A detailed assessment of Portugal's observance of the Basel Core Principles (BCPs) for Effective Banking Supervision published by the International Monetary Fund (IMF) in 2007 concludes that the country is fully compliant with 28 of the 30 principles and sub principles, and largely compliant with the remaining two principles. Further, Portugal's regulatory framework and supervisory practices are sound, its banking supervisor, the Bank of Portugal (BdP) is independent, active, and professional, and the overall financial system oversight is in line with international standards as well as European Union Directives. With Portugal's implementation of Basel II in 2007, the country has also moved toward a more formalized risk-based supervisory approach. In addition, it has also achieved greater compliance with the BCPs since the most notable shortcomings observed by the IMF in 2007 related to risk assessment and management by the supervised banks and risk-based supervision and inspections by the BdP were addressed.

General Overview

The most recent International Monetary Fund (IMF) report on Portugal (the 2008 Article IV consultation report) points towards a "sound and well supervised" (p. 2) financial system. The Bank of Portugal (BdP), the banking supervisor, is credited for effectively managing the vulnerabilities in the system that have been exacerbated by the global financial stress and the national macroeconomic conditions to make it resilient in the face of major macroeconomic shocks. In 2006, the IMF conducted a Financial System Stability Assessment (FSSA) for Portugal and published a detailed assessment on its banking supervision in 2007. The assessment concluded that Portugal's regulatory framework is modern and sound, and highly compliant with international standards" (2007a, p. 6). Further, the BdP's supervision of financial institutions was found to be "active, professional, and well-organized" (2007a, p. 6). The supervisory framework has achieved full compliance in areas like loan classification and provisioning that lagged behind international best practices before regulatory changes were introduced in 2002-2003. Areas that, per the assessment, still required improvement included banks' risk assessment processes and supervisory risk management. However, Portugal had indeed taken important steps in moving closer to full compliance on those fronts. Moreover, Portugal's financial sector laws, accounting practices, payment systems, transparency policies, and oversight practices are also in line with international standards and European Union (EU) Directives.

The BdP is an independent supervisor with a high level of operational, budgetary and administrative autonomy. It is backed by a comprehensive legal framework to address distressed financial entities and to activate financial safety nets. The supervisory system is a "combination of a traditional sectoral approach with a partially integrated functional approach" (p. 5), wherein the BdP is the ultimate prudential regulator and supervisor of banks, while the Portuguese Securities Market Commission (CMVM) is charged with the cross-sectoral supervision of the market conduct of financial intermediaries. Coordinated supervision is ensured through bilateral memoranda of understanding as well as a high-level committee, the National Council of Financial Supervisors (CNSF), which has representatives from the BdP, CMVM, and the Insurance and Pension Funds Supervisory Authority of Portugal (ISP). The BdP is an integral part of the European System of Central Banks (ESCB) and operates in pursuance of the European Central Bank (ECB) statute.

The 2008 IMF report proffers updates on the implementation status of the 2006 FSAP recommendations by the IMF. According to the report, the BdP issued Instruction No. 17 of 2007 requiring banks to adopt internal limits on exposure concentrations to certain sectors and regions. However, the report notes that banks have yet to establish these limits. Secondly, liquidity monitoring has increased with the BdP asking banks to report liquidity stress test results and contingency planning initiatives to deal with prolonged crises. With regard to banks' risk management systems and the BdP's supervisory capacity in this area, the report mentions that both have been enhanced with the adoption of Basel II and the institution of a risk-rating system by the BdP to guide its on-site inspections of major banks. Further, a software tool is being developed to support this risk-rating system. Bank capital levels have been increased through proactive BdP encouragement and the BdP is programming a new run of stress tests to be conducted in the second half of 2008 to test all materially relevant risks to the system. Looking forward, the IMF advises the BdP to further strengthen liquidity supervision and the deposit insurance scheme, ensure capital adequacy of institutions, and accelerate Basel II implementation to further enhance financial stability.

The 2006 IMF FSSA states that "Portugal's banking system - despite being relatively small and concentrated - generally compares well with other EU countries in terms of efficiency, profitability, and asset quality, with solvency also close to European levels, and these traits have held up well in recent years, despite a difficult operating environment" (p. 5). The 2007 detailed assessment adds that banks dominate financial intermediation and are formed into financial conglomerates. The state-owned bank, Caixa Geral de Depositos, is one of the two largest banks in the country. In all, as of 2005, there were 61 banks, 168 other credit institutions, 105 financial institutions, and 22 EU-bank branches supervised by the BdP. These banks were found to have adequate capital buffers, historically low non-performing loans, and adequate provisioning, although they were heavily exposed to the real estate sector and carried high levels of household and corporate debt.

