Success story:

The banking industry looks set to achieve its full potential in the coming years, outperforming other sectors of the economy With a record of consistent profitability and credit growth, the banking sector has benefitted from economic expansion in the past decade. Strong regulations are credited with having ensured that banks made it through the 2008 global financial crisis relatively unscathed. In 2014, the proposed end of the commodities supercycle, an economic slowdown and the prospect of rising international interest rates presented banks with new challenges. However, recent developments, such as accelerating de-dollarisation and the consolidation of microfinance providers, suggest that the industry is handling these issues well. As Luis Manuel Ordoñez, head of research at Inteligo, told OBG in August 2014, “The financial services sector has recently been doing better than other parts of the economy,” – a trend that looks set to continue going into 2015.

RESPONDING TO HEADWINDS: According to Ordoñez, following a period during which the Central Reserve Bank of Peru (Banco Central de Reserva del Perú, BCRP) had repeatedly raised the reserve requirements for banks, in the second quarter of 2013 the central bank began cutting rates as a way of stimulating the economy as Chinese demand for Peruvian exports eased. “These expansionist monetary policies have led to a rise in lending, particularly to large corporates, despite the slowdown in economic growth,” explained Ordoñez.

CREDIT GROWTH: As of June 2014, direct lending by the banking sector stood at PEN211.7bn ($75.6bn), having increased by 16% over the previous year. Mario Alberto Guerrero, head of economic studies at Scotiabank, told OBG that “recent growth in the banking sector has not been homogenous”. Commercial lending saw the greatest year-on-year (y-o-y) growth, rising by 17.5% to PEN138.8bn ($49.6bn) by June 2014.

Of this amount, PEN34.8bn ($12.4bn) went to the largest corporates, defined as organisations with annual revenues of more than PEN200m ($71.4m); PEN33.9bn ($12.1bn) to large companies with annual revenues between PEN20m ($7.1m) and PEN200m ($71.4m); PEN38.7bn ($13.8bn) to medium-sized firms, those with total borrowing needs of more than PEN300,000 ($107,100) but which do not qualify as large corporates or large companies; PEN22.6bn ($8.1bn) to small enterprises, those with total borrowing needs of between PEN20,000 ($7140) and PEN300,000 ($107,100); and PEN8.8bn ($3.1bn) to micro-businesses, those with total borrowing needs of less than PEN20,000 ($7140). Consumer lending and mortgages increased by 12.3% and 14.6% over the same period to reach PEN41bn ($14.6bn) and PEN31.8bn ($11.4bn), respectively, which was described by Guerrero as a “stable” rate of growth for these segments.

At a sectoral level, public administration and defence saw the greatest growth in credit, with loans rising by 117% between June 2013 and June 2014 to reach PEN607.32m ($216.81m). Over the same period, lending to the mining sector rose by 43.7% to PEN6.94bn ($2.48bn), while logistics and communications saw credit growth of 18% to PEN11.16bn ($3.98bn). Over the same period, manufacturing saw credit growth of 17% to PEN29.64bn ($10.58bn), credit to agribusiness saw a rise of 16% to PEN7.26bn ($2.59bn), and loans to retailers grew by 16.7% to PEN35.3bn ($12.6bn).

While noting that the mining sector had some of the strongest credit growth over the year to June 2014, Guerrero predicted that the nature of banks’ lending to this sector is set to change and slightly decrease overall. “With many of the large mining developments reaching completion, we expect to see mining companies’ requirements for finance shift towards working capital to sustain production. This in turn should lower the overall rate of credit growth from 16% to around 12% in 2015,” Guerrero told OBG.

Indeed, a rate of 12% would be more in line with the rates of credit growth that Peru has previously experienced. “After accounting for the statistical effects of factors such as El Niño and illegal mining, we could consider Peru’s economy to be growing at a rate of 4% per annum as of mid-2014. As a result, credit growth of 12% would represent three times this figure, which we consider appropriate given Peru’s current stage of development,” Guerrero told OBG.

