A Road Full Of Hazards

Mexico's NBFIs consist of regulated and nonregulated finance companies that mostly lend to micro, small, and medium enterprises (MSMEs) and to low-income individuals. S&P Global Ratings currently rates 25 NBFIs in Mexico, about 80% of which are subsidiaries of domestic or international groups, while the rest are independent entities. This article focuses on the latter group.

The independent NBFIs are confronting a deteriorating global macroeconomic outlook amid tightening financing conditions and market volatility. At the same time, concerns over global growth are rising--including a heightened risk of recession in the U.S. and eurozone--which we believe will likely drag down Mexico's economic activity. These factors are aggravating the already difficult conditions for NBFIs, given their heavy debt burdens (see chart 1) in the years to come--about 55% of which is denominated in foreign currency--and as investor confidence in this sector is eroding. The latter stems from, in addition to tough economy, recent defaults of two domestic payroll lenders. They occurred because Alpha Holding S.A. de C.V. (not rated) was suffering from accounting errors and governance deficiencies, while credit fundamentals of Credito Real S.A.B. de C.V. (not rated) deteriorated because of a shift in its business strategy that heightened risk appetite and due to the weakening risk management.

In the past few quarters, lower-rated issuers in emerging markets were struggling to refinance their debt amid the contracting access to credit markets. This is particularly the case for Mexico's independent NBFIs, which don't benefit from the parent group's reputation, name, or brand, or a high level of risk management and governance standards. These factors provide competitive advantages for the NBFI subsidiaries, which allow them access to a variety of financing sources at competitive costs, conferring opportunities to expand business at satisfactory levels of profitability. Therefore, the big question is whether independent NBFIs can raise financial resources in the domestic market to service debt, given that these entities are frozen out of international debt markets.

Can Mexico's Financial Market Meet NBFIs' Refinancing Needs?

In our view, the domestic credit market has more than sufficient liquidity for NBFIs to tap. Their total debt ($6.5 billion as of June 30, 2022) represents a marginal share of the Mexican financial system (see chart 2). Overall, Mexico's commercial and development banks have sound capital and liquidity levels to extend funding to NBFIs. In addition, despite the pension funds, insurers, and mutual funds' conservative investment strategies, we think they have room to provide financing to speculative-grade issuers, including NBFIs. To put things in perspective, NBFIs' debt that's maturing in 2022-2023 represents less than 15% of the annual average amount of debt placed in the Mexican debt capital market during the past five years. Therefore, the obstacles that NBFIs are facing are their ability to become attractive assets for potential creditors and restoring investor confidence after two industry players recently defaulted on their debt.

Unlike Mexican banks, which finance their operations mostly through diversified and low-cost deposits, independent NBFIs are mainly funding their lending activity through global debt issuances (about 50% of the funding base, including securitizations), followed by credit facilities from domestic banks (about 30%), and the remainder consists of domestic issuances and securitizations. Historically, NBFIs have struggled to widen their range of financing options while extending the funding terms and lowering costs. Starting in 2010, Credito Real and Financiera Independencia became the first independent NBFIs in the country to issue debt in the international markets and were later followed by their peers. When these companies tapped the international debt markets, they were able to access larger amounts of financing, at longer terms, and at attractive interest rates given the accommodative financing conditions that prevailed at that time. However, this resulted in a significant concentration in financing sources. Therefore, given that NBFIs will now be looking for domestic funding, smaller financing amounts with shorter terms and at higher costs will be available to them. This stems from tightening financing conditions both globally and locally because risk appetite is limited in providing funding to this sector.

On a consolidated basis, NBFIs' debt maturing during the second half of 2022 and in 2023 represents 22% of the total debt and about 18% of their projected total loans by year-end 2023 (see chart 1). Moreover, we estimate that about 25% of the aggregated loans that NBFIs extended will be amortizing during this period, so loan collections could cover about 1.3x-1.4x of the entities' debt maturing in 2022-2023, but this will depend on each company's growth strategy. Therefore, we believe that NBFIs still have room to address their debt maturities. However, the focus on preserving liquidity, rising funding costs, and slow credit growth will take a toll on their profitability.

