Banking growth in Mexico has increased profitability, but reaching new customers remains challenging

After absorbing heavy lessons that accompanied the financial crisis of the 1990s, Mexico’s banking system established a solid regulatory environment, and this resulting resilience allowed it to sail through the worst consequences of the 2008-09 global financial crisis. Today, stemming from further reform measures, Mexico’s banking industry enjoys high capital adequacy ratios and is benefitting from robust profit margins. While some stakeholders have pointed to the sector’s conservative approach as a reason for the slow progress in increasing penetration levels, the sector is in fact expanding financial services to a broader share of the population. Relative to the size of the Mexican economy, the country’s banking sector remains fairly small, dominated by a handful of large international bank groups.

Sector Mindset

The crisis that affected Mexico’s financial system in 1994-95 began with the government’s sudden devaluation of the peso against the dollar, which led to high levels of capital flight. This period instilled a degree of caution that has influenced subsequent industry oversight. As the sector was liberalised, regulations were reinforced and increased vigilance was taken by the main banks.

Current market players also tread carefully due to the realities of operating in an emerging market: high levels of informality prevent a broader expansion of banking services across different income levels, and issues related to the rule of law further push service providers to adopt a guarded attitude and focus on safer and more stable sources of business activity. For example, despite some provisions included in the 2014 financial reform, it can still take three to five years for a bank to recover an asset for some types of recoveries, leading banks to maintain activity with tried and true segments.

“There is this approach in the local banking sector that with the level of profitability that banks have, there is no need to take added risks to focus on new segments of the market,” Alfredo Calvo, director for financial institutions ratings at Standard & Poor’s Global Ratings, told OBG. “At the moment, banks are making money and they still have some room to grow with their existing customer base.”

Solid Bet

Underlining this perspective, recent results demonstrate the sector’s robust performance, both in terms of profits and the size of its loan portfolio. Banking profits climbed by 31.5% in 2017 to reach MXN137.7bn ($7.4bn), and domestic credit to the private sector, including banking and non-banking sectors, reached 34.2% as a percentage of GDP in September 2017. The sector has also been successful in implementing various Basel III regulations, with major banks adequately adhering to capital and liquidity requirements.

In spite of some volatility during the first half of 2017, stemming from the outcome of the US presidential election and the potential renegotiation of the North American Free Trade Agreement, the financial system and the broader economy were able to maintain steady growth and general solidity.

Market Structure

The sector remains structured around strong institutions operating under a robust regulatory environment. According to the National Banking and Securities Commission (Comisión Nacional Bancaria y de Valores, CNBV), there were 50 banks operating in the local market as of April 2018, with two new players arriving since the start of the year. After receiving regulatory authorisation in late 2017, South Korean bank Shinhan began operating in the country in January. Banco S3, a subsidiary of Spain’s Santander Group specialising in the deposit, custody and administration of securities, entered the market in February 2018.

A large proportion of the sector’s mass is concentrated among the seven largest banks, known as the G7. Although the total lending portfolio of the G7 increased from just over MXN2trn ($108.1bn) in 2012 to about MXN3.7trn ($199.9bn) by December 2017, the group’s share of the sector’s overall portfolio decreased from 83% to 78% over the same period, as smaller players made inroads.

Of the frontrunners, Spanish bank BBVA Bancomer remained the market’s biggest player, accounting for 22% of total sector assets in November 2017, according to Forbes. In second was Banco Santander with 14.3% of the total, followed by Citibanamex with 13.4%. Rounding out the G7, Banorte held 12.1% of sector assets, HSBC secured 7.6%, Scotiabank accounted for 5% and Inbursa had 3.9%.

Balance Sheet

Consecutive years of growth have allowed Mexico’s commercial banks to increase their combined assets to MXN8.9trn ($481bn) as of December 2017, up from MXN6trn ($324.2bn) in 2012. Total liabilities of all commercial banks rose over the period as well, from MXN5.4trn ($291.8bn) to around MXN8trn ($432.3bn). However, these are not consolidated figures, meaning they do not include credit cards or other add-ons.

Throughout, banks have maintained robust levels of capitalisation. As of December 2017 the capitalisation ratio of the sector as a whole was 15.5%, according to the CNBV. This figure is in line with what the industry has been posting in recent years, with capitalisation ratios considerably above the minimum regulatory requirement of 10.5%.

There is, however, a significant level of variation across institutions, largely due to differing operating models. Three banks – UBS, Pagatodo and Mizuho Bank – were above 100%, whereas other institutions had capitalisation ratios ranging from 12.5% to 19.5%. By the end of 2017 the overall fundamental capital coefficient for the sector was 13.3% and the basic capital coefficient was 14.2%.

