Uruguay Banking Report:

The banking industry in Uruguay is considered relatively resilient to potential domestic and external shocks, while country's economy is facing a tepid performance.

The country's banking industry consists of two state-run banks - Banco de la República Oriental del Uruguay (BROU) and Banco Hipotecario del Uruguay (BHU) - and nine private sector players, mostly international banks. The largest private sector players, in terms of assets, are Banco Santander, Itaú, BBVA, Scotiabank, Citibank, HSBC, Banco de la Nación Argentina, Heritage, Bandes Uruguay.

BROU is by far the largest bank, accounting for 45.2% of all assets in financial system.

Banks in the country - which are regulated by the central bank (Banco Central Del Uruguay) - remain solid in terms of capital. The banks' excess capital was 80% higher than the minimum regulatory requirement adjusted for credit, market, operational and systemic risks at the end of the first half, according to the central bank.

RISKS FOR BANKING SECTOR

Although Uruguay's economy and political risk are deemed stable, the banking sector shows some warning signs. In an August report, Standard & Poor's highlighted that risks in the Uruguayan banking industry are higher than those of its regional peers.

"Although the domestic banking sector benefits from a large share of customer deposits (relative to system loans), these deposits have been volatile in the past. However, in the last two years Uruguay's deposit base has been stable and resilient to withdrawals of non-resident deposits after Argentina implemented its Tax Amnesty, which concluded in March 2017; the approval of the fiscal transparency law in 2016; and the appreciation of the Uruguayan peso," S&P said.

"We believe several market distortions exist, such as the significant presence of government-owned banks, labor market rigidities, and the presence of non-deposit taking financial institutions, which stall efficiency and undermine profitability. Finally, central bank, BCU, has worked to align banking regulation and supervision with international standards, but we think there's room to improve, particularly in reducing dollarization."

BETTER PROFITABILITY, SLOW LOAN GROWTH FOR BANKS

In recent quarters, banks in Uruguay saw an increase in profitability led by the performance of both state-run banks.

Return on equity reached 17.8% in the second quarter of 2018, up from 5.3% in the year-ago period. The ROE of the state-owned banks reached 19.4%, up from 4.8% in 2Q17, while for private sector players it was 15.3%, up from 6.1%, according to central bank figures.

The loan portfolio of the country's financial system increased slightly to US$15.39bn in August, compared with US$15.31bn in August 2017.

However, the non-performing loan rate deteriorated, reaching 4.1% in August, up from 3.8% in 2Q17.

"We expect loan growth to be relatively slow given the slow growth expected for the economy. In addition, as the dollarization of the banks' balance sheet is high, foreign exchange volatility affects growth given the effect of valuation," Santiago Gallo, a banking sector analyst for Fitch Ratings, told BNamericas.

"In terms of loan quality, we expect to see a gradual deterioration but to remain under control at adequate levels."

BANKS SEEN AS TRUSTWORTHY

The banking industry in Uruguay has high levels of confidence among the population. According to a March survey from local polling institute Factum, Uruguayans have more confidence in the banking sector than in other institutions such as the police, the courts and the armed forces.

"What you have to understand is that for the vast majority of Uruguayans the concept of the bank is associated with the Banco de la República, which historically has been - according to other studies we have carried out since 1990 - one of the four best evaluated public agencies. That explains, in a strongly statist country, where there is a positive image and confidence in the state, that banks are the most reliable institution of all," said Eduardo Bottinelli, Factum director.

"Banks are the Banco República and therefore they are the state," he added.

ECONOMIC CHALLENGES AHEAD

The challenges for the local sector may come from the economy. Earlier this month, Fitch Ratings revised Uruguay's sovereign rating outlook to negative from stable.

"The revision of Uruguay's outlook to negative reflects persistent fiscal deficits and a high and rising debt burden that are eroding policy space to confront shocks, against a backdrop of tightening global financing conditions and a challenging macroeconomic environment in the region," said Fitch.

"Uruguay has seen one of the largest increases in government debt-to-GDP in the 'BBB' category since 2013 when it reached investment grade. Fitch believes the likelihood of fiscal adjustment measures is low in the forecast period through 2020, given that it includes an election cycle. Fitch expects the economy to remain broadly resilient to economic turbulence in the region," it added.

Although it has a stable political scenario, Uruguay can be vulnerable to the economic and political turbulence faced by its main neighbors and trade partners Brazil and Argentina.

Uruguay's economy is expected to expand less than initially projected in 2018 and 2019. GDP is expected to grow 1.5% this year and just 1% next year, according to economist team at Itaú Unibanco, which previously projected an expansion of 2% for both years.

The revision took place mainly due to impacts of Argentina's economic crisis on Uruguay's tourism sector. The tourism sector – which accounted for 7% of GDP, with Argentine tourists accounting for 70% of revenues – will be hit by the appreciation of Uruguay's currency against its Argentina's peer, according to Itaú.