Major Factors

Strengths:

• Low appetite for risk;
• Relatively low leverage of economic agents; and
• Solid operating performance in the past few years.

Weaknesses:

• Recession, high inflation, exchange rate volatility, and electoral uncertainty; and
• Low credit penetration and reliance on short-term deposits given some lack of confidence in peso-denominated assets. This is mitigated by sound solvency regime and liquidity.

Rationale

S&P Global Ratings classifies the banking sector of Argentina (B/Stable/B) in group '8' under its Banking Industry Country Risk Assessment (BICRA). Other countries in group '8' are Paraguay, Bolivia, El Salvador, Honduras, and Russia. Our bank criteria use our Banking Industry Country Risk Assessment (BICRA) economic and industry risk scores to determine a bank's anchor, the starting point in assigning an issuer credit rating. We're applying our anchor SACP of 'b+' for a commercial bank operating only in Argentina

In upcoming quarters, we expect domestic financial institutions to continue operating amid economic woes as Argentina's GDP contracts (at a rate of about 1.6% in 2019, compared with a contraction of 2.5% for 2018), restrictive monetary policy (with high minimum reserve requirements), and high interest rates (nominal and real) until inflation recedes. These factors are hampering credit growth in real terms and banks' asset quality metrics. However, we consider banks would be able to cope with potentially additional losses stemming from the weakening asset quality, given their adequate provisioning and capitalization above the minimum requirements and focus on more formal sectors of the economy. We expect asset quality to continue sliding in the coming months and gradually improve once large corporate and small- to mid-size enterprise (SME) loan cases are resolved and retail loan delinquency stabilizes. On the other hand, we expect the banking system to remain profitable, but with higher weight of gains from holdings in central bank securities that should more than offset higher charges for provisions in response to rising delinquency.

Argentine banks have been increasingly providing dollar-denominated loans, but most of these are to borrowers that generate income in dollars, such as exporters, which alleviates potential risk. Such loans represent 32% of total credit as of the end of May 2019 (factoring in the impact of the depreciation of the Argentine peso against the dollar). Indexed currency mortgages grew sharply in 2017 and the first half of 2018, but access to these loans is limited to higher-income borrowers--and mortgage lending has decelerated markedly since then. Delinquency metrics in this segment remained stable at 0.3% of total mortgages despite the spike in inflation.

Our industry risk assessment incorporates Argentina's enhanced regulatory framework after it implemented Basel III principles for capital requirement calculations and liquidity ratios, and rolled out aspects of international accounting rules. These factors align Argentina's financial system more closely with international standards. Nevertheless, risks for banks operating in Argentina are still high given a weak regulatory track record, historically low confidence of depositors in the system, and the absence of diversified long-term funding. Besides, in our opinion, the shallow domestic capital market and limited access to foreign capital markets result in a narrow range of funding sources for banks.

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Economic And Industry Risk Trends

The stable economic risk trend captures the more challenging conditions for banks operating in the country, mitigated by solid solvency and liquidity indicators to forestall market volatility. Our baseline economic scenario assumes a gradual decline in interest rates and inflation and a gradual recovery of the economy in 2020. This is predicated on broad continuity in economic policies after the elections later this year.

In our view, Argentina's industry risk is stable. This reflects our view that the banks will be able to maintain high profitability in 2019, owing largely to high interest earned on banks' holdings of central bank notes (LeLiqs). We expect a decline in profitability in 2020 as banks start adjusting their financial statements to inflation and as economic conditions start to recover and result in lower interest rates. We assume funding to consist of deposits, and that volatility of deposits would be manageable during the presidential election.

Economic Risk   |  9

We base our economic risk score for Argentina on our assessment of economic resilience, economic imbalances, and credit risk in the economy.

