The IMF/EU/ECB bailout for Portugal: Banking Sector Reform

The IMF/EU/BCE banking sector reforms are aimed at enhancing the resilience of the banking sector “by increasing capital requirements through market-based solutions, supported by a fully funded capital backstop facility. Safeguards to help ensure adequate banking system liquidity are strengthened. ”

The key measures include: a) require banks to raise their core Tier 1 capital to 9 percent by end-2011 and 10 percent at the latest by end-2012. Banks are supposed to raise the necessary capital through the market, with the exception of CGD which will raise the money by shedding assets (mostly its insurance business). The Government will also set up a contingent cash facility of €12 billion to rescue banks in trouble; b) increase by €15 billion (to €35 billion) the Government guarantee fund for bank bond issues which can be used for ECB refinancing; c) bring the BPN case to a close; and d) improve the Central Bank supervision system as well as the Deposit Insurance mechanism.

Since the Portuguese banks were not exposed to the sub-prime crisis or to a real estate bubble, the measures seem enough to maintain the sector for about two years until it can access the wholesale market again. However, should the Portuguese sovereign debt crisis continue beyond that or should a restructuring take place before that then new measures will be needed.

Yet the program can be considered to be a missed opportunity to force a much needed streamlining and change of the business model of the Portuguese banks. These have been plagued by a chronic lack of capital (tolerated by the authorities) which was used to preserve the control of the banks in the hands of a few insiders; while disguising a low profitability in a cozy government protected market. Moreover, some of the banks have a dangerous maturity mismatch caused by a low deposit base and a high exposure to long term loans to the mortgage sector, PPPs, utilities and some equity stakes.

In order to avoid that banks carry out their deleveraging mainly through a reduction of credit to the non-state-owned corporate sector and the household sector, with major social and macro-economic consequences, the banks should be forced to change their traditional business model.

For instance, this could be easily achieved by limiting their equity stakes in public companies (contributing to provide liquidity to the stock market and reduce the many incestuous relations). Likewise the Government should recapitalize adequately the surviving state-owned enterprises to reduce the banks’ exposure to that sector. Most importantly, the Government should nationalize the PPPs to remove them from the banks’ balance sheet. This should be financed by a long-term loan from the EU EFSF/ESM.

In conclusion, the authorities need to be more creative because the success of the financial sector reform and fiscal stabilization are inextricably intertwined for the good and the bad.