The Puerto Rico banking industry achieved a Pre-Tax ROE of 7.9% in the first nine months of 2011 after two years of negative bottom line. The improvement in the banking system profitability coincides with a period of weak economic activity and decreasing total assets. As a result, banks are facing the need to rationalize their expense structure locally to cope with increasing fixed costs relative to productive assets. Additionally, they are finding themselves with excess capital after a period when they had to strengthen their capital levels to face large credit losses. With limited opportunities to invest in the local market, banks are looking at alternatives to use their spare capital, like investing in existing outside operations, repaying debt or returning capital to their shareholders.

The Q2 2011 results confirm the success of the measures taken in the past years to reduce nonperforming assets and maintain appropriate capital levels. With banks ready to grow their core businesses in a challenging economic scenario with limited organic growth opportunities, a new competitive landscape has emerged. In this new landscape, stealing share through superior service and innovative marketing ideas while protecting margins will be the name of the game. So far, some banks have fared better than others under this new landscape, particularly in the commercial credit business where competition is most fierce. While we are optimistic that the banking sector credit performance will continue to improve and the market will slowly recover, it is still possible that the economy deteriorates further and that banks will need to refocus on loss mitigation.

In 2010 banks put substantial resources into mitigating risk and getting rid of toxic assets in order to reverse the declining profitability trend and start 2011 on a stronger footing. 2010 was also the year of consolidation, with the FDIC assisting in the acquisition process of three failed institutions: Westernbank, RG and Eurobank. Based on banks' participation in this acquisition process and the prospect of a second wave of consolidations in 2011, we have categorized the local institutions in three groups: 1) The Winners, Popular, Scotiabank, and Oriental, acquired the troubled banks under favorable terms growing their share of total assets from 34% to 44%; 2) The Targets, FirstBank and Doral, became the likely targets for a second round of consolidations; 3) The Spectators, Santander and BBVA, did not place winning bids during the consolidation process, and did not expand or reduce their operations in the Island. The three groups of banks will face separate challenges in 2011. The Winners will need to balance loss mitigation with business generation to offset the natural decline in the FDIC covered loan portfolio balances. The Targets will need to continue improving their capital levels and asset quality while entertaining or fending acquisition offers. And The Spectators will struggle to capture the attention of their parent companies if they want to expand their operations in the Island.