BPCGY Banco Comercial Portugues SA (PK)

By Patricia Kowsmann 

LISBON--Portuguese banks have been excluded from a European Union stress test release Friday, but that doesn't mean investors shouldn't be worried.

A slew of problems in the country's largest lenders--from capital requirements at state-owned Caixa Geral de Depósitos SA to a difficult sale of the "good bank" that resulted from the collapse of Banco Espírito Santo SA-- have raised concerns that Portugal could be in trouble again soon.

In a report released Wednesday, Moody's Investors Service called Portugal's banks, which are faced with low profits and souring loans, "among the most weakly capitalized institutions in the euro area." That, Moody's said, not only represents a major threat for a country whose debt is already too high but also limits growth prospects for the struggling economy.

"For the state, the weakness of the banking system forms a key liability, " it said.

Trouble in Portugal's banking system is neither unique nor surprising. Across Europe, banks' profits are being challenged by low interest rates, political and economic uncertainty, and new technologies that are making the old banking model obsolete. Since Portugal requested a three-year EUR78 billion ($87 billion) bailout in 2011, two lenders--Banco Espírito Santo and Banco Internacional do Funchal SA--have collapsed. In both cases, regulators found that risky lending took place.

A weak economic environment has rendered highly indebted companies unable to repay loans. Corporate debt stood at 110% of gross domestic product last year, according to the International Monetary Fund. The Portuguese central bank said total loans at risk of default stood at 12.2% as of end-March, but Moody's said the figure seems overly optimistic.

Now, the piling-up of bad news for some of country's largest lenders is generating what could become the perfect storm.

The government is currently negotiating with the European Commission and the European Central Bank a capital injection into Caixa Geral de Depósitos, the country's largest lender by assets. Analysts say the bank could need over EUR2 billion, and because it will be the state pumping in that money, the country's debt, already close to 130% of GDP, will rise further.

"Hence, any further debt increase to fund bank recapitalizations is a credit negative for the sovereign," Moody's, which already rates Portugal's sovereign as junk, said.

Meanwhile, Novo Banco SA, the "good bank" created from the collapse of Banco Espírito Santo, is posing problems. Novo Banco received a EUR4.9 billion capital injection from the state and domestic banks when it was created, and it should have been sold last year for at least that amount.

The sale, however, was postponed after the central bank struggled to find good offers. The lender also needed more capital and its portfolio of souring loans turned out to be larger than previously thought. A second sale effort is currently under way, and four parties bid for the lender last month.

The Portuguese government has said it is expected to be paid back for the EUR3.9 billion it injected into the lender, which means likely losses from a sale will have to be split among domestic lenders already struggling to turn profits.

Earlier this week, Fernando Ulrich, the chief executive of Banco BPI SA, one of the better-off lenders, said healthy banks are being unfairly burdened by the mistakes of others.

"Enough of collective solutions that throw on us and our shareholders the costs of other people's mistakes," Mr. Ulrich said.

The executive has been critical of an idea being mulled by the government and Portugal's central bank to create a system-wide "bad bank" to free lenders from souring loans. But such a solution could prove tricky given the transfer of the assets would create deeper capital holes at banks.

BPI is facing its own life-changing moment after the ECB told it in late 2014 to either raise a prohibitive amount of capital or shed its highly profitable Angolan unit after its exposure to the former colony's debt exceeded regulatory limits. The issue is yet to be resolved. The lender is currently subject to a takeover attempt from its largest shareholder, CaixaBank SA.

Meanwhile shares in Banco Comercial Português SA, the country's second-largest by assets, have fallen over 60% in the year to date on fears that it too may need more capital. Its fully-loaded core tier 1 capital ratio--a key measure of a bank's balance sheet strength--stood at 10.1% in the first quarter compared with an average for European banks of 12.3%.

According to Barclays, if the lender were to improve that figure to 11%, increase its coverage of nonperforming loans and repay EUR750 million it owns the state, it could require a capital increase of about EUR2 billion.

"While the bank could seek to bridge this gap through earnings, asset sales and private sector equity raising, these options seem particularly challenging in light of current market conditions and relative to the current market capitalization of the bank at around EUR1 billion," Barclays said recently in a note.

Banco Comercial Português said it would voluntarily disclose results from the European Banking Authority's stress test Friday night along with its second-quarter earnings.

The EBA will only publish the results of the 51 largest lenders in the EU, none of which are in troubled Portugal.

Write to Patricia Kowsmann at patricia.kowsmann@wsj.com

(END) Dow Jones Newswires

July 28, 2016 09:49 ET (13:49 GMT)

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