Are banking standards in Latin America improving? And which are the best banks? EM finds out in a new ranking that focuses on the banks' intrinsic strengths.
We also ask three experts for their views on the industry.
Participants:
Mauricio Larrain, chairman, Banco Santander Santiago
Arturo Jose Galindo-Andrade, research department, IDB
Peter Shaw, managing director, Fitch Ratings
EM: How strong is banking in Latin America generally?
Mauricio Larrain: 2005 should be a very good year for banking in Latin America as balance sheets are stronger and the economic outlook is highly favourable. Banking is getting stronger in Latin America. After various crises the environment for banks is very healthy.
In Chile banks have performed relatively well even in periods of lower economic growth. Now that the Chilean economy is picking up pace, lending is growing at a yearly rate of about 15% with very strong growth in retail banking. Banks in Brazil and Mexico have also performed well on the back of a more stable global economic outlook. In Argentina, following the debt restructuring, banks are once again generating investor interest. If another global crisis was to develop, Latin American banks are much better placed to cope successfully.
The main challenge for the region's banks is to increase banking levels. Even though lending has begun to grow at a rapid pace the ratio of loans to assets remains relatively low. As interest rates and inflation fall and if there is sufficient opening of markets, economic/political stability, and further deregulation coupled with an adequate supervision then banking levels should improve.
Arturo Jose Galindo-Andrade: Banking in Latin America and the Caribbean is comparatively small. The average level of credit to the private sector as a percentage of GDP in the region is only 32%, a rate significantly lower than that of other groups of emerging market countries (52%).
The size of credit markets is shockingly small when compared with industrialized countries (102.3%). Banking in the region is also extremely volatile. When compared with other regions, Latin America displays the highest average number of crises per country during the past 30 years.
Moreover, when ranking regions by the share of countries that have experienced two or more crises, Latin America comes out first, with 35% of its countries having experienced recurrent crises. This share is almost three times higher than in any other region.
This recurrence is particularly worrisome because banking crises are very costly. However, during the past decade, prudential regulation and supervision have been strengthened throughout the region and a set of financial safety nets have also been strengthening.
Nevertheless there are still crucial vulnerabilities that need to be addressed, particularly dealing with liability dollarization and excessive exposure to public sector risk.
Peter Shaw: The quality of banking in the region varies widely, to be expected in a group of countries whose ratings vary from A- to below B-. In general improving economies, convergence of regulation towards international standards, consolidation, and the often significant presence of strong foreign banks has contributed to improvement over the last decade.
EM: In 2003/4, we saw banks in some countries, notably Chile and Mexico focus on consumer lending. Is this still the trend?
Mauricio Larrain: This will be a trend that should continue at a very strong pace in Chile. Consumer lending including mortgage loans in Chile represents about 30% of total loans. Lending to large corporations represents about 50% of total lending. The stock of total debt per household over yearly annual disposable income is about 45% in Chile compared to more than 100% in more developed markets. This includes mortgage lending.
At the same time the amount of annual disposable income Chilean households have to pay their debts according to the central bank is about 14%, which is also low by international standards, so demonstrating the high potential for retail banking in Chile.
As interest rates have fallen significantly in the past few years, banks have begun to intensify their search for higher margin products and services that retail banking provides. At the same time there have been a number of mergers in the Chilean financial system, which have permitted the larger banks to increase their scale, and, therefore be more efficient and penetrate the retail market.
Arturo Jose Galindo-Andrade: Apparently yes. In 2004 the average growth rate of consumer credit, in real terms, in the seven largest economies of the region was close to 30% (24% excluding Argentina and Venezuela, which were recovering from crises).
In part this compensates for very strong contractions in recent years, and in many countries credit in real terms is still below 1998 levels. However, the trend seems to endure, as economies have got stronger. Commercial credit grew 9% in real terms in 2004 in the countries not affected by crises.
Peter Shaw: The focus on consumer lending is a trend seen across the region, and one we expect to continue. In Chile, wide disintermediation, and concomitant pressure on margins, have led banks down-market to bolster spreads and drive growing fee income.
Mexico's quality corporate borrowers can likewise access domestic and foreign banks, leading banks to start to rebuild consumer portfolios. Brazil's banks, which have historically under-lent to the private sector, have also followed this trend, bolstering margins and achieving significant earnings diversification from retail banking fees.
EM: Is there much lending to corporates?
Mauricio Larrain: Corporate lending still represents about 50% of all loans in the Chilean market. Growth rates are lower than the retail and SME lending rates but it is still an important part of a bank's business. Lending primarily consists of long-term project lending, bridge loans, working capital and foreign trade financing. This market is a very competitive and low spread business, but it is important to point out that it is just one part of the complete banking relationship.
