Ricardo Salgado, chief executive officer of Banco Espirito Santo SA, speaks during a news conference in Lisbon, Portugal

Portugal’s banks – a proxy for the health of the peripheral eurozone financial system as a whole – are balanced on a knife-edge.

Though they have sufficient capital for their current needs, and their funding outlook appears healthier than it did, the weak local economy is undermining lenders’ chances to make it through the crisis without further assistance.

All three of the big private-sector banks – Banco Espirito Santo, BCP Millennium and Banco BPI – have core tier one capital ratios, a pivotal measure of financial strength, in accordance with the latest demands from European regulators and the troika of the European Central Bank, IMF and European Commission that bailed out the country in 2011.

However, the relatively high numbers – ranging from 10.5 (BES) to 15 per cent (BPI) under outgoing Basel II rules – are not as comforting as they might appear. Aside from the fact that the ratios will fall 1 to 2 percentage points under the incoming Basel III rule book, there is a more fundamental problem: capital levels look certain to be eroded by the worsening loan losses that will come with still-rising unemployment (17.7 per cent) and shrinking GDP (-3.2 per cent last year) .

Four of the top six lenders last week reported first-quarter losses totalling more than €300m, reflecting the extent to which 10 consecutive quarters of recession have hit net interest margins and driven up impairment costs.

BES, Portugal’s second- largest listed bank by assets and the only one of the big three not to have taken state support so far, has both the lowest capital ratio and is potentially the most exposed to defaults on corporate loans, where the damage so far has been worst. Its share price tumbled by more than 10 per cent last week after reporting a first-quarter loss of €62m.

“At this stage we still have room for manoeuvre.” Ricardo Espírito Santo Salgado, BES chief executive, told the Financial Times. But he refused to rule out another cash call, adding: “We have to be prepared for a situation in Portugal that may not improve as we expected.”

For BCP and BPI, the risk is that they fail to repay contingent equity already supplied by the government a year ago as high-cost debt – with coupons rising from 8.5 per cent to 10.5 per cent over five years – potentially ushering in part-nationalisation. BCP still has €3bn outstanding and BPI €900m.

BCP is battling on a separate front to keep hold of its successful Polish subsidiary under EU state aid rules. But even if it wins that fight, it and others may be forced into selling foreign units if they want to avoid part-nationalisation.

The all-important factor is how long it takes for the banks’ non-performing loan (NPL) rates to peak. As Portugal’s recession has grown deeper and longer, lenders have been forced to push back forecasts of when NPLs will peak. Overall, NPLs increased from 5.2 to 6.7 per cent of total credit in the 12 months to February and continue to rise.

“If the recession bottoms out this year, credit risk costs could start to come down from mid-2014,” says André Rodrigues, an analyst with Caixa-Banco de Investimento.

But even if that optimism proves well founded, recovery will be tough, given how thin profit margins on lending have become. About 95 per cent of outstanding home loans – which account for close to half of all bank credit – are tied to the interbank Euribor rate, which has been cut to abnormally low levels over the past five years.

Banks have been forced to compensate by raising corporate borrowing rates, exacerbating already flimsy demand for business
borrowing. Lending has also been under pressure from a “recommendation” written into the bailout agreement for banks to cut their loan-to-deposit ratios to below 120 per cent by the end of 2014, leading to massive deleveraging. From an average 166 per cent for the sector three years ago, the top five banks have achieved, or are close, to the new ratio.

Deposits have held up well – in contrast to the situation in Greece and Ireland, and despite the fact that banks have pushed down interest rates on deposits from about 4.5 per cent for one-year money a year ago to about 2.3 per cent. Other sources of funding look in decent shape, too. Bank bosses took heart from the fact that the Portuguese government recently returned to the market with a 10-year bond issue, paving the way for banks to follow – though bankers still generally see coupons as being prohibitively high. Between them the big three private-sector banks have €13bn of wholesale funding maturing in 2013-15.

In addition, there is a combined €50bn of outstanding funding for the Portuguese banking sector as a whole from ECB special liquidity funds – though that money is due for repayment around the end of next year.

That all adds up to a sector that is muddling along. “We’re in the worst part of the cycle,” admits Nuno Amado, chief executive of BCP. “We are taking the medicine but we haven’t been cured yet.”

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