Economic resilience: Economic contraction and high inflation in 2019

Economic structure and stability.   Argentina's GDP growth prospects and inflation outlook deteriorated starting in the second quarter of 2018 amid market and exchange rate volatility given unresolved economic imbalances. GDP contracted 2.5% in 2018, and we expect a contraction of 1.6% in 2019, a gradual recovery starting in 2020 assuming continuity in policies with business confidence, investments, and consumption recovering. Nonetheless, S&P Global Ratings considers Argentina's economic growth track record weaker than that of other countries at a similar level of wealth and development, given its historical track record and future growth prospects.

Adjustment for GDP per capita.  Argentina's GDP per capita fell to $11,600 in 2018 from nearly $14,500 in the previous year, due to a sharp depreciation of the domestic currency against the dollar.

Already hhigh inflation rose further in 2019, undermining real purchasing power and shortening economic agents' planning horizon. We expect inflation to average 50% in 2019, compared with about 34% in 2018, creating distortions and complicating product risk pricing for the banking system despite projections that inflation will fall to about 30% in 2020.

Macroeconomic policy flexibility.   S&P Global Ratings downgraded Argentina in November 2018 given challenges associated with stabilizing the economy under the IMF program and a weaker growth, inflation, and debt profile. With a $55 billion IMF program, the Macri administration aims to reduce imbalances and vulnerabilities in the Argentine economy. Namely, to lower inflation, strengthen the fiscal and growth trajectories, as well as stability of the peso. A restoration of market confidence would facilitate greater reliance on global capital markets once the IMF ceases disbursing funds under the program. In the meantime, policy flexibility is constrained by the contours of the program.

There have been a number of iterations in the monetary and exchange rate program targets, including permitting greater flexibility to manage exchange-rate volatility than initially envisioned, given pressure on the peso amid electoral uncertainty. However, the Argentine authorities have successfully met most all the quantitative targets thus far. While the top-line fiscal deficit remains high, given a worsening in the government's interest burden associated with need for very high policy interest rates, the primary balance moved from a deficit to surplus by early 2019. Inflation appears to have peaked in March 2019, and the economy bottomed out in the first to second quarter of 2019. Execution risks persist on the fiscal side given weak growth and revenues, and on the inflation side given risk to exchange-rate dynamics. While placement of debt in the local market has been better than initial expectations, a shortening of maturities ahead of the elections, keeps funding needs and vulnerabilities high.

Political risk.   Our sovereign institutional assessment of Argentina incorporates a history of major shifts in economic policy following changes of political leadership. The government's implementation of the IMF program and the use of proceeds from the loans, which the IMF and other multilateral lenders granted, should help cover the government's fiscal funding needs for 2019. However, in the longer term, regaining market access depends on maintaining viability of the economic adjustment program with a continued to commitment to reduce the fiscal deficit, progress in lowering inflation amid consistent monetary and exchange-rate policies under a credible central bank and growth enhancing initiatives. Our rating assumes the next administration following the October election will largely maintain market-friendly economic policies, setting the stage for economic recovery in late 2019 or early 2020.

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Economic imbalances: we expect a pronounced shrink of credit in real terms for 2019   Argentina continues to cope with economic malaise since the external volatility in 2018, while the government is attempting to reduce imbalances. The still very high inflation and interest rates turned domestic banks more cautious. They have shifted their asset portfolios towards the greater use of central bank securities, while shrinking lending in domestic currency (in real terms) in 2019. We expect banks' loan portfolio to contract 20%-25% in real terms and depending on the exchange rate fluctuations, given that about one-third of the loan portfolio are denominated in dollars. We believe growth in credit would gradually resume once political uncertainties after presidential election dissipate and economic imbalances start diminishing, while assuming a continuity in policies over time.

We believe banks' exposure to the residential mortgage lending in indexed currency (Unidad de Valor Adquisitivo; UVA), which surged between 2016 and 2018, is limited. The volume of mortgage lending in Argentina is still limited and granted mostly to medium- to high-income borrowers, resulting in non-performing UVA mortgages 0.3% of total loans as of the end of May 2019. Therefore, mortgage lending won't significantly heighten economic imbalance risks, given that almost all residential loans are in domestic currency, unlike prior to the 2001 economic crisis, 71% of residential loans were denominated in dollars.

