Major Factors

Rationale

S&P Global Ratings classifies the banking sector in Peru (foreign currency: BBB+/Stable/A-2; local currency: A-/Stable/A-2) in group '5' under its Banking Industry Country Risk Assessment (BICRA). Other countries in BICRA group '5' include India, Ireland, Italy, and Panama (see chart 1).

Our bank criteria use our BICRA economic and industry risk scores to determine a bank's anchor, the starting point in assigning an issuer credit rating. The anchor for banks operating only in Peru is 'bbb-'.

In our criteria, we define the BICRA framework as one "designed to evaluate and compare global banking systems." A BICRA analysis for a country covers rated and unrated financial institutions that take deposits, extend credit, or engage in both activities. The analysis covers the entire financial system of a country while considering the relationship of the country's banking industry to the financial system as a whole. BICRA scores range from '1' to '10', with the lowest-risk banking systems in group '1' and the highest-risk in group '10'.

Peru's economic risk reflects its low GDP per capita levels, manageable economic imbalance, and relatively high exposure to foreign-currency lending and to lending to cyclical SMEs. We forecast real GDP growth of 3.7% for this year and 3.8% in 2019, up from 2.5% in 2017. The increase reflects improving investment conditions following less political uncertainty, our expectation that key investment projects will advance, more favorable metal prices globally, and the delayed effects of monetary easing and the resulting recovery in credit expansion. Peru's economic imbalances remain manageable, reflecting relatively low credit expansion of about 5.25% during 2017 and our forecasts of 10.00% for 2018 and 2019 (year-on-year). Credit growth has decelerated since 2016, mainly due to weak internal demand, but now investor and business confidence are improving. On the other hand, foreign-currency lending has significantly decreased, mainly because of the Peruvian central bank's (BCRP) incentives, but it remains relatively high (about 28.7% of total loans as of March 2018) and we don't expect it to further decrease in the next few years. Additionally, we believe the financial sector is exposed to a significant share of lending--about 28% of total loans--to cyclical sectors.

In general, we consider the industry risk for banks operating in Peru to be lower than that of its international peers in the same BICRA group. We believe that Peru has a sound regulatory framework, with ample supervisory coverage and periodic risk-based supervision under a highly professional regulator. Both the BCRP and Superintendencia de Banca y Seguros (SBS)--which regulates banks and insurance companies--are very active. During external shocks, authorities have introduced prudent measures to ensure overall financial stability. Moreover, Peru is fairly far along in implementing Basel III standards tailored for the domestic financial system. Peruvian banks have benefited from strong profitability and adequate capitalization levels in the past five years, and there are no significant market distortions that could alter the system's competitive dynamics in the in the next two years. We also believe the country's financial system has a healthy and diversified funding mix consisting of deposits, domestic market debt, and external debt (banks and market), as well as strong government support to provide liquidity if needed.

Chart 1

Economic And Industry Risk Trends

We believe Peru's economic risk trend is stable. We expect Peru's economic growth to gradually accelerate in the next two years, mainly due to increased public investment spending, higher investment confidence, and new mining projects. We also think that economic imbalances will remain manageable, reflecting relatively low credit expansion and the absence of asset bubbles. We believe non-performing loans (NPLs) will keep worsening in 2018 due to still weakening performance in the SME sector and low credit growth, but will remain manageable at about 3%, and will improve thereafter, supported by stronger investor and business confidence.

In our view, Peru's industry risk trend is stable. We expect the Peruvian financial system's funding structure to remain healthy, mostly relying on core customer deposits, and profitability to remain sound, although decreasing due to higher provisioning levels. We believe Peru will continue introducing regulation broadly in line with international standards and will continue proactively identifying problems and attacking them at an early stage.

Economic Risk  |  6

We base our economic risk score for Peru on our assessment of economic resilience, economic imbalances, and credit risk in the economy, as defined by our criteria.

