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Latin America’s banking sector is entering a new era that will likely see double-digit growth in assets and profits in most major countries.1 These advances will be driven mainly by four factors: GDP growth rates in the 4 to 5 percent range, falling interest rates, lengthening debt maturities, and the higher purchasing power of a growing middle class.
Meanwhile, competition is becoming more intense. The multinationals, having taken notice of the new opportunities, are increasing their investments across the region in hopes of taking market share from the leading local banks. Entrants with specialized business systems have the same goal; in particular, retailers have become quite aggressive in the consumer finance and credit card markets.
Fundamental changes that occurred during the 1980s and ’90s across regulatory, demographic, and political dimensions propelled this positive outlook. As a result, the macroeconomic variables that are critical to the development of the banking sector—such as a growing GDP per capita, lower government fiscal deficits, and falling long-term government bond rates—are already improving significantly.
What does this good news hold for local and multinational players? To compete with the multinationals, local banks must take advantage of their economies of scale, superior brand recognition, and networks in their home countries, as well as their better understanding of domestic markets and culture. Success may allow them to remain independent. As for the multinationals, they already have a big stake in Latin America, and some are looking to expand it. To do so, they must leverage their knowledge and talent management across the region, for these factors can give them important advantages over local leaders.
Favorable macroeconomic trends
To understand the new macro-economic context, you must understand the recent evolution of Latin America’s economies. For the purposes of this analysis, the past half century has been divided into three eras: post-World War II (the 1950s through the ’70s), transitional (the ’80s and ’90s), and the years after 2002.
During the post-World War II era, Latin America’s seven major economies grew at the impressive rate of 5.4 percent a year. GDP per capita increased more slowly, at a rate of 2.6 percent, because the population was expanding at the fast pace of 2.7 percent a year. This period’s economic growth was based on strong government intervention in the economy, the protection of local industries from imports, and the financing of government deficits with bank loans denominated in foreign currencies. Democratic liberties were limited in many of these countries, thwarting the evolution of the government institutions needed to reach higher levels of economic development.
That model collapsed during the late ’70s and early ’80s, when economic growth stalled, inflation surged, and most major countries in Latin America could not meet their foreign-debt payments. In the ’80s these problems came to be known as the LDC (less-developed country) debt crisis, which put at risk several US and European money-center banks that had provided loans to these countries. Two decades of stagnation and instability followed; poverty increased as income per capita stagnated. Furthermore, the region lost much of its relevance in the global economic scene—as it went into stagflation, developing countries in Asia and then Eastern Europe kicked off an impressive era of economic expansion.
Although this period of poor economic performance was harsh for the people who lived through it, there was a silver lining. The crisis began a gradual transition to a new model based on openness to foreign trade and investment, less government intervention in the economy, the financing of government deficits in the local bond markets, and greater democratic freedoms. The demographics also changed for the better: population growth rates declined to less than 2 percent as the fertility rates of the region’s women fell below three children each.
Like most transitions, this one was messy, but the payoff is already visible. On the macroeconomic front, the changes of the past few years have been remarkable. Inflation, once a chronic problem across the region, has come under control. During 2005 the weighted average inflation rate was 6.2 percent in the seven major countries, and 2006 figures should place it at around 5 percent. Governments have become fiscally responsible no matter what their position in the political spectrum, from Left to Right. The weighted average fiscal deficit of the seven major countries was only 0.8 percent of GDP during 2005. Argentina, Chile, and Venezuela actually ran budget surpluses.
The external front has also become stronger. Exports rose by 60 percent in these countries from 2002 to 2005, and their foreign-currency debt is down to 30 percent of GDP. As a result, interest rates are dropping fast, and the duration of financial instruments is increasing. A local-currency market for long-term government debt has become a reality in most of the bigger economies.
Of course, the evolution toward a more sustainable market-based economic model varies from country to country. Chile, which has enjoyed monetary stability for a longer period than other countries in the region, is already way ahead (Exhibit 1). Next in line is Mexico, which achieved monetary stability more recently but has already earned an investment-grade rating on its government debt. Following closely are Brazil, Colombia, and Peru, which are making rapid progress toward curtailing their government deficits and aspire to have investment-grade ratings soon.
