S&P Global Ratings expects a strong economic rebound in Colombia in the next two years, with real GDP growing about 7.0% in 2021 and 3.0% in 2022, after the 6.8% contraction in 2020. This would place Colombia among the countries with better economic prospects in Latin America in 2021-2022. In our view, the country's economic recovery will be driven by improving consumption and supported by the services sector and oil exports, which are quickly recovering in line with improving global demand.

In our opinion, in Colombia (like in other Latin American countries), people and various economic actors have learned to live with the coronavirus and deal with restrictions. In our view, the impact of potential new lockdowns would be less damaging to the economy than those last year. Therefore, we expect that the economic growth we saw in the first half of this year will continue in the second half and in 2022. We think economic prospects will be supportive for the Colombian banking sector in terms of business dynamics and its operating performance. Moreover, our expected economic conditions for the next 12-18 months could revive credit demand, mainly from households.

Despite our projected recovery, we believe downside risks persist for Colombian banks. These risks stem from still high uncertainty about the COVID-19 pandemic's duration--which could slow the recovery of consumer demand--and by the potential headwinds that could stem from monetary and fiscal tightening in next 12-18 months and the risk of new waves of social unrest. In our opinion, these risks could cloud Colombia's economic recovery prospects because they could weigh on investment and create a challenging and unpredictable political outlook ahead of next year's general election, which could postpone investment decisions from the private sector until there is more policy visibility. We'll closely monitor how these risks evolve in the next 6-12 months to assess their potential impact on Colombian banks' business and financial profiles.

Chart 1

Economic Rebound Will Revive Credit Demand

When the coronavirus outbreak arrived in Colombia in March 2020, the government instituted lockdowns, which resulted in a deep economic downturn. From March to May of last year, there was a spike in credit demand from Colombian companies seeking to strengthen their liquidity positions to withstand the looming economic crisis. During those months, corporate and commercial loans expanded between 11%-12%, but as the negative effects of the pandemic receded during the second half of 2020, companies prepaid the debt. After peaking at about 12%, corporate and commercial loans' growth moderated to less than 5% at year-end 2020.

We note that government-guaranteed loans from Fondo Nacional de Garantías (FNG; not rated) to micro, small, and midsize enterprises (MSMEs) boosted banks' loans to these types of entities. As of July 2021, MSMEs had about 90% of the government guarantees extended through FNG. However, the total amount of guaranteed loans under this program represents less than 4% of total loans in the banking system, so they weren't enough to offset the drop in credit demand from large corporations.

Along with the moderating demand for corporate and commercial loans, the challenging economic conditions and the rise in unemployment hurt households' income capacity and limited their demand for credit. As a result, consumer loans and mortgages expanded less than 3% and 6%, respectively, in 2020. Charge-offs in the non-secured consumer portfolio also contributed to the significant slowdown in overall consumer loans. Total loans in the Colombian banking system grew about 4% in 2020, the lowest level in the last 11 years, and just above the 2.4% observed in 2009 during the global financial crisis.

In our opinion, the strong economic rebound this year and next will be supportive for the Colombian banking sector and will boost demand for credit. We expect total loans in the banking system to expand 6%-7% this year and about 8% in 2022. In our view, credit demand from households will support overall loan growth as the vaccine rollout makes progress that will help boost the economy and improve private consumption. In addition, still low interest rates will incentivize demand for credit, in particular for secured loans such as payroll, auto, and mortgage loans. Even though we expect corporate and commercial loans to grow more in 2021-2022 versus 2020, this growth could be limited by factors that could lead companies to take a conservative approach toward investment decisions in the next 12-18 months. For instance, social protests and the upcoming general elections in May 2022 could make the political outlook more unpredictable, along with the proposed tax reform. Once there is more policy visibility, companies could start investments that they had postponed since the arrival of the pandemic, boosting corporate credit demand.

Digitalization Will Also Fuel Credit Growth

In our view, the digitalization of the Colombian banking system and the increasing number of customers using these technology tools will be crucial for credit expansion in upcoming years. For many years, Colombian banks have been investing in and strengthening their technology platforms to improve efficiencies and increase their customer base. The pandemic has accelerated the digital transformation of banks and customers and we expect this trend to continue. The progress is underscored by the large number of customers using banks' digital channels to obtain loans, make deposits, and acquire other products. In the future, we expect that traditional banking schemes will migrate to digital banking, with synergies between different business lines and banks taking advantage of potential alliances with fintech companies.

Chart 2

Despite Recovering Economy, Further Asset Quality Dip Ahead

We think the Colombian banking sector has entered a correction phase stemming from the economic downturn last year, the repercussions of which will be felt during the next 12-18 months. As a result, we expect banks' asset quality and profitability to deteriorate. However, we think that once the economy and employment resume growing, the banking system will return to an expansionary phase and nonperforming assets (NPAs; past-due loans over 90 days and foreclosed assets) and credit losses will return to more normal patterns.