REGIONAL CONCENTRATION: As of June 2014, 73.14% of outstanding bank loans were concentrated in Lima and Callao. These regions also saw the greatest credit growth between June 2013 and June 2014, increasing by 18.9%, in contrast to the relatively slower rate of credit growth of 10.7% experienced by the north-east regions of Loreto and Ucayali. The geographical distribution of deposits across the country paints a similar picture, with Lima and Callao accounting for 82.3% of all deposits held by financial institutions. However, Alberto Rhor, head of structural and market risk at Banco Financiero, told OBG, “In the future, the greatest potential for growth will be found in the regions. This is reflected in the particularly strong growth retail banking continued to experience in the regions, even as growth in that segment has slowed in Lima.”

SME LENDING: Lending to small and medium-sized enterprises (SMEs) should also play an important role in helping the regions to close the gap in lending with Lima and Callao. In the year to June 2014, lending to SMEs grew by 14.35%; however, this is expected to increase more rapidly in the coming years, in part due to the government’s infrastructure spending drive. As SMEs across the country get on board the government’s infrastructure projects, lending should pick up.

CONSUMER FINANCE: Similar to the SME segment, Guerrero expects consumer finance to catch up with corporate lending in terms of growth over the medium term to reach annual rates of around 12-15%. “The growth in consumer finance is being propelled by the increasing number of shopping malls. Peru has seen six new shopping malls open recently, and a further six are planned to open in 2015,” Guerrero said.

MORTGAGES: Guerrero also noted that there remains a large, untapped demand for mortgages. Mortgage lending has traditionally remained largely focused on customers in the wealthier socio-economic classes A and B, although those in the lower-income classes C and D are increasingly also gaining access to this type of finance, a trend that Guerrero expects will gradually accelerate. Nevertheless, Guerrero cautioned that “despite the greater potential that mortgage providers see in consumers in classes C and D, mortgage lending to this segment will continue to grow at a relatively slower pace due to the difficulties of evaluating these customers’ credit histories”.

Therefore, the growth of mortgage lending at around 15% per annum, while lower than the rates of up to 25% growth Peru experienced over the past decade, would appear the most likely scenario. This relative easing of the growth rate should also alleviate fears of a property bubble, according to Guerrero.

NON-PERFORMING LOANS: At the same time, growth in credit has been accompanied by a slight deterioration in credit quality. For example, as of June 2014, the proportion of non-performing loans (NPLs) on banks’ books stood at 2.36%, which was 0.29% higher than the corresponding figure for June 2013. This was caused by a 0.28% rise to 2.33% in the NPL ratio for commercial loans, a 0.31% rise in the consumer finance NPL ratio to 3.55%, and a 0.33% rise to 1.23% in the NPL ratio for mortgages. However, the Superintendence of Banking, Insurance and Pension Funds ( Superintendencia de Banca, Seguros y Administradora de Fondos de Pensiones, SBS) noted that overall the proportion of loans having to be restructured fell from 0.94% to 0.88% over the same period.

“The recent rise in general delinquency rates has been driven by an increase in NPLs in the microfinance segment,” Roberto Flores, head of strategy and economic research at Inteligo, told OBG. “However, this should not be a cause for concern, but rather an issue worth keeping a watchful eye on. It is also very important to remember that the banking sector comfortably exceeds Basel II requirements and remains highly liquid, so the possibility of a crisis such as a run on a Peruvian bank is very remote indeed,” said Flores.

This concentration of bad debts in microfinance is reflected in the variance in banks’ NPL ratios across all segments. For example, for commercial banks, the average NPL ratio for the largest corporates was 0.11% as of June 2014, whereas for large companies, medium-sized enterprises and small enterprises the NPL ratios were 0.43%, 3.89% and 8.68%, respectively. For instance, Rhor told OBG that he expected the credit quality of commercial lending to suffer in the short term due to the economic slowdown in 2014.

INTEREST RATES: Larger companies’ exposure to foreign exchange risk, as companies and individuals sought to take advantage of lower borrowing costs in dollars in recent years, could result in bad debts. In June 2014, the average interest rates for loans by banks to large corporates in soles and US dollars stood at 5.90% and 2.27%, respectively. The average rates payable by medium-sized enterprises were 10.75% in soles and 8.49% in US dollars, while micro-businesses were paying an average of 32.11% to borrow in soles. As for individuals, personal loans had average interest rates of 42.74% in soles, while mortgages were priced at an average of 9.35% and 7.74% in soles and US dollars respectively.

