Chilean banks recently reported second quarter financial figures that were influenced by several actions taken by the Chilean government in coordination with the central bank and regulators (Comision para el Mercado Financiero [CMF]) to buffer the impact of the pandemic ("Scope Of Policy Responses To COVID-19 Varies Among Latin America's Central Banks," June 3, 2020).

In the first half of the year, credit grew fairly quickly, with a large portion of lines guaranteed by the government (known as the FOGAPE program) as part of authorities' measures to ensure credit availability. The growth in these lines more than offset a contraction of the consumer loan portfolio, given payments from customers to the financial entities during the lockdown. S&P Global Ratings believes that part of the contraction in consumer lending could be reverted in the last quarter of the year, depending on economic developments.

At this point, Chilean banks' asset quality metrics haven't significantly worsened given the measures taken by authorities in the country, including extending existing loans and incorporating guaranteed loans. However, we expect asset quality metrics to start deteriorating beginning in the last quarter of this year and in 2021 as extended loans start to come due. In the meantime, entities in the financial system are building up provisions (both specific and additional) with a notable increase in corporate and enterprise provisions. We see more stable provisioning levels in the consumer segment, given increased charge-offs.

In our view, the industry's profitability will suffer this year because of the increase in provisions, but this will be mitigated by cost containment measures and better treasury results. Margins will decline amid lower rates for guaranteed loans and lower inflation, but to a large extent will be compensated by a significant decline in funding costs of COVID-19-related central bank lines and higher demand deposits in the system (that are cheaper than other deposits). These factors translated into a 25% decline in results in the first half of the year compared to 2019 (not counting losses of about $1 billion from goodwill impairment at Itau Corpbanca recorded in 2020).

Regarding banks' capitalization, postponing the new banking law to 2021, some reductions in dividend payments, and the special treatment of FOGAPE loans are helping banks to deal with the asset growth and lower profitability in 2020.

Chilean authorities have taken several actions to ensure liquidity in the system and credit availability in the economy in order to preserve the payment chain. An increase in demand deposits because of the actions of corporates and enterprises to build cushions to cope with the pandemic, has also strengthened liquidity. In addition, liquidity will likely initially benefit from the partial withdrawal of pension savings that are deposited in the system.

In April 2020, we revised the economic risk trend in our Banking Industry Country Risk Assessment (BICRA) of Chile to negative, as well as the outlook of financial entities operating in the country, reflecting the risk of adverse conditions due to the pandemic on top of residual effects from recent social unrest. (Refer to "Outlook On 11 Chilean Financial Entities Revised To Negative On Higher Economic Risk, Ratings Affirmed," April 3, 2020, and "Banco del Estado de Chile Outlook Revised To Negative Following Same Action On The Sovereign; 'A+/A-1' Ratings Affirmed," April 28, 2020.) In our view, these effects could translate into consistently higher economic and credit risks amid higher corporate leverage and lower individual income compared to those of Chile's peers. Higher risks could take a toll on financial institutions' financial profiles, particularly asset quality and capital and earnings. We're monitoring these risks in conjunction with mitigating factors.

Government Has Taken Measures To Boost Economy, But Contraction Still Expected

In the short term, the recent approval (July 23; in record short time) and implementation of a one-time withdrawal of up to 10% of individuals' pension savings in the country would give additional cushion for the population to cope with the pandemic and rising unemployment, on top on measures already taken by the government to boost the economy. Pension savings in Chile amount to about $200 billion, with expected withdrawals of about $14 billion to $16 billion. As of Aug. 12, about 8.6 million people (equivalent to 79% of affiliates and beneficiaries in the system) had requested withdrawals of funds for about $14 billion, with a high number of requests from people that had low amounts of savings. We expect that part of these withdrawals will be reinvested (especially by high-income individuals), part will be used to pay debt, but a high proportion will translate into consumption. This would have a positive effect on the economy, boosting activity for the upcoming quarters and possibly reducing the GDP contraction for 2020 by about 200 basis points (bps).

In addition, in June the government agreed to set up a fund for up to $12 billion to sustain the economy that will be spent over a two-year horizon in order to enhance financial support to households, with a focus on the middle class, and to provide fiscal stimulus for a fast recovery.