Private sector credit growth.   Credit in 2018 grew about 36% in nominal terms year on year, compared with inflation of about 34%. The growth drivers were the 68% rise in mortgage portfolio, commercial loans (36%), and consumer loans (24%). Also, higher lending incorporated the impact of the appreciation of the foreign currency on the loan portfolio.

For 2019, we expect loan portfolio to increase 25%-30% on nominal basis, below the expected inflation of about 50%. In the first half of the year, credit in pesos contracted in nominal terms amid very high interest rates, and low investments, business confidence, and consumption. We expect credit penetration in real terms of less than 15% in 2019, compared with 15.5% as of the end of 2018. Lending growth should pick up pace next year, given that political uncertainties--over the presidential election--and imbalances gradually recede.

Real estate prices.   There's no official data on the average annual change in inflation-adjusted residential housing prices in Argentina.

Over the last few years, real estate prices were influenced by movements in exchange rates because assets in the country are mainly traded in dollars, but loans are granted in UVA and pesos. In this sense, prices in 2016 were affected by the peso's sharp depreciation after the removal of exchange-rate restrictions. Furthermore, in 2018 and 2019, despite stable real estate prices in dollars terms, prices measured in domestic currency spiked as the peso's value plummeted. In this sense, exchange rate jumped to 37.7 ARS per USD by the end of 2018, from 18.7 ARS by the end of 2017.

According to data from Reporte Inmobiliario (a real estate platform that contains information about the regional real estate), the four-year average of real estate prices has rise in real terms about 28% as of December 2018. However, this data is only for the city of Buenos Aires.

Equity prices.   Inflation-adjusted equity prices have been volatile following swings in external conditions and developments in the local markets, with a 9.7% increase in real terms over the past two years, compared with 29% a year earlier when economic expectations were robust. Index movements don't affect the banking sector because its exposure to these instrument types is very low.

Current account and external debt position.   We expect Argentina to continue to depend on external financing to cover its fiscal and current account deficits, making it vulnerable to a shift in global market conditions, as was the case in 2018 and 2019. Last year, the Argentine government entered into a program with the IMF, which provides enough resources to cover the government's remaining budget financing needs for 2019.

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Credit risk in the economy: Deterioration of asset quality, but stabilizing and manageable credit losses

Private-sector debt capacity and leverage.   Since 2018, Argentina's per capita GDP dropped to $11,600 from nearly $14,500 in the previous year as a result of the peso's sharp depreciation and the economic contraction, reducing debt capacity of economic agents. For 2019, we expect per capita GDP to fall to about $10,700 amid sluggish economic recovery and the currency depreciation. The weakening in debt capacity is mitigated by the low leverage and focus on formal segments of the economy.

Credit penetration in Argentina has remained between 13% and 16%, with no substantial recovery since the country's economic crisis in 2001, prior to which the ratio was 22%-23%. This metric is the lowest in Latin America, followed by Mexico (26%) and Uruguay (28%), in contrast with Chile and Panama (85%-86%). Argentina's volatile economy has resulted in a more transactional system with a focus on short-term lending to the formal economy sectors, relatively high liquidity, and reliance on one-time effects and interest on securities. We expect credit penetration to remain low as long as economic variables (such as inflation and economic growth) don't stabilize, and medium- and long-term planning doesn't resume. Longer-term stability would allow the banking industry to expand its services to the lower-income slice of population, because household debt as a percentage of GDP is only about 7%, compared with peer BICRA countries with a 17% average. Lending to corporations and SMEs is also low, with corporate debt as a percentage of GDP at about 20%, compared with peers' average of 34%.