FOREIGN EXCHANGE RISK: The IMF has highlighted currency mismatches as one of the risks facing banks as well as the economy more widely. In comparison to historical levels of foreign currency imbalances that reached 25% for non-financial firms in 1999, the situation has vastly improved over the past decade. Nevertheless, the IMF noted that certain sectors – such as manufacturing, construction and large-scale retail in particular – have built up large foreign currency imbalances of between 7% and 17% of total assets.

While banking is not among the sectors that stand to suffer a direct loss in the event that the sol were to suddenly depreciate, the large losses such a move would precipitate in other sectors with foreign currency imbalances could hurt the banks. Having recognised the risks, “the government started taking steps to discourage lending in dollars starting from the end of 2012.” Ordoñez told OBG. Specifically, the government first introduced policies to encourage de-dollarisation in the vehicle finance and mortgages segments, where most loans were in dollars. “These measures started having a visible effect on the market in February 2013. Then in October 2013 the BCRP began broadening certain measures, such as obliging banks to increase their reserves in cases where credit growth exceeded set thresholds, to all lending in dollars, except for foreign loans,” Guerrero told OBG.

The BCRP has concurrently sought to stimulate the supply of credit in soles. According to Guerrero, since July 2013 the BCRP has reduced banks’ reserve requirements by a total of around PEN9bn ($3.2bn), thus freeing them to lend more in soles. Guerrero told OBG that the greater appetite for loans in soles has meant that interest rates have stabilised rather than fallen; in certain segments they have even continued rising.

CORPORATES DE-DOLLARISING: Growing demand for borrowing in soles was reflected in the fact that, as of June 2014, across the entire financial system ( including banks, non-bank financial institutions, leasing companies and other financial companies), PEN128.3bn ($45.8bn) of loans were in soles as well as $29.8bn in US dollars, representing increases of 23.1% and 6.0% respectively on 2013. Indeed, Guerrero told OBG that a significant portion of the strong growth in corporate lending, in particular since the second half of 2013, can be explained by the “substitution effect” of companies seeking to refinance themselves in soles. “Following the end of tapering and a 10% fall in the value of the sol, we started to see, beginning in August 2013, a rise in corporate demand for loans in soles,” Guerrero said. Stripping out this substitution effect, he estimated that credit growth during the year up to June 2014 would have been closer to 14% than the 16% recorded.

FIT FOR THE FUTURE: “This process of de-dollarisation is a significant structural change that will have a positive effect on the economy by making us better prepared for a rise in dollar interest rates,” said Guerrero. He expects the proportion of loans in dollars to fall from approximately 40% to 20% by 2019. This would reduce the vulnerability of creditors and borrowers alike by bringing the proportion of dollar lending into line with the proportion of borrowers who Guerrero assessed to have the ability to hedge their foreign currency risk or for whom borrowing in dollars makes sense because they have revenues in foreign currency.

As for banks’ own exposure to foreign exchange risk, the average Peruvian bank’s foreign exchange positions as of June 2014, calculated as the difference between assets and liabilities in foreign currency as a proportion of the previous month’s capital, was 4.41%, up from 1.43% a year earlier, according to data from the banking regulator, the SBS. After taking into account derivatives, banks’ average foreign exchange positions in June 2014 were 0.49%, down from 7.67% in 2013.

DEPOSITS: With respect to deposits, these reached PEN218.2bn ($77.9bn) in June 2014, a rise of 12.5% over the preceding 12 months. Dollar deposits grew at a faster pace than those in soles, with the former rising by 26.3% y-o-y to $31.7bn, and the latter growing by 4.5% to PEN129.7bn ($46.3bn) over the same period. This divergence between the two currencies occurred despite average demand deposit interest rates being 0.35% for soles and 0.22% for US dollars as of June 2014. For term deposits, the average rates were 3.65% and 0.11% for soles and dollars, respectively.

