is evidence that housing prices in Portugal are justified by economic fundamentals. “It is not possible to exclude the possibility of excessive appreciation in large urban centres,” says the BdP. However, “in June 2017, new housing loans continued to grow strongly (around 40% year-on-year) and began to show a greater weight in family housing transactions compared to previous years. However, the stock of housing credit continued to fall, though at a slower pace,” the document read.

Concerning companies and the construction sector, credit to the construction industry is said to be still falling, and although credit to real estate activity is still recovering, the recovery is still limited.

Another of the factors that stands out is the fact that the Bank of Portugal recognises the reduction in NPL (problematic credits, past due or at the risk of becoming so), but levels are still high in comparison with Europe. Therefore, banks must continue to reduce bad debts. Banks have been writing off (100% impairment) and selling their portfolios of NPLs and should continue to do so.

What Does the Financial Stabilization Report Say?

Three principal topics are highlighted in the Financial Stability Report: “The strategy for dealing with the stock of non-performing loans (NPL)”; “The segmentation of risk in spreads on new loans to non-financial corporations”; and the “Banks’ Leverage Ratios – the Portuguese case”.

The reduction of leverage and investment by non-financial corporations in Portugal is addressed through these topics: the vulnerability of Portuguese companies to the rise in short-term interest rates; real estate on the banks’ balance sheets; the financial vulnerability of Portuguese households and the evolution of housing prices in Portugal and implications for financial stability.

The Bank of Portugal reports that the Portuguese economy and the financial system have made significant progress in recent years. In 2017, some positive developments contributed to the consolidation of the stabilisation of the banking sector, notably the extension of the maturity of loans to the Resolution Fund, capital increases carried out by some of the leading banks operating in Portugal and the conclusion of the sale of Novo Banco.

At the level of vulnerabilities and risks, the high level of indebtedness of public administrations, private individuals and non-financial corporations remains one of the main vulnerabilities of the Portuguese economy, which remains at levels above those registered for the euro area. “The high level of indebtedness coupled with low potential growth makes the Portuguese economy more vulnerable to adverse shocks, particularly in a context where a process of the normalisation of monetary policy is expected to begin,” the press release said. “It is, therefore, crucial to continue the efforts to reduce public debt, based on strengthening the structural character of fiscal consolidation, and the deleveraging effort of households and companies in Portugal, taking advantage of the favourable macroeconomic and financial environment,” the institution led by Carlos Costa stressed.

At the banking sector level, “there have been significant improvements in non-performing loan (NPL) ratios and coverage in the non-financial corporation segment, although there are still very heterogeneous positions among banks,” the BdP stated. “Globally, between June 2016 and June 2017, there was a decrease of about €8 billion in NPLs, of which about €6 billion came from non-financial corporations. However, despite the recent improvements to insolvencies, the reduction of the NPL stock and the perception of the markets vis-à-vis Portuguese banks, the financial sector also continues to present vulnerabilities. The reduction of the NPL stock, which remains high, requires that the measures included in the comprehensive strategy continue to be adopted,” the banking regulator warned.

The NPL ratio decreased to 15.5% from 17.9% (for non-financial companies, it went from 30.3% to 27.5%); the coverage ratio for impairment increased from 43% to 46%, mainly reflecting progress in the corporate credit segment (from 46.4% to 49.2% in this segment).

The reduction of the high stock of bad debts (NPL) requires a comprehensive strategy, which involves acting in different areas and coordination among the various entities involved. At the national level, the policy of reducing non-productive assets relies primarily on three pillars that are complementary to each other, says the Bank of Portugal. These include the review of the legal, judicial and fiscal frameworks; the micro-prudential supervision actions under the Single Supervision Mechanism and the management of NPL portfolios, including possible systemic measures.

It is within the framework of this strategy that the Platform for the Integrated Management of Bank Credits has arisen, which was signed between CGD, BCP and Novo Banco (which is expected to start operating next year), with the objective of an integrated management of loans granted to companies which are debtors to several banks. “While not generating a significant decrease in the NPL levels in the short term, since it does not involve a transfer of assets out of the banks’ balance sheets, the platform should contribute to the overall NPL reduction effort, insofar as aims to “increase the efficiency and speed of the processes of credit and corporate restructuring,” says the BdP.

