Latin American economies have just emerged from one of the worst recessions in recent times. Now, they find themselves once again in a restrictive economic scenario due to inflationary pressure, increasing interest rates, and low economic growth. Moreover, political uncertainty in the region continues to act as a drag on investments, further pressuring economic performance. In this context, S&P Global Ratings thinks Latin American banks will likely face a scenario of low real credit growth, pressured margins, and weakening asset quality this year.

Thus far, Latin American banks have navigated through recent economic downturns in relatively good shape. In our view, solid profitability has been key in allowing banks in the region to withstand credit cycles and economic downturns in the past, and has helped them once more during the COVID-19 pandemic. We believe the high provisioning buffers and healthy margins will help banks steer through the challenging operating scenario we expect for this year.

Rising Interest Rates Will Prompt Banks To Increase Rates On Loans, Which Will Pressure Asset Quality

Although banks could transfer the growing financing costs to borrowers, this would push down the demand for credit, since at higher loan costs, individuals could postpone consumption and companies could delay investment decisions. This could hurt countries' economic activity, which is already suffering from political volatility and lack of investment. In addition, lower demand for credit could generate competition among banks, so they would not pass on the total increase in the cost of funding, which would pressure their margins.

Moreover, the combined effects of high inflation and rising interest rates would likely restrict the payment capacity of households and companies, and as a result, the quality of banks' assets. The combination of high inflation and interest rates could result in lenders being unable to pay their debts on time, which in turn could prompt banks to increase provisions, which would squeeze profitability.

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Political Instability Remains The Key Factor Affecting Economic Growth And Banks' Operating Performance

The region's key economies are facing political uncertainty and upcoming elections. In Peru, we believe persistent political deadlock is likely to constrain investment. The government has been at a standstill between the executive and the legislative branches for several years. President Castillo has faced impeachment proceedings and has to navigate a fragmented congress, which will keep policy predictability low. In early September of this year, Chile will vote on the new constitution that is now being drafted. Brazil's October 2022 national elections for the president, the national congress, and governors are driving politics in the country. In Mexico, we think mixed political signals and greater centralization of political decision-making under the current administration have undermined private investor sentiment and with it, GDP growth prospects. Finally, the second round of presidential elections in Colombia that took place on June 19 saw Gustavo Petro, the center left candidate, winning with a very tight result.

In our view, social unrest and political instability could pressure investment and economic performance. This could result in weaker internal demand, which could lead to lower lending growth and weaker asset quality for banks. Amid these factors, financial institutions' operating performance could struggle.

Fintechs Could Find Higher Funding Costs A Challenge

In our opinion, fintech companies that took advantage of the low interest rates will likely find it hard to compete with banks if they need to increase fees and interest rates to compensate for higher funding costs.

In Brazil, we believe the expansion of the fintech sector has been much faster than in the region's other countries and has increased competition in the domestic banking industry because of the implementation of several initiatives and the low interest rates. The initiatives included:

• Open banking, which has been implemented gradually because the need for consumers' consent has limited data sharing among financial institutions;
• The creation of the Positive Credit Database (Cadastro Positivo) which has been promoting sharing of clients' credit information;
• Regulation that enabled fintech companies to expand their product offerings without the intermediation of banks; and
• Asymmetric regulation, because less complex fintechs have softer regulatory requirements.

Despite the rapid growth of fintechs in Brazil, we have seen limited threat of disruption to major Brazilian banks so far--in line with our expectations--beyond the persistent need to invest in technology amid stronger competition. We think large banks' proactive approach, superior capacity to invest in expanding their digital platforms, and universal banking model will help them adapt to the competition and continue to dominate the Brazilian banking sector.

The regulator rolled out the abovementioned initiatives to promote competition just before the pandemic began, which prompted the central bank and all banks to shift toward protecting asset quality and helping borrowers suffering from the pandemic-induced economic shock. Despite Brazil's economy picking up last year, banks now grapple with a soft economy stemming from political uncertainty, high inflation, and rising interest rates. In our view, these conditions will strain fintechs' business model, given that they typically compete through lower fees and interest rates versus banks, which they could now raise amid the difficult conditions, causing competition to wane. As such, the central bank's original intention of reducing borrowing costs and promoting competition could be in jeopardy. In our opinion, because the current and upcoming operating conditions will challenge fintechs that have business models that compete by price, only those that have been able to offer a stronger customer experience will survive.

Mexican NBFIs Will Face Difficult Conditions This Year

Mexican NBFIs have been hit hard by the pandemic, as seen in their weakening credit quality and increasing refinancing risk. In addition to the tough economy, some of these entities face issues related to governance deficiencies and risk management, further complicated by the tough business and operating conditions for the sector. In our view, Mexican NBFIs will mostly focus on preserving liquidity and slowing credit growth in the next two years, which will weigh on profitability.

In addition, a significant challenge Mexican NBFIs will need to manage this year is refinancing debt, considering a complicated environment with interest rates moving up and weakened investor sentiment. With the rising interest rates, it will be difficult for NBFIs to transfer higher rates to their borrowers while their funding costs increase, which is also happening at a time of moderate loan growth expectations. Therefore, we expect profitability to be under pressure.

