Slower economic growth in Panama, following several years of strong expansion, may heighten the erosion of credit strength brought about by very high competition among local banks, says Fitch Ratings. In Fitch’s view, bank competition may actually intensify in times of less vigorous loan demand, exacerbating many banks’ already limited capital generation. Near term, there is a higher potential for industry consolidation, particularly among small banks with weaker financial profiles, and little potential for upward rating pressure across the sector.

Panama’s GDP averaged a robust 8.3% per year over 2010-2014, which fostered competition characterized by less stringent constraints on rates, tenors and other terms. The result has been broadly compressed profitability and weaker financial flexibility. As banks have accumulated less profit, capital levels have declined. Furthermore, many Panamanian banks target capital levels without substantive cushions. Differences between the best-rated banks and the rest of the system are growing in terms of loss-absorption capacities and risk appetites.

Banks have tried to compensate for lower margins by maintaining outstanding efficiency metrics. We do not believe that efficiency measures have room for improvement, thus profitability is more heavily dependent on maintaining exceptionally good asset quality. We believe that asset quality will deteriorate only modestly in the medium term, but enough that it could affect banks positioned at the weaker end of their rating levels. The absence of a central bank in Panama may limit the ability of the government to provide support for troubled lenders.

Some economic sectors are exhibiting less dynamism, including, for example, the Colon Free Trade Zone and certain public-sector investment projects. At the same time, a potential slowdown in the key sectors of construction and mortgage lending could eventually affect asset quality. None of these risks has materialized in generalized terms as of yet.

Good loan portfolio quality will be key for banks to maintain their credit profiles. Nonperforming loans (NPLs) were among the lowest levels in the region, at 0.92% as of June 2015. However, in a scenario of lower economic growth and rising unemployment, NPLs may double over the medium term, which would drive higher loan loss reserves, especially for some smaller banks.

Positively, Panama’s otherwise favorable economic environment has allowed banks to grow steadily in an already highly penetrated market. Domestic loans/GDP exceeds 90%, which is approximately twice the Latin American average. The slowdown in Panama’s GDP is expected to be modest, perhaps stabilizing around 6% over the next few years, roughly 2x Fitch’s forecast for Latin American averages over the coming years.