Economic resilience: Per capita GDP forecast at $6,850 at the end of 2018

Economic structure and stability.  With forecast GDP per capita of $6,850, Peru's economic prospects remain solid, though growth has slipped from the commodity boom years. We forecast real GDP growth of 3.7% in 20.8 and 3.8% in 2019, up from 2.5% in 2017. The pickup reflects improving investment following less political uncertainty, our expectation that key investment projects will advance, higher global metal prices, and the delayed effects of monetary easing and the resulting recovery in credit expansion. The combined impact of the El Niño weather phenomenon, increased political tensions, and lower business confidence, which slowed investment from both the private and public sectors, caused GDP growth last year to dip.

Additionally, a number of construction companies implicated in corruption probes found it difficult to obtain financing. Large infrastructure projects suffered significant delays, particularly the Southern Gas Pipeline and the Chinchero airport. To accelerate the implementation of projects, Congress passed the new Law 30737 in March 2018, which gives companies more certainty about the potential financial sanctions they could face. For this year, we expect higher public investment spending related to the reconstruction program for flooded areas, the Pan American Games, and the execution of major infrastructure projects. These projects include the Lima Metro Line 2 and the modernization of the Talara refinery, which are both moving ahead, albeit slowly. In addition, a recovery in mining investment in the country has accompanied the recovery in metal prices, with small and medium-size projects in the pipeline in the next two years.

Macroeconomic policy flexibility.  Peru's sound macroeconomic policies over the past two decades and its low debt burden give the government some room to expand its fiscal policy. The government's objective is to increase public investment this year and, at the same time, raise fiscal revenues while containing operating spending in the medium term. We assume the execution of the reconstruction program and large public investment projects will somewhat improve. Thus, we expect the general government deficit to widen to 3.4% of GDP in 2018 from 2.9% in 2017. We then expect the deficit to narrow to 2.2% of GDP by 2021, because of higher fiscal revenues following the implementation of some modest tax measures, stronger metal prices, and firmer GDP growth. We project the average annual increase in net general government debt to be 2% of GDP over 2018-2021. Our estimates are more conservative (meaning higher deficits) than the government's because of our lower growth and revenue projections.

Political risk.  Between December 2017 and March 2018, political tensions increased considerably in Peru, fuelled by various corruption scandals that hit politicians and businesses associated with bribes paid by the Brazilian construction firm Odebrecht S.A. The situation sparked controversy and tensions between the executive branch and Congress, seriously damaging business confidence. After surviving an impeachment vote in December 2017, former President Pedro Pablo Kuczynski (elected in 2016) resigned in March 2018. Vice President Martin Vizcarra assumed the presidency in a smooth transition that has since helped improve business confidence. The change of government also lessened political tensions with Congress. President Vizcarra appointed a new cabinet and has been coordinating with legislators to implement the economic agenda. Nevertheless, the political outlook remains challenging, given perceptions of the government's political weakness. This could hamper its ability to pass new legislation and execute public investments.

Table 1

Economic imbalances: Low corporate credit demand has slowed credit growth

We believe Peru is in an expansionary phase. Economic imbalances remain manageable, reflecting relatively low credit expansion over the past two years (about 5% year-on-year), recovering in 2018 at about 10%, and continuing with similar growth in 2019. Credit growth has decelerated since 2016, mainly due to increased political tensions, which slowed investment from both the private and public sectors; but these tensions appear to be stabilizing and investor and business confidence are improving.

Private sector credit growth.  Peruvian banks increased lending as the domestic economy boomed between 2006 and 2013, and even as GDP growth decreased sharply in 2014 and 2015. Credit to GDP increased to 42% in 2015 from less than 20% in 2006. Lenders focused part of their growth on the informal economy by offering microloans and subsidized mortgages. However, lending growth in Peru has downshifted markedly since 2016 as the economy has slowed. However, in 2018, after months of political uncertainty, followed by the resignation of President Kuczynski this March, the situation seems to be stabilizing, and investor and business confidence are improving. We expect credit growth to expand in 2018 by about 10% and to grow similarly in 2019 as credit demand from the corporate sector picks up.

On the other hand, a massive corruption probe in Brazil, Lava Jato, spread to Peru starting in 2016. The Brazilian construction giant Odebrecht S.A. admitted to bribing Peruvian officials in exchange for receiving contracts. In response, the Peruvian government passed a decree in early 2017 aiming to sanction construction companies operating in Peru that admitted or were found guilty of corruption. However, the decree has caused financial difficulties among construction companies, because they had difficulty getting financing for their projects. As a result, infrastructure construction in Peru has ground to a halt, hurting the country's economy. In order to resume the projects, Congress passed legislation in March to replace the last year's decree. The new law, in our view, could help remove the financial strain on construction companies and their suppliers, prompting banks to start lending again to this economic sector.