As the 2006 annual report of the BdP states, the central bank prepared draft acts in 2006 to transpose into Portuguese law EU Directives Nos. 2006/48/EC and 2006/49/EC implementing Basel II at the European level. The 2007 Financial Stability Report (FSR) of the BdP adds that since 2007, Basel II was being implemented in Portugal, although in the introductory year institutions had the prerogative of opting to follow Basel I or go for the more risk sensitive Basel II. However, starting 2008, all banks must apply Basel II in their capital calculations and risk assessment.

As the 2007 FSR points out, the average capital adequacy ratio of banks declined in 2007 to 10.2 percent owing chiefly to the deteriorating financial conditions globally. Total own funds of banks are projected to be tight in view of the global financial turbulence, avers the FSR. Income before taxes of banks increased a modest 3 percent, whereas profitability indicators declined, though not as much owing to strong income levels of 2006 that buffered the decline. Banks also increased their provisions in response to increases in impairment of loans due to negative assessment of financial capacity of customers by banks. As the FSR further notes, international activities of Portuguese banks showed an increase and made a considerable impact on their incomes, accounting for 20 percent of their consolidated profits or losses.

The Principles

1. (1) Clear responsibilities and objectives for each supervisory agency.

FC

Portugal is compliant with this principle, per the 2007 detailed assessment by the IMF. Two key pieces of legislation define the powers and responsibilities of the BdP as the banking supervisor. They are the Organic Law of 1998 and the 1992 Legal Framework of Credit Institutions and Financial Companies. Further, the BdP's Audit Department examines the activities of the Banking Supervision Department and reports to the Governor of the BdP as well as the Board of Auditors of the BdP regularly. The IMF suggests that the BdP could benefit from further institutionalization and procedural enhancements in supervision by introducing a quality control exercise.

1.(2) Operational independence and adequate resources.

FC

Portugal is compliant with this principle, per the 2007 detailed assessment by the IMF. The assessment further attests that "there is no evidence of government or banking industry interference in the performance of the supervisory functions of BdP" (p. 11). The Statute of the ESCB and of the ECB guarantees the BdP's independence. No governmental, EU or other external agency can interfere with or instruct the BdP in the exercise of its supervisory functions. The BdP is also financially independent and is not subject to the Organic Law's financial rules governing autonomous funds and services of the public sector. Its source of funding is the income obtained as a result of participation in the results of the currency issue of the ESCB, the interest from investments within the scope of monetary policy and from the management of reserves.

1.(3) A suitable legal framework for authorization and ongoing supervision.

FC

Portugal is compliant with this principle, per the 2007 detailed assessment by the IMF. The 1992 Legal Framework of Credit Institutions and Financial Companies empowers the BdP to authorize, refuse authorization, or withdraw the authorization of entities to carry on banking activities. However, non-EU entities can only be authorized by the Minister of Finance to carry on banking activities in Portugal. However, even in these cases, the BdP examines the applications and submits its conclusions for the Minister's final approval. The IMF advises delegating this latter authority to the BdP as well.

1.(4) A suitable legal framework to address compliance with laws as well as safety and soundness concerns.

FC

Portugal is compliant with this principle, per the 2007 detailed assessment by the IMF, since "the legal and regulatory framework of BdP is deemed adequate to its supervisory responsibilities and tasks, and the powers of BdP to ensure compliance with the rules regulating the activities of institutions are provided for in the LFCIFC [Legal Framework of Credit Institutions and Financial Companies]" (p. 14).

1.(5) Legal protection for supervisors.

FC

Portugal is compliant with this principle, per the 2007 detailed assessment by the IMF, and the 1992 Legal Framework of Credit Institutions and Financial Companies provides legal protection to the BdP staff.

1.(6) Arrangement for sharing of information between supervisors and protection of confidentiality of shared information.

FC

Portugal is compliant with this principle, per the 2007 detailed assessment by the IMF. The BdP has separate memoranda of understanding (MoUs) for cooperation and information exchange with both the domestic financial supervisors, the CMVM and the ISP. Further, the CNSF was created in 2000 to coordinate the exchange of information between the three financial supervisors as well as coordinate their activities in mutually relevant supervision cases so as to reduce regulatory gaps and inhibit conflict of competence. As for international cooperation, the BdP shares information with pertinent authorities and organizations in other EU member states, central banks and similar organizations. Information sharing with non-EU supervisors occurs in the framework of reciprocal cooperation agreements. Confidentiality obligation does not come in the way of information sharing as long as the recipient is subject to identical obligation of professional secrecy.

