Profits at Argentine banks, which steadily increased despite turmoil in the country, could be in for a beating as the country's new government strips away their main earnings driver.

While the Latin American country has suffered from a rapidly depreciating currency, rampant inflation and an economic recession in recent years, banks have continued to drive profit growth by taking advantage of sky high interest rates on central bank instruments, known as Leliqs. At their peak, the rate on these seven-day instruments from Banco Central de la República Argentina surpassed 85%, allowing banks to reap relatively easy and safe profits, even when adjusted for inflation.

However, that rate has fallen in recent months, and a new administration under President Alberto Fernández, who took office in December 2019, is working to push it even lower. Fernández's new leadership at the central bank has cut the benchmark Leliq rate three times in the past month, bringing the rate to just 52% — just below Argentina's 53.8% reported inflation rate for 2019.

The central bank, now led by Miguel Pesce, has signaled that further cuts are on the way. On Jan. 8, the regulator restricted the amount of Leliqs that banks can buy in an effort to precipitate the rate drop, and the government has introduced a new 30% tax on foreign currency purchases in an effort to deter banks from moving to dollars.

The recent changes adds to a series of obstacles challenging banks' ability to maintain profitability. Combined, Argentina's largest listed banks — Grupo Financiero Galicia SA, Banco Macro SA, Banco Santander Río SA and Banco BBVA Argentina SA — posted a roughly 200% year-over-year improvement in their third-quarter results, largely driven by investment income from Leliqs and other public securities. Few expect that to continue.

To be sure, banks already had been shrinking their exposures to public securities in the latter part of 2019 as rates began to decline and Fernández's election victory became apparent — falling to 1.534 trillion pesos in October 2019 from 1.928 trillion pesos three months earlier.

The retreat from Leliqs has been even more dramatic, as banks have increasingly shifted out of the seven-day instruments and into their one-day counterpart, known as Pase. The outstanding balance of Leliqs sank by about 40% between July 2019 and January 2020; over that same time frame, the outstanding balance of Pases jumped by nearly two hundredfold, to about 633 billion pesos as Jan. 6 from just 3.21 billion pesos, according to central bank data.

While its yield is markedly lower compared to Leliq — 687 basis points below the Leliq rate at the start of 2020 — Pase's shorter duration "is convenient for [banks] as long as uncertainty persists," Moody’s analyst Marcelo De Gruttola told S&P Market Intelligence.

However, he noted, the lower return "will affect their profitability."

In an effort to protect their margins, banks have accompanied the shift to Pases with lower offered rates on fixed-term customer deposits, dropping them to 35.35% as of Jan. 8 from 43.19% roughly a month earlier. However, as IDESA economist Jorge Colina pointed out, banks can only maneuver so much on this front without losing deposits. Private sector dollar deposits sank 37.3% in 2019, according to the central bank, while the increase in peso deposits significantly lagged the pace of inflation.

Lowering deposit rates much more could push depositors to withdraw their funds altogether and purchase U.S. dollars on the black market. If this happens, "they may feel pressed to bring their ... rates back up, relinquishing margins in a bid to retain customers," Colina said.

Taken together,Colina expects banks' profits to decline slightly in the local currency but sharply if looking at it in U.S. dollar terms. "Banks no longer have access to dollars at 60 pesos per greenback, but rather around 80 pesos," he said, referring to the new foreign currency tax.

Loan growth uncertainty

Banks already are looking for alternative earnings strategies, Fitch Ratings analyst Santiago Gallo told S&P Market Intelligence, but loan growth probably won't be part of the solution.

"Although it seems the government will keep looking to bring the rate down to negative in real terms, which would boost lending, it looks unlikely that any such recovery in lending will be possible in the middle of such a strong recession," he said.

Argentina's financial institutions turned away sharply from lending in 2019 as Argentina's economic woes bled into asset quality. Nonperforming loans rose to 5.3% of total loans in October 2019 — the worse ratio in more than a decade — from 1.8% a year earlier. As asset quality deteriorated, lending growth shrank, with peso-denominated loans to the private sector rising by just 17.3%, about a third of Argentina's inflation rate, and U.S. dollar loans sinking 31.4%. Perhaps even more worrying, peso-denominated personal loans slipped 4.1% in the year.

"We're not seeing banks aggressively push lending yet, and it's highly unlikely to happen in the short term, because this would imply a significant risk in the quality of assets," De Gruttola from Moody's noted.

In its first effort to bolster lending, the government recently softened reserve requirements for banks that take part in its Ahora 12 interest-free installment payment program. Under the program, banks can allocate up to 1.5% of their reserve requirements — up from 1% previously — towards the program, thereby obtaining a subsidized rate of 20% from the government on those funds. The central bank also said that it will lower reserve requirements for lenders that grant loans to small- and medium-sized companies at a 40% interest rate.

"We will have to see if these incentives are effective in this context, because the huge holdup preventing banks from lending is the recession," Christian Buteler, an independent financial analyst, said.

If the efforts are not adequately successful, Fitch's Gallo warned that the government may take a more aggressive stance by moving from lending incentives to forcing banks to grant loans to certain sectors.

Such a move, he noted, would almost certainly impact profits further.

As of Jan. 15, US$1 was equivalent to 59.99 Argentine pesos.