Real estate prices.  Residential home prices have only modestly grown in 2017, mainly because of political uncertainties. We expect property price growth to remain susceptible to political concerns and investor confidence during 2018. We believe prices in Peru have risen mostly because of the growing economy, investor confidence, and the scarcity of available area for construction near Lima in recent years, rather than because of a credit-fuelled real estate bubble.

While mortgage lending grew an average of 15.2% between 2012 and 2016, it slowed down in 2016 with a growth rate of 4.4% and then 7.6% in 2017. It then rose to 8.5% as of March 2018 (year-on-year). This segment represents only about 6.2% of GDP. SBS has tried to prevent imbalances stemming from banks' exposure to mortgage lending, which, together with banks' more conservative underwriting, has restrained mortgage lending growth.

Equity prices.  Equity prices have been volatile in Peru in the past five years, and the SP/BVL General Peru Index (Lima's stock exchange index) rose approximately 28% in 2017, 57% in 2016, and fell 33% in 2015.

During the first six months of 2017, the SP/BVL General Peru Index remained relatively flat, increasing only 3.4% (YTD), affected by Odebrecht corruption scandals and the effects of the "El Niño Costero." However, the local stock market recovered during the second half of the year, given the encouraging outlook for the global economy that stimulated commodity prices. Over the same time period, the performance of the U.S. stock market, whose indexes reached historical maximum levels, also boosted Peru's stock market. In this regard, relative volatility in Peru's stock market is not a major concern for our BICRA assessment, because the banking sector has very limited exposure to the stock market. Banks traditionally invest in government debt, and due to overall conservative investment practices, we don't expect this trend to change.

Current account and external debt position.   Peru's external profile is likely to stabilize on higher metal prices, with current account deficits averaging 1.3% of GDP and narrow net external debt averaging 18% of current account receipts (CAR) in 2018-2021. Copper production and exports will benefit new small and medium-size mining projects that will come on stream within the next two years. We expect direct investment to increase to $7.6 billion on average during this period, from $6.5 billion in 2017, because of these new projects. We expect ongoing net foreign direct investment (FDI) to fully cover the projected current account deficits. Peru continues to have a large difference of more than 100% between its net external liabilities (which include FDI) and its narrow net external debt, indicating the vulnerabilities of its external profile, because the country is exposed to potential shifts in FDI inflows to the mining sector. Peru's external financing needs are likely to stay around 75% of CAR plus usable reserves over 2018-2021.

Table 2

Credit risk in the economy: Still significant exposure to foreign currency lending and loans to SMEs

Private-sector debt capacity and leverage.   We believe that the still low expected GDP per capita of $6,850 as of the end of 2018 still constrains credit growth. Although Peru has had a decade of robust economic growth and private-sector leverage and access to banking have grown accordingly, they still remain lower than those of BICRA peers. As of the end of 2017, private-sector credit represents about 40% of GDP. We expect this ratio to slightly increase over the next two years to about 43% to 44%.

NPLs continued to increase during 2017, primarily due to poorer credit quality among SME, microenterprise, and consumer loans. The lower credit quality resulted from weaker internal demand, rising debt burden, and lower credit growth. Although we expect asset quality to continue worsening during 2018--with NPLs to total loans between 2.9%-3.0% --we believe these metrics are manageable for the banking system. Additionally, credit losses have remained low at less than 2%, and we expect this trend to continue.

Lending and underwriting standards.   Our view of the Peruvian financial system's lending and underwriting standards is moderated by its still significant exposure to foreign currency lending and to the cyclical SME sector, which increases credit risk.

Dollarization (in loans) has fallen consistently in the past decade, thanks to measures taken by the Central Bank of Peru, but it remains higher than those of international peers--around 28% of total lending as of April 2018, a level that has stayed relatively stable for the past year. Although banks generally offer dollar-denominated loans to dollar generators such as exporters, we believe there's still a significant amount of dollar-denominated loans offered to non-dollar generators. We also presume a relatively low usage of hedges to mitigate this risk. Overall, we expect relatively stable dollarization levels.