2. Clearly defined permissible activities for banks and control of the use of the word 'bank'.

FC

Portugal is compliant with this principle, per the 2007 detailed assessment by the IMF. The phrase "credit institutions" is clearly defined in the 1992 Legal Framework of Credit Institutions and Financial Companies. The law also distinguishes between the different types of credit institutions and explains whether they may or may not take deposits.

3. Criteria for structure, directors, operating plan, controls, financial condition and capital base.

FC

Portugal is compliant with this principle, per the 2007 detailed assessment by the IMF. The 1992 Legal Framework of Credit Institutions and Financial Companies lays down detailed requirements that have to be fulfilled in applying for a license. However, the assessment reiterates its criticism of the power given to the Minister of Finance to authorize non-EU banks and advises that the power be transferred to the BdP.

4. Authority to review and reject transfer of ownership.

FC

Portugal is compliant with this principle, per the 2007 detailed assessment by the IMF. The 1992 Legal Framework of Credit Institutions and Financial Companies defines qualifying holdings and significant influence over the management and makes it obligatory for the holding company to inform the BdP of the identity of its significant shareholders, changes in ownership due to direct or indirect mergers or acquisitions, and increases in significant shareholdings. Further, the BdP is empowered to reject a proposal for shareholding if it is not confident of the shareholder's integrity or if it determines that the person is not conducive to the sound management of the undertaking.

5. Authority to review major acquisitions and investments.

FC

Portugal is compliant with this principle, per the 2007 detailed assessment by the IMF. Further, the BdP is empowered by the 1992 Legal Framework of Credit Institutions and Financial Companies to instruct an institution to abstain from actualizing an acquisition or major investment if the former deems that it is in breach of applicable prudential rules or will violate prudent and sound management rules.

6. Minimum capital adequacy requirements (meet Basle Capital Accord for internationally active banks).

FC

Portugal is compliant with this principle, per the 2007 detailed assessment by the IMF. The assessment commends the BdP for stricter definition of capital than Basel I by requiring deductions of intangible assets and on exceeding large exposure limits. However, the 20 percent limit on the inclusion of innovative instruments in Tier I capital imposed by the BdP is 5 percent higher than the 1998 Basel Committee on Banking Supervision (BCBS) requirement for inclusion. Nevertheless, the 20 percent limit is imposed even in cases where the BCBS requirements are milder, such as on new and existing issues. Portuguese banks will be required to have an internal process to assess their capital adequacy vis-à-vis the risk they undertake and their projected business upon Basel II implementation. A majority of the Portuguese banks, including the big five holding 75 percent of the banking assets, have expressed their inclination to use the Internal-Ratings based method to calculate funds for credit risk; basic indicator method for the calculation of capital charge for operational risk; and internal models for market risk. In this context, the 2007 FSR of the BdP mentions that Basel II has been in implementation in Portugal since 2007 on a voluntary basis, and since 2008 on a mandatory basis.

7. A method exists for the evaluation of procedures related to loans, investments and portfolio management.

FC

Portugal is compliant with this principle, per the 2007 detailed assessment by the IMF. Banks are required by Instruction No. 72 of 1996 to control the credit risk arising from their activities and to involve their Board of Directors in controlling such risk by having them annually approve, implement, and review the policies and strategies of the bank vis-à-vis their credit risk.

8. Policies, practices and procedures for evaluating the quality of assets and the adequacy of loan loss provisions and reserves.

FC

Portugal is compliant with this principle, per the 2007 detailed assessment by the IMF. Further, it is evident that the provisioning requirements of the BdP exceed the economic provisions necessary to cover implicit risks in a loan portfolio. However, its loan loss provisioning rules "are not yet underpinned by a risk based system" (p. 31), notes the assessment. This situation should be remedied once Portugal moves towards Basel II and its approach in calculating credit risk and provisioning for it. In the interim, the assessment avers, "the presence in Portugal of a dual system of calculating provisions (economic and regulatory provisions), operated respectively by the banks and by their external auditors, provides an acceptable prudential approach" (p. 31). By way of recommendation, Portugal is advised to speed up the process of migrating to the Basel II risk based approach and update its credit register system, under which banks need to communicate the rating attached to loans above €500,000. The BdP is advised to lower this limit to €250,000. In this context, the 2007 FSR of the BdP mentions that Basel II has been in implementation in Portugal since 2007 on a voluntary basis, and since 2008 on a mandatory basis.

9. Prudential limits and management information system on concentration of exposure.

FC

Portugal is compliant with this principle, per the 2007 detailed assessment by the IMF, and "prudential limits that restrict bank exposures to single borrowers or groups of related borrowers are established in Notice No. 10/94, which is the result of the transposition of EU Directive (2000/12/EC, Title V, Chapter 2, Section 3)" (p. 32).

