DBRS: BES’s Ratings Confirmed at BBB (low), Negative Trend; Intrinsic Assessment Lowered to BBB

DBRS, Inc. (DBRS) has today confirmed the ratings of Banco Espírito Santo, S.A. (BES or the Bank) and associated entities, including BES’s Senior Long-Term Debt & Deposit rating at BBB (low) and Short-Term Debt & Deposit rating at R-2 (middle). All ratings have a Negative trend. These ratings were previously confirmed on 5 December 2012 following DBRS’s confirmation of the Republic of Portugal (Portugal) at BBB (low) with a Negative trend.

At the same time, DBRS has lowered BES’s intrinsic assessment (IA) to BBB from BBB (high). DBRS views BES as systemically important in Portugal. As the country’s third largest banking group, a major provider of financial services to the business and financial sector and a key participant in the financial markets, significant distress for BES, if not addressed promptly, could materially affect Portugal’s financial system and the country’s payment mechanisms. DBRS maintains its SA-2 support assessment for BES, which indicates an expectation of timely systemic support if needed. DBRS views the ability of the government to provide support as having been enhanced by the agreement with the EU/IMF that provides EUR 12 billion of resources to strengthen the capital base of Portuguese banks, of which approximately half of these resources have been utilised. DBRS notes that BES has not utilised any capital support from the State. With the current rating for the Portuguese sovereign below the BBB intrinsic assessment for BES, there is currently no uplift to the Bank’s ratings. Instead, the sustained stress on the sovereign puts downward pressure on the Bank’s final rating.

The confirmation of BES’s ratings is in line with the confirmation of Portugal’s long-term foreign and local currency issuer ratings at BBB (low) with a Negative trend. The confirmation reflects DBRS’s assessment that, despite an unfavourable external environment, Portugal has made significant progress consolidating public finances, unwinding external imbalances and implementing structural reforms. The statement from Euro area countries that additional financing would be available to Portugal, if necessary, as long as there is strict policy implementation in the context of the EU-IMF programme, provides additional support to the ratings. The Negative trend, however, recognises that there is substantial uncertainty regarding Portugal’s growth outlook with downside risks emanating from external demand, stressed economy-wide funding conditions and adverse effects from the fiscal consolidation effort.

In lowering the IA by one notch to BBB, DBRS factors in the increasingly difficult domestic operating environment which is significantly pressuring the Bank’s domestic earnings through higher credit and funding costs. Continued deterioration in the Bank’s credit profile is expected to continue through the foreseeable future. DBRS expects the Bank’s domestic earnings to remain under significant pressure throughout 2013, driven by margin pressures and elevated provisioning needs. Supporting the IA of BBB is the Bank’s well-positioned and diversified banking franchise that contributes to BES’s underlying earnings potential, as well as its continued success in maintaining liquidity and bolstering capital during a prolonged period of stress. BES has a sizeable international presence with a contribution to earnings that, despite being pressured, has been crucial throughout this economic downturn. DBRS views the Bank’s contribution from international earnings as further supporting the IA of BBB, which remains one notch above the Bank’s final rating of BBB (low).

BES reported positive net income of EUR 96.1 million in 2012, a turnaround from the negative results reported in 2011. While BES demonstrated its underlying earnings potential during this period of substantial stress in the domestic economy and disrupted financial markets within the Euro zone, the still challenging environment for Portuguese banks continues to pressure bottom line results. With provisions absorbing a sizable 84% of net operating income, or income before provisions and taxes (IBPT), DBRS views the Bank’s financial flexibility as constrained. The Bank’s international franchise continues to be a significant generator of earnings, contributing to 90% of consolidated net income, driven by BES’s core businesses in the Strategic Triangle - Africa, Brazil, and Spain (70% of international net income). Efficiency levels continued to be strong with a cost-to-income ratio of 44.6% at end-2012, which generally compares very well to Portuguese bank peers.

