Financial Services

The local banking industry has done a formidable job managing its operations in a historically challenging environment, posting positive levels of profitability since 2014, and registering a Pre-Tax ROE of 8.7% during the first half of 2017. While it has been able to weather the economic and fiscal headwinds which have been fiercely and relentlessly blowing through the Island since more than a decade ago, local banks are now faced with the catastrophic aftermath brought about by the passage of Hurricanes Irma (Sep. 6) and María (Sep. 20). Moody’s has estimated economic losses could amount to $95 billion. Large capital buffers of local banks will help mitigate the potential losses due to the myriad disruptions engendered by the hurricanes. Although banks have been able to gradually improve their asset quality, registering a 90+ days past due-non accruing ratio of 5.9%, loan quality issues could reemerge due to the negative impact on business and household income and expenses. The next issue will focus further on the macro-impacts of the 2017 hurricanes, leveraging what was learned from the effects of Hurricane Katrina on the U.S. Gulf Coast’s banking sector.

The local banking industry maintained a positive trajectory in the first quarter of 2017, registering a Pre-Tax ROE of 8.6% on an annualized basis, despite ongoing severe economic and fiscal hardships being faced by Puerto Rico. Economic growth forecasts pointing to continued contraction, uncertainties regarding the impact of imminent austerity measures, and tepid loan demand, among other downside risks, will likely continue to temper the performance of banks. Banks are advised to continue cost optimizing their operations, exploiting opportunities to enhance customer and shareholder value by leveraging emerging technologies, and strengthening their digital competencies to achieve greater productivity. The strong capital levels of banks, with the Tier 1 Risk Based Capital Ratio reaching 20.5% in YTD 2017, provide a robust capital cushion in the event that adverse risks materialize. The delinquency ratios have continued to decrease, with the 90+ days past due non accruing ratio reaching 6.3% in YTD 2017. In this issue we examined the historical and possible future trends of total loan originations and total loan portfolios, and their implications for banks.

In this final issue of 2015, we will be highlighting the main local banking trends of the past 10 years and offer our outlook for 2016. In the last decade, total employment has decreased by 20%, real GNP by 14% and the GDB’s EAI by 19%. Looking at macro banking trends specifically, the number of retail banks has decreased from 10 to 5, the number of branches has been cut by 34%, and total assets have experienced a reduction of 42%. Delinquency levels have remained at very high levels, with noncurrent loans and leases ratio averaging 10% in the 2006-2015 period compared to 2% between 2002 and 2005. Credit losses have translated into a deterioration of the pre-tax return on equity (ROE) of the local banking system which averaged 1.4% during the 2006-2015 period, compared to 17% between 2002 and 2005. Notwithstanding tough local market conditions, during the past years banks have done an extraordinary job at reducing the amount of troubled assets and have dramatically increased capital levels (risk-based capital ratio of 18.6% in 2015 vs. 10.6% in 2006). As a result, the banking sector currently boasts a much healthier balance sheet and a more robust capital position which will allow it to face the additional economic and financial stress expected for 2016 and beyond.

The local banking industry continues to weather the storm of economic and fiscal malaise that is gripping the Island. It has maintained positive, albeit modest, levels of profitability during YTD 2015, reaching a Pre-Tax ROE of 6.2% on a consolidated level. Profitability by individual bank exhibited notable variability. Popular, Scotia and Santander posted relatively strong levels of profitability, with Pre-Tax ROEs of 9.7%, 8.9%, and 7.2% respectively, while First Bank and Oriental produced ROEs below 1% (0.9% and 0.3%, respectively). Higher provision expenses due to heightened credit risk stemming from uncertainties regarding PR government assets and current shaky economic grounds, have adversely impacted local banks’ 2015 performance. Nevertheless, a strong capital base provides banks with an adequate cushion to assimilate potential future losses. Given the importance of the auto industry for the local economy and specifically for local banks and other financial institutions, this issue will provide an overview of key auto trends. New auto sales in Puerto Rico peaked in 2005 with 140,400 cars sold, dropping to 88,175 in 2014 (-52K units or -37%), continuing a downward trend in YTD 2015. This trend has important implications for local banks as well as for already strained public coffers.