We also think the Peruvian financial system is exposed to the cyclical SMEs sector. Microcredit and SMEs represent about 28% of total credit as of March 2018. The recent worsening in asset quality reflects the cyclicality of the SMEs sector.

Payment culture and rule of law.   Peru's payment culture and rule of law limit our credit risk assessment. We believe Peru's political institutions and judicial framework still have shortcomings: corruption scandals are common and the public distrusts the justice system.

According to the World Bank's Worldwide Governance Indicator, Peru is in the 34th percentile for Rule of Law and the 43th percentile for Control of Corruption indicators as of 2016 (the latest information available), somewhat better than its BICRA and regional peers such as Colombia, Panama, and China. Additionally, according to the Doing Business Index, Peru ranks 58th (out of 190 countries) in resolving insolvency as of June 2017; worse than its peers. Insolvency in Peru takes an average of 3.1 years to resolve and the recovery rate is 30%.

Table 3

Base-Case Credit Losses

We expect the Peruvian financial system's credit losses to continue increasing in 2018, but they should remain manageable; below 2%. Although banks have tightened their underwriting standards for the past three years and new vintages have posted better trends, the still low internal demand, investment, and credit growth have delayed improvement in asset quality.

Our credit loss estimate for Peru in the next two years incorporates the following assumptions:

• GDP growth of 3.7% for 2018 and 3.8% in 2019;
• Unemployment to gradually decline in 2018-2019 to 6.5% and 6.2%, respectively, from 6.9% in 2017; and
• Asset quality to weaken slightly by the end of the year and stabilize afterwards because of the stronger economy and tighter underwriting standards.

Table 4

Industry Risk  |  3

We base our industry risk score for Peru on our assessment of its institutional framework, competitive dynamics, and system-wide funding.

Institutional framework: Proactive regulations and supervision provide significant support

Banking regulation and supervision.   We assess Peru's banking regulation and supervision as intermediate, indicating our view that SBS adequately regulates and supervises the industry. SBS amply covers the industry: it supervises deposit-taking and non-deposit-taking entities, insurance companies, and pension funds. In general, the regulatory framework aligns with international standards, and we think SBS very actively issues new regulations to prevent potential risks. For instance, in the past few years, the regulator introduced higher regulatory reserve and capital requirements to reduce foreign currency lending in the historically dollarized economy. It also increased capital requirements to rein in credit growth and reduce risk exposure in mortgage and consumer lending. As a result of these measures, the dollarization of the loan portfolio decreased to around 28% of total lending as of April 2018.

SBS has advanced in implementing the Basel III framework adapted for the Peruvian financial system. The implementation had three steps: introducing buffers, creating new liquidity standards, and improving capital quality. The buffers capture economic cycles; systemic risks; and other risks such as single-name, geographic, and economic sector concentrations. SBS is working on Pillar 3 of the Basel requirements: leverage reporting and implementing the net stable funding ratio (NSFR). SBS hasn't revised its regulatory capital definition because this change would require amending the Financial Services Law.

With respect to capital quality, SBS introduced regulations that:

• Revise minimum maturity hybrids considered Tier 1 capital to 60 years from 30 years;
• Eliminate step-ups; and
• Change loss-absorption capacity (conversion of write-offs if Tier 1 capital or risk-weighted assets [RWAs] fall below 5.125%).

Furthermore, because the current legal framework doesn't allow banks to apply new deductions toward regulatory capital requirements, authorities increased the risk weight on intangibles to up to 1,000% from 100%, and on deferred tax assets (DTAs) up to 1,000% from 20%, to achieve the deduction effect.

