The perilous condition of Portugal's banks

BBC business editor Robert Peston on Portugal's financial predicament.

The Portuguese central bank has warned today that Portugal's banks have become too dependent on loans from the European Central Bank and will need to raise significant amounts of new capital to "resist additional adverse shocks".

The analysis of the weakness of Portugal's banks, contained in the Banco de Portugal's Financial Stability Report, is disturbingly similar to the structural flaws in Ireland's banks, which took Ireland to the brink of bankruptcy.

There is however one important difference, which some will argue makes Portugal's financial predicament more perilous: Portugal's banks have not only been borrowing colossal sums from the ECB, they have also been lending billions of euros to the Portuguese government, so that it can finance the significant gap between what it spends and its dwindling tax revenues.

This is how the central bank put it: "the expansion of Portuguese banks' balance sheets in the first half of the year essentially reflected the financing of general government".

That implies Portuguese banks lent between €11bn and €13bn to the Portuguese government in the first six months of 2010, based on statistics published by the central bank.

Over the same period, Portuguese banks found it almost impossible to borrow from commercial sources, from other banks and financial institutions. So they avoided insolvency by using two techniques, neither of which is sustainable over the long term.

They borrowed from what the central bank calls "institutions belonging to the perimeter of the respective banking groups" by selling bonds to them - which is in effect shuffling money from one bit of an organisation to another.

And they also borrowed from central banks on a colossal scale. In the first half of 2010, domestic Portuguese banks' borrowings from central banks - largely what they borrow from the ECB and the Banco de Portugal - increased from €15.7bn to €39.7bn.

By the end of June, Portugal's domestic banks were financing a staggering 9.6% of their balance sheets by borrowing from the ECB and other central banks.

Now the Banco de Portugal says that these banks' dependence on central banks has fallen a bit since the end of June, but remains unsustainably large. It says: "the unsustainability of the permanent large scale use of Eurosystem financing will require a redefinition of Portuguese banks' financing strategy, particularly in a framework of persisting major restrictions on access to financing in the wholesale debt markets".

Or to put it another way, the ECB is signalling that it wants its money back. And the ECB has no option but to do so, because it is in the invidious position of having channelled eurozone taxpayers' money, via Portuguese banks, to the Portuguese government for the funding of a public-sector deficit - estimated by Barclays Capital at more than 7% of GDP this year - without ever having sought the permission of eurozone taxpayers.

The ECB simply cannot, over the long term, finance a structural hole in public sector finances. To do so would ultimately destroy its credibility and undermine the value of the euro.

Of course, the ECB can't have its money back tomorrow or even soon. Because if it asked for the cash, Portugal's banks would of course be bust - and so too would the Portuguese government, which has been kept afloat by loans from Portuguese banks.

But the ECB can insist that Portuguese banks must take steps to become viable organisations that can once more fund themselves from commercial sources.

Now here's the painful rub for the Portuguese government and people. The Portuguese central bank says "the furthering of a credible fiscal consolidation process is essential for facilitating the reopening of the international financial markets to Portuguese banks, thus allowing for a more gradual adjustment of the Portuguese economy".

Which means that the rehabilitation of Portugal's banks requires the Portuguese government to take credible steps to shrink its deficit, by raising taxes and cutting expenditure.

But in doing so, the Portuguese government would probably generate an increase in unemployment and a contraction in revenues for private sector businesses, in the short term at least. Which, the central bank says, means defaults on corporate and consumer credit loans - which are already running at a high rate - could rise further, generating increased losses for banks.

All that - along with the need for the banks to meet the new Basel lll capital thresholds - is why Portuguese banks have to raise billions of euros in additional capital, as a protection against those possible future losses.

Which implies that the Portuguese government and Portuguese banks will collectively have to raise a colossal amount of new money over the coming weeks and months.

Can they obtain those tens of billions of euros from commercial sources, in the way that Portugal's finance minister has been insisting is possible? Maybe.

That said, the disclosure by the Banco de Portugal that the Portuguese government has only kept its head above water by borrowing from the ECB via Portuguese banks rather suggests that - like Ireland - Portugal's financial rehabilitation will require a substantial package of loans from the EU and IMF.‬‪

You can keep up with the latest from business editor Robert Peston by visiting his blog on the BBC News website.

More on this story

Around the BBC