There are some important exceptions to this trend. Venezuela is clearly following a different path, applying the previous model of government intervention over markets as a way to allocate resources and set prices. Argentina’s direction is less obvious. Following the peso’s devaluation and the debt moratorium of 2001, the country appeared to be regressing to the previous model. Now it is apparently moving closer to the region’s typical evolutionary path.
Implications for growth
Because the overall drop in interest rates will spur demand for loans across the board; that’s excellent news for the banking sector. So are longer maturities, which have opened the way for the growth of many products that require them, such as mortgages, auto loans, and corporate bonds. Finally, if the current GDP growth rates of 4 to 5 percent a year are sustained, with a resulting GDP-per-capita growth rate of about 3 percent, demand for consumer loans will probably increase significantly as more households gradually join the middle class.
Comparisons with emerging economies elsewhere illustrate the growth potential of banking in Latin America if it continues on its path to monetary stability. Deposits in the banking system represent only 32 percent of GDP in the region, compared with 66 percent in India, 75 percent in the Asia-Pacific’s emerging economies, and 166 percent in China. When this gap narrows, the banking sector’s growth potential becomes immense, as we have seen recently. In 2002 bank deposits in Latin America amounted to $465 billion. By 2005 they had grown by 60 percent, to $748 billion, even after adjustments for inflation. On the asset side, the growth opportunity in mortgages stands out. Except for Chile, which has enjoyed monetary stability for more than a decade, none of the major economies has experienced the conditions needed to develop this important market: mortgage loans represent 16 percent of GDP in Chile but only 9 percent in Mexico, 3.6 percent in Colombia, and less than 3 percent in the four other major economies (Exhibit 2). These numbers would actually be lower if governments didn’t use subsidies and forced-lending mechanisms.
The expanding assets of the region’s pension funds will support the growth of mortgages and other instruments that require longer maturities, for the funds will generate demand for mortgage-backed securities and other long-term instruments. Over the next decade, the asset base of these pension funds is expected to grow at an annual rate of more than 10 percent. The funds are the result of a pioneering experience—the privatization of the region’s pension systems. After watching Chile’s successful example, several countries switched from defined-benefit, pay-as-you-go systems to contribution-based ones. Among the large countries, Argentina, Colombia, Mexico, and Peru have all adopted variations of the Chilean system; only Brazil and Venezuela have stayed on the sidelines.
Where the opportunities are
During the past 15 years, the banking sector consolidated to a significant extent in Latin America’s major countries. The economic difficulties of the transition created a Darwinian process: the strongest banks expanded, and the weak were bought or forced to exit the market. The top five institutions hold more than 50 percent of all banking assets in Argentina, Brazil, and Venezuela; over 70 percent in Chile; over 80 percent in Colombia and Mexico; and over 90 percent in Peru.
Private-sector banks dominate the top rankings. Only Argentina and Brazil still have two government-owned universal banks in the top five: Banco de la Nación Argentina and Banco de la Provincia de Buenos Aires (in the case of Argentina), and Banco do Brasil and Caixa Econômica Federal (in the case of Brazil).
Multinational banks are an increasing presence in the top rankings, which local players once dominated. Four of the top five banks in Mexico, for example, are foreign multinationals. Across the region, and especially in Mexico, the largest foreign investments have been made by made by Spain’s Banco Bilbao Vizcaya Argentaria (BBVA) and Banco Santander Central Hispano (Santander), Citigroup, and HSBC. For now, Brazil and Colombia are the exceptions: in Brazil no foreign bank has yet reached the top five; in Colombia only BBVA has.
Strategic choices for local players
The local leaders that survived the consolidation of the past two and a half decades have been preparing for foreign competition. Their strengths are economies of scale and superior coverage in their home countries, as well as a thorough understanding of the local markets and culture. These are by no means insignificant advantages—banking in Latin America is still mostly a local business. The success of the leading banks is already being recognized by the equity markets with high market capitalizations, high valuation multiples, or both (Exhibit 3).
