Lending is key: banking sector must increase competition, lower commissions.

The Mexican banking system has come a long way since the body blow it was dealt by the devastating Tequila Crisis that erupted in December 1994.

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Those banks that were not destroyed altogether by the financial fall-out that ensued were left floundering. But a series of acquisitions by a clutch of foreign banks was critical in resuscitating Mexico's ravaged banking system.

Now, the country's four biggest banks, which account for three-quarters of the country's banking assets, are owned by the foreign giants BBVA (Spain), Citigroup (USA), Banco Santander (Spain) and HSBC (UK)--in that order.

The arrival of these banks has done much to bolster and recapitalize the banking system, although capital injections from the government have also been important.

"In general terms, we are much more comfortable with the financial conditions of the banking system, which is much stronger now than it was five years ago," said Ursula Wilhelm, senior banking analyst for Mexico at Standard & Poor's.

Wilhelm pointed to the effect that foreign banks have had on the system's level of capital, provisioning and risk assessment.

"But there are certainly weaknesses that still need addressing," she said.

Despite the wealth of good international practices that might have been expected to come with these banks, Mexico's banks remain dogged by criticism.

One major gripe has been that they have not been lending enough--arguably a bank's primary function--and thus have been starving the private sector of credit.

Instead, critics say, they have been making their money by charging unacceptably high commissions and transaction fees, which critics observe indicates a sorry lack of competition in the sector.

Nevertheless, the situation appears to be beginning to improve.

Lending On The Rise

One of the graver results of the financial crisis was that banks' ability to lend, as well as their confidence in doing so, was severely hampered, if not rendered impossible.

But credit has been growing faster in the last two years than at any point since 1995, despite the negative effects of a volatile interest rate environment in which rates were hiked nine times in 2004.

While the Mexican economy had previously been expanding without any parallel growth in credit--indeed, credit was actually falling--it is now growing at a rate of 28 percent. This is equivalent to six times the overall growth rate of the economy, which grew by a pleasing 4.4 percent during 2004 on the back of U.S. economic recovery.

Only two years ago, almost fourfifths of financial savings in Mexico were concentrated in the public sector. Now, significantly over half of savings--55 percent--are in the hands of the private sector.

Furthermore, the amount of credit cards in use has doubled in the last two years, with some 12 million in circulation. Including debit cards, this figure rises to 46 million.

In 2004, bank lending to the private non-financial sector grew by 19 percent in real terms: consumer loans jumped by an impressive 42 percent (although admittedly from a very low base), mortgages by some 20 percent, while commercial loans grew by 12 percent.

This means that lending to this sector now accounts for 9.9 percent of GDP, as compared to 8.6 percent in 2003. Banking analyst at Fitch Ratings Alejandro Garcia believes that, stable interest rates permitting, the Association of Mexican Banks' projection of up to 25 percent in the growth rate for lending during 2005 is "feasible."

Ironically, this growth in lending has triggered criticism from certain quarters that lending may be growing too quickly, without due attention to risk--although Standard & Poor's does not share such concerns.

"Although lending has been growing vigorously on the consumer side, we don't feel that this is something to provoke concern," said Wilhelm. "There has been a tightening of underwriting criteria and the way products are designed, and more tools are being used to assess risk.

"Growth criteria are much more conservative and there are prudent levels of leverage. Looking at asset quality indicators, bank quality and non-performing loans, we are not concerned about people taking on too much debt."

Commissions Still Formidable

If lending has been increasing encouragingly, banks so far appear to have failed to address the associated issue of high commissions adequately.

Although Manuel Medina Mora, former president of the Association of Mexican Banks, commented in March at the annual National Banking Convention in Acapulco that the reduction of commissions "has begun to be a reality," much remains to be done.

The governor of the Bank of Mexico, Guillermo Ortiz, said in Acapulco that greater competition would be "highly desirable," due to the widespread perception that margins on lending rates are still "excessive."

In actual fact, this is a notable softening of the stance he took at the same occasion last year, when he openly threatened to use the Central Bank's muscle to force banks into line on the issue of commissions.

