The new face of banking: foreign investors bet on Mexico's banks.

Until the international takeover of financial group Bital, Mexico's banks were expecting 2002 to be their calmest year since the 1994 peso devaluation brought the industry to its knees.

Seven years and 10 months after that event triggered a collapse in credit and the sharpest recession since the 1930s, experts say the country's banks have never looked stronger. But economic stability, they say, is creating new challenges as low interest rates force banks to start lending again in an effort to raise profitability.

"When have we seen a global economic crisis, like we're seeing now, when Mexican banks haven't been driven to the wall?" asked Philip Guarco, senior banking analyst for Latin America with Moody's Investors Service. "It's one of those rare occasions"

Subsidiaries of Spanish banks such as Santander Central Hispano (SCH) may be suffering in Argentina as the financial system buckles under the weight of that country's debt burden, but they're going from strength to strength in Mexico. SCH's Mexico unit, Santander Serfin, posted its highest-ever profits in the first half of this year.

Ironically, Guarco says the Spanish Central Bank told SCH to withdraw from the bidding for Bital, over concerns the parent bank's capitalization ratios are being weakened by losses in Argentina.

That left the way open for London-based Hongkong Shanghai Banking Corporation (HSBC), which has been relatively untouched by South America's troubles, to snap up a lucrative franchise in one of the sturdiest economies in the Americas. Europe's largest bank in terms of market value on August 21 offered to buy a 52% stake in Bital at US$1.20 per share. If it decides to purchase 100% of Bital it will pay US$1.14 billion, including an estimated US$300 million for a 26.6% stake held by SCH.

Analysts say an acquisition here was the logical next step for HSBC, which has a significant presence in the United States, Mexico's main trading partner and destination for nearly 90% of the nation's exports.

Bital's sale continues the trend toward foreign control of the nation's financial assets, 87% of which are now in the hands of international banks. Banorte and Inbursa are now the only sizable banks remaining under Mexican ownership. But more important to the health of the banking system, says Guarco, is the country's growing integration into the North American financial services industry.

Many economists believe the nation's preferential access to Canadian and U.S. markets provided by Nafta shield it from the worst effects of Latin America's economic turbulence. They say it was the Nafta factor--more so than good fiscal performance--that led Standard & Poor's (S&P) in February to grant its long-awaited investment-grade rating to Mexico's sovereign debt.

TOO MUCH OF A GOOD THING

The stream of good news has been a shock to the country's financial institutions. Citigroup's US$12.5 billion acquisition of Banamex helped make the peso one of the world's strongest currencies last year, which in turn kept the prices of imported goods in check. Investor expectations of continued low inflation contributed to a collapse in Mexico's benchmark interest rates.

Yields on one-month Treasury bills, or Cetes, have declined steadily from their peak of 80% in March 1995, as Mexico recovered quickly from the recession that followed the December 1994 devaluation. The average 28-day Cetes rate in the first six months of this year fell to 6.7% from 13.3% in the same period last year.

"I don't think they would have liked it to happen so quickly," said Guarco.

Banks, he says, had gotten used to investing in high yielding government paper. Indeed, when the quality of the banks' loan portfolio--their major asset--deteriorated rapidly as hundreds of thousands defaulted in the wake of the 1995 interest rate spike, they were left with few alternatives.

But last year banks faced declining profits as their net interest margins--the difference between the rates they pay depositors and the rates they charge on performing loans--began to fall sharply. The logical move was to hike commissions to offset the lower interest revenue, Guarco says.

Fee revenue (excluding pension funds) in the second quarter of 2002 rose 14% compared to the previous quarter, as banks hiked commissions on everything from mutual funds to cash remittances to ATM transactions.

Banks have also been trying to improve profitability through increased lending. Results have been mixed. Although efforts to raise interest margins by expanding consumer credit have been successful, lending to homebuyers and businesses, their main source of future loan growth, continues to fall. Total loan stocks are declining as banks work through the bad debt left over from the aftermath of the 1994-95 crisis.