Adjustment for lending and underwriting standards.   We continue to view lending and underwriting standards in Argentina as moderately conservative. Although mortgage lending spiked in 2017 and 2018, the share of these loans in the total loan portfolio is small and limited to prime lending. The use of collateral and cash flow analysis is common. As of March 2019, mortgages accounted for 10% of total loans, and 74% of mortgages were residential and the rest were commercial real estate loans. Only 6% of mortgages were in foreign currency, almost all of which were commercial. In addition, the terms of UVA mortgages include the possibility of extending the tenor if the inflation rate exceeds salary increases by 10%. This mechanism allows the borrower to extend the tenor up to 25%. For the rest of 2019, we expect origination of UVA mortgages to be low because of projected higher inflation, weak currency, and tighter conditions for loan granting.

Since the beginning of the year, dollarization in the country has increased in terms of total loans and deposits, mainly due to the dollar's sharp appreciation of the dollar against the Argentine peso, and a slight increase in loans and the stock of deposits in dollars (private-sector deposits). As of May 2019, about 32% of total loans and 39% of total deposits (both in nominal terms) were denominated in dollars, compared with 27% and 35% at the end of 2018, respectively, and 17% and 22% at the end of 2017. The system's level of dollarization was lower in 2015, given the restrictions the previous administration imposed on foreign exchange transactions.

We'll continue to monitor how the industry's level of dollarization evolves. However, we note that Argentine banks mainly grant loans in foreign currency to borrowers with dollar revenues--such as exporters and companies in sectors such as energy--given the lessons they've learned from the past and the current regulations in place. The banking segment provides traditional products. Lenders do not use derivatives and only use a small amount of securitizations to shift risks off their balance sheets.

Adjustment for payment culture and rule of law.   Low confidence in the legal system is a major weakness in Argentina, and could lead to worsening credit quality during economic distress. Although the insolvency regime improved after the last economic crisis, the bankruptcy process is still time consuming and inefficient. Overall, Argentina's low ranking in international indicators (such as World Bank governance indicators and transparency indices), the nationalization of the energy company, Yacimientos Petrolíferos Fiscales—YPF (B/Stable/--), and the pension fund AFJPs, allegations of high-level corruption, and amnesties for tax evaders are evidence of poor rule of law.

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Base-Case Credit Losses

Credit losses have remained low for the past five years despite the struggling and volatile economy. However, the banking system's non-performing loans (NPLs) are rising and credit losses have widened amid high inflation and interest rates, rising unemployment, and falling purchasing power. In this sense, as of May 2019, NPLs (90-day, past-due loans) rose to about 4.5% of total loans from 3.1% as of the end of 2018 and about 2% in previous years. The rise in NPLs stems from a large corporate case, some in the SME lending segment, and the deterioration in the retail lending segment. We expect this metric to be 4.0%-4.5% in the coming months and recede once large cases are resolved and the retail loan delinquency stabilizes.

We expect credit losses to widen to 1.2%-1.5% from less than 1%. In our view, Argentina's banks can cope with potentially additional losses stemming from the weakening asset quality, given their adequate provisioning and capitalization.

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Industry Risk   |  7

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

Institutional framework: Regulation is in line with international standards

Banking regulation and supervision.   We assess Argentina's regulation and supervision as intermediate because the authorities have made substantial progress in aligning with international standards that will allow the central bank to adequately oversee the industry. As a member of the Basel Committee, Argentina progressed in implementing Basel III. Specifically, it has defined regulatory capital levels that are in line with Basel III standards; introduced credit, market, and operational risk requirements; and established regulation for the pillars of Basel II. Moreover, since January 2014, banks have disclosed their Pillar III reports. Since 2015, the financial regulatory bodies introduced a liquidity calculation.