We're continuing to monitor the evolution of the industry and financial institutions in the country in a scenario of economic contraction, but we incorporate mitigating factors given authorities' actions, the release of pension savings, and some improvement in copper prices given the fast recovery in China. We forecast inflation to remain low, but it could increase in the last quarter of the year depending on higher demand for products, given the actions to boost individual consumption. Under these assumptions, reference rates would remain low and close to the current level of 0.5% at least for the upcoming quarters. For the rest of the year and 2021, the tone of the discussion to amend the constitution (that was originally planned for April), changes in the pension system, and the population's reaction after the social unrest in 2019 are key factors that could affect risks in Chile.

Growth Of Credit In 2020 Driven By Lines Guaranteed By The Government

The banking industry's loan portfolio grew 11% between December 2019 and June 2020 (on a nominal basis), driven by the wholesale segment that increased its participation to almost 60% of total loans in the system, from 57% at the end of 2019. This growth compensated for the declining trend in consumer loans, which dropped about 8% in the first half of the year. For 2020, we expect the industry's loan portfolio to grow 7%-8% on a nominal basis, assuming a recovery in consumer loan portfolio in the last few months of the year and incorporating new wholesale lines guaranteed by the government (FOGAPE) for about $13 billion to $15 billion, with the bulk of the loans already granted in the first half of the year.

When the pandemic began, banks saw loan growth in the corporate segment related to companies' use of lines to ensure liquidity. After that, the government implemented loans under the FOGAPE program (with a guarantee between 65% and 80%) to support companies' operations and prepare for the emergence from the lockdown. The capitalization of the FOGAPE fund has the capacity to grant up to $24 billion in new loans (equivalent to 8.5% of GDP and 9% of the system's loan portfolio), but we don't expect it to be fully used. The program aims to cover small and medium enterprises (SMEs), but was also extended to larger companies under the pandemic.

Banks in the industry took various approaches to the FOGAPE program. Banco de Credito e Inversiones (BCI) and Banco Santander Chile granted FOGAPE loans in a higher proportion than their market share of total loans, while Scotiabank Chile and Itau Corpbanca granted them below their market share (refer to chart 1). Banco del Estado de Chile (Banco Estado), as the country's only public bank, has granted about 50% of the total FOGAPE loan applications, with a focus on small and micro enterprises (refer to chart 2). As seen in the chart, Banco Estado has a higher proportion of loans granted to small companies and microcredit compared to other banks in the system (see chart 3).

Chart 1

Chart 2

Chart 3

Loan Extensions To Limit Nonperforming Loans For A Few Months, But Cost Of Risk Is Increasing

Like various other countries around the world, authorities in the Chile introduced the possibility for banks to extend payment installments on their loan portfolio. As of July 31, about 38% of the mortgage loan portfolio in Chile had extensions, 19% of consumer loans, and 37% of commercial (mainly comprised by SMEs). Considering these lines (extensions in large individual corporate loans are not reported), about 33% of the total had extensions. Chart 1 above shows the magnitude of the extensions granted by main banks. Banco Santander Chile and BCI have much higher-than-average extensions in in their commercial portfolios (about half of these loans) and mortgages (also about half). Banco de Chile and Itau Corpbanca had more extensions in their consumer portfolios (44% and 35% of loans, respectively).

These extensions are resulting in relatively stable nonperforming loans (NPLs), at least for the first nine months of the year (refer to chart 4), and given that the granting of FOGAPE loans also includes the extension of existing loans (because the aim of FOGAPE is to provide fresh money to sustain and emerge businesses from the pandemic). However, we expect NPL ratios to start worsening in the last months of 2020 and in 2021. Loan extensions and the subsequent payment culture of customers are relevant factors for the evolution of asset quality metrics in the upcoming quarters, giving entities some cushion to absorb the recession's impact.

Chart 4

However, banks in the country are building provisions both specifically for forecast NPLs, and additional provisions to incorporate the future impact on asset quality that models don't fully capture because they're influenced by loan portfolio extensions (refer to chart 5 to see the specific and total [specific plus additional] provisions over NPLs). As of June 2020, loan loss reserves accounted for 2.7% of the industry's loan portfolio and 3.3% taking into account additional provisions. We expect the stock of provisions to further increase due to recent additional provisions required by regulators on the deductible portion of FOGAPE loans (equivalent to about 5% of granted FOGAPE loans), which will be implemented this year.