Given the multinationals’ growing interest in Latin America’s markets, most of the local leaders run the risk of being acquired. If they wish to maintain their independence, they have three choices:
- Become too expensive. A bank could try to push its valuation multiple to levels much higher than those of potential foreign acquirers to make the acquisition price expensive and highly dilutive for them. Banco de Bogotá, for example, has a multiple high enough to pursue this goal.
- Become too large. Another strategy is to increase a bank’s market capitalization through aggressive organic growth and mergers with local rivals but without sacrificing too much return on equity. If the market cap is high enough, only the world’s largest banks would dare allocate so much capital to a Latin American acquisition. Bradesco, with a market cap of $37 billion, is a good example of a bank that has followed this strategy: among all of the multinationals in Latin America, only the largest could swallow such a big institution. Bancolombia is another example of a bank pursuing scale. After undertaking two mergers in 2004, it recently announced the acquisition of El Salvador’s largest bank.
- Pursue the two strategies simultaneously. Banco Itaú is a good example of an institution that is pursuing both strategies. With a market cap of $40 billion and a P/E ratio of 17, it has become very large and expensive to acquire. Itaú could itself become a multinational bank by leveraging its capitalization and know-how across the region, much as BBVA and Banco Santander Central Hispano (Santander) did not long ago. Itaú’s recent moves in Argentina and Chile may indicate its interest in this approach.
Achieving the growth and profitability required to keep valuation multiples high will not be easy. Falling inflation and interest rates spur demand for loans but also tend to compress margins, especially in a context of growing competition from multinational banks and specialized attackers. Banks that have higher spreads on credit products and are located in countries such as Brazil will face the greatest challenge.
The key to success will be to go on leveraging the advantages of scale and network coverage at the country level to offer customers greater convenience and to cut operating costs per transaction. It will also be important to develop the skills to innovate or to be a fast follower in the product lines that show the greatest promise of future growth: mortgages, auto loans, credit cards, and consumer finance.
Strategic choices for multinationals
Latin America’s importance to the profitability of the multinationals that have invested there has become very significant: for example, in 2005 the region supplied 46 and 32 percent of the profits of BBVA and Santander, respectively. The numbers of other multinational banks range from 8 to 15 percent, but all aspire to increase that proportion (Exhibit 4).
Knowledge and talent management are the biggest advantages these banks can leverage across Latin America to achieve their growth potential. Shared services across the region also give them an opportunity to generate economies of scale, though empirical evidence indicates that such economies have yet to be realized.
Latin American countries have many similarities in language, demographics, culture, and, to a lesser extent, regulatory frameworks. These similarities create an opportunity to transfer innovations and best practices, with only small adaptations, from country to country. Exploited properly, they will give the multinationals an important edge over the local leaders.
Managing talent is another advantage of multinational banks with a presence across Latin America, because executives can easily move from country to country within the region and remain effective. Institutions such as Citigroup, which has been fine-tuning its organizational model there for decades, have turned this capability into a significant competitive advantage. Citigroup can tap into its talent pool across the entire region when it has a specific leadership requirement. It also develops the skills of its executives by exposing them to varying responsibilities and challenges across many countries.
The next decade is shaping up as an exciting time for the players in Latin America’s banking sector. Their future prospects will be determined, to a great extent, by the bets they are placing now. Large countries such as Brazil, Chile, Colombia, Mexico, and Peru will continue to attract much of the attention as they build sustainable, market-based economic models. Smaller countries will go on offering attractive opportunities as well; for example, HSBC recently paid $1.8 billion for Banistmo and Citigroup $1.5 billion for Cuscatlán, two of Central America’s leading banks. The banking sector’s further development along the lines described here will likely provide a great boost to the overall economy. The growth of some key sectors, such as housing, infrastructure, and consumer durables, will depend largely on the availability and cost of bank financing. 
About the Author
Luis Andrade is a director in McKinsey’s Bogotá office.
Notes
Correction:
An earlier version of this article misstated the ownership status of Ford Credit of Mexico. The reference to Ford Credit has been deleted. We regret the error.