The current administration removed some of the measures its predecessor introduced, including the caps on loan rates, minimum rates on term deposits, the quotas for loans to SMEs, and the authorizations for fee increases. As part of Argentina's recent program with the IMF, the government has committed to implement the following measures that would strengthen the central bank's autonomy, including:

• Enabling the central bank, along with the Ministry of Finance, to set inflation goals for three-year periods;
• Eliminating transfers from the central bank's to the Treasury;
• Improving the central bank's balance sheet through the repurchase of "Letras Intransferibles" (treasury bonds that the central bank acquired, which can't be sold in the market), while eliminating LEBACs (central bank securities); and
• Submitting legislation to Congress to reform the central bank's charter in order to strengthen its autonomy.

Regulatory track record.   In response to the 2001-2002 financial crisis, the government impose a deposit freeze to stop a run on banks, which we viewed as regulatory weakness. At that time, banks' balance sheets were mostly dollarized, foreign currency lending wasn't hedged, and banks' exposure to the public-sector loans was very high. The previous administrations' many reforms mainly had a political and social agenda, rather than a preventive one to ensure the health of the financial system. The central bank's lack of independence and limited authority to address problems shifted its focus towards supporting government policies.

Adjustment for governance and transparency.   Argentina's governance and transparency is adequate, in our view. The banking system discloses sufficient information, and banks' reports and financial statements are standardized. The central bank publishes a semiannual Financial Stability Report and a monthly Banks Report. Furthermore, since January 2014, banks disclose Market Discipline reports, which are in line with Basel Pillar III guidelines. The banking system began implementing some International Financial Reporting Standards (IFRS) this year.

Competitive dynamics: Still profitable banking system despite low credit intermediation

Risk appetite.    The Argentine banking system's average return on assets (ROA) for the past three years was 3%-4.5%. Banks benefited in previous years from extraordinary events such as the peso's depreciation, high rates on central bank securities, and in many cases, negative real interest rates for funding costs with deposits.

For 2019, we expect the composition of earnings to remain similar to that in 2018. In this sense, we still expect a relatively high proportion of earnings from securities given that banks have allocated excess liquidity and part of the minimum reserve requirements into central bank securities (Leliq) and government bonds, which accrue very high rates. Despite a contraction of credit in real terms, we expect the higher loan interest rates to more than compensate for higher funding costs of term deposits and the implementation of remunerated sight deposits, but with some lag. At the same time, we expect banks' results to incorporate higher provision charges in response to the worsening credit quality metrics. Overall, we expect ROA of about 4% this year, compared to 4.2% in fiscal 2018. In 2020, results are likely to slip because of the implementation of inflation adjustments and IFRS9, causing provisioning requirements to rise, mitigated by the potential resolution of specific cases in the corporate segment.

The Argentine banking system offers traditional products with no high-risk lending. Asset growth has been moderate over the past few years amid high inflation and subdued economic growth, and commercial practices are generally conservative. Although the system's profitability is higher than those of other sectors, we don't think it's due to a high risk appetite. In our view, the improvement of competitive dynamics in Argentina depends on a more favorable economic outlook, stabilizing political trends, and lower inflation and interest rates.

Adjustment for market distortions.   We believe the banking system in Argentina exhibits the following characteristics that could distort competition and earnings:

The significant presence of government-owned banks or government-related entities (GREs). The largest bank in the country, government-owned Banco Nación, held about 23% of the system's deposits and 16% of loans as of March 2019. Banco Nación and the other 16 government-owned banks and GREs account for about 43% of total deposits and 35% of total loans. These banks tend to have competitive advantages, such as cheaper funding, because they benefit from a portfolio of captive clients--public-sector employees--and some receive deposits from the judicial system. Also, some entities offer subsidized interest rates for certain types of loans and have guarantees from their respective local governments for their deposits.

We expect inflation to remain high, making risk pricing difficult and hindering long-term lending.

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System wide funding: Mainly funded by deposits, but stability has historically been a risk

Core customer deposits.   The Argentine banking system's main source of funding is deposits, which represented about 83% of total liabilities as of May 2019. The issuance of senior and subordinated bonds accounts for slightly less than 4% of total liabilities as of the same date. We expect funding structure to remain similar in 2019 amid the likely low credit growth.

