OREANDA-NEWS. A sluggish operating environment makes it difficult for Portuguese banks to build up capital, deliver adequate profits and boost capital through earnings retention, Fitch Ratings says. Portugal emerged from a deep recession in 2013 and we forecast modest GDP growth of 1.2% in 2016, rising to 1.4% in 2017.

Santander Totta has the best capital position among Fitch-rated Portuguese banks, while most of the others are under pressure to improve capitalisation. Caixa Geral de Depositos (CGD) and Banco Comercial Portugues (BCP) are in the process of strengthening capital, and Montepio is executing a divestment plan. But asset quality is still a major weakness for the banking sector and, in our opinion, makes banks vulnerable to downside risks from the highly indebted Portuguese economy. The unreserved portion of problem assets exceeds 100% of capital at CGD, BCP and Montepio.

In our opinion, CGD is not facing regulatory capital shortfalls and its current efforts to boost capital reflect a drive to grow lending and support economic growth. The bank's capital plan involves a EUR2.7bn capital injection from the state and conversion of state-held EUR900m contingent convertible bonds into equity. The state will also transfer ownership of some shares it holds in a CGD subsidiary and CGD also needs to raise around EUR1bn of subordinated debt in the market.

BCP's capital position is vulnerable and this weighs on its rating. Discussions with Fosun Industrial Holdings to inject new capital into the bank could provide some relief.

The Portuguese regulator defines 'credit at risk' exposures as loans in arrears for 90 days or more, associated loans falling due, restructured loans previously in arrears and not fully covered by collateral and other loans that justify its classification, namely where debtors face bankruptcy or liquidation. Credit at risk exposures represented 12.2% of total risk exposures in the banking sector at end-March 2016. The European Banking Authority's definitions, which are stricter, say non-performing exposures across the country's six leading banks have reached 19% of total exposures.

A material improvment in asset quality will largely depend on positive economic developments in Portugal and a recovery in real estate prices, neither of which look promising for now.