The local banking industry on a consolidated basis has been able to maintain positive returns in the first half of 2015, reaching a Pre-Tax ROE of 5.9%, highlighting the resilience of this sector despite steep challenges in Puerto Rico’s operating market. The Island is undoubtedly traversing one of the most challenging economic and fiscal periods of its post-World War II history, as has been consistently chronicled in past issues. Real economic output has decreased by close to 15% since FY 2006, the liquidity drought that ails the government could ultimately lead to a partial government shutdown and population decline continues unabated reaching historic proportions in 2014 with a net migration of -64,000. Furthermore, on Aug. 1 the government made an incomplete payment to cover the Public Finance Corporation’s (PFC) debt which has been seen by Wall Street and the investor community as the Commonwealth’s first-ever default. Given current elevated capital ratios, the industry will be able to withstand additional economic deterioration in the short-term. However, a worsening of economic and fiscal conditions may lead to higher non-performing loans, higher credit provisions and a depletion of capital levels. This issue will briefly examine local credit unions exposure to $1.1 billion in PR government debt, sector which might be dealt a hard blow if public sector defaults continue.

The local banking industry underwent a reconfiguration during the first quarter of 2015 after federal and local regulators shutdown Doral following years of struggling with profitability and inadequate capital levels. Popular and FirstBank aptly seized the opportunity of acquiring a large part of Doral’s assets and deposits, further strengthening their leading position in the local market. The reshaped banking industry registered a pre-tax ROE of 8.0% in Q1 2015, showing a strong improvement vis-à-vis 2014 despite operating in a challenging environment. The most recent macroeconomic and fiscal indicators point to continued economic contraction in fiscal years 2015 and 2016 and severe governmental liquidity problems which will continue to pose challenges for local banks. However, extremely strong capital levels will help banks cope with potential future difficulties. Delinquency ratios continued to increase in Q1 2015, trend that must be closely observed. In this issue, given the profound economic and fiscal issues Puerto Rico is facing, an analysis of the exposure of local banks to government-related assets and deposits is presented. Lastly, given the growth in assets of International Banking Entities, a brief analysis of this important sector of the Island’s financial system is also put forth.

The local banking industry posted modest earnings in 2014, reaching a Pre-Tax ROE of 3.4% on a consolidated basis. When excluding Doral, which was ultimately closed by the OCFI and the FDIC after years of financial and legal troubles and was the only bank to report negative returns in 2014, the pre-tax ROE of the industry reached 6.8%. While productivity levels improved in 2014 vis-à-vis 2013, as did capital levels, the delinquency ratio for the industry, after four consecutive years of decline, experienced some deterioration. The 90+ days past due non accruing ratio increased from 6.0% in 2013 to 7.3% in 2014. In anticipation of potential future losses due to nonperforming assets and a macro-economic environment riddled with uncertainties, local banks have increased their loan loss reserves. Doral, after struggling to survive for several years, was ultimately closed by the FDIC and partially bought by Popular and FirstBank, who will further solidify their positions in the local banking market. In this issue we analyze some of the potential impacts of the 2015 tax reform, whose major component is the introduction of a value added tax (VAT), on the overall economy and specifically the banking sector. There are both downsides and upsides to the proposed transformation of the Island’s tax code.

The local banking sector reached positive returns in 2014 YTD, registering a pre-tax ROE of 3.1% (8.3% excluding Doral), despite the ongoing acute fiscal and economic challenges. Economic activity continues to contract according to the GDB’s Economic Activity Index and job numbers remain at historically low levels. Falling oil prices should provide a much needed, although limited, positive impact on the Island’s economy, increasing consumers’ disposable income. Still high credit provision levels and decreasing leverage continue to adversely affect profitability of banks. Capitalization levels continue to be strengthened for all banks except Doral, which is now considered significantly undercapitalized by the FDIC. Delinquent loans have been creeping up in recent quarters, trend that should be closely monitored.

Puerto Rico’s banking industry, despite navigating through years of tough economic times, has been able to maintain positive returns, registering a pre-tax ROE of 5.3% during the first half of 2014. Banks with relatively high exposure to PR Government-related assets have continued to de-risk their balance sheets to reduce potential headwinds. Reaching pre-recession levels of profitability remains elusive given continued asset reduction, increasing regulatory costs and intense competition. Capital adequacy continues to strengthen for most banks, while the NPL ratio for the industry deteriorated with respect to 2013. Consumer lending, which continues to support the ever increasing consumerist behavior of Puerto Ricans, offers a bright spot for some banks with good margins and charge offs under control.

The local banking industry’s Q1 2014 Pre-Tax ROE reached 6.8%, certainly a positive development given the beleaguered state of the economy, but still remains well below pre-crisis levels of profitability. Cost rationalization and strategic focus in high-performing areas is critical given a local environment with few organic growth opportunities. Capital ratios continue to improve for most banks while asset quality slightly deteriorated during this last quarter. The behavior of NPL ratios is certainly something that should be closely tracked in the coming quarters, particularly in light of worsening labor market indicators. The potential further deterioration of the Island’s precarious economic and fiscal state could adversely impact those banks with sizeable exposure to PR government’s loans, deposits and securities.