Mexican Commercial Banks

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1 Top 30 Mexican Commercial Banks 1

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3 INTRODUCTION Ratings Services welcomes you to the Top 30 Mexican Commercial Banks, our most recent study on the Mexican banking industry. This report includes among other research pieces our Banking Industry Country Risk Assessment (BICRA) for Mexico, which assess and compares global banking systems using economic risk and industry risk factors; our latest rationale on Mexico; one commentary highlighting our growth prospects for the Mexican banking system and the challenges it could face ahead. Also, this publication includes the rationales of the banks rated by that are part of the Top 30 Mexican commercial banks. In addition, we prepared profiles of the non-rated commercial banks specifically for this publication. The Mexican banking system has grown at moderate rates, reflected in a low banking penetration with respect to other countries in the region. In our view, future loan growth prospects will be limited by factors that set pressure on the household credit capacity, such as the low per capita GDP, a large informal workforce and a relatively weak rule of law. In this sense, the maintenance of adequate underwriting standards would allow banks to keep growing with healthy asset quality and adequate profitability levels. In addition, we believe that capitalization and the systemwide funding will keep supporting the banking industry s performance. We believe that you and other investors worldwide will find our thought leadership commentaries on the sector and our individual bank profiles an important research tool that will facilitate investment decisions. Santiago Carniado Latin America Lead Analytical Manager Financial Services Ratings Services Sergio Garibian Analytical Manager Banks Financial Services Ratings Services 3

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5 TABLE OF CONTENTS Introduction... 3 Mexican Banks Are Well Positioned To Handle Future Growth Fueled By Loans To Consumers And Small And Medium Enterprises... 6 Mexico Long-Term Foreign Currency Rating Raised To BBB+, Local Currency Rating Raised To A ; Outlook Is Stable Bank Industry Country Risk Assessment: Mexico Mexican Financial Institutions And Four Insurance Companies Upgraded After Similar Action On The Sovereign Methodology For Our Selection Of 30 Banks Individual Bank Profiles BBVA Bancomer Banco Nacional de México Banco Mercantil del Norte Banco Santander México Banco HSBC Banco Inbursa Scotiabank Inverlat Banco del Bajío Banco Azteca Banco Interacciones Banco Regional de Monterrey Banco Multiva Banca Afirme Banca Mifel Banco Compartamos Banco Ahorro Famsa Banco Ve Por Más Banco Coppel Banco Invex Bansí American Express Bank México Bank of Tokyo-Mitsubishi UFJ Banco Monex CIBanco ABC Capital Banco Wal-Mart Volkswagen Bank Consubanco Actinver Autofin Related Research Mexico s Financial Reform Delivers Mixed Results Credit Conditions: Growth In Latin America Expected To Pick Up In 2014 Amid Continuing Financial Market Volatility Latin American Banks Lean On Adequate Funding And Liquidity Amid Market Uncertainties Are Good Old Days Over For The Largest Emerging Market Banks? What Does The Rollout Of Basel III s Capital Rules Hold For Latin American Banks? For Mexican Banks, Consumer Lending Is Fueling The Rise In Loss Provisions Will Troubled Mexican Homebuilders Hurt Mexican Banks Credit Quality? S&P Risk-Adjusted Capital Ratios Provide a Consistent Assessment of Latin American Banks Credit Quality Contacts

6 MEXICAN BANKS ARE WELL POSITIONED TO HANDLE FUTURE GROWTH FUELED BY LOANS TO CONSUMERS AND SMALL AND MEDIUM ENTERPRISES Dec 10, 2013 Mexico s consumer segment--including mortgage loans--accounted for 39% of total loans in the Mexican banking industry as of June 30, 2013, and we believe this segment will boost overall lending growth during the next two years. Loans to small and medium enterprises (SMEs) will also support the sector s growth as the SME segment is becoming more attractive for most participants, and since the government has launched a guarantee program for these loans. We believe consumer and SME loans will expand faster than lending for the banking sector on the whole, which should grow 11.5% this year and 13.0% in Given that loans to these two segments have higher delinquency levels with respect to other asset classes, we believe that banks must proceed with caution to avoid significant deterioration in asset quality. In our view, Mexican banks are well positioned to handle future loan growth to consumers and SMEs, which would require higher provisions. Expanding banking penetration remains a key task for Mexican banks, in our view. At the end of 2012, private credit represented less than 26% of the country s GDP, one of the lowest ratios in Latin America; banking penetration in Chile, Brazil and Colombia stood at 77.9%, 53.5% and 36.7%, respectively, in the same period. However, we expect lending expansion to slow in 2013 compared with the past two years before picking up slightly in 2014, reflecting a strong correlation with the country s economic growth. Our expectations for Mexico s GDP growth rate for 2013 is 1.0%-1.5%, and around 3.0% for 2014, while for Latin America we expect GDP growth rates of around 2.5% in from 2.8% in and around 3.0% in Overview We expect the Mexican banking sector s lending to expand by about 11.5% in 2013 and 13.0% in Retail loans, mortgages, and SME loans will drive growth during the next 12 to 18 months. The Mexican banking sector s capitalization will remain stronger than that of other financial systems in Latin America. Credit loss provisions relative to operating revenues are increasing, although banks earnings capacity will remain adequate. Asset quality metrics are deteriorating due to higher consumer lending, but we don t expect this to hurt profitability. We expect Mexican banks to maintain good operating performance during the next 12 to 18 months. Profitability will benefit from improving net interest margins (NIMs), due to a higher proportion of retail loans, and better efficiency (measured as noninterest expenses to operating revenues). These would generate good returns on assets (ROAs) of about 1.25% on average, despite our expectation for higher provisions against bad loans. Good profitability and adequate asset quality metrics will allow banks to maintain their adequate internal capital generation capacity. As a result, we expect Mexican banks capital levels to remain as a credit strength. Although the U.S. Federal Reserve announced its decision to maintain its $85 billion monthly bonds and mortgages purchases, we believe this monetary policy will change in the near future. Tapering of these buybacks will likely alter the dynamics of capital flows into Latin America, including Mexico. In fact, the expectation that the Fed will change its monetary policy has made Latin American currencies highly volatile for the past few months, and Mexico has been no exception. In addition, we expect financing costs to go up. However, foreign-currency funding accounts for just 8% of the Mexican banking sector s total deposits, interbank loans, and repos (as of Aug. 31, 2013). Moreover, the sector s funding base consists predominantly (85%) of low-cost deposits, and it maintains a loan-to-deposit ratio consistently below 100%. As such, we expect the effect of lower foreign currency funding to be limited. According to our new stable funding ratio (measured as available stable funding divided by stable funding needs) the sector s average was 102%, and its liquidity (measured by broad liquid assets to short-term wholesale funding) was 1.5x as of June 30, Both ratios are, in our view, adequate under our base-case scenario. 6