For NBFIs' asset quality, since the beginning of the pandemic, nonperforming assets (NPAs) have increased, reflecting the entities' exposure to micro, small, and medium enterprises (SMEs) and to low-income borrowers, which were the hardest hit by the fallout from the pandemic. Given the government's small economic stimulus for SMEs to offset the pandemic's impact, the damage to these sectors was relatively severe. Therefore, we expect NPAs will remain above historical levels in 2022 and will return to pre-pandemic levels gradually in the next two years. Given the impact of weaker asset quality on profitability due to higher provisions, and considering the already mentioned effect of increasing interest rates, we expect NBFIs' profitability to be under pressure this year.

The Argentine Banking System Remains Exposed To Domestic Issues On Top Of Global Trends

Macroeconomic and policy factors in Argentina have exacerbated distortions in the domestic financial system. Very high inflation--which ramped up further in the last few months--, anemic credit demand and investments, and the cautious approach to lending among financial entities amid interventionist interest rate regulations from the government have resulted in a consistent decline in credit growth. We expect credit to GDP will plunge to unprecedented levels of below 10% in 2022 and 2023. The current conditions have led banks to increase their exposure to the public sector, mainly in central bank securities and government bonds--especially those adjusted to inflation--to mitigate losses in balance sheets related to applying inflation adjustments. Overall, holdings of central bank instruments and government bonds accounted for 38% of banks' total assets at the end of March 2022, versus 26% a year earlier.

For the rest of the year, we think Argentina's economic woes will further compress banks' profitability, especially those of smaller banks that are more exposed to monetary assets. Still, in general, banks have high liquidity and regulatory solvency (with reduced dividend distributions) to cope with volatilities. In addition, the system has had manageable credit losses despite the withdrawal of borrower relief measures related to the pandemic and the charge-offs of legacy corporate loans.

Banks In The Region Are Gradually Incorporating ESG Factors Into Their Decision-Making

Latin American banks have been actively integrating environmental, social, and governance (ESG) factors into their decision-making by not only focusing on reducing their individual negative impact, but, more importantly, through their intermediary role by actively directing credit toward issuers or projects that are ESG-friendly and engaging with clients to adopt sustainable practices. Moreover, developing new sustainable products have been also part of financial institutions' strategy, particularly in asset management and investment banking divisions. The sustainable debt market is significantly growing, which creates market opportunities for both investment and underwriting businesses.

Banks' increased attention to ESG is reflected in their investor presentations and results calls, which have a notable focus on these factors. Regulators in the region are also incorporating ESG factors into their agendas, focusing on standardizing data and reporting as well as incorporating ESG factors in banks' strategy, credit and investment decisions, and governance. For example, Brazil's central bank has requested comments for ESG regulation that it's working to introduce, and the Chilean regulator has recently led a regional conference on climate change in which other Latin American regulators participated. In this context, larger banks are working to prepare for regulation to come. The main obstacle is the lack of information, especially from the middle-market segment and small companies that banks in the region lend to because of their lack of formal policies. We also note that regional players are focusing more on promoting sustainable initiatives rather than excluding or restricting financing to environmentally-intensive sectors.

Even though many Latin American economies heavily rely on extractive industries, banks' exposure to these industries is limited. This is because the main companies operating in these industries are large and can access the international markets, and also need long-term financing that local banks don't typically offer. Finally, many multilaterals and development banks are offering funding lines to promote social and environmental initiatives in the region. In our view, this presents a significant opportunity because these institutions also provide technical knowledge and quantitative models and help improve governance, transparency, and reporting.

Latin America's Sustainable Debt Market Is Increasing And Still Has Lots Of Room To Grow

Although the sustainable debt market is still small in Latin America compared to the global market (less than 5% of global sustainable bond issuances), total issuance in the region in 2021 was higher than the sum of the last seven years. Moreover, sustainable issuances make up 35.0% of total issuances in Latin America so far this year compared to 31.0% in 2021 and only 9.3% in 2020.

Although only around 6% of the region's sustainable issuances are from financial institutions, we see substantial room for growth. The financial industry is involved in investments and financing across a wide range of green and social projects from renewable energy to financial inclusion, and these have been steadily increasing in the past few years. Moreover, its corporate clients have also started to use sustainable financing options such as sustainability-linked bonds. In our view, the rising issuance of these types of bonds is because proceeds are typically not ring-fenced for specific environmental or social projects. As a result, sustainability-linked instruments have proven more flexible and accessible than use-of-proceeds instruments for a variety of issuers that are advancing their sustainability goals and agendas. As a result, amounts are usually larger for those type of issuances and many issuers are able to access the sustainable debt market.

Chile, Brazil, and Mexico are the main markets in the region for sustainable debt (more than 80% of issuances):

• Chile's performance is driven by multiple sovereign sustainable bonds in the last three years. Chile issued the first global sustainability-linked bond for a sovereign, which was linked to the country's greenhouse gas reduction targets and renewables diversification mix. Half of the government issuances in 2022 so far have been related to ESG (environmental, social and governance), while in 2021, 65% were ESG-related.
• Brazil is the most diversified market with more than 125 different issuers of these bonds.
• In Mexico, non-sovereign issuances have increased, although they're still concentrated in a few companies and sectors.