Mexico's shadow banks are on shaky ground following the defaults of Crédito Real SAB de CV SOFOM ENR and Alpha Holding SA de CV.

Crédito Real defaulted in February after missing a principal payment on its CHF170 million bonds due 2022, triggering downgrades from rating agencies. As a result, its shares plunged 93% from an August high and the issuer's $500 million worth of bonds, which had been as high as 102.44 cents on the dollar in April 2021, are now 12.54 cents on the dollar. Meanwhile, peer Alpha filed for bankruptcy last year after reporting accounting errors and subsequently defaulting.

As a result of the turmoil, even solid nonbanking financial institutions, or NBFIs, are feeling the squeeze from investors. Financiera Independencia SAB de CV SOFOM ENR, Unifin Financiera SAB de CV, Docuformas SAPI de CV and Operadora de Servicios Mega SA de CV SOFOM saw 10% to 20% declines in their bond prices year over year in the first week of March. NBFIs may have a harder time refinancing as investors could increase rates, implement less flexible funding conditions or raise the overall credit risk for the segment.

"When a big NBFI with a strong solid position like Crédito Real defaults, it obviously presents red flags to the sector," Carlos Gómez, an equity analyst for Intercam Banco, said. "It won't necessarily hurt NBFIs' operations, but it can hurt the perspective that investors or other kinds of stakeholders have about this segment."

Shadow banks dominate Mexico’s economy, Gómez said. Banking penetration in Mexico is the lowest among OECD countries, with more than half of Mexicans aged 15 and up without a formal bank account, according to the Organisation for Economic Co-operation and Development. That means many individuals and small businesses turn to NBFIs for financing. Those segments were among the hardest hit during the pandemic, and will be key to NBFIs recuperating credibility and improving the climate for their own refinancing.

"Right now, others are struggling with the asset quality of their own portfolios on top of the reputational risk. There are no bonds available for these companies, banks are beginning to shy away from them," according to Victor Herrera, a partner at Miranda Ratings Advisory. NBFIs can resort to structured finance, but the cost of this financing has been going up following the problems in Alpha Holding and Credito Real.

"Others are suffering in trying to get new financing. Forget about growing, it’s just refinancing debts before their maturities," Herrera said.

NBFIs have to put the brakes on growth and focus on collecting loans and paying off debt, Herrera said

They have to "prove to the market that they are viable businesses and that the asset quality is in good shape," Herrera said.

It won't be an easy task. The Mexican central bank in March lowered its GDP forecast for 2022 to 2.4% from 3.2% previously, citing weaker-than-expected economic results for the last quarter of 2021. Early this year, BofA Securities cut its Mexican economic growth projection to 1.5% from 2.5%, while the International Monetary Fund reduced its estimate by 1.2 percentage points to 2.8%.

"Look at the environment we're having, interest rates are creeping up, the speed of the economy is slowing down," Herrera said. "Borrowers of these companies are going to be further strained to pay off their debt within the next few months."

Additionally, the recovery in credit demand for NBFI segments is stalled, S&P Global Ratings Senior Director Alfredo Calvo said. The labor market is still seeing weak dynamics that are leading to lower income, and businesses are still reeling from a lack of government support during the pandemic.

Beyond operational improvements, the shadow banks will have to demonstrate better corporate governance.

"One of the more important tasks is to strengthen the governance, the transparency, the communication with the market," the exact issues faced by Alpha Credit and Crédito Real, according to S&P Global Ratings analyst Jesus Sotomayor.

A lack of clear regulations doesn't help.

"The thing is, because some of these entities are not regulated, sometimes they don't have the best governance guidelines as you might expect in an institution that's beginning to have that size," Herrera added.

Other ways to improve regulatory oversight for NBFIs include migrating their accounting standards to IFRS 16 and strengthening their boards by adding independent members, Sotomayor said.

As of March 30, US$1 was equivalent to 19.85 Mexican pesos.

This S&P Global Market Intelligence news article may contain information about credit ratings issued by S&P Global Ratings. Descriptions in this news article were not prepared by S&P Global Ratings.