7 Mexico s Modest Growth Prospects Are Hampering Lending Expansion After the global financial crisis--which resulted in a severe contraction in Mexican GDP by 6.0% in the banking system s total loans have grown at a compound annual rate of 12.4% during the last three years, after surpassing 22% during 2006 and During the second half of 2012 and the first half of 2013, the slowing Mexican economy has further undercut lending growth. In our view, lower-than-expected U.S. GDP growth, tighter conditions in global financial markets, the contraction in Mexican government spending during the first half of 2013, and soft domestic demand resulted in a sharper-than-expected slowdown in Mexico s economy. We expect this slow down to remain during the second semester of 2013 due to the current economic conditions and considering the extensive damage from Hurricane Ingrid and Tropical Storm Manuel. As a result, we expect about 11.5% growth in lending for the banking sector by the end of GDP growth expectations for 2014 are more optimistic (around 3.0% versus the 1.0% to 1.5% estimate for 2013), and we believe the lending pace will rise to about 13.0%. Consumer loans and mortgages have boosted the sector s expansion in recent years. During the past 12 months, these two business segments grew 17.6% and 9.8%, respectively, while corporate and commercial loans--including loans to financial institutions and government--increased by 8.4%. We expect these growth rates to continue apace through 2013, and keep supporting the banking sector s growth during the next two years. Mortgages, credit cards, and payroll discount loans accounted for 43%, 26%, and 11% of banks overall consumer loans, respectively, as of June 30, We expect mortgage lending to keep growing at low double-digit rates during 2013 and 2014, with growth in credit cards and payroll discount loans at about 15%. Mexican banks have expanded the share of consumer loans to 38.9% of their aggregate portfolios as of June 30, On the other hand, the pace of growth has slowed for corporate and commercial loans, including financial institution and government loans. In our opinion, this reflects the fact that large Mexican companies have been tapping low-cost funding through market issuances (replacing banking debt) due to low interest rates during the past few years. However, we expect that once the Fed begins tapering its bond and mortgage purchases, yields will increase, and corporate borrowers will look more to banks for financing. The latter, along with our expectation of higher credit supply for SMEs will likely spur lending growth of above 10% for the commercial segment, during the next two years. We believe corporate and commercial loans will keep representing about 60% of total loans during 2013 and Rising Proportion Of Consumer Loans Of Mexican Bank s Total Loans Other consumer loans Auto loans Payrolls Personal loans Credit cards Mortgages (%) 100 Consumer loans/total loans (Right scale) 39.5% % 39.0% % % % 37.5% % % 0 June 30, 2011 June 30, 2012 June 30, % Source: Comisión Nacional Bancaria y de Valores 7

8 Financial Performance Remains Adequate Despite Increasing Credit Costs The Mexican banking sector continues to generate good profitability levels. We believe this is due to moderate credit expansion, an improving trend in NIMs--which now represents one of the highest margins among its regional peers like Peru, Colombia, Brazil, and Chile--and good efficiency levels that are in line with those of these regional peers. In our view, the sector s higher risk appetite--as the rising share of consumer and SME loans demonstrates--will raise provisioning costs. However, we expect asset quality metrics to remain adequate, mitigating pressure on bottom-line results by containing credit costs. We believe profitability will remain relatively stable during the next 12 to 18 months, as we expect ROA to be about 1.25%, efficiency levels of 50%-55% (noninterest expenses to operating revenues), and credit loss provisions of about 25% of operating revenues. The rising share of retail loans and mortgages--38.9% as of June 30, 2013, up from 35.8% at the end of and higher penetration of the SME business segment have improved the sector s NIMs, given that these products have higher lending rates. We expect NIMs to keep rising during 2013 and 2014, as banks continue to expand their consumer and SME business lines. In an effort to stimulate consumption, and therefore boost the country s economic performance, the central bank has been lowering its reference interest rate, which is currently at 3.50%. In our view, this won t weaken the banks NIMs because on the lending side, we do not expect asset rates to drop significantly; deposits account for 85% of the banks funding, and the loan-to-deposit ratio is consistently below 100%, keeping funding costs low and relatively stable. In light of these factors, we expect average NIMs of about 7.3% during the next 12 to 18 months from 6.8% during 2010 and During the past several years, credit loss provisions have represented about 20% of the sector s operating revenues. By the end of 2013 and 2014, we expect this ratio to increase to 25% due to higher nonperforming loans (NPLs) in consumer portfolios and, to a lesser extent, commercial portfolios (related to troubled large homebuilders). At the end of the first half of 2013, credit loss provisions for consumer loans accounted for 69% of total provisions, followed by commercial loans at 22% (up from 12% in 2012), mortgages at 6%, and government loans at 2%. The banking regulator announced new rules for provisioning commercial loans-- based on 12-month expected losses--at the end of the second quarter of However, the deadline for complying with the new rules is Dec. 31, 2013, and we don t expect banks bottom-line results to weaken, given that banks will use capital to meet the new reserve requirements in most cases. Return On Average Assets Among Latin American Banking Sectors Mexico Brazil Chile Peru Colombia (%) jun

9 Mexican Banks Adequate Risk Positions Are Supported By Its Asset Quality And Manageable Credit Losses Due to the global financial crisis, the Mexican banking sector s nonperforming assets (NPAs, which include both nonperforming loans and foreclosed assets) peaked at 3.3% of total loans at the end of 2009, while gross credit losses topped out at 6%. Although NPAs were slightly higher than crisis levels at the end of the first half of 2013 (3.5%), loan loss reserves covered them by 1.5x. In addition, gross credit losses during the past 12 months were a manageable 2.6%, significantly below 2009 levels. In our opinion, Mexican commercial banks will struggle to maintain adequate asset quality metrics due to the prevailing global and local market conditions, subdued GDP growth of 1.0%-1.5% in 2013, the rapid pace of growth in consumer and SME loans, and, to a lesser extent, exposure to troubled large homebuilders (see Will Troubled Mexican Homebuilders Hurt Mexican Banks Credit Quality? published on July 15, 2013, and For Mexican Banks, Consumer Lending Is Fueling The Rise In Loss Provisions, Aug. 8, 2013). Consumer loans accounted for 67% of gross credit losses at the end of 2011 and 75% for Although NPLs related to commercial loans have risen at a faster pace (40%) than for total loans (33%) during the past 12 months, we expect consumer loans will still represent the bulk of gross credit losses at the end of In view of these factors, we believe gross credit losses could total about 3% during the next 12 to 18 months, and that NPAs will rise but remain manageable and fully covered by reserves. In our view, these asset quality metrics would still be in line with those of its banking system peers, providing stability to banks risk positions. Mexican Banking Sector s Charge-offs 100.0% 90.0% 80.0% Commercial Mortgages 5.6% Consumer Other 6.0% 5.0% 70.0% 60.0% 4.2% 3.7% 4.0% 50.0% 40.0% 30.0% 2.5% 2.4% 2.9% 3.0% 2.0% 20.0% 10.0% 1.0 % 0.0% jun % Internal Capital Generation Will Support Adequate Capitalization For several years, we have considered capitalization to be one of the Mexican banking sector s main strengths. When the Mexican banking regulator announced its intention to implement Basel III rules at the beginning of 2013, we were confident that it would be a relatively smooth process considering that, in general, Mexican banks capital consists primarily of Tier 1 elements and given that the average regulatory capitalization index for the industry (15.95% at the end of 2012) was considerably higher than the minimum regulatory requirement (8% before the implementation of Basel III rules). At the end of the first half of 2013, the banks average regulatory capitalization was 16.22%, well above the Mexican regulator s new minimum of 10.5%. The funding, liquidity, and leverage ratios assessment will be in effect through 2018 under Basel compliance. 9