While banks' dependence on deposits should indicate lower funding risks, deposits have been volatile in the past in Argentina. Therefore, we consider deposit stability a relevant factor to monitor. Total deposits declined about 5% between the end of August 2018 and mid-September 2018, with a subsequent gradual recovery. This is also important in light of the larger deposit base in foreign currency, after the elimination of foreign restrictions in late 2015, the enactment of the tax amnesty program in 2016 and 2017, and sharp appreciation of the foreign currency against the Argentine peso. Total deposits have remained relatively stable despite the currency's sharp depreciation, mitigated by high levels of liquidity in the system.

Growth of deposits rose 60% year on year on nominal basis in 2018, due to greater deposits in dollars, the impact of the weakening peso, and the 40% growth of deposits in domestic currency on nominal basis. As a result, the proportion of deposits in dollars increased to about 31% of total by the end of 2018 from 22% in 2017. We expect this metric to be 35%-40% until political and economic conditions improve.

At the same time, we're seeing funding costs increase for financial entities, stemming from remunerated accounts to companies and a growing time deposits base. We expect entities to be able to pass through a significant portion of this increase in costs to customers given the short-term nature of the loan portfolio, although there will be some lag.

Given 100% of retail deposits and a haircut of 50% of corporate deposits, our funding ratio estimates that domestic core customers have funded about 111% of system-wide loans by the end of 2018, compared with 95% in 2017, taking into account a moderate growth of loans. For 2019, we expect this metric to remain at similar to the one in 2018 and gradually decline afterwards as long as economy recovery and credit growth gains pace.

External funding.   Banks have a low dependence on external funding, stemming from limited access to financing given the high economic and political risks and the government's freezing deposits during the 2001 crisis. The banking sector's net external position over system-wide loans was negative in 2018, because market volatility increased and appetite for Argentina debt diminished. We don't expect the trend in external funding for domestic banks to change in coming years.

Adjustment for domestic debt-capital markets.   The domestic capital market remains very shallow and narrow. It's mostly dominated by sovereign bonds and GREs, such as YPF. During the market volatility in 2018 and 2019, very few domestic issuances occurred. Over the medium term, we expect the capital market in Argentina to gradually benefit from the "Ley de Financiamiento Productivo" law.

Adjustment for government role.   We assess the government's role in providing liquidity and guarantees during periods of market turmoil as weak. During Argentina's 2001 economic and financial crisis, the government imposed a deposit freeze that lasted for almost a year. Although the freeze halted a systemic bank run and prevented bank failures, the regulator was unable to provide liquidity at the right time and regain depositor confidence. However, liquidity in the banking system has improved since 2001, and during the 2008-2009 global financial crisis, the central bank was able to use several tools to maintain liquidity in the financial system. Under the current administration, international reserves have recovered to about $68 billion by the end of July 2019 from their lowest level of $24.1 billion on Dec. 17, 2015.

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Peer BICRA Scores

Argentina's economic risk is higher than those of peers, given erratic economic performance and high inflation, factors that distort the purchasing power of individuals and make it difficult for banks to adjust prices. Despite recent deterioration of asset quality, Argentine banks' metrics and losses remain manageable.

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Government Support

Although the central bank has the explicit purpose of acting as a lender of last resort and the country has a deposit insurance framework, we consider the Argentine government's support to the banking sector to be uncertain. The government has a poor track record of supporting the banking sector, as seen during the 2001 financial crisis. Furthermore, even though the government's financial flexibility and reserves have improved, we're uncertain about its ability to effectively support banks in the event of financial distress.

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Related Research And Criteria

• Banking Industry Country Risk Assessment Update, June 27, 2019
• Sovereign Rating Methodology, Dec. 23, 2014
• S&P To Publish Economic And Industry Risk Trends For Banks, March 12, 2013
• Analytical Linkages Between Sovereign And Bank Ratings, Dec. 6, 2011
• Banks: Rating Methodology And Assumptions, Nov. 9, 2011