Demonstrating the power of its franchise and its ability to adjust to an increasingly difficult operating environment, BES continues to maintain a high level of banking income (or net revenues). The Bank improved its net revenues by 32% YoY to EUR 2.6 billion in 2012. While BES managed to improve its net interest margin (NIM) to 1.70% in 2012 from 1.68% in 2011, this was largely due to the Bank’s increased exposure to longer-term Portuguese sovereign debt. While contributing to higher asset yields and providing BES with an alternative revenue source, increased exposure to the Portuguese sovereign elevates BES’s risk profile. With declining loan yields and higher funding costs, BES’s customer spread remains pressured. The Bank generally manages to achieve wider spreads on its loan book than peers, mainly due to its loan mix, but historically low interest rates in the Euro zone are having an impact. Furthermore, access to the wholesale markets, while positive from a funding perspective, is increasing liability costs.

With the Portuguese economy remaining weak, deteriorating credit quality is taking its toll on the Bank’s results. In 2012, provisions increased by 41% to EUR 1.2 billion and absorbed a sizable 84% of IBPT. Overall credit problems remain elevated with an overdue loan ratio of 4.3% at the end of 2012, up from 3.0% a year earlier, although below the average for the Portuguese financial system of 6.6%. Driving this ratio is the Bank’s corporate exposure, with an overdue loan ratio of 5.2%, and consumer & other exposure, with an overdue loan ratio of 7.4%. Overdue mortgage loans remain relatively low at 0.9% at the end of 2012. It is important to note that overdue loan ratios are reported per Bank of Portugal standards, which include only the portion of the loan that is non-performing (rather than 100% of the outstanding amount as in IFRS), making international comparisons difficult. The Bank’s credit-at-risk ratio, which includes the total credit and interest past due, other restructured credit and insolvent/bankrupt credits, stood at 9.4% at the end of 2012. This compares to 7.9% at 2Q12 and 6.6% at the end of 2011, demonstrating the continued deteriorating trend in asset quality ratios.

DBRS views BES as maintaining a solid liquidity and funding position, given the current environment. Positively from a ratings perspective, BES gained access to the international capital markets in October 2012 (3-year EUR 750 million senior unsecured) and January 2013 (5-year EUR 500 million senior unsecured). The issuances were heavily oversubscribed with over 225 global participants in each of the deals. BES also tapped the markets in December 2012 with a USD 450 million issuance of exchangeable notes linked to Bradesco shares. Despite this, the Bank remains exposed to potential liquidity risk as access to markets may continue to be restricted in 2013 due to macroeconomic concerns. While BES is appropriately reducing its wholesale funding through deleveraging, this adds to earnings pressure. The Bank reduced its loan-to-deposit (LTD) ratio to 137% at 4Q12, down from 147% at 1H12, with a plan to reduce this ratio to 120% by year-end 2014. Further, BES maintains a liquidity buffer that allows it to access the ECB to refinance wholesale funding maturities which DBRS considers to be adequate given the stability of deposits at BES. Positively, BES’s net ECB usage declined 29.5% YoY to EUR 6.9 billion at 31 December 2012, or 9% of total liabilities.

BES has continued to strengthen capitalisation without government aid through earnings retention, reductions in RWAs, and the completion of a EUR 1 billion rights issue in 2Q12. Capitalisation levels are in excess of regulatory minimums with a Core Tier 1 ratio of 10.5% according to Bank of Portugal (10% minimum required) and 9.9% according to EBA (9% minimum, plus a buffer for sovereign debt exposure). DBRS also notes that the Bank has improved its tangible equity / tangible assets ratio to 7.56% at end-2012 from 6.41% at end-2011.

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 for 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 rating is endorsed by DBRS Ratings Limited for use in the European Union.

Lead Analyst: Lisa Kwasnowski
Approver: William Schwartz
Initial Rating Date: 19 April 2011
Most Recent Rating Update: 5 December 2012

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