The solidity of Mexico’s financial system has been underscored by the positive results of stress tests carried out by the IMF in conjunction with the CNBV and Banco de México (Banxico), the central bank. In its November 2016 “Financial System Stability Assessment” report, the organisations concluded that the local financial system had high levels of solvency and was prepared to endure macro-financial shocks from a combination of sources. The CNBV conducts these stress tests annually, and Mexico passed with even better results in March 2018.

The tests showcase the particularly strong position of Mexico’s larger banks, found to be capable of remaining well capitalised under an unfavourable scenario. It was also determined that all G7 banks had sufficient liquidity in both foreign and domestic currency. Some of the smaller banks, however, showed more weaknesses, specifically in the scenario of a prolonged recession. This could wipe out around 30% of some banks’ capital.

While the high capital adequacy points to the sector’s overall strength and stability, it also spotlights the additional resources that could be funnelled through to the economy. “Looking at the level of banking capitalisation, it is far ahead of the 10.5% minimum stipulated in the Basel III regulations,” Calvo told OBG. “Banks could comfortably operate with capitalisation rates of 11% or 12%, so that leaves between 300 and 400 basis points of capital that could be deployed to increase credit allocation. However, the right incentives do not exist for credit to grow more than it has at the moment.”

Regulatory Overhaul

Well-received financial reforms were introduced by the authorities in 2013 and 2014, however, room for improvement still remains in certain aspects of regulation. The reforms envisioned a stronger role for commercial banking institutions in credit allocation across all sectors, and also underlined the need to establish robust legal and operational conditions for development banks so they can adequately contribute to the country’s economic progress.

Included in the regulatory changes were measures to reduce and penalise undesirable behaviour among sector players, and improve consumer privacy and protection. These took the form of strengthening the regulatory powers of the CNBV and establishing the National Commission for the Defence and Protection of Users of Financial Services.

Later initiatives further reinforced consumer rights. In October 2015 Banxico introduced new rules to ease necessary procedures for account holders to shift their salary payments to a new account or banking provider, and a similar regulatory change made it easier for those with housing credit to change mortgage lenders.

Big Bank Rules

More active oversight of pivotal institutions has also helped focus regulatory efforts where they can have the most impact. In mid-2016, and in accordance with the implementation of Basel III regulations, the G7 banks were designated by the CNBV as domestic systemically important banks (D-SIBS). This determination has placed more stringent liquidity requirements on these institutions.

Monitoring the G7 is critical because of the way they interact with the non-banking financial system. Stemming from large-scale financial conglomerates, the weight of the G7 banks is distributed through networks of subsidiaries that operate across brokerage, pensions and insurance. “What has helped us secure the solidity of the sector is focusing on the banks’ systemic risk, and reducing it whenever possible,” Álvaro Meléndez Martínez, chief economist at the CNBV, told OBG.

As such, these institutions are mandated to have an extra capital buffer on top of the base 10.5% capitalisation requirement, ranging from 0.6% to 1.5% depending on the specific amount of risk that they could potentially bring to the overall financial system. The biggest additional buffer requirement fell on BBVA Bancomer, which needed an extra 1.5%, followed by Banco Santander and Citibanamex with an extra requirement of 1.2%. Lower requirements were enforced on Banorte, at 0.9%, as well as HSBC, Scotiabank and Banco Inbursa, which are all required to maintain an additional 0.6% on their base capitalisation level. Although three years remain for the adoption of the extra capital requirements, the capitalisation rates of all G7 banks already exceeded the mandated buffer percentages as of late 2017.

Liquidity Requirements

The sector’s implementation of Basel III regulations is also evident when considering market players’ adherence to liquidity thresholds. In accordance with the latest international banking regime, institutions were mandated to maintain a liquidity coverage ratio (LCR) of 60% beginning in 2015, and add an extra 10% per year in order to reach a LCR of 100% by 2019.

In light of this goal, the aggregate LCR of domestic banks rose from 152.5% in the third quarter of 2016 to 174.9% in the fourth quarter of 2017. In April 2018 the CNBV reported that as of December 2017 all banks in the system were in compliance with the LCR rules, including Banco Finterra, Banco Sabadell, and the Industrial and Commercial Bank of China Mexico – three banks that began operations after the new rules were established at the start of 2015. Of the sector’s top-seven banks, Banco Inbursa had the highest average LCR at 196.5%, followed by Santander at 176.1% and Scotiabank at 151.7%.

Credit Push

Notably, these ratios have been maintained amid successive years of credit expansion. Between 2012 and 2017 total lending as a percentage of GDP rose from 22% to 38%, according to data gathered by HR Ratings, a Latin American credit rating agency. Total lending rose from MXN2.7trn ($145.9bn) to MXN4.5trn ($243.2bn) over that period. As of April 2018 the total credit portfolio of the industry’s 50 banks had reached approximately MXN4.83trn ($261bn), according to the CNBV. This represented a 4.6% increase over April 2017 when 48 banks were in operation.

