By Laura Noonan and Sergio Goncalves
LISBON (Reuters) - A month after Portugal emerged from its international bailout, its lenders are far from the promised land they might have hoped for.
Most predict losses for 2014 due to a weak economy, low credit demand and a resulting price war that depressed loan rates to levels the chief executive of second-largest listed bank, Millennium BCP's (BCP.LS) Nuno Amado, says are too low.
Yet while ratings agencies continue to hold the sector among Europe's weakest, several of the country's most senior bankers told Reuters they believe the worst is over.
"They (rating agencies) were late in understanding the situation of many banks (before the crisis) and now I think they are late again in recognising the major improvements that are taking place in Portuguese banking," said Fernando Ulrich, chief executive of Portugal's third-largest listed bank BPI (BBPI.LS).
It was day-to-day concerns of growth and recovery that were last week top of the minds of Amado, Ulrich and the chief executive of Santander Totta, Portugal's third-largest bank, rather than an executive shakeout at their rival Banco Espirito Santo (BES.LS).
After months of wrangling with the Bank of Portugal, BES's founding family agreed to cede its seats on the bank's board and their patriarch Ricardo Espirito Santo Salgado stepped down as chief executive.
The central bank's key aim was to avoid any threat to BES and any risks to confidence in the broader banking system, which has assets of almost 460 billion euros ($624.5 billion) or 2.8 times Portugal's economic output as measured by GDP.
The three largest Portuguese banks are valued at 1.003 times their book values, just a whisker away from the 1.01 times average multiple of the banks that make up the STOXX Europe 600 (.SX7P) banks index, according to Reuters data.
At the heart of the banking sector's outlook is the state of the domestic economy.
As Portugal emerges from its deepest recession since the 1970s, unemployment has fallen from its 16.3 percent high in 2031 to 14.9 percent by March 2014, but remains well below the single-digit levels that were the pre-crisis norm.
It is a populous banking market. A short stretch of Lisbon's main thoroughfare, Avenida da Liberdade, boasts branches of Portugal's four big domestic banks, along with a Deutsche Bank (DBKGn.DE) branch and an outlet of Spain's BBVA (BBVA.MC).
Nearby, at the Praça Marques de Pombal, stand branches of Britain's Barclays (BARC.L) and Banco do Brasil (BBAS3.SA) - both of which are reportedly considering pulling out.
Portugal's banks had an average return on equity of minus 10.2 percent in 2013, against a positive 6.6 percent for Europe's 30 largest quoted banks.
With 45 billion euros of cheap ECB funding - one of the highest levels in the euro zone - Portuguese banks should have an advantage over peers.
"We view the operating environment for Portuguese banks as still difficult," said Pepa Mori, lead analyst for the sector at ratings agency Moody's, pointing to concerns about bad loans, weak profits and low loan demand.
Her colleague Johannes Wassenberg gives short shrift to suggestions ratings agencies are slow to recognise improvements. "That’s the eternal reaction of issuers when we take rating actions that are not upgrades," he said.
Moody's recently upgraded its outlook for the Portuguese state, but not for its banks, while fellow agency Standard & Poors upgraded the outlook for the sovereign and all banks except BCP, but still has considerable qualms.
S&P's methodology gives Portuguese banks a score of seven out of 10, where 1 is lowest risk, meaning it sees the sector as among the weakest in the eurozone.
Moody's Wassenberg said: "It's a very very fragile economic environment ... Some of the banks are extremely vulnerable."
Many equity analysts are also cautious on Portuguese banks. Reuters data shows BCP is the only one of the top three listed lenders with an overall "buy" rating, with seven of 13 analysts recommending it.
But BPI's Ulrich does not believe Portuguese banks are structurally weaker than those in the rest of Europe. "The banks that had losses last year was mainly due to a very high level of credit impairments, and I don’t see why this would repeat."
Reuters research shows impairment charges ate up 54 percent of total income at Portugal's three largest listed banks in 2013, dipping to 52 percent in the first quarter of 2014.
Banks predict a fall in loan losses this year, but the ratio of bad loans to total loans could continue to rise from the 16.9 percent of loans deemed "at risk" at the end of March.
One banking expert familiar with the Portuguese market, who asked not to be named as he is not authorised to speak to journalists, said he fears the system could already be storing up its next round of non-performing loans by lending too cheaply, at rates which don't adequately reflect the level of risk being taken.
"The interest rate was, for the good names, one year ago near 6 percent. We are now speaking about 2 percent," said Santander Totta's Antonio Vieira Monteiro.
Monteiro insists he can still make money at these rates, particularly since he has 3.7 billion euros of ECB funding costing him just 0.15 percent per year.
Santander Totta's profits were up 300 percent for the first three months of 2014.
But his peers don't all share his rosy view. "In my opinion they (loan prices) are coming down too fast,” said Amado. "There is a risk that the prices are too low.”
The BCP boss - whose bank is set to announce a 2 billion euros share issue, according to sources familiar with the matter - believes the ECB's new cheap four-year funding programme could help boost lending volumes, since it will enable banks to make more longer-term loans.
But BPI's Ulrich said companies won't start borrowing again en masse until there are clearer signs of economic recovery.[ID:nL6N0P4612] [ID:nL6N0P13X0]
Another trend which could be positive would be a reduction in the number of banks.
"In a shrinking market it would make sense to have fewer banks," said Ulrich. "The economics of consolidation are there, but I don’t think it will happen."
Monteiro agreed that prospects of consolidation are slim in the short term, since banks must first get control of their own issues.
"I think we are two thirds of our way, we have to do one third more," said Amado of the sector's restructuring effort.
"I understand that we have a much more difficult situation vis-a-vis our European counterparts, however, I don’t understand why, if we passed the last three or four years as we did, we have not an opportunity that is larger, in terms of evolution."
Pre-crisis, Amado's bank had 10,000 staff and 1,400 branches in Portugal. By the end of 2015, it will have 7,500 staff and 698 branches. "Do you see many other companies doing that?"
International diversification also helps, he said. Major banks all have large operations outside Portugal, including some with returns on equity as high as 30 percent.
Their overall performance is winning some fans, with shares across the three largest listed banks up an equally weighted average of 53 percent in the last two years.
"Portuguese banks show multiples that are comparable with banks in other countries," said Ulrich. "I think the markets are recognising the recovery."
(The story has been refiled to correct bank names in 29th and 30th paragraphs; also corrects spelling of place name in 11th paragraph)
(Editing by David Holmes)