10 According to our risk-adjusted capitalization (RAC) measure, the Mexican banking sector s capital levels remain adequate. The average RAC ratio was 9.7% at the end of We don t expect any significant pressure on this ratio considering our loan growth expectations for the banking system at year-end 2013 and Despite the higher share of loans to consumers and SMEs, which generally come with higher capital requirements, we expect banks internal capital build-up will continue to support adequate RAC ratios during the next 12 to 18 months. Risk- Adjusted Capital Ratio Among Latin American Banking Sectors* (%) Mexico Chile Peru Brazil Colombia *As of December On Oct. 31, 2013, Mexico s Congress approved the fiscal reform proposed by The Peña Nieto Administration. The fiscal reform includes a change in the fiscal regime regarding dividends distributed by legal entities in Mexico (see our FAQ titled How Mexico s Proposed Tax And Energy Sector Reforms Could Affect The Sovereign Ratings, Oct. 10, 2013). This fiscal reform considers establishing a 10% tax on the dividends paid--corresponding to income generated since Jan. 1, by a Mexican legal entity to its shareholders, when these are national or foreign individuals or legal entities. In this sense, we believe that some legal entities- -including banks--could choose to push up dividends payments that were originally budgeted after year-end This would be reflected in higher payout ratios in 2013 versus 2014, as, in general, we do not expect additional dividend payments during However, we believe that if commercial banks operating in Mexico were to choose to pay dividends to their shareholders that correspond to income generated before Jan. 1, 2014 in advance, their RAC ratios would return to current levels in about six to 12 months. This is because we believe that banks respective internal capital generation capacities would support their capital, and because 2014 dividends would be marginal with respect to those paid in We believe that the Mexican banking system will continue to face challenges as banks try to maintain asset quality metrics at manageable levels and good operating performance, considering current economic growth prospects for the country and greater participation in the consumer and SMEs segments. However, we believe banks are poised to handle future growth based on better economic prospects for the coming years considering their adequate capitalization levels and good profitability. Analytical Contacts: Alfredo Calvo, Mexico City (52) ; alfredo.calvo@standardandpoors.com Arturo Sanchez, Mexico City (52) ; arturo.sanchez@standardandpoors.com Jose M Perez-Gorozpe, Mexico City (52) ; jose.perez-gorozpe@standardandpoors.com 10

11 MEXICO LONG-TERM FOREIGN CURRENCY RATING RAISED TO BBB+, LOCAL CURRENCY RATING RAISED TO A ; OUTLOOK IS STABLE Dec 19, 2013 Overview The passage of a landmark energy reform, supported by some changes in the fiscal framework, bolsters Mexico s growth prospects and fiscal flexibility in the medium term. We are raising our long-term local currency sovereign credit rating on Mexico to A and our long-term foreign currency rating to BBB+. We are raising our short-term local currency rating to A-1 and affirming our short-term foreign currency rating at A-2. The outlook is stable, balancing the challenges of implementing these ambitious reforms in 2014 and 2015 with the benefits of increased fiscal flexibility and more dynamism in the economy that we expect to be realized only over the medium term. Rating Action On Dec. 19, 2013, Ratings Services raised its long-term local currency rating on Mexico to A from A- and its long-term foreign currency rating to BBB+ from BBB. At the same time, we raised the short-term local currency rating to A-1 from A-2 and affirmed the short-term foreign currency rating at A-2. The outlook on our long-term credit ratings on Mexico is stable. We raised the T&C assessment to A+ from A. Rationale The Mexican Congress and state legislatures just passed a constitutional amendment to open the energy sector to private investment. This is a watershed moment for Mexico. The energy sector has been effectively closed to private investment during the last 75 years. The amendment requires the passage of important secondary legislation next year, and successful implementation of this reform in the coming years will be crucial. In our view, the approved changes to the constitution, including the so-called transitory articles that provide more detail on the opening of the sector, have the potential to attract significant investment across the entire energy sector. Tapping into Mexico s vast oil potential should energize investment and growth throughout the economy, but we also believe that we won t see its tangible effects on economic activity for a number of years. The ratings on Mexico reflect its track record of cautious fiscal and monetary policies, which have contributed to low government deficits and inflation, bolstered economic resilience, and contained fiscal and external debt levels. However, the sovereign s limited fiscal flexibility and moderate trend economic growth rate have constrained the ratings. About one-third of the country s total budgetary revenues comes from the oil sector, which renders the government vulnerable to volatile oil prices and potential declines in oil production over the medium term. In addition, the non-oil tax base is low at 9%-10% of GDP and has historically proven politically difficult to increase. Passage of this landmark energy reform not only bolsters Mexico s growth prospects but also its fiscal flexibility by eventually strengthening its oil revenue base. Recent changes in Mexico s budgetary framework will likely result in continued solid fiscal management in Mexico. The government has introduced measures aimed at reaching greater transparency in its fiscal target; it has legislated caps on a portion of discretionary spending in order to reduce pro-cyclicality in the budget. Although the passage of these new policies is an important signal of the government s intentions, only through effective implementation will the government establish a track record. The government aims to save more windfall oil revenues than it has in the past--up to 10% of GDP--in a so-called sovereign wealth fund. While this could further bolster fiscal flexibility, meaningful savings would likely only materialize when production from the new oil contracts begins in the coming years. The congress also approved a tax package aimed at raising non-oil revenues by almost 2.5% of GDP by In the past, the government has had difficulty realizing projected increases on the tax base following tax reforms. Assuming the full increase in revenue is in fact realized, which depends on eliminating the subsidy on domestic gasoline, non-oil revenues would remain low compared with peers globally and weigh on fiscal flexibility. General government revenues of about 19% of GDP compares with revenue of more than 30% of GDP for Mexico s peers we rate similarly. 11