But he reiterated that "greater competition is needed to improve the quality of services and stimulate the reduction of commissions and interest rates." Although banks are moving in the "right direction," he warned that "distortions" still exist.

"Banks are going to have to lower their commissions to gain the favor of their customers--the benefits of competition are not very visible in this country," said Pablo Ruiz, a banking analyst for Mexico City's Vector Casa de Bolsa.

"There is competition on certain levels, but it has never been enough to lower commissions, that still looks very far off. It depends on whether someone is willing to break the equilibrium. At the moment everyone keeps their commissions high, and it will stay that way for as long as the banks continue to behave collusively."

While commissions are unquestionably much higher in Mexico than in other countries, bankers point out that discrepancies between countries in the rates they charge are not unusual, even between fully developed countries.

In Europe, Italy's banks charge commissions that are no less than 16 times higher than those in Holland.

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Furthermore, bankers argue that costs in Mexico are higher and, unlike elsewhere, banks carry the burden of costs that are not directly related to their business, due to a low level of automation in the payments system.

Nevertheless, fees have become a key source of income for banks--revenues have increased because of increased transactions, but also because of an increase in the level of fees.

"It is generally perceived that bank clients are having to pay more but are not getting anything additional for those prices," observes Wilhelm. "The concentration of the system in only a few players means that such negative practices by banks are even more questionable now."

The main problem, according to Wilhelm, is a lack of external pressure on banks to make them cut their fees--with one exception.

"The Central Bank has tried to incentivize banks to reduce fees, but so far has not really been successful. Banks just said OK, we'll lower our fees--but the reality is that nothing has changed and there is no real pressure to do so," she said.

Despite this, banks pledged at Acapulco to lower inter-bank commissions by between 10-20 percent. This should have a favorable knock-on effect for businesses and consumers, they say, with reductions in consumer rates of a similar magnitude.

How soon, though, is another question.

"I do expect commissions to fall--in the medium term--but credit will also grow. The penetration of the banking system is incredibly low at the moment so the opportunities to grow the share of their lending business should more than make up for a gradual reduction in commissions," said Carlos Peyrelongue, head of Merrill Lynch in Mexico.

Foreign Ownership Scrutinized

Some say despite the fact that over 85 percent of Mexico's banking assets are now in foreign hands--including some of the largest and supposedly most competitive banks in the world--this has failed to have an effect on lowering commissions or increasing competition significantly in the sector.

"There still isn't much competition, particularly in savings and deposits, although credit is a bit more competitive," said Ruiz. "In terms of service, the system has advanced a bit, but it still isn't even close to the levels of service in other countries.

"Despite the experience and knowledge that these foreign banks have brought with them, you can't conclusively see the benefits very clearly."

Another problem associated with foreign ownership is that foreign-owned banks base their decisions on principles and guidelines that are not necessarily compatible with those required by Mexican regulators.

For example, there are discrepancies between international accounting principles, tax standards and provisioning levels with which international banks must comply, and those required by the Mexican system.

"To close those discrepancies, given the reality of the banking system, it would be appropriate for Mexican regulators to review and modernize those gaps between foreign principles and guidelines, and those requested domestically," said Wilhelm.

There are other negative aspects to foreign-owned banks, she said, "although they may not actively be harming the system."

"Foreign investments in Mexico's banking system are made for one purpose: to enhance profitability. Their decisions must be viewed in that context and, in the short term, they are not always in the best interests of what domestic regulators would like in terms of the development of the system," she explained.

Pablo Ruiz observed that in certain extreme scenarios--such as a global crisis on the scale of the aftermath of September 11, 2001--when the world begins to divide itself into opposing sides, there could be significant consequences to the Mexican banking system as a result of foreign ownership.

"But then it becomes much more complicated to evaluate, and I leave that to the politicians," he said.

Nevertheless, by belonging to larger institutions with assets spread across the world, Mexico's foreign-owned banks are much better protected against further national crises than those banks with all of their assets concentrated within the country.