At the beginning of the pandemic, the Colombian banking regulator approved a program to defer loan payments for borrowers facing financial hardship because of COVID-19. Loans under this program peaked at about 40% of total loans--one of the highest levels among Latin American banking systems--reflecting that some banks automatically included consumer and mortgage customers in this program, regardless if they needed it or not. Then, at the end of June 2020, the regulator announced the second phase of the relief program, consisting mostly of identifying troubled borrowers to restructure their loans. The regulator extended this phase of the program until Aug. 31, 2021. With figures as of May 2021, the share of loans under the debt relief program decreased to less than 7%, and most of these loans have been restructured.

Chart 3

In our opinion, the relief program, interest rate cuts, and some debt restructuring have cushioned the hit to the earnings capacity of banks' clients. These factors--along with the above-average charge-offs in the consumer portfolios, mostly from unsecured products--allowed for a gradual deterioration in banks' NPAs. We still anticipate asset quality metrics to worsen further this year, mostly due to consumer loans and loans to MSMEs. But in 2022-2023, we expect asset quality to gradually recover and stabilize, supported by the expected strong economic recovery. In this sense, we forecast NPAs--currently 3.6% of total loans, including foreclosed assets, as of May 31, 2021--to peak at about 4.25% in the next 12 months and to drop toward 3.75%-3.90% in 2022-2023. We assume NPAs will remain fully covered by reserves and that credit losses--estimated as new loan-loss provisions to total loans--will stand at about 3.5% in 2021 after peaking at 3.7% in 2020, and then return to historical average levels of below 3% in 2022 and 2023 as the impact of the pandemic dissipates.

Chart 4

Exposure To Risky Sectors Is Manageable

Despite Colombian banks' exposure to consumers (about 46% of total loans as of June 2021, including mortgages) and to MSMEs (about 8.5% of total loans), which represent increasing risks for the sector due to their vulnerability to economic downturns, we see particular characteristics in the consumer portfolios and mortgages that we think could mitigate these risks. For example, we still view corporates and households' debt levels as manageable and expect them to stay below the average for emerging markets. In addition, secured consumer loans--payroll, auto, and mortgage loans--represent more than 65% of total household debt. Payroll-deductible loans have proven to be resilient in past crises and they have maintained low delinquency levels for several years. As of May 2021, payroll loans represented about 38% of total consumer loans and 11.5% of total loans in the banking system. Moreover, nonperforming loans for payroll loans (NPLs; nonperforming loans over 90 days) ranged between 1.4% and 1.6% during the first five months of 2021 compared with 3.1% to 3.7% for the consumer portfolio. Mortgages represent about 15% of total loans in the system as of June 30, 2021, about 95% of which are originated by banks and the rest are securitized. The loan-to-value (LTV) ratios are regulated: banks can't lend more than 70% of the price of a home and 80% for low-income housing. In both cases, the current LTVs are significantly below the limits, which in our opinion helps mitigate mortgage exposure because customers have already contributed a significant portion of the total cost of the property. This is an incentive to keep meeting their future payments.

Colombian banks' exposure to sensitive economic sectors is manageable and, for the next 12 months, we're cautiously optimistic about the recovery path for most industries, considering that the gradual improvement in global economic activity will help restore business fundamentals to pre-pandemic conditions. Various sectors are performing better than we originally expected at the onset of the pandemic last year. Commodity-driven industries, for instance, are benefiting from the sharp increase in commodity prices, including metals, crude oil, and agricultural products. Also, essential consumption in Colombia remains resistant to the region's economic risks, and businesses are rapidly adapting to the shift in consumer preferences toward goods and services that improve the stay-at-home experience, including connectivity, entertainment, and comfort.

Profitability To Recover Only Gradually

In our opinion, Colombian banks have brighter profitability prospects after bottom-line results dropped by 53% in 2020 from pre-pandemic levels in 2019. Although we forecast a strong economic rebound for Colombia, we think the banking sector's profitability will recover more gradually. For instance, we expect the banking system's net profits will reach or even exceed pre-pandemic levels after 2022.

One of the most relevant factors that hampered banks' net profits in 2020 was the significant increase in provisions (about 38% compared to 2019), which reflected the weaker economic conditions limiting banks' customers income capacity, and lower revenues from the loan portfolios and related fees because of the weak credit demand. Additionally, since the pandemic began, banks have been operating with above-average liquidity. Due to the lower credit demand, banks put a significant amount of their financial resources in low-risk and highly liquid securities that had lower interest rates. Therefore, the higher liquidity also somewhat limited banks' profits.

As discussed above, we see downside risks for Colombian banks, such as the pandemic and social instability, that could hinder profitability in the next two years. Lingering effects of the pandemic could limit growth of banks' revenues and lead to higher provisions to offset customers' weaker credit quality. In addition, the general elections in 2022 could postpone investment and credit decisions from the private sector. As of July 14, 2021, the debt relief program has allowed banks' customers to reduce, on average, their outstanding debt by 28.5%, or interest rates by around 200 basis points, or extend their maturity by about 29 months. Therefore, restructures under this program will limit the rapid rebound of banks' profitability to pre-pandemic levels. Also, interest rate curves are already pricing in the expectation that every major central bank in Latin America will start lifting interest rates this year. If U.S. interest rates rise earlier than we expect, this would likely accelerate interest rate hikes in the region and result in higher funding costs for banks and pressured net interest margins.