Performing loans to the private sector, comprised of consumer, housing and commercial loans whose interest and principal are actively being repaid, grew by 2.1% in real terms between July 2001 and the same month this year, Banco de Mexico figures show. The total private sector credit portfolio, however, shrank 6.6% in that period to $499.1 billion pesos as banks reduced past-due loans by 34.2%.

The banks' total consumer finance portfolio, made up of credit cards, auto loans and personal loans, grew by 31.1% in inflation-adjusted terms during the 12 months to July 2002. But mortgage and commercial loan portfolios shrank by 12.7% and 11.7% respectively during the same period.

ROLL UP, ROLL UP

Consumer credit helps lure lost customers back to the banks and improves interest margins, even though performing consumer loans comprise just 13.2% of the banking industry's total private sector credit portfolio.

The Spanish-owned banks last year launched what turned out to be a successful range of consumer products. Santander Serfin introduced its Serfin Light low-fee credit card with an interest rate capped at 24%, and its Maxicuenta Millionaria checking account linked to monthly lottery draws. BBVA Bancomer started to lend to customers who receive their salary through the bank and expanded credit card and auto lending.

BBVA Bancomer's portfolio of performing consumer loans grew 31.6% in real terms in the second quarter compared with the year-earlier period. It posted the first quarterly increase in its net interest margin since December 2000. Performing consumer loans at Santander Serfin increased by 81.6% year-on-year during the first six months, helped by Serfin Light and a low comparison base. The bank says it handed out 255,000 new cards during that period.

Car buyers are proving to be an important revenue source for banks since they purchase other financial products, such as insurance, in addition to auto loans.

HSBC will inherit a thriving auto credit business from Bital, which has a 12% share of the car loans market. The nation's No. 3 car financier has seen its auto loan portfolio grow from zero in 1999 to $5 billion pesos in July 2002, thanks to the recent boom in new car sales.

Use of credit fell drastically after the 1995 crisis and remains low. Total lending to the private sector as a percentage of gross domestic product (GDP) is just 18%, compared with 70% in Canada and the United States, 65% in Chile and 35% in Brazil, World Bank figures show. Credit cards in circulation fell from about 14 million in 1994 to 7 million as of March 2002.

Jason Mollin, a Latin American banking analyst at Bear, Stearns & Co in New York, notes only about 75% of "bankable" customers have so far opened a checking or savings account. Mexican banks typically provide 1.4 services per customer compared to five in the United States.

"It's not only about getting more clients into the system, it's about selling more products to the same clients" to ensure continued profitability, he said.

Mollin compares the profitability of BBVA Bancomer and Banorte with Main St. banks in the United States such as Bank of America, FleetBoston and Wells Fargo. He finds the Mexican banks generate a return on equity ratio of 15% to 16%, "slightly below their U.S. counterparts."

Lower profitability, however, is offset by lower stock price valuations and high growth potential in consumer and commercial lending. He's not expecting a return to growth in the mortgage sector anytime soon.

"We're very positive on Mexican banks.... We think 10% growth in performing loans (at BBVA Bancomer) next year is actually very conservative since it means growing them by US$1.5 billion, or less than US$900,000 per branch," he said.

AT ODDS WITH BUSINESS

Commercial lending has been particularly hard hit by Mexico's low economic growth over the last 18 months.

The weakness of the economy, which last year fell into recession in tandem with the slowdown in the United States, has reduced businesses' appetite for expansion and the demand for new credit. With Mexico's economic destiny so closely tied to that of the United States, economists say any near-term revival of commercial lending depends on what happens north of the Rio Bravo. So long as the United States avoids sliding back into recession, the Finance Secretariat expects Mexican GDP to grow 1.8% this year and 4.4% in 2003.

"The industry isn't so ready to lend when there are no signals of growth," said Nathaniel Karp, an economist at BBVA Bancomer.

Bank credit in Mexico is concentrated in big companies that arguably need it the least. Three hundred of the nation's largest companies hold 74% of the total commercial loan portfolio of US$34.3 billion, National Banking and Securities Commission figures show.

