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Mexican Banks Brace For Widening Credit Losses

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Mexican Banks Brace For Widening Credit Losses

Weak Economy And COVID-19 Intensify Strains On Mexican Financial Institutions

The Mexican banking system has been one of the hardest hit in the world during 2020, in terms of negative rating actions. This is because of COVID-19 and the collapse in oil prices, along with an economy that slowed in 2019. These factors have increased economic risk for the financial sector, prompting us to revise our BICRA on Mexico to a weaker category and downgrade domestic financial institutions, as well.

Mexico had structural economic weaknesses before the pandemic--due to the limited investment dynamics--that resulted in a mild economic contraction in 2019 and amplified the impact of the pandemic. To the extent that the coronavirus has continued to spread in the country and that the damage to the economy has deepened, we have been adjusting our economic forecast for 2020. We currently expect a 10.4% contraction this year and a weak recovery in 2021, at about 3.7%, one of the weakest among emerging markets. This reflects Mexico's relatively meager policy response to COVID-19, with fiscal stimulus so far totaling about 1% of GDP, mostly consisting of direct transfers to households, and with limited support to small- and medium-size enterprises.

Chart 1

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Chart 2

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Asset Quality Will Deteriorate, But The Extent Of Damage Is Uncertain

As in other countries, the central bank and the banking regulator in Mexico have taken measures to cushion the impact pandemic-induce economic crisis. The central bank, in addition to having reduced its policy rate by 300 basis points since the beginning of this year (currently at 4.25%), has focused on providing liquidity to the financial system. Moreover, the banking regulator approved a debt moratorium program that allowed borrowers facing financial hardship from the coronavirus pandemic to defer loan payments (for up to four months with the possibility of extending it for an additional two months), as long as they weren't past due as of the end of February 2020. Moreover, the CNBV loosened the provisioning requirements for such loans, provided temporary exceptions on liquidity requirements, and allowed banks to use their regulatory capital buffers to keep expanding their loan portfolios without damaging their minimum regulatory capitalization.

The debt moratorium program, mainly for the consumer loans (including mortgages) and loans to small and midsize enterprises (SMEs), ended on July 31, 2020. We estimate that loans qualifying for this program represented about 20% of total loans as of the same date. This ratio is similar to those in Brazil and Chile, but significantly lower than in Panama and Colombia (see chart below).

Chart 3

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It's uncertain how many loans under this program could become delinquent. According to our estimates, the Mexican banking system could post net losses in 2020 if about 20% of the deferred loans become past due that would require provisions to jump. However, in our opinion, the likelihood of banks posting a net loss is low given that about 65%-70% of loans under the relief program are consumer loans, mortgages, and loans to SMEs (on average with a four-month deferral) and payments on about 85% of these loans have resumed.

The second phase of the borrower relief program--which the banking regulator recently announced and whose adoption is not mandatory for banks--would be restructuring loans to borrowers whose income capacity has been damaged by the economic crisis. In general, this phase would allow borrowers to reduce their monthly payments by 25%, either through lower interest rates, extending loan terms, or charge-offs. However, we don't expect banks to participate heavily in this program. This is because as the payment deferrals are ending, results have been better than expected, and customers are meeting their financial obligations. In our opinion, banks, in general, have been preparing to face the potential deterioration on asset quality. Banks that entered the economic crisis with healthy balance sheets and that--conservatively--anticipated creating provisions this year in the face of the severe economic shock, won't need to move to the second phase of the borrower relief program. We believe the banking sector has the ability to maneuver in this complicated situation by restructuring some loans--under the new economic conditions of their customers--without needing to use the provisions that the regulator authorized under this new program.

COVID-19 Will Bite Into Asset Quality And Profitability

In our view, lockdowns in Mexico haven't been as stringent and lengthy as in Argentina, Colombia, and Peru. However, the government's very small fiscal stimulus package to diminish the pandemic's impact, along with limited support to the labor market and businesses, will delay recovery in consumption and investment. In this sense, while we forecast that most economies will return to their pre-pandemic (fourth-quarter 2019) GDP levels in 2022, Mexico might do so in 2024, assuming a constant growth rate. Our base-case scenario assumes that the Mexican economy will contract 10.4% in 2020, and grow only 3.7% in 2021 and 2.6% 2022.

