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.

The local banking industry's 2013 pre-tax ROE adjusted for the sale of NPAs portfolios by Popular and FirstBank during the first two quarters of the year was 7.6%, the highest level since 2006 but still well below pre-2006 levels. Continuous cost rationalization measures, increasing pricing and fees, leveraging economies of scale and expansion in other markets of those banks with non-PR operations will be critical during 2014 and beyond to raise returns given a local context of continued diminishment of banks' assets and few organic growth opportunities. Obtaining precrisis levels of profitability remains elusive in the short-term given economic hardships dating back to 2006 and Puerto Rico's general obligation debt rating dip to non investment grade in early February 2014 by S&P, Moody's and Fitch.

The local banking sector reached an adjusted pre-tax ROE of 5.4% in 2013 YTD, an improvement when compared to 2012 but still very far from reaching pre-crisis levels of profitability. This adjusted rate does not include the adverse effects the sale of non performing loan (NPL) portfolios had on the sector's bottom line. The Island's current economic outlook characterized by a protracted contraction, low aggregate demand, no clear growth drivers in the shortterm, warnings from credit agencies of a potential downgrade to Puerto Rico's general obligation bonds, a housing market that still faces steep challenges and disconcerting labor market indicators, presents few opportunities domestically for the local banking industry to perform at levels prior to 2007 when it reached double digit rates of profitability.

The banking industry's YTD 2013 pre-tax ROE adjusted for the sale of NPLs portfolios by Popular and FirstBank was 3.9%. The industry delinquency levels continue to improve and solvency ratios remain very solid. In this banking report we are taking a closer look at the mortgage business which represents 37% of the industry's total loan portfolio. As we will see, mortgage margins may reduce in the short/medium term driven by low originations in the context of rate increases, the implementation of new federal regulations and the recent and future repurchases of recourse portfolios. Both in the mortgage business and at the total bank level, workout efforts will need to be combined with cost reductions in order to boost profitability.

The local banking industry reached a pre-tax ROE of 7% in Q1 2013 once we eliminate the negative impact from the sale of non performing loan (NPL) portfolios by Popular and FirstBank. The current environment of low leverage and still high provision expenses, is preventing the industry from reaching profitability levels in line with the pre-crisis period. The recent sales of NPL portfolios have helped decrease the delinquency levels but may also impact the local property prices given the discounts involved in the purchase prices which have ranged between 32% and 53% of the unpaid principal balance (UPB).

The profitability of the Puerto Rico banking industry in 2012 was positive for the second consecutive year (3.4% ROE in 2012 and 6.3% in 2011) thanks to the reduction in the provision expense. However, higher profitability levels are not likely to materialize in an environment of still high charge-offs and slow credit activity. The debt burden that Puerto Ricans face in the coming years is likely to push credit activity further down and maintain delinquency at higher levels compared to pre crisis years. In this context, there will be pressure to increase pricing and fees and leverage economies of scale with additional consolidation.

As we have commented in previous reports, the Puerto Rico banking industry maintains its slow but solid recovery with its pre-tax ROE in 2012 (Jan.-Sep.) at 4%, approximately 14 percentage points above the 2009 and 2010 levels. Furthermore, the Q3 2012 pre-tax ROE reached 6.7%, the highest profitability level since Q2 2011.