The "AAA" companies, such as Femsa and Cemex, with annual sales of more than US$500 million, don't require loans from Mexican banks "except for a little working capital shortfall," Guarco said. These corporations' credit ratings are in any case higher than a bank like Banorte, so they go directly to the international bond market.

Banks have shunned large, heavily indebted companies in cyclical industries like steel and construction that can't sell global bonds because their credit rating is lower.

Only about 20% of companies with annual sales of between US$100,000 and US$50 million use bank credit. A series of central bank surveys shows half of all small- and medium-sized companies sidestep the banks by getting some form of credit from suppliers.

Smaller companies will be perceived as "very highrisk until banks grow more confident 'the rule of law' is being enforced," enabling them to recover credit guarantees rapidly, said Karp.

Banks contend the lack of unified federal laws governing loan guarantees--and the resulting disparity in the speed at which creditors can recover collateral--act as a drag on lending to companies. They point to the difficulty they had. recovering sureties in the aftermath of the 1995 economic crisis as evidence courts fail to take property rights seriously.

"The banks have placed great emphasis on their unhappiness (with the law regarding loan guarantees)," said Ursula Wilhelm, director of financial institutions rating at S&P in Mexico City. "But we don't think it's the only factor why lending isn't growing. It has to do with a much more rigid credit selection, fewer lending opportunities, the economic downturn and little demand for credit."

RESIDING POTENTIAL

Home loans, which represent 12% of total private sector lending, are where banks face their greatest challenge, if they are to revive long-term lending--and long-term profitability.

Analysts say the best prospects for growth are in the middle-income and residential housing market, where homes typically fetch upwards of $500,000 pesos.

Pent-up demand for middle-income housing could drive a US$10 billion-a-year expansion even though that market is currently only growing at an incremental rate of US$300 million a year, according to Softec S.C., a Mexico City real estate consulting company.

Yet banks are only now returning to the housing market after a seven-year hiatus.

"The amount of new mortgage loans in Mexico is inconsequential to the banks' profitability," said Guarco. "They're really still sticking their toes into the water, and no one's even covered up to their ankles yet. ... They are scared silly about going into (mortgage lending) without the security of knowing they can repossess, that they can get their money back," he said.

Some state legislatures have made an issue of not letting the police repossess homes, said Jorge Alfaro, executive director of consumer credit at Banca Serfin. "That makes us much more cautious in choosing who we're ready to lend to."

Laws have been enacted with the aim of speeding up the process of recovering loan guarantees, but the political will to enforce those laws is lacking, Alfaro says.

One proposal is to develop a set of rules concerning debt default and have local magistrates apply them uniformly. The federal Supreme Court would have to forge a consensus on the code with the courts and lawmakers in each of Mexico's 31 states so that it is exercised consistently.

"The problem is that it's a tremendously anti-popular move," said Mario Rodarte, a director with the Center for Economic Studies for the Private Sector (CEESP).

Memories of homes, cars and consumer durables being seized by banks between 1995 and 1998 persist in the minds of millions. So the image of the government lending a hand to rich bankers at the expense of the poor is an easy target for any politician looking for a quick boost to his or her opinion poll ratings, Rodarte says.

Other commentators argue the industry won't admit that it flooded the judicial system with a wave of repossession cases the courts couldn't cope with. The cause of the crisis thus had less to do with a faulty legal system than the bursting of the credit bubble following a botched privatization in the early 1990s. Moreover, the banks panicked, yanked up interest rates and failed to lend a sympathetic ear to debtors who asked for less onerous repayment terms.

"The bank-client relationship was very hurt and I think the banks haven't recognized they have a strong responsibility for what happened," said Eugene Towle, a consultant and partner at Softec.

As a result, banks are now very picky about who they lend to. They ask for a down payment of at least 30%, much higher than the 5% to 10% usually required by U.S. banks.

"When someone puts 30% down on a house, the probability of them defaulting is pretty low," said Guarco.

By contrast, banks are happier to give auto loans because cars are easier to confiscate and borrowers don't gain title to their vehicle until they pay off the loan.

