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Portuguese Banking Reforms: Integration into European Union Played Key Role in Reshaping of Banking Sector

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 1999
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IMF Survey:How would you characterize the health of Portugal’s banking sector prior to the country’s entry into the European Union in 1986?

Decressin:Portugal nationalized its banking system in March 1975, and the sector subsequently developed in an environment characterized by pervasive public intervention in the economy and large macroeconomic imbalances, including public sector borrowing that exceeded 20 percent of GDP in some years. To deal with the deficit, the government resorted to monetization, credit ceilings, and capital controls, which it hoped would enhance its ability to mobilize and channel resources.

The expansion in the monetary base helped distort banks’ balance sheets: deposits grew much faster than credit to the private sector, and excess reserves were channeled to the purchase of government paper, directly or indirectly through low-interest deposits at the central bank. Virtually all of Portugal’s interest rates were fixed administratively, with subsidized rates accorded to certain projects. In real terms, interest rates were low or negative. On the eve of Portugal’s entry into the European Union, many banks found themselves inadequately capitalized and recording losses.

IMF Survey:Portugal subsequently carried out extensive reforms of its banking system. What did this entail?

Decressin: While early banking reforms had already been implemented under a stabilization program supported by an IMF financing arrangement in 1983-85, the reform process was invigorated subsequently, with the result that a system once tightly controlled by the state has, by now, been transformed into a fully liberalized and modern one.

The reform encompassed domestic deregulation, privatization, and the opening of Portugal’s capital account. It was essential to first reduce the large macroeconomic imbalances that had prevailed during part of the 1980s. Once that was done, the reforms proceeded gradually and in stages. The liberalization of the legal and operational framework of the banking system as well as the reform of monetary policy instruments were initiated before stateowned banks were reprivatized and capital controls abolished. Legal and operational reforms allowed private banks to operate alongside public banks, granted the central bank more autonomy, and provided for a shift to universal banking (which allowed banks to participate in both commercial and investment activity). In addition, prudential regulations were strengthened considerably.

On the monetary side, the authorities deregulated interest rates, abolished credit ceilings, and introduced open market operations. They dismantled capital controls gradually, giving priority to transactions most directly linked to international trade and right of establishment and, finally, embarked on an ambitious privatization program.

IMF Survey:Did Portugal’s integration into the European Union and later preparations for the euro spur the reform process?

Decressin: Portugal’s integration into the European Union played a crucial role in reshaping the banking system. Key in this regard was the European Union’s Second Banking Coordination Directive, which Portugal incorporated into domestic law in 1992. This directive provided for universal banking, gave credit institutions a single license to do business in EU countries, and defined the conditions under which a new bank could be opened or an existing bank could be closed by the central bank. In concert with other EU members, prudential regulations were strengthened through directives on the Bank for International Settlements solvency ratio, loan-loss provisioning, capital requirements for market risk, and large exposures.

These reforms also paved the way for integrating the banking sector within the European Union—a process that will be catalyzed by the euro. Within the Portuguese banking sector, rising competition and, as prospects for early EMU participation brightened, declining interest rates have caused intermediation margins to narrow. This, in turn, has triggered an ongoing consolidation in the banking system and prompted banks to forge extensive links with other markets, notably insurance, to preempt competitive pressures from nonbank financial institutions in the mobilization of resources and develop new sources of income.

IMF Survey:How well positioned is Portugal to deal with increased competition in the euro area?

Decressin: Portugal’s largest banking groups, which accounted for 80 percent of banking system assets in 1997, are reasonably well positioned to withstand the intensified competition. Their recent performance generally compares well in terms of profitability with other major European banking groups, although a smaller fraction of their income stems from commissions and related business. The major European banks tend to be larger, with higher productivity. But lower personnel costs (and also a flexible wage system that ties salaries to bank performance) have to some extent compensated for the productivity differential.

A number of the smaller banks, however, may find themselves under considerable competitive pressure, which suggests the process of consolidation is not yet finished.

IMF Survey:What challenges lie ahead?

Decressin: The euro will catalyze the integration of financial markets and give further impetus to the ongoing restructuring in Europe’s financial services industry. Intermediation activity is likely to rise, but competition will also intensify. This will pose essentially three challenges for the Portuguese banking system.

First, Portugal’s banks will need to generate more revenue from fees and commissions while reducing overstaffing and rationalizing the branch network. Banks have already taken significant strides in this regard. They will also have to tackle the challenges raised by the Year 2000 problem.