Chart 5

Chart 6 shows the evolution of the cost of risk, which has increased to about 1.8% of total loans in the first half of 2020 (annualized) from 1.4% in 2019 (that already incorporated higher provisions due to social unrest last year); compared to the 1.2% average in 2014-2018.

Chart 6

Chart 7 shows the quarterly evolution of cost of risk by business segment. The corporate segment's risk cost is growing more quickly than other segments. Cost of risk in the consumer segment declined in the first half of the year compared to the fourth quarter of 2019. This resulted from payments during the lockdown, but also due to continued charge-offs (considering that charge-offs of the consumer loan portfolio in Chile are done after 180 days, compared to longer periods in other jurisdictions). The measures taken by authorities to buffer the effects of the pandemic and the withdrawal of pension savings should bring some temporary relief for individuals and loan portfolio performance in this segment.

Chart 7

The quarterly annualized cost of risk and net charge-offs (NCOs) is illustrated in Chart 8. The cost of risk is increasing faster, while NCOs have stayed at similar levels in the last quarters. Chart 9 indicates NCOs by business segment, with some increase in NCOs of consumer loans, but stable levels in NCOs in company and enterprise loans.

Chart 8

Chart 9

Profitability Hurt By Higher Provisions, But Remains Manageable

We expect higher provisioning in 2020 and part of 2021 to dampen profitability, but this would be mitigated by cost containment actions taken by financial institutions. In addition, lower interest rates of FOGAPE loans and lower projected inflation (given the active position of banks in Unidad de Fomento [UF]; currency indexed by inflation) will hurt margins, but this will be compensated by lower funding costs of COVID-19-related lines provided by central bank and increased treasury results.

As discussed earlier, these factors led banks' results to decline 25% in the first half of 2020, compared to the same period last year (and excluding in 2020 goodwill impairments of about $1 billion from Itau Corpbanca). We expect return on average assets to be at about 0.6% this year, compared to 1.1% on average in the last three years.

Capitalization Ratios Influenced By Regulator's Actions

As part of the regulator's actions to deal with the pandemic, it postponed the implementation of the new banking law in Chile. Despite some reductions in dividends in 2020, the lower earnings forecast for this year and part of next year could require, in some cases, additional efforts from banks to implement the new law in 2021.

The regulator in the country recently proposed a change in the treatment of loans guaranteed by the government (FOGAPE loans). The proposal involves including guaranteed lines in the calculation of risk-weighted assets (instead of computing part of these loan guarantees as tier 2 capital), with the risk weight lowering to 10% from 100%. The measure would increase tier 1 metrics and decrease tier 2 ones, and would give more room to compute additional provisions as effective tier 2 capital. S&P Global Ratings takes a similar approach in the risk weight of the guaranteed loans in its calculation of risk adjusted capital (RAC) ratios. A potential revision of Chile's BICRA economic risk trend would affect capital metrics for some of our rated financial institutions in Chile.

Authorities' Actions And Market Dynamics Have Also Strengthened Funding And Liquidity

As discussed above, the government, in conjunction with the central bank and regulators, has taken various measures to ensure the liquidity of the financial system and to manage volatility. These measures include implementing programs that ensure liquidity for lending and that result in lower funding costs to compensate for lower interest rates and the temporary suspension of limits on liquidity metrics. The central bank also implemented bank and corporate bond purchasing programs. The possibility of the government acquiring treasury bonds in the secondary market as part of measures to temper future volatilities is also under discussion.

As of June 2020, the financial system reported a solid liquidity position, strengthened by the high proportion of demand and time deposits from clients and lines from the central bank. The system's net total loans to deposits ratio was 126% at the end of June, despite the growth in FOGAPE loans.

Chart 10

Key Factors To Monitor For Chilean Banks

We expect the financial industry to continue building provisions and closely doing risk management of its loan portfolio. We'll monitor the impact to the economy and the banking system of the partial withdrawal of the pension savings (as of August 12, pension funds had already paid $6.7 billion of withdrawal requests). Key developments for the financial system are the evolution of the economy after the pandemic dissipates, and the political agenda with the upcoming discussion to amend the constitution and potential changes in the pension system. We believe the population's reactions to proposed constitutional and potentially pension changes and the tone of the discussions will be instrumental in shaping Chile's trajectory after the pandemic.