Baby steps toward reform are nevertheless being made in other areas.

Middle-income contributors to the nation's largest state-run housing trust (Infonavit) can now pledge their Infonavit savings to a bank as a mortgage guarantee. Traditionally, access to Infonavit funds was restricted to buyers of low-income homes. The scheme, called Apoyo Infonavit, is attractive to banks, says CEESP's Rodarte, because costs and risks are low. It's managed cheaply through Infonavit offices and banks can recover the savings from the institute if the contributor defaults.

Analysts say banks need to show more willingness to finance housing construction if they are to make greater headway in the market for new homes.

Fortunately, the government last September provided what observers hope will be a solution to under-funding in the housing market when it set up Mexico's equivalent of the U.S. Federal National Mortgage Association (Fannie Mae). The main role of the Sociedad Hipotecaria Federal (SHF) will be to create liquidity for banks and non-bank financial institutions (Sofoles) by securitizing mortgages. The SHF will begin the process of buying loans and selling bonds backed by borrower payments on those credits in the fourth quarter, a SHF spokeswoman told BusiNESS MEXICO.

Falling interest rates are sooner or later expected to lead to a housing credit revival as monthly installments get closer to rent payments. In March 2001, the lowest annual interest rate on a fixed-rate bank mortgage was 24%. Eighteen months later, Scotiabank Inverlat was offering 14.9% for the first five years of a 20year mortgage.

PAIN FOR BITAL

Banks have also been lending cautiously because they must obey a strict set of rules that say how much capital they must have to confront the risk of default on their assets.

Issued by the Finance Secretariat in 1999, the rules aim to bring the industry into line with standards established in the 1988 Basel Capital Accord. The accord says banks must have a ratio of capital to riskweighted assets of at least 8%. While the industry's average ratio has for several years exceeded the Basel minimum, the secretariat decided to improve capital quality by making banks decrease the range of assets they can book as base capital.

The most important rule says the percentage of deferred taxes comprising base capital must fall to 20% by Jan. 1, 2003, from 40% this year.

That requirement is what finally forced Bital's hand, analysts say. Faced with a capital shortfall of more than US$500 million they would have to fund themselves, the majority of the bank's shareholders decided to sell to HSBC, and let the British bank perform the recapitalization.

Though causing pain for Bital, tough rules are evidence that Mexico is tightening formerly lax capital formulas and improving transparency, the Finance Secretariat says.

"What's important is that we are moving toward international standards in the calculation of capital, so that you can make sure that what you see is really what you get," explained Ingrid Cerwinka, who is adirector of financial analysis at the secretariat.

TWENTY YEARS LATER

Those who lament the banking system's passing into foreign hands blame a string of errors that began with an ill-judged nationalization by the administration of President Jose L6pez Portillo on Sept. 1, 1982.

"If it weren't for L6pez Portillo, the institutions would still be in the hands of (Mexican) nationals," former Bital President Antonio del Valle Ruiz told local media on the 20th anniversary of the state takeover.

A faulty privatization less than a decade later left banks undercapitalized, lacking in regulatory oversight, and administered by amateurs. That fatal combination led to a near total meltdown when economic crisis struck in 1994-and left taxpayers with a US$100 billion tab for the cleanup.

Fears of foreign ownership, however, have proven to be misplaced, analysts say. Mexico's financial institutions are now more profitable, more efficient and better managed thanks to these international banks.

The entry of fresh players like HSBC into the market and increased competition with the Spanish banks from veterans such as Citigroup and Scotiabank will only improve conditions for consumers, says S&P's Wilhelm.

Nor are concerns about what happened in Argentina pertinent here. For starters, Mexico's sovereign debt burden as a percentage of GDP is much lower and the country more stable politically, so massive capital flight from foreign banks is highly unlikely. Nafta also provides an important economic insurance policy, says Guarco.

"Mexico's an incredibly different place to Argentina," he concludes. "It's like the old real estate call: 'Location, location, location.'"

Andrew Watson is a freelance writer and a finance reporter at a Mexico City daily.