12 We expect real GDP growth of 3% in 2014 and 3.5% in 2015, up from 1.2% in The increase reflects a pickup in the U.S. economy and reversal of some one-off factors in Mexico that underpinned low growth in The lead time needed to realize increased investment in Mexico s oil sector does not suggest any immediate boost to investment, except for that associated with improved investor sentiment. We project that the general government deficit will rise higher than 3% of GDP in 2014 but decline sometime thereafter. We expect net general government debt to be about 37% of GDP over the next several years. Mexico s external vulnerability has risen somewhat over the past two years despite a low current account deficit, given higher nonresident holdings of locally issued government securities. We estimate these holdings at US$140 billion this year, higher than US$121 billion as of December 2012 and up from US$69 billion in As a result, the country s external debt, net of liquid assets, is more than 40% of current account receipts (CAR) from an average 32% during We expect the ratio to remain about 43% of CAR over the forecast period as the pace of these inflows moderates somewhat. The absence of large current account imbalances (at about 1.5% of GDP) results in comparatively low external financing needs versus some peer issuers. The Mexican peso is freely floating and, by our criteria definition, an actively traded currency. Our local currency rating on Mexico is two notches higher than the foreign currency rating. We based the notching on several factors. These include our assessment of Mexico s policy flexibility and supportive institutional framework, which includes the country s independent monetary policy and track record of stable inflation and a floating-exchange-rate regime. In addition, Mexico has an active local currency fixed income and money market, which accounts for about 40% of GDP. The A+ transfer and convertibility assessment is three notches higher than our BBB+ long-term foreign currency sovereign credit rating. It reflects opinion that the likelihood of the sovereign restricting access to foreign exchange needed by Mexico-based nonsovereign issuers for debt service is significantly lower than the likelihood of the sovereign defaulting on its foreign currency obligations. Mexico s open foreign exchange regime and outward-oriented economic policies suggest a lower likelihood of resorting to such restrictions in a downside scenario than in more interventionist sovereigns. CARs account for more than 30% of GDP. Outlook The stable outlook balances the challenges of effectively implementing the numerous reforms in 2014 and 2015 with their benefits--increased fiscal flexibility and more dynamism in the economy--that are likely to begin in subsequent years. The improved prospects for private investment as a result of the energy reform will likely take time to translate into higher economic growth and a stronger, less-volatile revenue base. A more dynamic energy sector is likely to strengthen the competitiveness of the nonenergy sector over time. We could raise the ratings should faster-than-expected and effective implementation of the recent reforms strengthen Mexico s growth and fiscal profile rapidly while keeping external vulnerabilities in check. Failure to effectively implement the recent reforms over the next few years could contribute to potentially weaker investor confidence and low GDP growth. Inability to gradually reduce dependence on volatile energy revenues, combined with unexpected changes in fiscal policies, could increase the vulnerability of public finances to adverse shocks. The resulting erosion of Mexico s economic and financial profile could lead to a downgrade. 12

13 Summary Statistics Mexico--Selected Indicators e 2014f 2015f 2016f Nominal GDP (bil. MXN) 10,533 11,404 12,257 12,094 13,282 14,531 15,588 16,390 17,557 18,844 20,323 Nominal GDP (bil. US$) 966 1,044 1, ,052 1,172 1,184 1,280 1,382 1,520 1,666 GDP per capita (US$) 9,174 9,796 10,228 8,213 9,589 10,571 10,572 11,323 12,104 13,174 14,298 Real GDP growth (%) Real GDP per capita growth (%) Change in general government debt/gdp (%) General government balance/gdp (%) General government debt/gdp (%) Net general government debt/gdp (%) General government interest expenditure/ revenues (%) Other depository corporation claims on resident nongovernment sector/gdp (%) CPI growth (%) Gross external financing needs/cars plus usable reserves (%) Current account balance/gdp (%) Current account balance/cars (%) Narrow net external debt/cars (%) Net external liabilities/cars (%) f--forecast Other depository corporations (DC) are financial corporations (other than the central bank) whose liabilities are included in the national definition of broad money. Gross external financing needs are defined as current account payments plus short-term external debt at the end of the prior year plus nonresident deposits at the end of the prior year plus long-term external debt maturing within the year. Narrow net external debt is defined as the stock of foreign and local currency public- and private-sector borrowings from nonresidents minus official reserves minus public-sector liquid assets held by nonresidents minus financial-sector loans to, deposits with, or investments in nonresident entities. A negative number indicates net external lending. CARs--Current account receipts. CPI--Consumer price index. The data and ratios above result from own calculations, drawing on national as well as international sources, reflecting independent view on the timeliness, coverage, accuracy, credibility, and usability of available information. Related Criteria And Research Related Criteria Sovereign Government Rating Methodology And Assumptions, June 24, 2013 Methodology For Linking Short-Term And Long-Term Ratings For Corporate, Insurance, And Sovereign Issuers, May 7, 2013 Criteria For Determining Transfer And Convertibility Assessments, May 19, 2009 Related Research Credit FAQ: How Mexico s Proposed Tax And Energy Sector Reforms Could Affect The Sovereign Ratings, Oct. 10, 2013 Mexico, May 30, 2013 Sovereign Defaults And Rating Transition Data, 2012 Update, March 29,

14 In accordance with our relevant policies and procedures, the Rating Committee was composed of analysts that are qualified to vote in the committee, with sufficient experience to convey the appropriate level of knowledge and understanding of the methodology applicable (see Related Criteria And Research ). At the onset of the committee, the chair confirmed that the information provided to the Rating Committee by the primary analyst had been distributed in a timely manner and was sufficient for Committee members to make an informed decision. After the primary analyst gave opening remarks and explained the recommendation, the Committee discussed key rating factors and critical issues in accordance with the relevant criteria. Qualitative and quantitative risk factors were considered and discussed, looking at track-record and forecasts. The chair ensured every voting member was given the opportunity to articulate his/her opinion. The chair or designee reviewed the draft report to ensure consistency with the Committee decision. The views and the decision of the rating committee are summarized in the above rationale and outlook. Analytical Contacts: Lisa M. Schineller, PhD, New York, 1 (212) ; lisa.schineller@standardandpoors.com Roberto H Sifon-Arevalo, New York, 1 (212) ; roberto.sifon-arevalo@standardandpoors.com Sebastian Briozzo, Buenos Aires, 54 (11) ; sebastian.briozzo@standardandpoors.com 14

