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Safeguarding financial stability is one of the three pillars of the Economic and Financial Adjustment Programme of Portugal - in place since June 2011 - together with fiscal consolidation and structural reform. The safeguarding of financial system stability is one of Banco de Portugal's core missions. To achieve this goal, we have put in place a comprehensive strategy aimed at reinforcing bank solvency, protecting banking system liquidity, enhancing the effectiveness of the supervision of the financial system, and improving the regulatory framework.
This strategy has been implemented over the last three years and has delivered on several fronts. Today, the Portuguese banking system is more capitalised, more transparent and in a more favourable liquidity position. Today, we benefit from improved supervision and a stronger regulatory framework. This was achieved in the context of a very demanding domestic and external environment, characterized by the structural rebalancing of the Portuguese economy and the persistence of financial fragmentation and economic weakness in the euro area.
Strengthening solvency and liquidity
The core Tier 1 ratio of the banking system increased from 8.1 per cent at the end of 2010 to 11.9 per cent at the end of the second quarter of 2013. The more stringent capital ratios aimed at strengthening the resilience of the banking system in the context of a very strong adjustment of the Portuguese economy. This resilience is especially important at times of economic adversity, where the recognition of impairments is a dynamic exercise with a powerful impact on banks' net income and capital positions.
Besides solvency, the liquidity position of the main banking institutions has also improved considerably. At the end of 2010, the loan-to-deposit ratio of the Portuguese banking system was around 160 per cent. At the end of 2012 it has come down to 128 per cent, decreasing further to 123 per cent in June 2013. The shutdown of capital markets to Portuguese banks in 2010 put pressure on the banking system's liquidity. In this context, banks had no option but to embark on a deleveraging process towards a more sustainable funding structure - a funding structure that would be less sensitive to changes in the risk perceptions of international investors.
The positive trend in the loan-to-deposit ratio reflects the behaviour of households' deposits - which, after growing sharply in 2011, remained relatively stable from 2012 onwards - and a fall in credit granted by banks. The behaviour of bank deposits contrasts with developments in other Programme countries. It is a sign of depositors' confidence in the soundness of the Portuguese banking system, something that we must absolutely preserve.
Strengthening the regulatory framework and the supervisory model
The improvement in the banks' solvency and liquidity position was accompanied by a major upgrade in both the regulatory framework and the supervision approach.
The new approach has relied on a new set of instruments, of which I would highlight the banks' funding and capital plans, the stress tests and the horizontal inspections carried out by Banco de Portugal.
Main challenges ahead
These developments are encouraging and show that significant progress has already been achieved. I have no doubt that we are now much better equipped to deal with emerging financial strains then we were at the outset of the current financial crisis. Nevertheless, there are still major domestic and external challenges facing the future evolution of the Portuguese banking system.
Domestically the main challenge to the banking system is profitability. Firstly, default in the credit portfolio has been increasing due inter alia to the prolonged economic recession, even though the flow of new defaults has been declining, consistent with the signs of recovery in the real economy. The decline of NPL was accompanied by an increase in impairments and as a consequence the NPL coverage remained relatively stable throughout the period. Secondly, net interest income has narrowed (from 1.5 per cent in December 2010 to 1.05 per cent in June 2013). Thirdly, despite the adjustment achieved to-date, banks currently bear operating costs that are out of step with the "new normal", in which the economy will be less leveraged than before the financial crisis.
To respond to these challenges, the institutions must take action on various fronts:
At European level, the negative interaction between sovereigns and banks has to be credibly and effectively broken, and the normal functioning of the money and debt markets in the euro area must be re-established. The creation of the Banking Union is key in this process.