About 60% of the operating profits in the corporate lending segment come from non-lending activities such as cash management, corporate finance and treasury services. These businesses are higher yielding then lending, but to penetrate these markets many times it is necessary to provide lending in order to attract clients and cross-sell the higher yielding products.
Arturo Jose Galindo-Andrade: While it is true that corporate lending did not grow much in 2004, it is important to keep in mind that their share in the stock of total credit is still comparatively large (on average 67%). Moreover, in most countries corporate bond markets have been booming, and to a great extent they have substituted credit, at least for the biggest firms.
Peter Shaw: In the less developed markets, with under-developed local capital markets, the corporate sector is still largely reliant on the banking system for credit; the sectoral breakdown of corporate exposures generally mirrors the makeup of the local economy.
In Brazil, corporate exposure dominates exposure to the private sector, despite the rapid growth of retail lending. This is also the case in most Andean markets, as well as throughout the Central American countries, other than Panama.
EM: Is fee income rising as banks place more emphasis on services and cross-selling?
Mauricio Larrain: In 2004 the rate of growth of fee income in the Chilean banking system was lower than in previous years as the competitive environment intensified. Santander Santiago after various mergers has the largest client base in Chile, but there is still important space to improve the product per client ratio. Therefore, the focus has been to reduce some fees as a way to get clients to use more products.
The bank is also placing greater emphasis on efficient methods to improve cross-selling. Corporate banking now has targets related to increasing retail banking clients through alliances with its large corporate customers. The real estate lending segment is also being used as a more efficient way to directly sell mortgage loans through developers to increase cross-selling. As a result the outlook for fees is positive as cross-selling ratios rise.
Arturo Jose Galindo-Andrade: We have not seen a strong trend in this regard. Currently the average value of the non-interest income to assets in the seven largest Latin American countries is around 1.8% (about 34% of interest income). In 2003 the figure was not significantly different. Banks face increasing competition, which tends to exert downward pressure on the cost of financial services.
Peter Shaw: Historically dependent on net interest margins, many of the leading banks in the region have been successfully building recurring service-based fees. This has been accomplished by leveraging consumer lending, by building the use of credit and debit cards, and by packaging basic banking services together in fee-based packages priced to maximize profitable usage of these service. Having said this, net interest income continues to contribute the lion's share of revenues for most banks in the region.
EM: Are Latin American banks becoming more efficient?
Mauricio Larrain: Absolutely. The main force behind this rise in efficiency has been M&A activity as banks search for scale and large investments in technology. In Chile this process is highly advanced as the four largest private banks account for 60% of total loans and have an efficiency ratio of only 55%.
In 2004 Santander Santiago reached an efficiency ratio of just 46%. In Brazil and Mexico there is even further room for improving efficiency through consolidation. As interest rates fall and margins come under pressure banks will intensify the penetration of retail lending, but this also requires banks to be more efficient as these higher margins could be eroded by inefficient distribution and back office capacities.
Arturo Jose Galindo-Andrade: Compared to their counterparts in developed countries, Latin American banks operate at relatively high costs. On average, during the 1990s, overhead costs as a share of assets were close to 5% in Latin America, The same measure was lower than 2% in developed countries.
Interest rate margins, another measure of efficiency, are three times larger in Latin America and the Caribbean than in developed countries. However there has been a tendency towards increasing efficiency, as foreign banks have entered the region and competition has increased. Nonetheless, there still is a long road ahead as far as raising efficiency levels.
Peter Shaw: The banks are most efficient where they have to be. In Chile and Panama, for example, where spreads are the tightest, banks display efficiency measures that compare well with those of developed-market banks.
In Mexico, where balance sheets of the large banks are dominated by government exposures, revenues have not yet risen to the point where efficiency measures have shown sustained improvement.
Most Brazilian banks also continue to show efficiency measures, which lag well-developed markets. Rigidities built into local labour laws also continue to make it more difficult to reduce payrolls relative to developed markets.
EM: What impact have foreign banks had on the industry?
Mauricio Larrain: The presence of foreign banks has been very beneficial to the development of local financial systems. First, they have added to the intensity of competition, which results in a better product. The larger foreign players have also made important investments in technology and other measures to increase the efficiency of the local banking systems. Finally foreign payers have brought with them know-how in terms of credit and market risk evaluation which is key to a stable banking system.
