The importance of the financial system to the economy dwarfed its direct impact on employment and income. A well-functioning financial system served not only to increase the mobilization of saving but, more importantly, to direct capital resources toward their most productive uses. Since the mid-1980s, when commercial banking and insurance were reopened to private initiative, the Portuguese financial system had evolved toward greater liberalization, diversification, and internationalization.

Although the private financial sector had grown rapidly, the eleven nationalized banks and eight public insurance companies still accounted for 80 percent and 60 percent of their respective markets in 1989. Notwithstanding their improved operating conditions and higher solvency ratios, the profitability of most nationalized banks was depressed by their large holdings of low interest bearing public debt. Bad and doubtful loans continued to burden several state-owned banks. The nationalized banks were also plagued by undercapitalization, overstaffing, and an excessive branching structure. Many of these banks had large pension liabilities, which, being unfunded, were not reflected in their balance sheets. The continuing structural problems of the state banks dated back to the late 1970s and early 1980s when the Portuguese government followed a "soft budget" policy that emphasized social or political objectives over market criteria. Banks were required by law to extend preferential credit, usually at negative real interest rates, to the large nonfinancial public enterprises, as well as to the general government. Relaxation of the normal banking sanctions against troubled or failing public enterprises threatened the capital of the banks and their own financial viability. The Bank of Portugal's quantitative credit controls served mainly to facilitate commercial bank financing of the large deficits of the consolidated public sector. The administrative control of credit penalized private small and medium-sized enterprises, in particular.

Portuguese financial markets experienced accelerated change after the country joined the EC in 1986. Deposit and lending rates were freed, new money market instruments were introduced, and in 1990, the Bank of Portugal removed credit ceilings on commercial banks. The Lisbon Stock Exchange was modernized with more stringent rules governing the disclosure of financial information, as well as precautions against insider trading.

Enabling legislation in 1984 allowed private banks and insurance firms to be organized. By the late 1980s, six new foreign bank branches were established: Manufacturers Hanover Trust, Chase Manhattan, Barclays, Banque National de Paris, Citicorp, and Générale de Banque of Belgium. Four majority Portuguese private banks were also set up: Banco de Comércio e Indústria (BCI), Banco Internacional de Crédito (BIC), Banco Português de Investimento (BPI), and Banco Comercial Português (BCP). By December 1990, BCP had become Portugal's leading and fastest growing private commercial bank with total assets of nearly US$6 billion. A number of privatec8a te investment (para-banking) institutions and venture capital funds had also become part of the financial picture since the mid-1980s.

During the first phase of "partial" privatization--in 1988 before the 1989 constitutional amendment--the government selected a medium-sized bank (Banco Totta e Açores) and two public insurance companies (Aliança Seguradora and Companhia de Seguros Tranquilidade) as the first to be privatized. Share issues for 49 percent of these companies were substantially oversubscribed in 1989. After passage of the Reprivatization Law in April 1990, the sale of the remaining 51 percent of both Tranquilidade and Aliança shares took place later that year, and an additional 31 percent of Banco Totta e Açores shares were also sold. Other 100- percent privatizations of financial firms envisaged for 1991 included the Banco Português do Atlântico, the country's largest commercial bank.

Significantly, the late 1980s saw the reemergence of some of the prerevolutionary family groups in Portugal's economic landscape, particularly in the financial sector. As an example, the Espíritu Santo family became the majority shareholder in BIC and in the Espíritu Santo Sociedade de Investimento and was reported to be attempting to retake control of the Tranquilidade insurance company. The return of some of these dispossessed family groups to Portugal reflects a turnaround in confidence in Portugal's future, as well as the prospect for reinvestment of large sums of flight capital.

Notwithstanding the privatization trend, the Portuguese government intended to maintain an important position in the financial system in addition to its control over central banking through the Bank of Portugal. The two major financial groups reserved for the state included, first, the Caixa Geral de Depositos, the largest savings bank the Banco Nacional Ultramarino (a commercial bank) and Fidelidade (an insurance company). The second group dealt with international trade and export promotion and consisted of Banco de Fomento e Exterior (an investment bank) Banco Borges e Irmão (a commercial bank) and an external credit insurance company, Companhia de Seguros de Créditos (Cosec). Together, these two financial groups accounted for about 40 percent of Portugal's banking transactions in 1990.

Data as of January 1993