15 BANK INDUSTRY COUNTRY RISK ASSESSMENT: MEXICO July 8, 2013 v Economic Risk 5 Industry Risk 3 Economic Resilience Economic Imbalances Credit Risk In The Economy High Risk Very Low Risk High Risk Institutional Framework Competitive Dynamics Systemwide Funding Intermediate Risk Low Risk Low Risk BICRA Group 4 Government Support Supportive v Major Factors Strenghts: Stable macroeconomic framework; Low private-sector leverage; Absence of economic imbalances, or asset price bubbles; and Stable and large deposit base and adequate funding alternatives. Weaknesses: Low GDP per capita, slow economic growth; Economy is highly dependent on the U.S. economy and vulnerable to its business cycles; Significant informal workforce; and Inefficient rule of law. Rationale Ratings Services classifies Mexico s (local currency A-/Positive/A-2; foreign currency BBB/Positive/A-2) banking sector in group 4 under its Banking Industry Country Risk Assessment (BICRA). Other countries in group 4 are Brazil, Peru, Qatar, Malaysia, and South Africa (see Chart 1). A BICRA is scored on a scale from 1 to 10, ranging from the lowest-risk banking systems (group 1 ) to the highest-risk (group 10 ). BICRA Comparison: Mexico Versus Peers Peru Peer Average* Higher Risk Less Risk Economic resilience Economic imbalances Economic Risk Credit risk in the economy Institutional framework Competitive dynamics Industry Risk Systemwide funding * Peers are Brazil, Mexico, Czech Republic, Israel, Malaysia and South Africa.Each concentric line corresponds to our six-point scoring system. Points father away from the center indicate higher risk. Source: Standard & Poor's Financial Institutions Ratings Standard & Poor's

16 Our bank criteria use our BICRA economic risk and industry risk scores to determine a bank s anchor, the starting point in assigning an issuer credit rating. Mexico s economic risk is 5 and its industry risk is 3. The anchor for banks operating only in Mexico is bbb. Mexico s economic risk reflects its low per capita GDP, which limits the country s ability to withstand economic downturns and constrains household credit capacity. Although Mexico has maintained macroeconomic stability, its economy still lacks dynamism. Low-income levels, a large informal workforce and relatively weak rule of law limit credit growth prospects and banking penetration. These conditions result in high credit risk. On the positive side, the Mexican financial system shows no economic imbalances as credit has grown at a moderate pace compared to GDP, and housing prices have remained fairly stable over the past five years. With regards to industry risk, in our view, banks have adequate underwriting standards, good profitability, thanks to a healthy competitive environment. Its adequate regulatory framework follows international standards and has fostered healthy capitalization levels in the system. An adequate and stable core customer deposit base supports Mexico s systemwide funding. Economic And Industry Risk Trends We view Mexico s economic risk as stable. We believe that even if the government is successful in passing and implementing reforms to foster macroeconomic stability, improve competitiveness and productivity throughout the economy, and strengthen Mexico s fiscal accounts, the effects on the financial system will be gradual. In particular, we do not expect a dramatic improvement in per capita income levels or rule of law over the short term. Also, we expect credit expansion to remain moderate and housing prices constant, leading to stability in terms of economic risks. In our view, Mexico s industry risk is stable. We believe that the financial system s funding structure and its competitive environment will remain healthy over the coming years. We also believe that its institutional framework will continue to develop and that Mexico will adopt International Finance Reporting Standards (IFRS) at some point over the next two to three years. On the other hand, if Mexico implements interventionist measures, through the upcoming financial reform, that cause distortions in the system, we would view this as a negative development. Economic Risk Mexico s 5 economic risk score is based on our assessment of its economic stability and resilience as high risk, our assessment of the economic imbalances as very low risk, and our assessment of credit risk in the economy as high risk. Economic resilience: High risk Our assessment of economic resilience is based on Mexico s low per capita GDP (see Table 1), which limits the country s ability to withstand economic downturns and constrains household credit capacity. Our assessment also considers the historical lack of dynamism in the country s economy and its vulnerability to U.S. business cycles, despite macroeconomic stability and relatively low political risk. Table 1 Resilience --Year ended Dec f 2014f Nominal GDP (bil. $) 1, ,036 1,161 1,177 1,348 1,470 Per capita GDP ($) 10,165 8,107 9,437 10,473 10,515 11,923 12, (%) Real GDP growth 1.2 (6.0) Inflation rate (CPI) Change in general government debt as % of GDP Net general government debt as % of GDP f--forecast. Source: Financial Institutions Ratings.

17 Economic structure and stability. Government policies have fostered economic stability, though GDP growth has averaged a low 2.3% in the past 11 years and 1.1% on a per capita basis. This slow growth rate does not satisfy demographic or work force trends and productivity is weak. Key economic sectors lack competitive dynamism, and are dominated by a few large companies. Poverty rates have risen and the population, whose income is insufficient to cover basic needs (food, health, education, clothing), rose to 52% of the total in 2010 (last figure available), up from 48% in 2008 and 43% in The banking sector has the capacity to grow, but credit provided by financial institutions is still very low, at 26% of the GDP (18% if we only consider commercial banks). Due to the lack of more buoyant growth prospects and given the size of the informal workforce and poverty rate, the banking system has limited prospects for expansion without incurring higher risks. Mexico s economy grew at 3.9% in 2012, thanks to robust domestic demand and net exports. We expect growth to slip to 3.2% in 2013, as the output gap has closed and given weakness in U.S. industrial production in the second half of We then expect growth to average 3.4% in the next several years, near estimates of potential GDP growth, although this rate is subdued compared with that of most other emerging economies. Robust reform momentum, however, could lead us to improve our medium-term growth outlook. Macroeconomic policy flexibility. Mexico shows an adequate track record of cautious fiscal and monetary policies, which have contributed to low government deficits and inflation, have bolstered economic resiliency, and contained fiscal and external debt levels. However, the sovereign s limited fiscal flexibility and modest medium-term growth prospects constrain our economic risk assessment. About 35% of the country s total budgetary revenues come from the oil sector, which makes the government vulnerable to volatile oil prices and potential declines in oil production over the medium term, especially since the non-oil tax base is low. We expect Mexico s fiscal debt and deficit indicators to remain fairly steady. We also expect net federal debt, which was 36% of GDP in 2012, to remain stable during The federal deficit will edge lower, averaging 2.6% of GDP in , down from 2.8% in Mexico s revenue base--its non-oil tax base in particular--is lower than that of its peers and constrains the sovereign ratings. We expect overall public sector revenues to hold steady at about 23% of GDP in This is consistent with expected federal revenues of 18% of the GDP, but is much lower than that of most of its similarly rated peers, which tend to have revenues exceeding 30% of GDP (a median of 33% of GDP for BBB sovereign ratings). Mexico s formally independent central bank conducts its monetary policy under an inflation-targeting framework, amid a floating exchange-rate regime. The Banco de México (Banxico) has a single mandate: to maintain stable, low inflation rates; therefore, it supports sustained growth and job creation. Inflation has remained in the single digits since Since January 2008, Banxico s operational target has been the overnight interbank rate to manage inflation and inflation expectations. The inflation target for is 3%, with a margin of plus or minus 1%, unchanged in recent years; however, inflation in Mexico has never dropped below 3%. For 2013, a closed output gap and well-contained wage increases underpin a stable inflation outlook. We expect inflation to average 3.5% in 2013 and Political risk. Mexico s political parties support sound macroeconomic policymaking, which has an established track record of cautious macroeconomic management. Well-trained technocratic teams have led the government s economic management. The independent central bank garners broad support, as its efforts to maintain low inflation. The fiscal framework incorporates a rules-based budgetary process, with a fiscal responsibility law that sets parameters in terms of the maximum size of the deficit and incorporates oil prices into the budget. The new administration has an ambitious reform agenda, which is aimed at improving competition and productivity throughout the economy and strengthening the country s fiscal accounts. The financial reform in the agenda might benefit the banking sector; however, there is a latent possibility that it will include interventionist measures, which we would consider as negative. During the last decade, previous administrations were unsuccessful in implementing reforms, given their contentious nature and the need to coordinate across party lines in Mexico s politically divided Congress, as is still the case today. In our view, there is a greater likelihood that reforms will be approved, due in part to the president s stronger political capital. However, passage is by no means assured. Economic imbalances: Very low risk. The economic imbalances factor focuses on credit-fueled asset price bubbles and persistently lopsided current account flows, which affect financial institutions. 17