10. Arm's length rule and monitoring for connected lending.

FC

Portugal is compliant with this principle, per the 2007 detailed assessment by the IMF. Connected lending to board members, owners of qualifying holdings, and to groups of clients that comprise the bank's parent company or its subsidiaries is restricted or prohibited by the 1992 Legal Framework of Credit Institutions and Financial Companies.

11. Policies and procedures for country risk and transfer risk.

FC

Portugal is compliant with this principle, per the 2007 detailed assessment by the IMF as Notice No. 3 of 1995 requires specific provisioning for country and transfer risks.

12. Measuring and monitoring market risk. Limit and/or specific capital charge on market risk exposure.

CP

Portugal is largely compliant with this principle, per the 2007 detailed assessment by the IMF. Different credit institutions use different levels of sophisticated and complex risk management tools to address different types of risks. Trading book risks are managed through more advanced techniques, than are banking book risks. Credit risk stress testing is also rarely done, although the banks have demonstrated a capacity to undertake them. Internal risk rating models have been recently instituted for use by the BdP regulations, and hence their practical applicability has not been tested. BdP requirements on banks’ scenario analysis, stress testing and contingency planning, as well as periodic validation or testing of the systems to ensure the best practice to measure market risk are incorporated in Annex IX of Notice No. 7 of 1996 and in Instruction No. 22 of 2005. The BdP is developing its expertise and hiring additional specialized staff to monitor banks' compliance with the above requirements, the assessment notes.

13. Comprehensive risk management processes.

FC

Portugal is compliant with this principle, per the 2007 detailed assessment by the IMF. The BdP conducts comprehensive risk management not through explicit regulations but by making individual recommendations on the maintenance of a minimum liquidity ratio. It has issued a set of High Level Principles through Circular-Letter 100/05/DSBDR to guide institutions on improving their contingency planning frameworks. Further, once Portugal adopts the Basel II rules through relevant EU Directives, the BdP will also institute a capital charge to regulate operational risk. In this context, the 2007 FSR of the BdP mentions that Basel II has been in implementation in Portugal since 2007 on a voluntary basis, and since 2008 on a mandatory basis.

14. Adequate internal controls.

FC

Portugal is compliant with this principle, per the 2007 detailed assessment by the IMF. The assessment further states that the fundamental rules on internal control systems for credit institutions are established in Instruction No. 72 of 1996, as also in the Company Law, the 1992 Legal Framework of Credit Institutions and the Financial Companies and Instruction No. 103 of 1996.

15. Strict "know-your-customer" rules and high ethical and professional standards.

FC

Portugal is compliant with this principle, per the 2007 detailed assessment by the IMF. The 2004 Anti-Money Laundering Law covers credit institutions, which are also subject to BdP regulations including Instruction No. 26 of 2005 on Anti-Money Laundering, Instruction No. 72 of 1996 on internal control, and Notice No. 11 of 2005 on opening deposit accounts.

16. Effective supervisory system consisting of on-site and off-site supervision.

CP

Portugal has been adjudged largely compliant with this principle by the IMF's 2007 detailed assessment due to "the existence of some small shortcomings identified in the overall assessment" (p. 47). However, the IMF is quick to add that supervision is of a very high standard. Nevertheless, due to the high level of banking intermediation in Portugal, the levels of risks banks take, and in the context of the EU integration, the standards of assessment have also risen, and the IMF looks for more than the observance of essential and additional criteria of this principle to give a country a full compliance rating. The assessment anticipates that the incorporation of Basel II and the implementation of a formal risk rating system will "enhance the systematic nature of [the BdP's] supervision activities and have its internal risk management process migrate towards a risk based supervision" (p. 47) so that inspections of institutions are prioritized based on their risk profiles and systemic importance. Other shortcomings relate to the BdP's off-site supervision, in particular its user-unfriendly credit risk register as a supervisory tool due to its limited data accessibility that is not well integrated with other off-site tools. In response to the IMF's recommendation to introduce a formalized risk rating methodology, the Portuguese authorities assert that a risk-focused supervisory approach is already in place and is being formalized and will be implemented soon. In any case, as the authorities note, a formal methodology is only an additional criterion and not an essential one. Further, the credit risk register is also being used and has proved to be a very effective tool in providing detailed information on banks' credit exposures. Moreover, the 2007 FSR of the BdP mentions that Basel II has been in implementation in Portugal since 2007 on a voluntary basis, and since 2008 on a mandatory basis.

