Payroll deductible loans' (PDLs) presence in the consumer segment in Mexico has grown over the last decade and they've had lower default rates than traditional consumer loans. Although PDLs' credit risk is lower than other retail products by nature, payroll discount lending within nonbank financial institutions (NBFIs) has had notable operating vulnerabilities in the past because they rely on the transfer of funds from the employer to the payroll loan company. These transfers can be subject to delays that hurt asset quality indicators and cash flow collection. Other potential risks have been clients' high debt and the lack of a solid regulatory framework to protect contract agreements between employees and intermediaries.

While these risks have been a notable characteristic of the regulatory framework in Mexico, S&P Global Ratings believes that the recent initiative to reform several laws related to payroll lending would make the industry more transparent, aligning the sector norm with international best practices and partially mitigating operational and political transition risks. In the long term, if the reform is approved, it could gradually translate into lower delinquency levels and reserve consumption for the sector. However, the reform could also tighten financial margins and profitability because other financial institutions and large competitors could increase their appetite for the sector.

Main Points Of The Reform Will Foster Transparency

In our view, one of the main changes that benefits the industry in terms of collection is the implementation of an irrevocable mandate to remit to the lender all deductions within four days of having paid the worker's salary.   Although current agreements already require the transfer of funds, the new law establishes significant legal consequences for an employer that doesn't remit the deductions to the lender. This mandate, if approved as it is considered in the proposed initiative, enhances the collection mechanism but still relies on a third-party mediator (the employer) to collect the deductions and transfer the funds. We think that the proposed legislation will strengthen the sector's regulatory framework because it enhances legal security and reinforces the agreements between NBFI payroll lenders and employers.

The reform introduces a maximum repayment capacity--interpreted as a ceiling in the level of debt (50% of the borrower's income)--that will reinforce client protection.   The industry's main players had already followed a debt ceiling guideline in their internal policies, establishing a cap of about 30%. Even though this reform will apply to both banks and NBFIs, we think that it could have a larger effect in the short term on smaller participants because they follow more aggressive underwriting policies. The bill also clarifies the type of entities that can originate payroll loans and the minimum standards they need to operate. Overall, in our view these measures will help prevent possible fraud, abusive practices, and could represent an opportunity to increase governance standards within the sector.

Finally, the new law could require that contract agreements between lenders, borrowers, and employers must be publicly registered at The National Commission for the Protection and Defense of Users of Financial Services (CONDUSEF; its Spanish acronym).   The reform also establishes the obligation of the employer to implement a platform to manage the payroll deductions that all related parties (regulator, lender, and employer) can examine. In our view, this could foster better governance and transparency in the payroll credit business, but we note that there could be financial obstacles and operational challenges in implementing the reform. Moreover, we believe that fundamental changes to institutional features (staff capacity, organizational culture, technology systems, and others) could take several years.

The reform initiative is in the opening stage of endorsement and might still change as it progresses. The Senate's bill was sent to the Chamber of Representatives (Cámara de Diputados) where its approval could happen during the current legislative term.

The Reform Could Benefit ABS Deals Backed By Payroll Loans

We believe the proposed reform, if approved, could be beneficial for asset-backed securities (ABS) deals backed by payroll loans by promoting transparency in the sector and providing greater certainty about the legality of the collaboration agreements under which payroll discounts are made. In our view, the proposed modifications would align legislation in Mexico with those of other countries in the region such as Colombia and Brazil.

From a legal perspective, the bill would strengthen the legal framework for these assets. Key factors that would boost the framework would be including the concept of payroll credits in the law (which to date isn't recognized in existing legislation), establishing the employer's obligations to carry out the transfer of deductions, and including the possible consequences in case of non-compliance with these obligations.

If approved, employers would be required to implement an online platform within 24 months, which should be automized and auditable, that includes all the information related to the payroll deduction loans. In our view, this could reduce the administrative complexity for both the employers and the servicers and could reduce our view of operational risk in these transactions.

The bill also addresses origination standards for these ABS deals. While most of the originators are already following these practices in their underwriting policies, if properly implemented, we think the previously mentioned changes could result in loans with higher credit quality by limiting borrowers' potential debt, consulting credit bureaus, and recognizing the preferential priority for borrowers. In addition, the credit agreements and collaboration agreements must be publicly registered before CONDUSEF, which could in our view increase transparency for investors.

In recent years, there have been a limited number of issues backed by payroll credit in Mexico, with only four transactions placed since 2018 to date for an amount of approximately MXN3.45 billion. In our opinion, such reforms could make this asset class more attractive to both issuers and investors, which could result in a greater number of transactions.

After A Decline In Loan Originations In The Payroll Segment, We Expect Sluggish Growth This Year

The pandemic's main effects on Mexico's payroll segment have been a sharp decline in credit volumes and lower interest income flow. The weak loan demand caused by the social distancing guidelines, combined with the deep economic contraction (estimated at about 8.5% in 2020), have resulted in a steep drop in interest revenues. Historically, payroll lending to government employees has grown aggressively in Mexico while private companies' payroll loans have maintained a steady positive pace; nonetheless, after the onset of COVID-19 infections and the adoption of social distancing measures, payroll loan originations dropped significantly. PDLs within commercial banks contracted 2.4% compared to the five-year compound annual growth rate (CAGR) of 6%, while rated NBFIs focused on payroll had loans reduced 7% in 2020, on average, versus the five-year CAGR of 26%. We consider that the impact of the second partial economic lockdown in Mexico City and the state of Mexico in December 2020 and January 2021 might not be as sharp as the first, but again damaged payroll lenders' origination and profitability prospects.

Despite adverse economic conditions in the country, we expect payroll lending growth to gradually rebound as the economy slowly reopens and the vaccination program evolves. We forecast payroll loans to grow slightly above our expected 3.6% credit growth for the overall Mexican banking system this year.

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Moreover, we continue to consider payroll loans as relatively less risky than other consumer loans in Mexico, especially payroll loans with closed-circuit agreements between the lender and employer--which eliminates the willingness to pay issue that habitually causes other consumer loans, such as credit cards and personal loans, to default. However, the unemployment rate recovery within the private sector and operational and political risks on the public side will be key factors to monitor as we track potential upcoming credit losses for Mexico's PDL sector.

Chart 2

Delinquency Levels Of Payroll Loans Within NBFIs Have Remained Resilient Amid The Pandemic

Several industry players offered relief programs to support their customers by deferring automatic withholdings for up to three months (May, June, and July 2020). Loans under the relief measures represented about 5% of total loans, while other NBFIs that offer different products as well as the banking industry needed to grant forbearance to a greater extent. The PDL industry has been more resilient than other industries because of the payroll-deductible mechanism and the traditional stability in the employment turnover rate of Mexican government agencies. Considering these factors, we continue to believe the effect of the COVID-19 pandemic on payroll loans will be less versus other consumer products such as credit cards and personal loans.

Chart 3

Overall, we continue to think the PDL segment will be more resilient than other consumer products amid the pandemic, and we expect the proposed reform, if approved, could make the payroll loan industry more transparent, potentially lowering the sector's delinquency levels and reserve consumption in the long term.