DBRS: BES’s Ratings Unchanged Following 2011 Results; Intrinsic Assessment Lowered to BBB (high)

DBRS, Inc. (DBRS) has today commented that its ratings of Banco Espírito Santo SA (BES or the Group) remain unchanged after the Group’s 4Q11 results announcement. DBRS rates the Group’s Senior Long-Term Debt & Deposits at BBB (low) and Short-Term Debt & Deposits at R-2 (middle). All ratings have a Negative trend. These ratings were downgraded on 31 January 2012 following DBRS’s downgrade of the Republic of Portugal to BBB (low) with a Negative trend.

Following the Group’s 4Q11 results announcement, DBRS is lowering BES’s intrinsic assessment (IA) to BBB (high) from “A”. DBRS views the substantial stress in the domestic economy and disrupted financial markets within the Euro zone, which continue to exacerbate the funding and liquidity pressures, as significantly pressuring the Group’s earnings through higher funding costs, the adverse impact of deleveraging and the elevated costs of credit. Furthermore, the Group now faces pressure to raise additional capital and continue deleveraging by June 2012, given the new EBA capital requirements that include a sovereign-related capital buffer, which results in BES needing to bolster capitalisation during a time of unprecedented stress in the markets. While BES has maintained its franchise strength and sustained its international earnings, DBRS views its domestic earnings power as having been weakened and its funding access as still constrained by the negative impact of the sustained crisis and ongoing sovereign stress. Additionally, the Portuguese economy is weakening, rather than recovering. DBRS views these challenges as warranting a lowering of the Group’s intrinsic assessment to BBB (high) from “A”. DBRS maintains its SA-2 support assessment for the Group, which indicates an expectation of timely systemic support in case of need, but, given the sovereign’s rating of BBB (low), this support does not bring any uplift for the final rating of BES from its IA. Instead, the sustained stress on the sovereign puts downward pressure on the Group’s final rating.

Supporting its IA of BBB (high), which remains two notches above BES’s final rating of BBB (low), BES has demonstrated its ability to adjust in various ways to the adverse environment. The Group has been fairly successful at maintaining its revenues throughout this prolonged crisis, supported by BES’s sizable international presence that has offset weakness domestically. BES has also been successful at controlling expenses, building up liquid resources and improving its capital levels. To bolster capital, the Group has utilised various resources, including non-strategic asset sales and a debt-for-equity exchange in December 2011 in order to boost its core Tier 1 capital ratio to 9.2% at the end of 2011. While DBRS views BES as taking appropriate steps to meet regulatory requirements, these actions have utilised some of BES’s contingency resources, leaving it with fewer alternatives to boost capital levels during sustained period of stress. Nevertheless, given that BES has thus far coped reasonably well with the stressed environment, DBRS expects it to continue to demonstrate this adaptability in coping with the continued difficult environment.

DBRS notes that in 2011 the Group reported its first annual loss during the extended financial crisis, despite positive net income in 1Q11 and 2Q11. Driving this net loss of EUR 108.8 million in 2011 was the partial transfer of BES’s pension fund liabilities to the Portuguese state (-EUR 76 million, after tax), impairments and losses related to BES Vida (-EUR 144 million, after tax) and losses related to non-core international loan sales (-EUR 55 million, after tax). Excluding these items, BES would have reported positive net income of EUR 166.6 million in 2011. DBRS notes that this transfer of BES’s pension fund liabilities will negatively affect core capital in 1H12, further pressuring the Group’s regulatory ratios in a time of stress. BES’s domestic revenues are supported by its franchise strength in key customer segments, particularly corporate lending, that enables BES to defend its margins. The advantages of the Group’s geographic diversification were evident in the positive net income of EUR 160.8 million generated in BES’s international businesses, with the international components of its Strategic Triangle – Brazil, Africa and Spain – contributing to 75% of international net income. DBRS views BES’s success in building out its international franchises as supporting the Group’s intrinsic strength, given that the contribution is helping to compensate for the pressure on its domestic businesses.

With the Portuguese economy weakening, deteriorating credit quality is taking its toll on the Group’s results. Provisions of EUR 848.3 million in 2011 were up 59% YoY and exceeded net operating income of EUR 821 million. In 2Q11, BES reinforced provisions with an additional charge of EUR 126 million based on expected asset quality deterioration and, in 2011, the Group covered the totality of the EUR 125 million in provisioning needs identified by the SIP inspection. DBRS views elevated credit costs as absorbing a substantial portion of recurring earnings and significantly reducing the resources to grow capital through retained earnings. Given the outlook for the economy, a reduction in provisioning does not appear likely in the near-term. BES’s overdue loans ratio is trending upward, reaching 3.0% at the end of 2011, though this remains below the average for the Portuguese financial system of 4.8%. Given the current macroeconomic outlook for Portugal, further asset quality deterioration is likely.

DBRS views BES as appropriately reducing wholesale funding needs through its deleveraging plan, which has helped BES to reduce its loan-to-deposit ratio to 141% at end-2011, down from 165% a year ago. Despite reducing its commercial gap significantly, BES remains reliant on wholesale funding. With no access to the wholesale markets, BES’s usage of the ECB as its primary funding source has increased to EUR 8.7 billion at year-end 2011, or 10.8% of total assets, up significantly from EUR 3.9 billion at year-end 2010. This amount far exceeds the Group’s expected ECB usage at the end of 2011 of less than 5% of total assets, although it does now include EUR 5 billion of three year funding from the LTRO. The Group has approximately EUR 6 billion of collateral available to pledge for central bank funding, which exceeds debt maturities of EUR 3.4 billion in 2012. While DBRS views the Group as taking the appropriate steps to maintain a comfortable liquidity buffer, continued inability to access the wholesale markets negatively pressures the Group’s funding and liquidity profile and adds further negative pressure on the Group’s intrinsic strength.

Notes:
All figures in Euros (EUR) unless otherwise noted.

The principal applicable methodology is the Global Methodology for Rating Banks and Banking Organisations. Other methodologies used include the DBRS Criteria – Intrinsic and Support Assessments. Both can be found on the DBRS website under Methodologies.

The sources of information used for this rating include company documents, DBRS’s rating on the Republic of Portugal, and SNL Financial. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

This commentary was disclosed to the issuer and no amendments were made following that disclosure.

This credit rating has been issued outside the European Union (EU) and may be used for regulatory purposes by financial institutions in the EU.

Lead Analyst: Roger Lister
Approver: Alan G. Reid
Initial Rating Date: 19 April 2011
Most Recent Rating Update: 31 January 2012

For additional information on this rating, please refer to the linking document under Related Research.