Guerrero pointed out that private pension fund administrators (Administradoras de Fondos de Pensiones, AFPs) were responsible in part for the rise in dollar deposits, as they had limited options for raising their exposure to the dollar given the relative scarcity of dollar securities to purchase in the local market and the restrictions on investing in foreign assets.

“This has created the illusion that deposits are generally undergoing a process of dollarisation too, which is in fact not the case once the AFPs’ deposits are excluded,” Guerrero told OBG. Nevertheless, Rhor still expects the inflow of deposits from institutional investors such as AFPs to continue past this year and into 2015. “When interest rates eventually begin to rise, this will have an impact on the performance of mutual fund investments and therefore make term deposits a more attractive option. This should enable the banks to continue offering loans at low rates for some time to come,” Rhor predicted.

SOLVENCY & LIQUIDITY: Indeed, a combination of prudent management and effective regulation is apparent in other key indicators of the banking sector. The average capital ratio of Peruvian banks as of June 2014 stood at 14.41% – well above the 10% ratio required by law. According to data from the SBS, this afforded the banks PEN9.8bn ($3.5bn) in capital reserves to overcome any financial shocks. Meanwhile, the liquidity ratios at the end of June 2014 stood at 29.7% in soles and 53.1% in US dollars. These figures were significantly higher than the minimum ratios of 8% in soles and 20% in US dollars required by the regulator. Return on equity (ROE) ratios continued to fall in the first half of 2014, with banks’ average ROE for the second quarter standing at 19.96%, which was a decrease of 1.57% compared to the same period one year earlier. Nevertheless, with ROEs set to remain above 15%, Guerrero told OBG that the Peruvian market should continue to attract foreign investors.

MARKET STRUCTURE: The sector’s high levels of profitability and concentration have led to suggestions that it is insufficiently competitive. “The so-called big four banks control 90% of the banking sector, which makes it a difficult market to enter unless one comes with a distinct proposition,” said Alejandro Rabanal, head of equity research at Credicorp Capital.

The big four are Banco de Crédito del Perú, BBVA Continental, Scotiabank and Interbank. As of June 2014, the big four, alongside the sector’s other 13 commercial banks, held PEN270.2bn ($96.5bn) in assets, equivalent to 88.6% of the financial industry’s total of PEN304.9bn ($108.8bn). Of the other 45 institutions that make up the industry, the SBS classed 31 as non-bank financial institutions, including the three main classes of microfinance institution (see analysis); two as leasing companies; and the remaining 12 as “other financial companies”. The non-bank financial institutions and other financial companies held 6.6% and 4.8% of the banking sector’s assets, respectively.

COMPETITION: However, Guerrero argued that this high degree of concentration among a few banks with respect to assets masks the strength of competition that exists in individual product lines. “If you look at the market for personal loans, credit cards or SME lending, you will find many players besides the four major banks, while even in the large company segment there are more than 20 banks competing for business. In the case of the corporate segment, the “big four” banks face competition from foreign banks and the debt capital markets, making this one of the most competitive segments of the market,” said Guerrero.

Rhor told OBG that competition among the banks was particularly fierce in the commercial banking segment – to the extent that this had created problems. “Against a backdrop of rising costs as a result of mounting regulatory requirements, such as Basel II, over the past couple of years we have seen banks lending at rates as low as 1.5% or 2%, which are unsustainable,” Rhor said. This drove the banks to go searching for business in new segments of the market. According to Rhor, this explains why the larger banks found themselves all converging on the SME segment at the same time and then suffering mounting losses due to companies in this segment quickly becoming overindebted. Looking to 2015, Rhor expects the SME segment to start improving, aided by a recovery in the economy as well as greater discipline by the banks. “Banks have learned from their mistakes and several have withdrawn from the SME segment altogether,” Rhor told OBG.