Regulatory track record.   We believe Peru's regulatory track record is strong. In our view, the institutions that together oversee the industry (SBS, the Ministry of Finance, and the BCRP) proactively identify problems at an early stage and act quickly to remedy them (please see the regulation and supervision section). We believe that these institutions have significant power to take corrective actions. They efficiently handled the impact of Russia's 1998 default and the global financial crisis in 2008-2009. During Russia's default, the authorities adopted measures that included intervening in foreign exchange markets to prevent the Peruvian sol's sharp depreciation and corresponding severe effects on banks' balance sheets. The government provided foreign-currency liquidity lines, reduced reserve requirements, bought credit portfolios from banks, and created programs to foster banks' mergers and reorganizations with the participation of new investors. During the 2008-2009 crisis, Peru's economy was on a stronger footing, international reserves were larger, and the banks held greater liquidity and solvency positions. Nonetheless, authorities promptly introduced preventative measures, including lower reserve requirements and longer terms for liquidity facilities. They also worked to contain exchange rate volatility.

Since 2014, the BCRP has tackled dollarization in the financial system while providing liquidity in soles.

Governance and transparency.   In our view, the Peruvian banking sector's corporate governance is at least adequate. We think it has conservative governance standards, given that boards of directors have greater numbers of independent members. The regulator discloses a satisfactory amount of financial information, with high frequency, timeliness, and solid reporting standards.

Competitive dynamics: Banks have a moderate risk appetite and a fairly stable market share

Risk appetite.   We believe Peruvian banks' risk appetite is moderate, given the low share of innovative and complex products and the absence of sophisticated securitization, both of which indicate limited risk-shared lending. For the past three years, the system's overall profitability has been sound, with an average return on equity (ROE) of 16.4%, better than that of other economic sectors such as energy, industrial manufacturing, and public services. Profitability of the latter sectors has suffered in the past three years, with an average ROE of 7.6% during the first semester of 2017. In addition, non-bank financial institutions' (NBFIs) performance has been weaker than those of banks, particularly Cajas Rurales and Municipales, since 2012. These companies focus on SMEs and microlending; the rates on these loans have fallen with increased competition. The credit quality in these portfolios worsened, generating credit losses. NBFIs are taking corrective actions such as market consolidation (acquisitions and transfer of assets and liabilities following liquidation).

Industry stability.   We assess industry stability as at least moderately stable for various reasons. First, banks' market shares have remained fairly stable for the past five years. The financial system in Peru consists of 16 private commercial banks, one public bank (Banco de la Nación), and 38 NBFIs, all of which are regulated. The three largest banks-- Banco de Crédito del Perú (BBB+/Stable/A-2), BBVA Banco Continental (BBB+/Stable/A-2), and Scotiabank Perú (BBB+/Stable/A-2)--have had a joint market share of about 60% of total loans for the past five years, and given their financial strength, they stabilize the industry. Finally, the likelihood of new entrants that could alter the competitive dynamic is low because of the difficulty of competing with well-established and large institutions.

On the other hand, several mergers and acquisitions among NBFIs occurred in the past four years. The consolidation occurred because these entities' financial profiles had corroded. NBFIs focus on lending to micro and small enterprises (MSEs). Between 2010 and 2013, competition in the SME lending sector increased as new participants entered the market, likely because of the appeal of broader margins. However, the increasing competition reduced net interest margins and weakened underwriting standards. The latter, combined with the slowing economy, increased NPLs and credit losses. Lower margins, higher losses, and poor efficiency have since decreased NBFIs' profitability, even jeopardizing the solvency of some entities.

We believe that there could be further consolidation among NBFIs, which would benefit the financial system. As NBFIs consolidate, new investors with better expertise will enter the market, improving risk management and operating efficiency. In any case, we believe the consolidation doesn't imply significant instability risks for the industry, because deposits at NBFIs made up about 10% of total deposits as of April 2018.

Market distortions.   We don't believe that the presence of government-owned banks or NBFIs cause market distortions. As of the end of 2017, government-owned Banco de la Nación represented 6.8% of the system's total assets, with a focus on particular niches like infrastructure, second-floor lending for mortgages to lower-income borrowers, agribusiness, and public-sector workers. SBS supervises and regulates NBFIs, ensuring that they meet the same regulatory requirements as traditional lenders. NBFIs account for around 9% of total system assets as of the end of 2017, and recent increased competition in SME lending didn't create instability in the market, even though it decreased credit quality. The government doesn't intervene in the banking system's operating dynamics, such as interest rate caps, administrative controls over deposits, or significant directed lending.

