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

DBRS Ratings Limited (DBRS) has today confirmed the ratings of Banco Espírito Santo, S.A. (BES or the Bank), including its Senior Long-Term Debt & Deposit rating at BBB (low) and Short-Term Debt & Deposit rating at R-2 (middle). The trend remains Negative.

At the same time, DBRS has lowered BES’s intrinsic assessment (IA) to BBB (low) from BBB. In lowering the IA by one notch to BBB (low), DBRS recognizes the pressure the Bank is facing on its fundamentals due to the prolonged stressed economic environment in its home market. One of the main drivers for the lower IA is the sustained deterioration in asset quality, which has compressed domestic earnings both by lowering net interest income and through higher credit costs. International earnings are also down, reducing the Bank’s ability to offset these domestic pressures. Overall, the lower levels of income before provisions and taxes (IBPT) are not sufficient to absorb the elevated cost of risk which, if it continues at its current level, will continue to pressure BES’s capital generation capability.

BES, whose franchise is predominantly in Portugal, has been impacted by the challenging environment in its home market. As such, BES’s rating is currently limited by DBRS’s Long-Term sovereign debt rating on the Republic of Portugal of BBB (low) with a Negative Trend. As Portugal’s third largest banking group by assets and by maintaining the SA-2 support assessment for the Group, DBRS anticipates that BES would likely receive some form of timely systemic support in a highly stressed scenario. However, with the current sovereign rating of BBB (low), the same level as the IA for BES, there is currently no uplift to the Bank’s final rating from its IA. The Negative trend recognises that there is substantial uncertainty regarding Portugal’s growth outlook with downside risks emanating from internal and external demand, uneven economy-wide funding conditions and adverse effects from the fiscal consolidation effort.

Underpinning the IA of BBB (low) are the Bank’s well-positioned and diversified banking franchise that contributes to BES’s underlying earnings potential along with its robust risk management procedures, which have enabled the Bank to hold credit-at-risk ratios lower than the average of the Portuguese banking system. BES has a strong franchise in its home market, with a leading market share for corporate customers, which is reinforced by a nationwide branch network and a solid presence in internet banking. Additionally, BES has a growing international presence which has been increasingly contributing to the Bank’s earnings, but this contribution has not been sufficient to offset the impact of growing credit costs in BES’s home.

BES reported a net loss of EUR 518 million in 2013. Net interest income decreased 12% year-on-year (YoY) pressured by the deleveraging process the Bank is undertaking, historically low Euribor levels, deteriorating asset quality, and a lower contribution from the Bank’s Treasury portfolio. Nevertheless, DBRS notes that BES was able to reduce its funding costs in 2013 and this had a positive impact quarter-on-quarter on net interest income. Provision charges increased 19% YoY for a total amount of EUR 1.4 billion in 2013 absorbing 1.86 times the amount of IBPT. Loan impairments increased 23.3% YoY, driven both by the deterioration in asset quality as well as a conservative approach adopted by the Bank in anticipation of the forthcoming European Union/European Banking Authority Asset Quality Review (AQR) and stress tests. DBRS expects the Bank to continue to face pressure on profitability throughout 2014 due to the challenging macroeconomic outlook in Portugal with a weak economic recovery and a high unemployment rate. Further asset quality deterioration, albeit at a slower pace, and deleveraging is expected.

The Bank’s risk profile has deteriorated throughout 2013 due to the difficult economic environment in which it operates. By the nature of its business BES’s credit portfolio is primarily exposed to corporates, representing 73% of total exposure, with mortgages representing 22% and consumer lending the other 5% of total exposure. The Bank reported an overdue loan ratio of 6% in end-2013, up from 4.3% at end-2012. Driving this ratio is the Bank’s exposure to corporate business, with an overdue loan ratio of 7.3%, and its exposure to consumer and other individual credit with an overdue loan ratio of 9.0%. Overdue mortgage loans remain contained at 1% at the end of 2013 (up only 10basis points YoY). 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 10.6% in 2013, up from 9.4% at the end of 2012. Despite the asset quality deterioration BES’s indicators still compare favorably with the average of the Portuguese banking sector. Furthermore, DBRS notes that the Bank’s coverage ratio for credit-at-risk loans has been improving throughout 2013 to reach a level of 65% compared to 57% at year-end of 2012 and 64% as of December 2011.

DBRS considers that the Bank has continued to improve its funding structure since 2009 as it has reduced its dependence on wholesale funding and increased its deposit base. This fact, together with the deleveraging of the loan book, has led the Bank to report a loan-to-deposit ratio of 121% at December 2013, down from an elevated 198% at June 2010. DBRS also notes that the Bank has regained access to capital markets since November 2012, with three different issues through to April 2014 totaling EUR 3.8 billion. Nevertheless, funding costs remain higher than the pre-crisis levels. Overall the Bank’s liquidity position remains adequate, as BES reported ECB eligible assets of EUR 18.6 billion (pre-haircuts) as of December 2013, provides a cushion for future repayments of EUR 5.5 billion of net ECB funding, as well as bond redemptions from 2014 through 2018.

DBRS views BES’s regulatory capitalisation as adequate. Over the last three years the Bank has strengthened its capital ratios through a rights issue, a reduction in risk-weighted assets (RWAs) and liability management exercises. However, given the complex economic environment in which BES operates, DBRS considers its equity of EUR 7.05 billion as of end-2013 as providing only a modest cushion of loss-absorbing capital over some of the minimum regulatory requirements. The loss reported in 2013 has reduced BES’s common capital base, and another period of severe losses would place pressure on the Bank’s capitalization levels. At December 2013, the Bank’s Core Tier 1 capital ratio was 10.6% based on the Bank of Portugal’s calculations and 8.2% based on Basel III fully loaded criteria. The Bank’s common tangible equity / tangible assets ratio declined to 6.99% and end-2013 from 7.56% at end-2012.

A further sharp deterioration in asset quality that would force the Group to incur significant losses would put more pressure on BES’s capital base and ultimately could lead to further rating action. DBRS would view positively a reduction in the cost of risk and an improvement in BES’s profitability that would allow the Bank to restore its loss absorption capacity by increasing its capital buffer.

Notes:
All figures are in 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: Support Assessment for Banks and Banking Organisations and DBRS Criteria: Rating Bank Capital Securities – Subordinated, Hybrid, Preferred & Contingent Capital Securities. These can be found can be found at: http://www.dbrs.com/about/methodologies

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

DBRS does not audit the information it receives in connection with the rating process, and it does not and cannot independently verify that information in every instance.

Generally, the conditions that lead to the assignment of a Negative or Positive Trend are resolved within a twelve month period. DBRS’s outlooks and ratings are under regular surveillance

For further information on DBRS historic default rates published by the European Securities and Markets Administration (“ESMA”) in a central repository, see:
http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

Ratings assigned by DBRS Ratings Limited are subject to EU regulations only.

Lead Analyst: Rui Croca
Rating Committee Chair: Roger Lister
Initial Rating Date: 19 April 2011
Most Recent Rating Update: 17 April 2013

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