The recent improvement in the solvency of the leading Portuguese banks, the recovery of the Portuguese economy and real estate prices, create a more favourable context for reducing the level of NPLs in the banks’ balance sheets.

“Available evidence does not point to a reduction in risk differentiation in the pricing of new bank loans to non-financial corporations. However, the current context of economic recovery, increased competition between banks and rising real estate prices, requires a careful monitoring of the pricing of new loans to companies,” the report states, adding that it has been witnessing less restrictive practices in recent years in the granting of housing loans and strong growth in consumer credit in the context of rising real estate prices, economic recovery and increased competition among banks.”

At this level, the Bank of Portugal considers the adoption of measures “to strengthen the assessment of the creditworthiness of private borrowers by the institutions.” But according to the Jornal Econômico, they are not measures at the level of capital, but rather at the level of the debtors’ valuation practices. For example, the possibility of introducing an interest rate factor in the calculation of clients’ effort rates when considering a loan.

“It is crucial that financial institutions continue to adequately and prospectively assess the creditworthiness of borrowers by avoiding excessive risk-taking in new credit flows, notably in mortgage lending,” the document reads.

The Report says that “in particular, it is important to continue the current path of reduction of unproductive credits (NPL), in accordance with the plans agreed with the Single Supervisory Mechanism and the Bank of Portugal, especially given the need to meet regulatory requirements, including the minimum liability requirements to absorb losses in the event of a bankruptcy (MREL). ”

At this point, it should be noted that the Single Supervisory Mechanism will allow a transitional period for the issuance of these bonds (high-risk debt securities to absorb losses in the event of bail-in) in the market, so that it is not flooded with issues throughout Europe.

At the level of macroprudential policy, and to ensure that the Portuguese financial system maintains an adequate capacity to absorb shocks, without compromising the financing of the economy, the Bank of Portugal maintained the phase in defined in the European regulation for the reserve fund rate of funds themselves; maintained the countercyclical reserve at 0% of the total amount of exposures at risk in the fourth quarter of 2017 (which is explained by the fact that in Portugal the credit to GDP ratio continues below its long-term trend); and determined the reserve rate applicable to a set of institutions which it identified as “other systemically important institutions” (OSII), extending for a further two years the deadline set for meeting reserve levels.

“The low profitability of the sector and its high exposure to sovereign, real estate and emerging economies with poor economic performance are other vulnerabilities that may contribute to the materialisation of risks to financial stability,” says the Bop.

The report stresses that the adjustment of banks’ cost structures is, in some cases, still insufficient in the face of changes in income. This adjustment implies temporary costs in the short/medium term (investment inherent in the technological transition and adjustment of staff).

The banks’ business model is already being challenged by technological innovation and changes in the legal frameworks. Competition is emerging from new companies specialising in digital financial services (Fintech). At this point, they are still mainly focused on the payment systems segment, but will soon compete with banks in other areas.

The example of the BdP is the entry into force of the new directive on payment systems in the European Union’s internal market (January 2018), which will allow providers of non-banking services to provide specific payment services through dedicated computer applications. “While posing a challenge to the traditional financial intermediation activity, it also constitutes a stimulus to the implementation of new information technologies in banking,” says the banking regulator.

Among the risks pointed out by the report, it is also worth highlighting the possibility of global risk premiums being re-evaluated as a result of geopolitical developments, hindering access to financing by the most indebted economic agents. “The prolonged environment of low interest rates should, on the other hand, continue to put pressure on the financial margins and profitability of the Portuguese banking sector, but also creates incentives for less restrictive lending and, consequently, a deleveraging of the economy that is slower than needs be,” reads the document.

The Bank of Portugal stresses the fact that we still have an incomplete banking Union. “It is thus essential to ensure a complete alignment between those who can take decisions and who has the responsibility to ensure financial stability,” says the institution.

Original Story: Jornal Econômico – Maria Teixeira Alves

Translation: Richard Turner