As a result, Mexican banks will be navigating under very challenging operating conditions during this period. We expect the banking system's nonperforming asset (NPAs; past-due loans of more than 90 days and foreclosed assets) ratio to rise to about 3.5% in 2020 from the historical level of about 2.0% and to drop to 3.0% in the next two years. This estimate assumes that 5%-10% of deferred loans will sour. We also assume that NPAs would be fully covered by loan-loss reserves and that net charge-offs to total loans would increase to 4% from an average of 2.5% of the past three years.

Recently, S&P Global Ratings analysts published their expectations for the credit metrics' recovery to the pre-pandemic levels among rated corporations ("COVID-19 Heat Map: Updated Sector Views Show Diverging Recoveries", Sept. 29, 2020). In Chart 4, we show Mexican banks' exposure by sector level impact and recovery.

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Chart 4

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The increasing provisioning requirements to face the deteriorating asset quality will dent profitability. In addition, low business volumes as a result of weakening credit demand and decreasing interest rates, will deepen the fall in bottom-line results. As such, we expect the banking system's net profits to drop about 50% in 2020 and to recover to pre-pandemic levels in 2022. In this sense, the average return on equity (ROE) would be about 8% in 2020 and recover to 13% in the next two years, while return on assets (ROA) would be about 0.8% and pick up towards 1.7%.

The Banking Sector's Strong Credit Fundamentals Cushion The Blow

Prior to the pandemic, Mexican banks expanded their loan portfolios at a compound annual growth rate (CAGR) below 7% for the past three years. During this period, credit rose through conservative growth strategies and stringent lending policies, preventing the industry from expanding its reach in the country--measured by credit to the private sector to GDP, which remains one of the lowest in Latin America (30% at the end of 2019). However, the system's asset quality metrics improved. Therefore, Mexican banks generally entered the pandemic with healthy balance sheets and capitalization levels, which were among the highest in the region. According to our estimates, the consolidated risk-adjusted capital (RAC) ratio for the Mexican banking system was about 10% at the end of 2019. This reflects the strong capitalization levels with which the largest banks in the country (holding about 80% of total assets in the banking system as of June 30, 2020) are comfortable expanding their businesses.

In our opinion, the maintainance of solid capitalization levels for several years has been possible thanks to the sound asset quality and profitability. Aside from capitalization, another important credit factor behind the sector's resilience are the historically robust levels of loan-loss reserves. As of July 31, 2020, NPAs in the banking system represent 2.2% of total loans plus foreclosed assets, and loan-loss reserves cover 1.6x the total amount of NPAs (1.4x on average during the past five years).

In order to measure the potential resilientcy of Mexican banks to the pandemic-induced economic crisis, we built an exercise in which we added the banking system's total NPAs and foreclosed assets, and netted them with the total loan-loss reserves. Then, we included in that amount the total loans under borrower relief program. Finally, we contrasted that credit exposure with the banking system's total capital. We found that banks capital cover around 1.2x the credit exposure under stress. Moreover, we estimate that about 50%-60% of the loans that entered the relief program have already resumed payments, relieving pressure on banks' capital. Therefore, we conclude that the banking sector holds strong credit fundamentals, which will cushion the blow. This exercise considered the Mexican banking system's regulatory capital as of July 31, 2020.

Chart 5

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However, smaller banks with above-average NPAs and below-average financial resources to face expected (reserves) and unexpected (capital) credit losses, and that engaged in aggressive lending before the pandemic, will be more vulnerable to the economic shock caused by COVID-19. The seven largest banks in Mexico hold around 80% of the banking industry's total assets and are in good shape to face pandemic-induced crisis. Medium-size and small niche banks comprise a diverse group of entities from a credit stand of view. For instance, niche banks have smaller loan portfolios with higher customer and sector concentrations, while their NPAs and loan-loss reserve coverage average 3.0% and 1.2x, respectively as of June 30, 2020. These ratios are weaker than those of the seven largest banks 2.1% and 1.7x. On the other hand, niche banks are more dependent on wholesale funding. Their total deposits represent less than 50% of their total liabilities, and their deposit bases have larger concentrations than those of the country's largest banks. However, according to the banking regulator's solvency metrics, niche banks hold higher capitalization levels than the seven largest banks.

We will continue to monitor the credit fundamentals of each niche bank.

Related Research

This report does not constitute a rating action.

Primary Credit Analyst:Alfredo E Calvo, Mexico City (52) 55-5081-4436;
alfredo.calvo@spglobal.com
Secondary Contact:Claudia Sanchez, Mexico City (52) 55-5081-4418;
claudia.sanchez@spglobal.com

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