18 In our view, Mexico continues its expansionary phase, reflected in moderate credit expansion that will likely continue over the next two years. Housing prices have been relatively stable since the global economic slowdown in 2008, which, in our view, is the result of more restrained mortgage credit supply. The country s GDP growth has also been moderate over the past two years following a strong rebound after the 2009 recession. For the next two years, we expect no major changes unless reforms take place, which could lead to faster economic and credit growth. In our base case, we consider GDP growth of 3.2% and 3.5% for 2013 and 2014, respectively. This will probably lead to a mild slowdown in credit growth, which could be about 12% annually through This would add 1% annually to Mexico s credit-to- GDP ratio over the next two years. We also expect housing prices to remain stable with an annual real growth of about 1% over the same period. Credit losses might edge up during 2013 and 2014 due to the expected slight economic slowdown and the current slump in the homebuilders sector; however, this represents only a small portion of the total loan portfolio. These assumptions support our assessment of very low risk with regards to economic imbalances. Private-sector credit growth. Mexico has one of the lowest ratios of domestic credit to private sector and nonfinancial public enterprises to GDP in Latin America, at about 26% (18% if we only consider commercial banks and exclude Infonavit and Fovissste-- two government-affiliated lending agencies--and other nonbank financial institutions). Private-sector debt to GDP has remained fairly stable over the past five years, with credit growth adding an average of 0.5% to this ratio over this period. We expect banking penetration to remain very stable in the next two years; our base case assumes about 28% by In our view, low banking penetration is partially due to the following factors: a significant informal economy, low average incomes (measured by per capita GDP), borrowers relatively weak track record for paying off loans--specifically the informal workforce, the small and medium enterprises (SMEs) relatively unsophisticated accounting practices, and a challenging legal environment. The government is currently working on a financial reform to tackle some of the factors that constrain banking penetration. However, in our view, results won t be immediate due to the need for long-term structural changes. Increased banking penetration requires systemic, cross-agency, and cultural changes over the next few years (please see Mexican Financial Reform Is Welcome, But Its Benefits Will Take Time to Emerge, published on RatingsDirect on April 16, 2013). Real estate prices. Real residential housing prices have grown at a very slow pace, 0.9% on average over the last three years, and we expect to hold steady for We believe housing prices should pick up slightly over the next two years as the government increases credit availability through its various agencies and in particular through Infonavit. Still, we don t expect greater credit access to result in asset price bubbles. There is no reliable source of information for commercial real estate (CRE) prices in Mexico; however, the banking sector s exposure to the construction and CRE sector is limited. During the 1995 financial crisis, loans to this sector resulted in major losses for the banking system and the deposit insurance agency (IPAB) after the rescue. As a result, real estate developers, especially housing developers, were financed by specialized non-bank banks (Sofoles) before the crisis of , but most of these finance companies defaulted after the crisis and only major developers are financed by banks. As of year-end 2012, the banks loans to this sector accounted for only 1.5% of total loans. The recent defaults by large developers will likely contribute to a slight increase in bank losses during 2013, although this will have little impact across the system. Equity prices. The banking system has very limited exposure to the stock market. Banks traditionally invest in government debt instruments, and due to overall conservative investment practices and the small and concentrated stock market in Mexico, we don t expect this trend to change. Current account imbalances. Mexico s external vulnerability rose somewhat over the past year, despite a very low current account deficit, since nonresident holdings of locally issued government securities have continued to increase sharply. These holdings were $121 billion as of December 2012, up from $69 billion in As a result, the country s external debt, net of liquid assets, increased to 41% of current account receipts in 2012 from an average 32% during the previous five years. We expect the ratio to hold steady during 2013 and 2014 as the pace of these inflows moderates somewhat. The absence of large current account imbalances (at about 1% of GDP) results in lower external financing needs than for some of Mexico s peers. Our projections are for Mexico s gross external financing needs--defined as current account outflows plus short-term debt by remaining maturity, as a percentage of current account receipts and usable reserves--to average 85% in

19 Table 2 Mexico--Economic Imbalances --Year ended Dec (%) Annual change in domestic credit to the private sector & NFPEs as % of GDP Annual change in residential housing prices (real): national f 2014f (0.2) (1.0) (0.2) Annual change in equity index (inflation-adjusted) (10.8) Current account balance as % of GDP (1.68) (0.63) (0.20) (0.86) (0.82) (1.06) (1.27) Net external debt as % of GDP f--forecast. NFPEs--nonfinancial public sector enterprises. Source: Financial Institutions Ratings. Credit risk in the economy: High risk. Our credit risk score summarizes our view of a banking sector s credit risk relative to its exposure to households and companies, and to the sovereign. We assess credit risk largely by looking at private-sector debt capacity and leverage, lending and underwriting standards, payment culture and rule of law, and sovereign government credit stress. Private-sector debt capacity and leverage. Significant income disparities exist because a large part of the population lives in poverty and the large informal workforce characterizes the Mexican economy. Informal employment accounted for 59.9% of the total workforce, according to the National Geography And Statistics Institute (INEGI). GDP per capita is slightly above $10,500, and only a small portion of the population has access to credit from commercial banks. Monthly salaries below $500 represent the earnings of 58% of the working population (according to INEGI), leading to highly vulnerable payment capacity. The corporate sector mirrors this disparity, signaling the overwhelming differences between large successful corporate groups and unsophisticated SMEs, which have limited access to credit and historically have financed their needs through their suppliers. In our view, Mexican banks have adequately allocated credit to the formal economic sector, including individuals with monthly salaries above $500, medium-size enterprises, large corporations, and, to some extent, small companies. But banks have not been successful in selling their services to the low-income population or the informal sector. We consider these customers highly risky for banks, based on credit losses that financial institutions have incurred while penetrating this sector. Some of the risks, in our view, include a weak payment culture, limited income and scant background information on borrowers whose financial health fluctuates sharply with business cycles. Lending and underwriting standards. Lending and underwriting standards have improved significantly since the Tequila Crisis of Fixed-rate lending is more important, exposure to foreign exchange is low and focused on exporters, and loans are more conservatively structured in terms of collateral and guarantees. In general, credit-risk management practices are based on stronger credit models than in the past. Debt-collection practices have become more important and are now an integral part of credit-risk management. A more efficient credit bureau has also supported the banks underwriting standards. Commercial banks provide lending mainly to large- and medium-size corporations, based on cash-flow analysis and guarantee requirements. There is a natural concentration of the banking system in the top-20 largest exposures, although there are regulatory and internal credit-risk management limits on individual companies, and on sector and group exposures. Despite these limits, we view this concentration as somewhat risky since the default of one of the largest corporations could have a negative impact on the entire banking system. On the retail side, banks have remained fairly conservative, in particular after 2007 when rapid growth of credit cards led to high losses during the 2009 crisis. Since then, banks have focused on loans that have some sort of collateral (i.e. payroll discount, auto, and mortgage loans), and on the upper income of the formal sector. Despite these conditions, it is actually consumer and mortgage lending that has driven overall portfolio growth over the past two years, with an average nominal increase of 17.6% per year, versus 11.4% in the corporate portfolio. 19