Arturo Jose Galindo-Andrade: The impact has been mixed. The reduction of entry barriers allowed foreign capital into the region's financial system, stimulating competition. Foreign banks are more efficient, and some of this has spread to domestic banks.
In some countries the entry of foreign banks has also been associated with increased lending to SMEs and to the housing sector, but this is not a generalized pattern throughout Latin America. There also is strong evidence suggesting that foreign banks have helped reduce the volatility of credit at times when deposits have been very volatile. However, during periods of strong economic contraction, they appear to have curtailed credit more than their domestic competitors.
Peter Shaw: The most affected market has been Mexico, where four of the five biggest banks, and 80% of the system's assets, are in the hands of foreign banks. While this has improved the financial strength of these banks, credit policies introduced by foreign shareholders may have contributed to mute lending growth.
Among the big markets, Brazil has seen the least direct impact, with only one of the top five private sector banks in foreign hands. Indirectly, the influx of foreign banks has also contributed to local regulation moving towards international practices.
EM: Are there too many banks in Latin America?
Mauricio Larrain: We believe there is a direct correlation between the levels of inflation and interest rates with the optimal number of banks in a region. As interest rates and inflation decline bank margins come under pressure, which can only be contrasted with an increase in retail lending.
Retail lending has much higher spreads, but also involves higher transactional costs and credit risks. Therefore, scale is key to the success for a retail franchise. As Latin American banks become more retail the number of relevant players should diminish. This has been the case in Chile. The bigger banks are more efficient, more profitable and have a greater proportion of the retail lending business.
Arturo Jose Galindo-Andrade: In many countries the number of banks has shrunk significantly. The average Latin American country has 30% fewer banks now than in 1995. As this process unfolded, strong concerns grew about its impact on the banking industry. The main concern was that concentration would lead to less competition.
However, what we see today is that the reduction in the number of banks has been positive in many ways. Mergers and acquisitions, plus the entry of foreign institutions, have lead to more competition in banking throughout the region.
Peter Shaw: Most of the region's banking systems have seen significant consolidation. At times brought on by systemic crises, this consolidation has reduced the number of banks and concentrated banking assets in fewer institutions, generally a trend that has contributed towards the strengthening of the region's banking systems.
EM: Are banks becoming more regional in their outlook?
Mauricio Larrain: A leader in this sense have been the Spanish banks such as Grupo Santander Central Hispano, which has taken important steps to create a regional franchise, especially in terms of integrating computer systems and of having common credit and market risk policies and other guidelines.
The next step is to further increase co-ordination in terms of product development and commercial strategies, but this depends on the level of banking in the various countries. Non-foreign players have not made many advances in terms of regionalizing their operations.
Arturo Jose Galindo-Andrade: Certainly. Many foreign banks now have subsidiaries in several countries in the region, and several Latin American banks are operating in neighbouring countries. Regional banks are particularly important in Central America.
Peter Shaw: Not really; investments in several countries are largely limited to the foreign banks that have invested in the region, namely BSCH, BBVA, HSBC, and to a lesser degree, Bank of Nova Scotia, Bank of America, and Citibank. With the exception of a few Central American banks, most indigenous banks have remained focused principally on their home markets.
EM: Is the regulatory and legal environment improving?
Mauricio Larrain: After a series of intense banking crises in the 1980s and 90s, banking regulation has greatly improved. This has been a positive force in terms of improving the outlook and stability for Latin America banks. Basel II will be a key advancement.
Arturo Jose Galindo-Andrade: Unfortunately, updating the legal and regulatory framework has been a very slow process. One of the key areas of regulation for the performance of the banking system is the protection of creditors' rights and the efficiency of the courts.
Brazil and Mexico have recently carried out significant reforms to their bankruptcy laws. Most countries, however, are lagging on this score. Regarding prudential regulation, important steps have been taken but there is still much to do in many countries.
Peter Shaw: Banking regulation across the region has moved towards international standards, with the pace of this convergence varying among countries. The principles of Basel I have been widely adopted, with capital requirements generally stiffer than the 8% minimum embodied therein.
The use of ratings has grown, and most regulators have required some form of internal loan classification, and credit bureaus and more frequent inspection have contributed to greater consistency in such classifications. The legal framework has evolved more slowly, with bankruptcy law reform lagging regulatory improvements.
EM: What impact might Basel II have?
Mauricio Larrain: Basel II should be a positive as credit risks are better categorized and operational and market risks, which have been major factors in worsening banking crises, are better provisioned for. This will lead to a more stable banking environment, which is key as the world becomes more global, but also more volatile.