Although a great deal of sensitivity and suspicion continues to surround the issue of foreign ownership, as Jorge Hierro, head of investor relations for Banamex (owned by Citigroup) explains, it was the best solution for a tricky situation.

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"After such a terrible crisis, there was no other choice. Obviously, in an ideal world, I would have preferred the banking system to remain in Mexican hands. But I would still prefer a strong banking system owned by foreigners than a weak banking system owned by Mexicans," he said.

Tequila Crisis Fallout

Another politically sensitive issue, and also a lingering specter of the Tequila Crisis, is closer to being resolved--the dispute related to Fobaproa, Mexico's former deposit guarantee fund set up to absorb debt and prevent a massive run on the banks after the 1994-95 crisis.

But profitability for Mexico's seven largest banks continues to be affected. The seven banks are BBVA Bancomer, Banamex, Serfin, HSBC Mexico, Santander Mexicano, Banorte and Inbursa, which together account for 85 percent of the system's assets--although Serfin and Santander merged in December 2004 to become Banco Santander Serfin. In 2004, these banks were struck by one-off losses of 3.6 billion pesos.

This was mostly to do with the fact that Banamex and Bancomer reached an agreement over the dispute with IPAB, Fobaproa's successor.

Mexico's two largest banks fully recognized the impact of the resolution of the Fobaproa fiasco, meaning that they would assume the cost of loans sold to Fobaproa after the 1995 crisis.

An audit as a result of last July's agreement between IPAB and the four banks implicated in the Fobaproa dispute is expected soon, and only then will the full costs that banks must absorb be known.

Banks were also hit hard by a volatile interest rate environment in 2004. Net trading revenue fell 72 percent to 4.2 billion pesos, compared with 15.2 billion pesos in 2003. However this was cushioned somewhat by stronger net interest revenue, which boosted fee income. So although 2004 saw net income in the banking system fall by 21.3 percent to 22.0 billion pesos, operating profit increased by 16.5 percent to 45.2 billion pesos from 38.8 billion pesos in 2003.

Attractive Acquisitions

The strong growth and performance in the last decade of the sofoles, as Mexico's mortgage lenders are known, has led to considerable consolidation in the financial industry recently, as banks seek to grab a piece of the action in Mexico's recovering property market.

Sofoles have become attractive acquisition targets for Mexican banks due to their ability to enhance banks' business profiles with expertise and mature loan portfolios in areas not currently targeted--in particular mortgage lending to the lower income segments of the population.

Meanwhile, it suits the sofoles to become a member of a sound financial group, thus strengthening their funding structure.

These mutual benefits have triggered a number of acquisitions, in particular the US$375 million acquisition of Hipotecaria Nacional (Hipnal, the largest mortgage sofol) by Bancomer (Mexico's largest bank in terms of assets). Also Scotiabank Inverlat is to acquire at least 80 percent of Credito y Casa, the third largest mortgage sofol.

According to Alejandro Garcia at Fitch Ratings, there is also "plenty of room for growth" in other business lines, such as small and medium enterprises (SMEs) or retail consumer financing, in which Bancomer and Banorte made ground in 2004.

It is also likely that there will be more international agreements as banks compete to expand their position among the U.S. Hispanic market--particularly for loans, deposits and remittances--following Bancomer's acquisition of Laredo National Bank to boost its remittance flows.

Other important changes characterizing the banking sector throughout 2004 include more stringent reserve requirements since December 2004 after the banking regulator--the Comision Nacional Bancaria y de Valores--published new rules for assessing loans and setting credit reserves. The goal is to strengthen the quality and depth of credit assessments on each bank's exposure.

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So this year could present a number of interesting business opportunities for banks, especially if the integration of Hipnal and Credito y Casa are deemed to be successful, potentially leading to further acquisitions of sofoles.

Lending should also increase, although at what pace remains unclear.

But most agree that increasing lending is the key priority for banks in the coming year, a healthy economic climate permitting.

With some luck, increased lending will contribute to heightening competition, a necessity if commissions are to start their much-desired decline.

Benedict Mander ([e-mail]) is a freelance journalist based in Mexico City.