20 Payroll discount loans, which now account for 4.4% of the total commercial banks loan portfolio, grew by 50.8% in real terms during These loans perform better than credit card loans, although their quality is not outstanding, and in our view, sustained rapid growth of this asset class could bring additional credit risk to banks. As of year-end 2012, payroll discount nonperforming loans (NPLs) were 4% and gross charge-offs were 5.3%. Credit card NPLs were 4.8% and gross charge-offs were 14.7%. We believe payroll discount loans will maintain this rapid pace, although below that of Mortgage loans represent about 16.8% of commercial banks total loan portfolio, with an average loan to value of approximately 72% in the past two years. These loans are mainly provided at fixed rates and over recent years include unemployment insurance that normally covers up to six months of debt service. Banks provide mortgage lending primarily to the medium- to high-income segment of the population, which represent about 83% of the mortgage portfolio, and NPL levels are currently at an adequate 3.7% and have been consistently decreasing since their peak of 4.6% in The overall composition of Mexico s commercial banks loan portfolio is adequate with very limited exposure to high-risk sectors (i.e. construction) or foreign currency-denominated loans. The banking system does not make significant use of asset-backed securities, and therefore we rule out hidden off-balance sheet exposures from our analysis. In our view, underwriting standards reflect adequate asset quality with manageable nonperforming assets, which have averaged 3% over the past five years. Banks weathered the 2009 crisis despite the increase in credit losses thanks to effective provisioning standards: loan loss reserves averaged a 1.6x coverage over the past five years. Commercial banks gross credit losses have consistently decreased to 3.1% from 6% during the 2009 crisis. We expect gross credit losses to be 3.3% in 2013 and 3.5% in 2014 as a result of the expected economic slowdown, and to some extent, defaults among homebuilders. Payment culture and rule of law. In addition to income disparity and the substantial informal workforce, Mexico s legal framework and high corruption indexes also hamper financial development, despite some progress during the past 10 years. Relatively weak property rights and complex and unreliable judicial processes reflect a challenging legal environment in the country. Reforms, such as a unified registry for movable collateral and changes to the bankruptcy and commerce codes have made a dent, but there is still room for improvement. On the other hand, improvements in credit bureaus have helped financial intermediaries to better assess risk and have improved payment culture, although poor credit culture has sometimes led to high, unaffordable debt levels. Guarantee execution processes continue to be lengthy and costly. Table 3 Mexico--Credit Risk In The Economy --Year ended Dec (%) f 2014f Per capita GDP ($) 10,165 8,107 9,437 10,473 10,515 11,923 12,872 Domestic credit to the private sector & NFPEs as % of GDP Household debt as % of GDP Corporate debt as % of GDP* Nonperforming assets as % of total loans (year-end) Foreign-currency lending (% of total lending) *Includes external financing for corporates. Only commercial banks. NFPEs--Nonfinancial public sector enterprises. f--forecast. Source: Financial Institutions Ratings. 20

21 Industry Risk The industry risk score for Mexico is 3, based on our assessment of institutional framework, competitive dynamics, and systemwide funding. Institutional framework: Intermediate risk. Our institutional framework risk score is based on an analysis of banking regulation and supervision, regulatory track record, and governance and transparency. Banking regulation and supervision. We assess Mexico s banking regulation and supervision as intermediate. The Mexican regulatory body (CNBV) monitors banks closely and frequently. CNBV s supervision is adequate, and supported by effective systems that provide granular information. The CNBV also supervises all deposit-taking institutions (including credit unions and savings entities that serve middle- to low income individuals) and brokerage and exchange firms. However, supervisor staff turnover somewhat weakens institutional continuity and efficiency. Mexican regulatory standards are mostly in line with international parameters, except for the absence of IFRS accounting, which we expect the industry to adopt in the next two or three years. Following the Tequila crisis, Mexico s regulation has moved toward a risk-oriented approach. Currently, banking regulation is aligned with international standards including capitalization, money laundering, related party transactions, and financial statements disclosures. In January 2013, Mexico was the first country in the region to adopt Basel III capitalization rules, which did not have a major impact on the banking system. Furthermore, stress tests applied by the CNBV, the Financial Sector Assessment Program (FSAP), and central bank of Mexico show that the system could withstand severe stress scenarios. Mexico has strengthened its regulations, addressing past problems by limiting single-name and related-party lending and implementing provisioning requirements based on expected losses. The Ministry of finance and Mexico s central bank and local regulator (CNBV) oversee all banks, which are responsible for more than 80% of lending activities. There are a few financial institutions that do not fall under the scope of the regulator, mainly non deposit-taking institutions. Many of these entities failed during the recent financial crisis, given their dependence on wholesale funding, which became scarce during that period. There a few remaining non-regulated financial companies, and although information for these institutions is limited, we believe they represent a small proportion of the system. Currently, all financial entities that issue debt in the markets are subject to regulation. The 2006 amendment to the banking law clearly determined the paths that regulators and the IPAB can take to solve banking crises. Furthermore, after the implementation of BASEL III, new regulatory capitalization minimums were set at 7% for Tier 1 capital, 8.5% for basic capital, and a 10.5% global capitalization ratio. Preventive measures begin if any of these limits are breached, but become more severe if the bank s capital falls below basic or Tier 1 capital minimums. If all limits are breached, the bank becomes subject to the resolution regime. The government is currently developing a financial reform, which aims at increasing banking penetration and reducing credit cost. While some of the measures might be oriented towards improving the rule of law, we may expect initiatives to control interest rates or minimum lending requirements. Legislation is currently before Congress, but has not yet been discussed and will likely change before a vote. Although in its current form it includes no interventionist measures, we do not rule out that these measures could be added. In our view, interventionist measures, such as interest rate controls or government-directed lending, could lead to distortions in the financial system and could harm the regulatory framework. Regulatory track record.in our view, the Mexican regulatory track record is supportive of a healthy financial system, and its authorities, including the central bank have proactively taken measures to protect the banking system. There are early-warning capitalization limits, and given the importance of foreign bank subsidiaries in the system, regulators have implemented specific measures to protect local subsidiaries from capital flight or capital aid that would weaken their financial standing. These limits include related party transactions in terms of liquidity, daily normal operations, and parent loan or debt acquisitions. Despite these improvements, there have been some issues in the system that had denoted some regulatory and supervisory weaknesses. A clear example was the boost in the state and municipality delinquency rate in 2010, which additional transparency would have helped to prevent. 21