While lending growth continues, the rate of credit expansion saw a significant slowdown over the course of 2017. This was caused by a number of factors, according to BBVA Research, including lower real wages due to rising inflation during the year and the related drop in consumption. The climb in interest rates has also made loans more expensive, both in the corporate segment and elsewhere. Growth in private sector mortgages, for example, fell from 14.9% to 12% in the year to December 2017.

However, the easing of inflation from mid-2017 onwards is expected to continue throughout 2018 to settle at the central bank’s target rate of 3%. This could create more spending room in household and corporate budgets, and impact those respective lending segments positively in 2018.

Commercial Credit

A strengthening of demand from large-scale private businesses from 2015 onwards led to high growth in commercial credit allocation, which began expanding at a faster rate than other types of private credit at 5.2% in 2015 and 8.4% in 2016. Although growth fell to 4.8% in 2017, commercial credit rebounded to expand by 10% year-on-year (y-o-y) in January 2018, amounting to just over MXN3trn ($163.6bn), according to a sector report published by the CNBV in March 2018.

Loans to businesses grew by 14.3% to reach 74.6% of the total commercial loan portfolio, with government entities and financial institutions accounting for 18.6% and 6.8% of the portfolio, respectively. Because of the size of their credit requirements and generally lower risk, banks have seen their share of business loans to large corporations expand from 77.4% of total commercial credit allocation to 80.7% between January 2017 and January 2018. SMALL BUSINESS LENDING: The increase in loans to larger businesses has contributed to a shrinking share of small business loans within the banking system’s commercial credit portfolio. Total credit extended to micro-, small and medium-sized enterprises (MSMEs), including all assets rather than just core assets, rose from MXN241.6bn ($13.1bn) in 2012 to MXN439.5bn ($23.8bn) by December 2017 on the back of calls from the CNBV to support these businesses. However, higher delinquency and default rates, coupled with doubts over MSME performance under an unfavourable economic environment, made banks scale back lending to the segment from the beginning of 2017. This shift saw the share of corporate credit going to MSMEs fall from 22.6% to 19.3% in the year to January 2018.

Consumer Credit

When it comes to individuals, the CNBV recorded that consumer credit increased by 8.6% y-o-y to reach approximately MXN972bn ($52.5bn) in January 2018, accounting for 20.5% of total lending that month. This is a slower growth rate than for the whole of 2016, when HR Ratings reported consumer credit growth of 18.6%. This slower expansion of consumer credit could in part stem from the loss of buying power caused by higher inflation rates that affected many Mexican citizens in 2017. The consumer segment has also been exposed to relatively higher rates of non-performing loans (NPLs) in recent years.

One type of lending that the banking system can count on to post healthy returns is credit card debt, which makes up approximately 40% of all consumer credit. This expanded by 8.6% between January 2017 and the same month of 2018 to reach MXN384bn ($20.8bn). However, new credit card sign-ups were largely limited to existing customers. “In the past, banking institutions offered credit cards on the open market, reaching out to customers of other banks,” Calvo told OBG. “But after the 2008-09 global financial crisis this was the market segment that presented the biggest losses, so banks moved away from the open market and now offer credit cards mostly to their own customers.”

Personal credit, meanwhile, surged by 12.7% y-o-y to MXN208bn ($11.2bn), outperforming than the 2.9% rise in payroll loans – credits linked to salary accounts – which totalled MXN226bn ($12.2bn).

Non-performing Loans

Even with the considerable growth in credit allocation over the past five years, the banking sector has been able to keep a firm grip on the rate of NPLs. A large number of housing credit defaults contributed to the NPL rate peaking at 3.4% in 2013, but it then fell to 3.1% in 2014 and shrank further to 2.6% in 2015. Over 2016 and 2017 the NPL rates were maintained at a relatively healthy rate of 2.2%. “The system is loaning more, but it is also loaning smarter,” Martínez told OBG. “On top of this, about 48% of the current loan portfolio is made up of credit to companies, which means they are productive loans.”

Deposits

Credit expansion has been sustained by the sector’s access to financial resources, especially bank deposits. The rate at which banks were able to attract fresh deposits, however, slowed in 2017. Total money held at domestic banks expanded by 8.8% y-o-y in January 2018 to MXN4.9trn ($264.8bn). Deposits on call continued to represent the largest component of banking resources, at just over MXN3trn ($162.1bn), up 5.7% y-o-y. Term deposits, however, grew much faster than on-call deposits – reversing the trend seen in 2016 – posting expansion of 19% between January 2017 and January 2018, reaching roughly MXN1.2trn ($64.8bn).