Arturo Jose Galindo-Andrade: It depends on the country you analyze. A few countries in the region have a remarkable regulatory and supervisory framework.
Most probably, these countries will find it useful to move into one of the modalities of Basel II, most likely a version of the IRB (Internal-Ratings Based) approach. Due to the lack of development in rating agencies it is unlikely that the standardized approach will become widely used.
However, most Latin American countries still are behind in complying with the Basel I core principles. In those countries the adoption of Basel II can be a very risky proposal, if they chose to pursue it, since it is unlikely that both banks and supervisors are up the tasks of implementing and monitoring a system like the IRB.
In these cases it is still preferable to push towards compliance with Basel I, making amendments to properly value particular types of risks such as liability dollarization and excessive exposure to government risk.
Peter Shaw: The timetable for the adoption of Basel II will vary widely across the region, with the foreign owned banks likely to lead the way, speeding adoption in those markets where they dominate.
The bulk of the region's banks will eventually adopt the standardized version. One of the principal hurdles to broad adoption of the IRB, and to the quantification of operational risk, is the still early stage of the broad national databases necessary for robust default and loss given default statistics.
Profile - winner
Banco Santander Santiago
It is a measure of Santander Santiago's sound management, financial discipline and product innovation that it is Latin America's highest rated company. The bank has an 'A' rating from Standard & Poor's, an 'A-' one from Fitch, and a Baa1 rating from Moody's. Even if Santander's Santiago's Spanish parent support is stripped out of the equation, and only the bank's intrinsic strength is considered, it still receives a 'B' rating from Fitch.
Chile's biggest financial institution is a model for other banks in the region to follow. Formed following a merger between Santander Chile and Banco Santiago, Santander Santiago offers the full range of banking services in Latin America's most developed financial market. Its business is split into five segments: large corporates; mid-sized corporates; small corporates; mid-upper income individuals; and mid-lower income individuals.
The bank's strategy is simple, according to Robert Moreno, manager of the investor relations department. "Basically it's to grow our market share in retail lending, while on the corporate side we want to increase our volumes in non-lending businesses."
On the retail side, which accounts for 52% of the loan book and between 60% and 70% of overall profits, the bank is leveraging off its big distribution network. Santander Santiago has nearly two million customers – of which 1.7 million are private individuals – and Moreno says the bank wants more but increasing the number of loans is key. "There's a higher spread in retail lending compared to corporate lending," he says.
The bank has no specific target in mind but "we want to grow [our loan book] faster than the market," adds Moreno. In the fourth quarter of last year, Santander Santiago saw its consumer loans grow by 8.1% compared to the end of the third quarter.
This increase will lead to other opportunities, he says. Cross-selling other products, for example, is one area the bank is placing more emphasis. "We're the most efficient bank in Chile," says Moreno. "Our efficiency ratio is 46%."
As for its corporate business, the bank is making strides in cash management and other treasury services, such as selling derivatives. Cash management, in particular, is a big growth area in Chile and can be much more profitable than corporate lending, according to Moreno.
It's in providing services such as cash management where the bank's size and credit ratings prove useful. "Providing cash management requires size. It involves a number of operational issues so it's good to have a big branch network," he says. "Also having high credit ratings gives us an advantage with the big corporates."
The bank is lucky in that it operates in Latin America's most advanced country. For example, mortgages account for between 15%-20% of the bank's loan book, something that other banks in the region can only wish for. As Moreno says: "The mortgage market is not well developed in other countries." Chile also has an open system, where it's relatively easy for a bank to gain a licence. That openness helps create a very competitive environment, says the Santander Santiago official.
The bank also benefits from having a strong parent. Although Santander Santiago operates as an autonomous, local bank it shares some of the same platforms of Spain's Banco Santander Central Hispano (BSCH). That allows the Chilean outfit to have access to systems that are much more advanced than found in other Latin American banks. Santiago Santander's risk management practices, therefore, mirror those of BSCH.
Looking ahead, Moreno says the bank will continue to concentrate on organic growth. With the merger behind it – that was completed in 2003 – the bank is now fully focused on making big profits.
Key personnel
Chairman – Mauricio Larrain Garces
Chief executive – Oscar von Chrismar
Head of international banking – Sergio Innocenti
Outstanding features of Santander Santiago
∑ The highest rated company in Latin America
∑ Fee income grows by 36% in Q4 2004, on a year-on-year basis
∑ A BIS ratio of 14.9% and tier 1 capital of 10.1%
∑ Mortgage loans increase by 4.1% between Q3 and Q4, 2004
∑ Core deposits expand by 5.1% between Q3 and Q4 2004