22 Governance and transparency. We believe that corporate governance in the Mexican banking sector is adequate. Governance has improved with the entrance of foreign banks into the system by giving strength to risk-management areas and bringing more knowledgeable and independent board members, but we also see conservative governance standards in domestic-owned banks, were boards of directors include a sufficient proportion of independent members. Transparency has improved significantly, but could be further developed. Regulators require banks to report their monthly financial statements. Accounting standards are adequate and are moving closer to the international standards. Yet, there is room for additional intra-group transactions and exposures disclosure. We expect Basel III to add more information disclosure and add transparency to the banking system. On the other hand, there is limited information regarding compensation practices and this will likely continue to be murky in the near future. The CNBV issues detailed monthly reports on commercial banks financial statements. Competitive dynamics: Low risk The competitive dynamics factor represents the structural implications of the competitive landscape. We assess this through risk appetite, industry stability, and market distortions. Risk appetite. We assess risk appetite as restrained for the system. Risk appetite among Mexican banks has decreased significantly following the Tequila crisis. The banking system s profitability (as measured by return on equity [ROE]) is comparable to that of other sectors in the economy, thanks to adequate asset quality, good risk pricing, and despite the banks good capitalization levels. Restrained risk appetite is one of the reasons behind slow credit growth to the private sector. The Mexican banking system provides traditional lending products and has tended to eschew complex and riskier products. Securitization declined in 2008 and 2009 and the market has yet to regain momentum, therefore hidden risks in off-balance sheets do not pose a risk. Although it is worth to mention that even at its peak, securitization was not very important in banks. Industry stability. We view the Mexican banking system as very stable due to its long standing composition in which the three largest private banks-- BBVA Bancomer S.A., Banco Nacional de Mexico S.A. (owned by Citigroup), and Banco Santander (Mexico) S.A. Institucion de Banca Multiple Grupo Financiero Santander--have dominated the market over the past several years, accounting for more than 53% of commercial banks total market share, and we don t expect significant changes. If we add Banco Mercantil del Norte S.A. Institucion de Banca Multiple Grupo Financiero Banorte, HSBC Mexico S.A., Banco Inbursa S.A. Institucion de Banca Multiple Grupo Financiero Inbursa and Scotiabank Inverlat, S.A., the next largest institutions, the figure rises to 81%. After the Tequila crisis, the composition of the banking system changed dramatically as global banks acquired the largest domestic banks. Foreign-owned bank participation in the commercial banking system is about 65%. The largest banks dominance poses significant entry barriers, in our view. Large, foreign-owned, Mexican subsidiaries performance and profitability levels have greatly benefited their global parent banks, and we view their exit from the Mexican market as unlikely, despite problems they might be facing in their home countries. In the past decade, about 10 new banks began operating, many of which with a strategy of increasing market penetration in services to the low-income population, with no relevant results. Some of these banks are part of a retail store groups such as Famsa, Wal-Mart, and Coppel and through their retail stores aim to serve the financial needs of their customers. These banks benefit from an existing customer base, loyal customer credit history, and distribution channels; however, their market share remains very small. The CNBV recently approved five new banks, but we don t expect them to have a significant impact on the composition of the banking system. Market Distortions. The Mexican government doesn t own commercial banks, and domestic finance companies represent a small portion of the banking sector s total lending. Still, the government has two large financial entities, Infonavit and Fovissste, entirely focused on housing lending to public servants, low-income formal population, and to some extent medium and high income formal employees. It also supports infrastructure development, residential developers, local and regional government financing, SMEs, exporters, and other sectors through its development banks: Banco Nacional de Comercio Exterior, Nacional Financiera, Banco Nacional de Obras y Servicios Publicos, Sociedad Hipotecaria Federal, and Banco del Ahorro Nacional y Servicios Financieros (Bansefi). 22 Development banks mostly perform second-floor activities and in some exceptional cases offer direct loans, however, their market share is a relatively low 11.4% of total commercial loans. Furthermore, most of the activities of these institutions focus on sectors that commercial banks don t serve. In our view, the development banks operations don t cause distortions in the system. The current federal administration is gradually shifting the development bank strategy in order to reduce lending activities and to increase guarantee schemes (the government will offer a guarantee percentage to share the risk of a loan) so that commercial banks become interested in some segments such as SMEs and home developers.

23 The government has a large presence in the residential mortgage market through Infonavit and Fovissste (see Chart 2). Although these institutions have a large share of the mortgage market, they pose no threat to commercial banks, and in our view, they cause no distortions. These institutions receive mandatory contributions from formal employees as their funding, and commercial banks have no access to these funds. Infonavit focuses on low-income, formal employees, a sector which banks have avoided historically. Infonavit also offers products for medium- to high-income workers in joint participation with commercial banks. Fovissste offers credit only to public servants, and its operations are similar to those of Infonavit. Mortgage Portfolio Market Share Others 1.5% Banks 30.6% Infonavit 58.2% Fovisste 9.7% Other nonbank financial institutions have a 9.4% market share in terms of total loans in the system, which we believe is relatively low. In our view, these companies generate no distortions for banks and offer virtually no competition in the same segments; most of them have high-cost funding structures and are focused on segments that banks don t serve. So far the government has avoided interest rate controls and other types of interventionist measures. Thus, the introduction of initiatives such as these would be negative if they result in market distortions. Table 4 Mexico Competitive Dynamics --Year ended Dec (%) f ROE of domestic banks ROE of corporate sector System-wide return on average assets for banking sector Net interest income-to-average earning assets for banking sector Market share of largest three banks* Market share of government-owned and not-for-profit banks* Market share of nonbanks in total system-wide assets* *Market share of banks is only measured within commercial banks, other market shares are measured with respect to the financial system as a whole. f--forecast. ROE--Return on equity. 23