Learning to Live in a Competitive Market

Less than two years ago, Mexico’s banks were a fragmented, undercapitalized group of mostly locally owned institutions whose main line of business was lending to the government. Those banks that had managed to survive the country’s financial collapse in late 1994 had virtually cut off their credit lines to consumers and businesses. Instead, for the next six years, the Mexican banks focused on profiting from the fat spreads to be earned by lending to the government.

“Anyone who survived [the 1994 crisis] has been pretty much a money manager,” says Othon Ruíz, chief executive officer of Banorte, one of Mexico’s few remaining locally owned financial institutions, which is based in the northern city of Monterrey. With interest rates on government paper of between 25% and 30% a year, and deposit accounts paying under 5%, banks could make a small fortune. During the second half of the 1990s, says Ruíz, Banorte was “doing business on a deposit basis,” both growing deposits and investing them in government paper.

Today, the players and the environment in which they operate are radically changed. Three-quarters of the Mexican banking system is under the control of three multinational banking groups: Citigroup, Banco Santander Central Hispano and Banco Bilbao Vizcaya Argentaria. Together they hold almost 80% of the country’s banking assets. This consolidation and influx of foreign capital has strengthened the banking system, improving its capital structure, technology and management.

At the same time however, interest rates in Mexico have plunged and the main source of profits for Mexican banks has become severely constrained. Now, banks need to increase their lending to businesses and consumers, lower provisioning their costs, make their operations more efficient and increase their generation of fee-based income. Total loans in the Mexican banking system may only represent 15% of the country’s GDP, compared with 70% in the US, but this suggests that the industry is ready for rapid growth.

Manuel Medina Mora, chief executive officer of Banamex, the country’s largest bank since Citigroup bought it for $12.5 billion in May, says banks are reorienting themselves to begin acting once again as financial intermediaries between depositors and borrowers. “I think our main challenge lies in the credit area,” says Medina-Mora. “We have the challenge and the opportunity of channeling our savings and deposit base into lending both to the business and consumer sectors.”

Much of the country’s financial system collapsed in 1994, when the peso crashed. This was the result of massive credit expansion in the first half of the 1990s, for which neither the government regulators nor the recently privatized banks were prepared. The government of President Carlos Salinas had sold many of the banks held by the government since the 1982 debt crisis to stock brokage firms with little or no understanding of the banking business.

“You had a situation in which you had new bankers, and all the marbles to play with,” says Ruíz. “There was no credit culture, so whoever was asking for credit was not really aware of the risk they were taking and whoever was granting it was not really aware of the risk he was taking. Supervision was very poor.”

Interest rates soared after the collapse of the peso in December 1994, driving the country into a severe economic recession. The result was a wave of loan defaults that pushed banks to the brink of collapse. The government intervened to preserve the financial system’s solvency. It set up Fobaproa to do the job and the bank rescue agency took over nearly 30 financial institutions. IPAB, its successor agency, is now in the process of finishing the seven-year clean up that is likely to wind up costing $100 billion. The rescue operation will only be over once the sale of Bancrecer, the only bank still under government control, is completed in September.

Bank balance sheets are healthy again, largely free of the problem loans that undid them. According to an August report by Moody’s, “The Mexican financial system is much better capitalized and enjoys a much greater long-term profitability outlook than at any other time since the privatization of the banks in the early 1990s because of the recent successful marshalling of both foreign and domestic capital.”

Maybe, but the banks are likely to face considerable challenges ahead because they must operate in a far more competitive market than before. “We think the profitability of Mexican banks is going to be under some pressure,” says Peter Cardinal, chief executive officer of Grupo Financiero Scotiabank Inverlat, the country’s seventh-largest bank, which is owned by Canada’s Bank of Nova Scotia. “There will be a focus on higher-margin consumer loans, fee income and much more rigid cost controls.”

Banorte’s Ruíz says that with short-term interest rates having dropped by eight percentage points this year alone, banks have to reorient their businesses and begin implementing sound credit control policies. “Of course we have a lot of work to do with regard to cost reduction and efficiency,” he says. “But most of the actions in that direction take some time, so we have to work in other areas, implementing cost reduction on one side and generating more business on the other side so that you can get a better cost-to-revenue ratio.”

Simply lending more is not enough. Banks need to increase cross-selling of new financial products to their current clientele and attract new customers into the banking system without an excessive decline in credit quality. Banks now service only about a third of the country’s 21 million households, and much of that business consists of deposit accounts. Ruíz says that one of Banorte’s goals is to make sure that it is getting as much business as possible from existing customers. “It’s by far more productive to do more business with the customers that we have as opposed to growing the customer base,” he says. “Cross-selling is a very important strategy for us.”

Ruíz wants to sell more credit cards, insurance, auto loans and home mortgages. “You have to be sure that customers, whether they are corporate or individual, are part of your target market and approach them with a solution.”

Banks are using technology to provide those solutions quickly and efficiently. For example, car dealers can now send credit applications electronically to a Scotiabank Inverlat branch and within three hours receive the potential customer’s credit history. This may sound banal, but achieving this has required banks to develop sophisticated database systems, communication networks as well as aggregating client data.

Peter Cardinal says the bank has cautiously expanded its portfolio of mortgage and car loans since 1996, but with a far lower tolerance for risk than the bank would assume in Canada. It requires higher down payments and debt-service capabilities than Scotiabank in Canada. “We have very rigid loan-to-value policies as well as payment capacity requirements,” he says. “Our lending is a lot more prudent.”

Many of the major banks have become full-service financial services operations, offering customers insurance, as well as pension plans and mutual fund management. Banks own pension fund management companies known as Afores. They are growing at a rate of about $5.5 billion a year. Merrill Lynch says that by 2010, the Afores should accumulate assets of $100 billion. Mutual funds are a novelty, but they are growing fast too. Aggressive promotion of these products by commercial banks helped assets under management grow by 51% in the first six months of this year.

The large banks are also focusing on developing products for the vast mass of middle- and low-income Mexicans that has never even opened a bank account before. Millions of people work or own businesses in the informal economy. However, the banking system does not meet their needs. One of the reasons for this is the high cost of using the banking system. “We really need to penetrate the Mexican economy and create formal mechanisms of payments throughout society,” says MedinaMora. “And that means that we have to cut transaction costs significantly. We need to become more efficient otherwise we will not reach the many millions of Mexicans that cannot afford to pay the structure of traditional banking.”

Banamex will benefit in this area of business from its merger with Citigroup, which owns Asociados, a company that caters to low-income customers by making much smaller loans than are available at conventional banks. “If we are able and creative enough to get to new forms of products and delivery channels and ways to either finance or handle payments we will perform the role that is expected from the banks in Mexico,” he says.

Although Mexican banks know they must reduce transaction costs for one segment of new customers, they must raise costs for others. For decades, banks in Latin America made such healthy returns on lending at high interest rates that they could absorb transaction costs for many of the services they provided. Borrowers ended up largely subsidizing customers who simply used the bank for transactions such as check writing and handling payroll.

As pressure on margins grows with the drop in interest rates, Mexican banks are starting to charge for services they once performed free of charge. Now, they need to earn a return on their investments in technology, branch resources or tellers’ time.

“It is [these] services that require the most investment from banks. Technological platforms, the branch networks, the ATMs,” says Medina Mora. “So providing services requires a lot of investment. [Before], we did not charge the full cost for services. We now have to move toward that and we have done this for the last three years but we still have a long way to go.”

He says that the trend “will rationalize the use of services. You are reflecting the right price in a market economy I would say that is the sensible way to go and a sensible way to run a bank.”