OREANDA-NEWS. Mexican banks expect the recent increase in the interest rate target announced by the central bank (Banco de Mexico or Banxico) will benefit their profitability, says Fitch Ratings.

On June 30, Banxico increased by 50 basis point the target for the one-day interbank overnight interest rate (target rate) to 4.25%. This is the third increase in the last six months. Fitch expects the rate increase to translate into wider net interest margins (NIM) for Mexican banks and greater incentives to expand credit activity. This will positively impact their profitability, whose balance sheets have typically demonstrated high sensitivity to changes in interest rates. New loans and existing company-focused variable rate loans, which comprised half of Mexican banks' total loan portfolio at end-March 2016, tend to immediately capture interest rate changes. Funding costs also increase, but not at the same speed and magnitude, since a significant portion of its funding comes from stable customer deposits that carry no or low interest rates.

Mexican banks have a very low cost funding structure, which benefits from a rising interest rate environment. Around 57% of the bank's funding comes from customer deposits at no cost; which means adjustments to banks' funding costs from interest rate increases are lower than their lending price adjustments. At end-March 2016, customer deposits accounted for 83% of Mexican banks' total liabilities.

Mexican banks' NIM has remained at around 5.5% to 6.0% over the previous five years. Fitch has already observed some benefits from the interest increases of December 2015 and February 2016, since the banks are already captured the additional profits from the 25 to 50 basis points, which took the interest rate up to 3.75% before the June 30 increase.

Despite the benefits in the NIM, trading income may show a negative immediate effect, especially those related to fixed income portfolio valuation. Nevertheless, as a result of the last interest rates increases, most Mexican banks have already taken conservative positions and built defensive portfolios to contain potential trading losses, that is, at short-term, with risk associated with the federal government and daily reviewable interest rate securities, which has allowed them to contain any potential losses of trading revenues. Trading income has historically represented a low share of banks' profits, on average 5% of the total gross income, therefore the benefit of a wider NIM could overcompensate for any losses or lower profits arising from their securities investment portfolios.

Among other effects, the interest rate rise will increase borrowers' costs, which could negatively affect delinquency rates and generate higher credit costs for banks, mainly in credit card portfolios, which are generally at variable rate. However, credit cards have experienced moderate growth of over 4% in the past two years and their share of the banks' total loan portfolios has been decreasing, representing 8% at March 2016, compared with 14% during 2008-2009. In addition, interest rates in retail portfolios are mainly influenced by credit and operating costs, rather than moderate adjustments in policy rates. Consequently Fitch believes any impact from increased delinquency would be containable for Mexican banks.

Although the markets maintained upward expectations regarding the interest rates, these have been exceeded by the magnitude and the timeframe dictated by Banxico. Nonetheless, Fitch recognizes this is a result of the current economic conditions that have adversely impacted the Mexican peso value and to prevent this translating into higher inflationary pressures in the country.