17. Regular contact with bank management and understanding of bank's operations.

FC

Portugal is compliant with this principle, per the 2007 detailed assessment by the IMF. The BdP maintains frequent contact with supervised institutions. Meetings are held with the Board of Directors and senior management as well as management at different levels. The frequency and intensity of these contacts depend upon "the risk profile of the institution, its significance in the banking system and the adequacy of its internal controls" (p. 48), the assessment notes.

18. Analytical reports and statistical returns on solo and consolidated basis.

FC

Portugal is compliant with this principle, per the 2007 detailed assessment by the IMF. The 1992 Legal Framework of Credit Institutions and Financial Companies requires credit institutions and financial companies to provide the BdP with all pertinent information that it requests in order to monitor their "degree of liquidity and solvency, the risks they take, the compliance with the laws and regulations governing their activities, their administrative organization, the effectiveness of their internal control and data processing security and control procedures" (p. 49), the assessment avers.

19. Independent validation of supervisory information through on-site examination or external auditors.

FC

Portugal is compliant with this principle, per the 2007 detailed assessment by the IMF. The BdP monitors the activities of the supervised institutions by analyzing reports and information submitted by them through off-site analysis and by on-site inspections to verify the submitted information. The law also requires external and statutory auditors to report to the central bank all material facts as discovered during audits as also any breaches of laws and regulations by the audited entities.

20. Ability to supervise on a consolidated basis.

FC

Portugal is compliant with this principle, per the 2007 detailed assessment by the IMF. The 1992 Legal Framework of Credit Institutions and Financial Companies empowers the BdP to supervise credit institutions on a consolidated basis, and stipulates that financial holding companies be assimilated into credit institutions for this purpose. Further, the BdP lays down appropriate rules to govern institutions on a consolidated basis.

21. Consistent accounting policies and practices that provide a true and fair view of the financial condition of the bank.

FC

Portugal is compliant with this principle, per the 2007 detailed assessment by the IMF. The rules on Pillar III of Basel II will be applied in Portugal through the relevant EU Directives. They will stipulate advanced obligation on disclosure of information. In this context, the 2007 FSR of the BdP mentions that Basel II has been in implementation in Portugal since 2007 on a voluntary basis, and since 2008 on a mandatory basis. With regard to International Financial Reporting Standards (IFRSs) adoption, the 2007 IMF assessment notes that the BdP "participates in the Committee of European Securities Regulators’ database that collates all enforcement decisions relating to financial information, and this may be used as a benchmark" (p. 59). Also, essential criterion No. 11 of this principle does not apply to Portugal because the BdP "has internal resources that assure the conduct of on-site and off-site examinations" (p. 59), adds the assessment.

22. Adequate supervisory measures to ensure timely corrective action.

FC

Portugal is compliant with this principle, per the 2007 detailed assessment by the IMF. The BdP has at its disposal a broad range of remedial action and corrective measures to penalize and correct supervised institutions when they are in violation of prudential regulations.

23. Banking supervisors must practice global consolidated supervision over their internationally-active banking organizations.

FC

Portugal is compliant with this principle, per the 2007 detailed assessment by the IMF. The 1992 Legal Framework of Credit Institutions and Financial Companies charges the BdP with responsibility of supervising the activities of credit institutions and financial companies conducted in foreign jurisdictions.

24. International exchange of information with other supervisors.

FC

Although the 2007 IMF detailed assessment concludes that Portugal is compliant with this principle, it does note that the BdP has not concluded any information sharing agreement with a non-EU country whose bank has a branch in Portugal because "the home supervisor was unable to assure the same level of confidentiality protection as provided by Portuguese law" (p. 66). The assessment, therefore, calls for the putting in place an information exchange framework with such countries to "exchange a minimum level of information" (p. 66) even though the exposure of such banks may not be high in Portugal. The Portuguese authorities respond by pointing out that they are committed to concluding bilateral MoUs with every country whose bank is operating in Portugal and vice versa.

25. Supervision of local operation of foreign banks and information sharing with home country supervisors.

FC

Portugal is compliant with this principle, per the 2007 detailed assessment by the IMF. As the assessment notes, the 1992 Legal Framework of Credit Institutions and Financial Companies provides that "in accordance with the harmonized 'single market regime' established at EU level, credit institutions authorized in other EU Member States which carry on activities in Portugal through a branch are not subject to prudential supervision by BdP, provided they are subject to supervision by their home authorities" (p. 66). However, the BdP does cooperate with the home supervisors to supervise their liquidity. Information sharing with home supervisors is also conducted under the terms and procedures established by the EU Directives (in the case of EU countries) or separate MoUs signed between the BdP and its non-EU counterparts.