Table 5

Systemwide funding: Strong economic fundamentals, with a stable deposit base tempered by high dollarization

Core customer deposits.   The Peruvian banking sector's funding mix reflects a stable deposit base, although the still high and volatile amount of dollar deposits presents concerns. As of April 2018, deposits were about 82% of the system's funding, and issued debt--in both local and international markets--was about 9%. Other types of financial obligations, such as credit lines with international organizations (development banks, multilateral lending agencies, or repos with the BCRP), were around 9.1%.

We define Peru's core deposit base as 100% retail and 50% corporate. We've incorporated 50% of BCRP's repos into our analysis since 2014 because we believe this is a very stable funding source. Core customer deposits have remained stable, funding about 80% of total domestic loans in the past four years. We expect this ratio to remain around the same level in 2018 and 2019. As of March 2018, the system's dollar-denominated deposits accounted for 36.2% of total deposits, slightly below the 41.0% at the end of 2016.

Dollar-denominated deposits continue to represent a significant share of total deposits in Peru, even as a stronger economy and lower inflation in the past decade have helped boost sol-denominated deposits. However, as the sol weakened during the 2008 global financial crisis, and again in 2014-2015, households shifted to dollars to prevent losses on their savings. Moreover, institutional investors also shifted their investments to dollars, which, given the large size of these investments, had a significant impact.

External funding.   Many banks took advantage of the favorable conditions to issue debt abroad during 2013 and 2014 and lengthened their maturity profiles. However, since 2015, external issuances have become less attractive because of the BCRP's measures to reduce dollarization. In our view, the financial system has low exposure to external funding: it represents slightly below 9.4% of total domestic loans as of the end of 2017, down from 18.3% in 2012. We expect the share of external funding to decrease.

Domestic debt-capital markets.  In our view, Peru's debt capital market is narrow and shallow. Private-sector issuances were 8.3% of the GDP at the end of 2017. The private sector has very few issuances with long-term maturities. Large Peruvian issuers have been increasingly tapping international markets in the past few years because that allows them to issue debt with longer terms, in larger amounts, at lower prices; and to reduce creditor concentration risk. Furthermore, large Peruvian institutional investors look for investments abroad because they're more liquid than domestic bonds, given the domestic secondary market's lack of depth.

Government role.   We believe that the government has had a strong role in providing liquidity to the system in the past, and we believe it will provide guarantees and liquidity to support the banking system in case of future market turmoil. During both the 1998 Russian crisis and the 2008-2009 financial crisis, Peruvian authorities used several tools to ensure the system had sufficient liquidity, preventing a liquidity crisis (please see the regulatory track record section). Furthermore, the BCRP has actively fostered liquidity in local currency to reduce dollarization and to support credit growth, particularly during 2015 and 2016.

Table 6

Peer BICRA Scores

Peru has one of the weakest GDP per capita in its BICRA group (after India), limiting its economic resilience. Peruvian banks have lower economic imbalances than those of most of Peru's peers, reflecting slower credit growth, the absence of credit or real estate bubbles, and their low exposure to the commercial real estate sector. Peruvian banks have the weakest position compared to peers in terms of credit risk, reflecting the system's high dollarization, exposure to cyclical sectors, and weaker payment culture and rule of law. However, Peru has a better industry risk score than some peers because of its strong institutional framework supported by the regulator's solid track record.

Table 7

Government Support

In our opinion, the Peruvian government supports its banking system. The government has supported both the entire system (during past crises) and specific entities, and we expect this behavior to continue. As of the end of 2017, the government's international reserves represented 29.5% of Peru's GDP, which it could use to support the banking system. Additionally, as of the end of 2017, the Ministry of Finance's Fiscal Stabilization Fund contained $6.3 billion--about 3.0% of GDP--and the ratio of private-sector credit to GDP was 40.2%. Therefore, given the system's size, the government has adequate capacity to support it if needed.

Table 8

Related Criteria And Research

Related Criteria

• Banking Industry Country Risk Assessment Update, June 2018, June 20, 2018
• Sovereign Rating Methodology, Dec. 23, 2014
• Banks: Rating Methodology And Assumptions, Nov. 9, 2011

Related Research

• Peru 'BBB+/A-2' Foreign Currency Ratings Affirmed; Outlook Remains Stable, June 15, 2018