INTERNATIONAL PLAYERS: In a competitive market where scale is a cost advantage, smaller players and new entrants must find a niche in order to succeed, according to Alberto Morisaki, deputy manager of economic research and statistics at the Peruvian Banking Association (Asociación de Bancos del Perú, ASBANC). This – in addition to banks’ respective commercial strategies – has caused some large international banks that lacked local scale or a particular niche to exit the market in recent years; for example, HSBC announced the sale of its Peru business to Colombian banking group GNB in 2012, while in October 2014 Citibank said that it would be pulling out of consumer banking in the country. Meanwhile, February 2014 saw the entry to the market of ICBC, a Chinese firm that is the world’s third-largest bank by market capitalisation. “Around 80 Chinese companies operating in Peru will be the niche target of Chinese banks such as ICBC,” Morisaki told OBG.

ELECTRONIC MONEY: While foreign players like ICBC have concentrated on banking clients with international trade finance needs, some local banks are seeking to grow their customer bases by supporting the development of electronic money. Having gathered the banks together to collaborate on a common electronic money platform that should work across all telecoms providers, Morisaki told OBG that ASBANC planned to test this new platform in a pilot project scheduled to run for six months, starting in the second half of 2015.

Guerrero told OBG that electronic money would be of particular help to SMEs. “It will have a positive impact on SMEs by allowing them to pay their suppliers more easily and by accelerating the flow of funds between businesses. For instance, we have seen these benefits emerge from the pilot projects that CrediScotia, the microfinance arm of Scotiabank, has been running in San Juan de Lurigancho,” Guerrero said.

Morisaki told OBG he expects the electronic money project to bring an additional 1.5m people into the financial system within a year of its full launch. “Electronic money has a part to play in promoting financial inclusion as well as in helping to deliver state benefits and services, such as pension payments, to segments of the population that currently may not have access to such things,” added Guerrero.

An important difference between Peru’s vision for electronic money and that of countries like Kenya, where such systems have existed for many years, is that Peru aims for it to become a means of drawing people into the regular financial system rather than a parallel system operating in isolation, according to Morisaki. With such a vision in mind, the local banks have started to regard electronic money as an opportunity rather than as a threat.

CAPITAL MARKETS: Another piece of the fabric of Peruvian financial services that the banks are becoming more closely involved with is the capital markets. “Banks fundamentally have had no great interest in seeing the capital markets develop, as these represented a competitor to the profitable corporate lending sides of their business,” Aldo Ferrini, the deputy CEO of AFP Integra, told OBG. However, as banks seek various ways to grow their capital markets divisions – for example, through Credicorp setting up of Credicorp Capital in 2012 – this looks likely to become less of an issue, which will ultimately benefit the capital markets.

REGULATION: Underpinning these developments are the country’s regulatory authorities, comprising the BCRP and the SBS. “Peruvian banking regulations have always been strict by international standards, both in terms of reserve and capital requirements as well as in areas such as the transparency of fees and charges. On balance, this strict regulatory regime has served the industry well,” Guerrero told OBG. The IMF has also praised the authorities for their “proactive use of prudential measures”, which helped to prevent the buildup of sector vulnerabilities during the global financial crisis and during the subsequent surges in capital flows.

Notwithstanding the sophistication of the regulators, there also remain areas in which Peruvian banks could still do more to bring their practices into line with international standards. For instance, Jose Luis Sarrio, a partner and head of the international business centre at Grant Thornton Peru, told OBG that “there are banks which have corporate clients with revenues reaching $300m per annum of whom they do not request audited financial statements. These clients have still been able to obtain loans from the banks, based on long-established relationships and lending against collateral rather than based on a proper analysis of their cash-flows and the credit risk that they pose.”

OUTLOOK: As the banking sector continues to mature, Sarrio expects such practices to become the exception rather than the norm. Another sign of the industry’s growing maturity is that in coming years its growth rate is expected to ease to more closely reflect the three-times-GDP-growth rate regarded as normal for banking in emerging markets, with the consensus being that the sector will continue to grow at a rate of around 15% per annum. The BCRP told OBG it views a credit growth rate of 15% per annum as reasonable, given the current size of the financial sector as a proportion of GDP compared to those of the country’s neighbours. Indeed, the ratio of private sector domestic credit to GDP stood at 31.4% for Peru at the end of 2013, compared to 50.3% and 105.9% for Colombia and Chile, respectively, demonstrating the large scale of the opportunity that lies ahead for the banking sector in Peru.