The extent to which banking institutions will be able to rely on deposits to grow lending will likely depend on the conditions the sector faces over 2018-19. As of the end of 2017 banks were not relying too heavily on interbank lending or money markets to expand credit, two segments that displayed divergent behaviours in 2017. Funds secured by banks from money markets and issued credit titles grew by 7.7% y-o-y to reach MXN562bn ($30.4bn) as of the first month of 2018, while interbank lending and funds secured from other organisations moved in the opposite direction, experiencing a 3.3% decrease to MXN316bn ($17.1bn).

Monetary Policy

Having averaged a relatively low 2.8% in 2016, higher inflation put pressure on the Mexican economy over much of 2017, leading to more restrictive monetary policy. Not only did the economic uncertainty following the US presidential election in November 2016 push the peso downwards, but rising petrol prices resulting from liberalisation measures added to the inflationary burden as well. At the close of 2017 inflation reached a 17-year high, settling at 6.77%, according to the National Institute for Statistics and Geography.

December 2017 saw Banxico raise interest rates by 0.25 percentage points, stating in early 2018 that dealing with high inflation required “timely and firm monetary policy action”. This was a prelude to further rate increases at the central bank’s meetings in February and June 2018, which brought the interest rate to a nine-year high of 7.75%. The first quarter of 2018 saw inflation recede back to 5.04% as of March, and by May the rate hovered around 4.51%.

Monetary policy tightening was a key reason for a reduction in the rate of new credit allocation throughout 2017. With the authorities showing a firm commitment to fighting inflation, further rate changes will depend on how price growth progresses over the course of 2018; Banxico has expressed confidence that inflation will move closer towards its target rate of 3% during the year.

Infrastructure

While policy direction can often be revised from year to year, infrastructure expansion represents a more stable, long-term pursuit. The sector has allocated significant resources to widen its distribution networks and reach new customers. The number of fully fledged bank branches increased by 300 between 2012 and 2017 to roughly 12,400 locations across the country, while other physical contact points grew by 22,000, according to the Mexican Association of Banks (Asociación de Bancos de México, ABM). Distribution has also expanded through digital means, with the number of customers using online banking services growing from 19m to 38m over 2012-17.

Despite the addition of new brick-and-mortar branches over the last few years, a slowdown in this type of physical branch expansion is a common characteristic of mature markets. “There has been a transformation of banking services towards more digital branches, where the customer interaction with the bank is improved through executives and technological means, mixing retail offers with corporate banking services,” José Ignacio Valle, partner for financial services at Deloitte, told OBG.

Inclusion

Although gains have been made, broadening the sector’s reach is an ongoing challenge. The share of Mexican adults with a bank account in a formal institution rose from 35.1% to 44.1% between 2012 and 2015, according to the latest report by the Council on Financial Inclusion (Consejo Nacional de Inclusión Financiera, CNIF), published in mid-2017. In addition, the volume of banking transactions using cards nearly doubled from 1.5bn in 2012 to 2.8bn in 2017. However, over half of the population still remains outside the formal financial system. This illustrates large growth potential for the industry, but also the sector’s difficulty reaching new customers in certain segments of society.

In this regard, mobile services are playing a leading role in opening up new growth opportunities. The CNIF report states that as of the end of 2017 there were 15.2m mobile banking contracts in Mexico, a substantial increase from 247,473 contracts at the end of 2011. Mobile and online digital banking services present exponential growth possibilities for the sector, especially among Mexico’s young population. However, making the switch to new distribution channels is not always easy. “Traditional banking has very robust control mechanisms, but transforming that to a digital stage takes time and resources,” Ignacio Valle told OBG. “That transformation is taking a lot of time in Mexico.”

Efforts to improve financial inclusion are expected to come from non-traditional banking actors as well. The March 2018 passage of Mexico’s Law to Regulate Financial Technology Institutions – known as the Fintech Law – will give the financial sector a boost by regulating technology-based firms operating in the banking and insurance segments (see analysis).

Fintech companies are well placed to improve financial inclusion, but they might not necessarily contribute to higher banking penetration rates in the short to medium term. They may, however, help point the way forward for traditional market players that are looking to partner with such firms or incorporate similar services into their portfolio (see Global Perspective). “The business model of traditional banking must change. We are at a point where banking institutions have reached a sort of summit in terms of growth, so they need to innovate their distribution channels, adding some variety to the mix,” Ignacio Valle told OBG.

Outlook

The ABM has predicted that the sector is likely to maintain substantial growth rates in 2018. The general external economic environment will likely add pressure on the economy and the financial system in the near term, but even with some degree of macroeconomic instability, Mexican banks have proved their ability to strengthen their positions by adhering to strict liquidity and capitalisation ratios, which will allow the system’s most important institutions to withstand potential shocks.

While the new Fintech Law is expected to open additional opportunities for the banking sector, it is still too soon to tell whether or not these services will be able to markedly expand traditional banking penetration. A more likely scenario over the medium term is a rising level of cooperation between traditional financial institutions and new technology-based platforms as established banks attempt to reach new segments of the local market.