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Increasing Public Sector Exposure a Credit Negative for LatAm Banks

Increasing Public Sector Exposure a Credit Negative for LatAm Banks

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Fitch Ratings-New York/Monterrey-20 November 2020: Financial and credit pressures will intensify for Latin American (LatAm) banks in 2021 as continued market volatility, weak loan growth, tighter margins, higher credit and operating costs and increasing public sector exposure reduce ratings headroom, Fitch Ratings says. Negative rating pressures have resulted in downgrades for most LatAm sovereigns and government-related entities (GREs) over the past three years, while the ratings of nine sovereigns still have Negative Rating Outlooks amid the accelerated economic fallout from the pandemic.

Sovereign exposure varies among the largest LatAm banking systems, and is primarily in fixed income securities issued by central banks, federal governments or development banks. Mexican, Colombian and Brazilian banks also have relevant sovereign loan exposure at 27%, 26% and 19% of total sovereign exposure, respectively. Conversely, sovereign loan exposure in Panama, Chile and Peru ranges from 8% to 13% of total exposure, while loan exposure in Argentina it is very limited.

As private sector credit demand declined amid a sharp deterioration of economic conditions in 2020, bank loan growth decelerated, with banks heavily focused on collections and management of deposits and liquidity. Excess liquidity has mostly been placed in lower yielding public sector securities, which are generally viewed as the safest investment in a market relative to other domestic issuers.

Fitch views banks’ increased holdings of public-sector assets negatively from a credit perspective given LatAm governments’ weakened credit profiles and the banks’ increasing concentration risk. Mexican banks are the most exposed to public sector assets, while exposure has increased substantially in Argentina where banks mainly invest in central bank securities and other sovereign bonds given the lack of alternative profitable options. We do not expect banks to materially reduce their sovereign exposure in the short term, given the lower capital requirements and attractive risk-adjusted returns for portfolios.

The banks’ sizable government securities holdings have come under pressure, with market volatility reducing net income due to mark-to-market losses. The extent that bank profits are pressured as public sector bond prices fall with rising sovereign risks will depend on the accounting treatment of securities portfolio on balance sheets.

LatAm banks’ considerable sovereign credit risk is from sizable public sector exposures on both sides of the balance sheet. GREs or other public entities such as states and municipalities are usually substantial depositors in LatAm banking systems, which can be more unstable in times of market stress.

In Mexico, credit exposure to states and municipalities became less attractive after the 2016 Fiscal Discipline Law, which reduced profitability for banks. Reforms to the law will allow states and municipalities to raise their indebtedness, allowing banks to potentially increase their public sector exposure, which would be viewed negatively for credit. Attractiveness of state and municipal credit exposure in very low rated countries could decline in the long term when economic activity and private sector lending resumes.

In addition to direct exposure to the sovereign, Fitch’s bank operating environment (OE) scores incorporate sovereign and broader country risks related to banking in a particular jurisdiction. The OE is a high influence factor for most rated financial entities in the current crisis. It is usually constrained by the sovereign rating, which in turn, acts as a rating constraint for the banks´ stand alone, or viability ratings (VR).

The sovereign rating is also a relevant constraint in countries with highly interventionist governments such as Argentina, Ecuador and Bolivia. The potential uplift of bank ratings above the sovereign is typically limited to a maximum of two notches. However, OE scores can diverge from the sovereign Rating Outlook if sovereign strengths are more tied to fiscal and not macroeconomic trends as in Mexico, Peru and Chile.

Fonte : www.fitchratings.com