Second, as the large banking groups expand into new areas of business to maintain profitability, supervision will have to adapt. The Portuguese authorities are working on a more structured and formal approach to information sharing and cooperation between the Bank of Portugal, the insurance supervisory authority, and the stock exchange supervisory commission.

Third, over the past few years, restructuring efforts have benefited from above-potential economic growth and a household credit boom. Such favorable conditions cannot prevail indefinitely. Our simple econometric model analyzed the banking system’s sensitivity to the economic cycle and provides a rough idea about the potential decline in profitability as the current economic boom unwinds.

IMF Survey:Is the domestic credit boom a source of concern?

Decressin: Ultimately, only the next downturn will bear out the soundness of such lending, but Portugal’s household indebtedness remains below that in other EU countries (for example, Germany, the Netherlands, and the United Kingdom) and the sharp decline in interest rates of recent years has alleviated its financial burden. Also, household credit, unlike credit to nonfinancial enterprises, is almost fully collateralized, and the mortgage credit has not fueled a real estate boom. Moreover, the growth in credit to nonfinancial enterprises, which typically is more sensitive to economic conditions, has remained moderate until recently. But the sharp acceleration in credit growth since 1997 cannot continue unabated without raising concerns about the thoroughness of banks’ credit approval process. Given that under EMU the Bank of Portugal can no longer raise interest rates to dampen credit growth, the burden will fall fully on the supervision of lending practices.

IMF Survey:What lessons might other countries usefully draw from Portugal’s experience?

Decressin: In contrast to a number of other countries, Portugal’s financial liberalization has triggered comparatively modest and more balanced credit growth and no sustained increase in net external lending. Typically, credit booms after financial liberalizations are attributed to the increase in opportunities to take on more risk in the presence of mechanisms, such as limited liability, that distort bank managers’ lending decisions.

Portugal’s experience seems to confirm the common wisdom that to avoid excess, financial liberalization has to proceed gradually, be appropriately sequenced, and be supported by both a prudent macroeconomic stance and a strengthening of supervision. Portugal benefited from three things:

  • Prudent macroeconomic policy. A tight monetary policy, which was called for when the escudo joined the exchange rate mechanism (ERM), and convergence toward the Maastricht criteria became the centerpiece of Portugal’s economic policy. This policy circumscribed the scope for a domestic lending boom, particularly after credit ceilings were abolished.

  • Orderly sequence of reforms. Fiscal consolidation preceded deregulation, since the whole banking system had been geared to providing low-cost financing to the public sector. Financial liberalization then proceeded gradually. Private banks were permitted to operate alongside public banks well before the financial system was deregulated, allowing expertise to grow in an environment where the scope for risk taking remained limited—some of these private banks that started operating in the 1980s grew to become the buyers of key state-owned banks a decade later. A preparatory framework for moving to indirect methods of monetary control was established before the abolition of credit ceilings. In addition, interest rates were deregulated before credit ceilings were lifted, allowing banks to charge risk-adjusted rates of return and rebuild profitability. In the final stage, the capital account was opened, the forces of competition were unleashed by privatization, and the scope for activity was widened by allowing universal banking.

When foreign borrowing was about to take off in the early 1990s, it was reined in by temporary controls on capital inflows—namely, through the introduction of a compulsory non-interest-bearing deposit with the central bank on financial loans from abroad and restrictions on forward transactions, as well as on the purchase of domestic securities by nonresidents. And when the scope of risk taking was widened significantly around 1992 with the opening of the capital account and the introduction of universal banking, the ERM turmoil provided Portuguese agents with a vivid example of the risks of international activity. This experience is thought to have contained risk taking thereafter.

  • Strengthened supervision. Perhaps most important, deregulation was accompanied by a strengthened supervision by the Bank of Portugal. Several laws conferred on the Bank of Portugal both greater autonomy and increased powers of supervision and control. Prudential regulations were reinforced considerably in the context of the adoption of the EU’s Second Banking Directive. In addition, Bank of Portugal staff characterize their approach to supervision as having become increasingly “risk-based” rather than “rules-based.”

Copies of IMF Staff Country Report 98/127, “Portugal: Selected Issues and Statistical Appendix,” are available for $15.00 each from IMF Publication Services. See page 30 for ordering information.

Ian S. McDonald

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