Chart 6

Tax Reform Could Further Pressure Profitability

On July 20, the government presented a new tax reform proposal to Congress that could be approved before the end of 2021 and go into effect in 2022. Its objective is to release pressure on Colombia's fiscal position by collecting an additional COP15 billion in taxes, mainly by increasing corporate income taxes and removing the financial benefits of the most recent reform (2019). According to the proposal, the corporate tax rate would reach 35% in 2022 (versus 31% in 2021 and 30% in 2022 according to the current fiscal code). The proposal would also extend a 3% surcharge--currently paid by banks and set to expire in 2023--until 2025, thus reaching a 38% rate. If the reform passes, we think the higher tax burden will pressure banks' profitability. However, in our view, Colombian banks that generate a significant part of their profits abroad will be able to somewhat cushion the impact of this reform. For instance, the three largest commercial banks in Colombia-- Bancolombia S.A. (BB+/Stable/B), Banco Davivienda S.A. (BB+/Stable/B), and Banco de Bogotá S.A. (BB+/Stable/B)--hold about 55% of the assets in the banking system as of June 30, 2021. On average, a third or more of their profits are made by their subsidiaries in Central America; tax rates in these countries are significantly lower than in Colombia. In addition, these banks, along with others that operate exclusively in Colombia, could also somewhat offset the reform's effects by growing their loan books in certain business lines that are exempt from paying taxes, such as loans to social housing or leasing.

Risk-Adjusted Capital Remains A Key Short-Term Risk

We consider that the Colombian banking regulator is making efforts to strengthen and align regulations with international standards, in particular through the recent implementation of the financial conglomerates law and adopting Basel III capitalization rules, effective January 2021. However, we don't think these measures will address in the short term the banking system's main weakness: the risk-adjusted capitalization (RAC) of the three largest commercial banks. We currently assess these banks' RAC ratios as either weak or moderate because of the large goodwill that they generated through their acquisitions in Central America, which we deduct from total capital. In addition, about 30% of these banks' balance sheets are exposed to these countries, which in general face higher economic risks than Colombia and so represent higher risk weights. In our view, to the extent that regulatory solvency ratios under the new Basel III standards incorporate capital conservation buffers and the systemically important banks buffer, these entities will need more capital to operate. We expect our RAC ratios to strengthen, but this could take more than two years.

Wholesale funding concentrations also still represent a challenge for Colombian banks. However, we expect gradual improvements in the next 12-18 months based on the regulator's net stable funding (NSF) requirements that stress wholesale deposit outflows. In our view, the pandemic-related economic crisis is straining the Colombian banking sector and will test the effectiveness of the recently improved institutional framework. We will monitor if the regulatory improvements enhance RAC ratios for banks with exposure abroad and lower wholesale funding concentrations, which will allow banks to weather the pandemic.

Chart 7

Sovereign Downgrade Could Tighten Financing Conditions

On May 19, 2021, we lowered our long- and short-term foreign currency ratings on Colombia to 'BB+/B' from 'BBB-/A-3' ("Colombia Long-Term Foreign Currency Rating Lowered To 'BB+' On Persistent Fiscal Weakness; Outlook Stable," May 19, 2021). In our opinion, losing the investment-grade country status will represent an additional hurdle for banks operating in Colombia. So far, solid liquidity in the banking system and manageable debt profiles have cushioned the impact after the downgrade. However, if the economic recovery takes longer than expected--making banks' operating conditions even tougher--and if interest rates rise faster than we expect, financing conditions could tighten. We think the next 6-12 months will be key to evaluate how risks that banks will face evolve and their potential impact on rated Colombian banks' business and financial profiles.

Related Research

• Global Banking Country Outlook Midyear 2021: Tantalizing Signs Of Stability, July 22, 2021
• Emerging Markets Monthly Highlights: Faster Vaccination Pace Still Not Sufficient To Beat The Pandemic, July 15, 2021
• A Little More Clarity, A Little Less Gloom: An Update On Our Bank Credit Loss Forecasts, July 15, 2021
• Credit Conditions Emerging Markets Q3 2021: Slow Vaccination Prevents A Robust Recovery, June 29, 2021
• Economic Outlook Latin America Q3 2021: Despite A Stronger 2021, Long-Term Growth Obstacles Abound, June 24, 2021
• Three Colombian Financial Institutions Downgraded To 'BB+' From 'BBB-' On Same Action On Sovereign, Outlook Stable, May 20, 2021
• Colombia Long-Term Foreign Currency Rating Lowered To 'BB+' On Persistent Fiscal Weakness; Outlook Stable, May 19, 2021
• Banking Industry Country Risk Assessment: Colombia, Jan. 15, 2021
• Bulletin: Industry Risk Trend In Colombia’s BICRA Revised To Stable From Positive As COVID-19 Will Test Regulatory Framework, Dec. 11, 2020