Tough Earnings Season Ahead As Growth Slows And Asset Quality Weakens

In our opinion, due to the NBFIs' current funding crunch, one alternative is to slow the pace of credit originations and allocate loan collections to strengthen liquidity. In this sense, we expect loan volumes to grow at high-single digits in 2022-2023, on average and in nominal terms, after recent periods of substantial credit growth. This could result in weaker asset quality metrics and pressure profitability during this timeframe.

Since the beginning of the pandemic, Mexican NBFIs' nonperforming assets (NPAs; nonperforming loans of more than 90 days and foreclosed assets) increased, reflecting their credit exposure to MSMEs and to low-income borrowers, which were the hardest hit by the economic fallout. Intensifying the impact was the Mexican government's relatively low economic stimulus measures to offset the pandemic's damage.

We estimate consolidated NPAs among independent NBFIs will remain above historical levels in 2022-2023, at 6%-7% of total loans, and could return to more normal patterns in 2024. This is because we believe Mexico's weak economic recovery and employment dynamics--we expect real GDP growth to be only about 1.7% in 2022 and 1.9% in 2023--high inflation, and increasing interest rates will slow investment and consumption, pressuring income levels of NBFIs' borrowers. Given the impact of weaker asset quality on profitability due to higher provisions, along with increasing financing costs for NBFIs, we expect a tepid recovery in their profitability, with average return on assets at 1.0%-1.5% during this period, which will be low given the credit risk the lenders face.

Chart 3

A Small Piece In The Credit Puzzle

We expect Mexican NBFIs to remain a relatively small part of the domestic financial sector, given their funding challenges ahead and the deteriorating economic conditions that will limit demand for NBFIs' credit in the next 12 months. As of March 31, 2022, total assets of the Mexican NBFI sector (including securitizations of finance companies and two government-related entities, Infonavit and Fovissste) represented about 8% of GDP. This is much smaller than commercial banks' assets at 43%, according to Banco de Mexico's June 2022 Financial Stability Report. Moreover, we estimate that the consolidated loans of the independent NBFIs that we rate are less than 10% of total loans of their domestic regulated and nonregulated peers.

What's Next?

We expect the NBFI sector to learn from Credito Real and Alpha's woes: governance flaws, lack of transparency, and weaker risk management than that of the Mexican banking sector, which operates under strict regulations and supervision. We believe that addressing these issues will bolster NBFIs' growth prospects and financial performance. However, this could take time because the entities' current priority will be securing funding in the short term.

We expect Mexican NBFIs to face tough operating conditions during the next two years, heightened by refinancing risks. While international debt markets remain closed to these issuers, we expect them to refinance their debt in the domestic debt and capital markets (including securitizations) and through bank financing (including syndicated loans). There's ample liquidity in the domestic market, but the challenge for NBFIs is to become attractive assets for potential creditors. Moreover, we expect NBFIs to focus on preserving liquidity and slowing credit growth in order to cover large debt obligations. However, this will depend on each entity's strategy. Such actions would alleviate the refinancing pressure; however, profitability will take a hit during 2022-2023.

Although three of the five NBFIs have stable outlooks (see chart 5), we don't rule out additional rating actions. This is because of Mexico's tepid economic recovery--one of the weakest in Latin America--along with deteriorating global macroeconomic conditions and downbeat investor confidence in the sector, which could drag down NBFIs' creditworthiness. Therefore, the prospects for these companies will remain murky for the next two years. We believe the main challenge for NBFIs is to revive the confidence of market participants in this sector in order for them to access financing, resume growth, and return to historical profitability levels.

We'll be closely monitoring NBFIs' liquidity amid the upcoming debt maturities. We will also track potential changes in asset quality because a significant increase in NPAs and credit losses could restrict NBFIs' capacity to service debt. In our view, NBFIs that have a relationship with domestic lenders--commercial and development banks, and other market participants (pension and mutual funds, for example)--and relatively small debt amounts coming due in the next two years, will be able to maneuver through the industry headwinds.

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