Banco Santander Mexico, S.A.

Good day, everyone, and welcome to Banco Santander, Mexico's fourth quarter 2020 earnings conference call. Today's call is being recorded. Following the speaker's remarks, there will be a question and answer session. I'd like to turn this conference over to Mr. Hector Chavez, Managing Director and Head of Investor Relations, who will make some opening remarks and introduce today's other speakers. Please go ahead, sir.

Thank you, operator. Good day and welcome to our fourth quarter 2020 earnings conference call. We appreciate everyone's participation today. By now, everyone should have access to our earnings press release and the presentation for today's call, both of which were distributed yesterday after the close of the market and can be found on our investor relations website. In response to your kind feedback, this quarter we have reduced our prepared remarks in order to allow for more time for Q&A. And also, we have included in the appendix of this earnings presentation a slide with information on our responsible banking standards for your reference. Presenting on our call today will be Hector Grissi, Executive President and CEO, Didier Mena, our CFO, and Rodrigo Brand, Executive General Director of Public Affairs. Before we begin our formal remarks, allow me to remind you that certain statements made during the course of this discussion may constitute forward-looking statements which are based on management's current expectations and beliefs and are subject to a number of risks and uncertainties, including COVID-19, that could cause actual results to materially differ, including factors that could be beyond the company's control. For an explanation of these risks, please refer to our filings with the SEC and the Mexican Stock Exchange. Hector, please go ahead.

Thank you, Hector. Good morning to everyone, and good afternoon to those of you participating from Europe. I hope that you and your families are managing to stay healthy and safe in this particular situation that we're going through. Following a very difficult year during which our markets and our operations were disrupted by the pandemic, our top priority remains safeguarding employees and customers. A product approach to safety in our balance sheet have enabled us to withstand the aftershocks of the pandemic to date. This quarter, we delivered some financial operating results in still a very weak operating environment. Despite a small year-over-year contraction on our loan book, we maintained solid performance levels in loans to individuals, particularly mortgage and auto loans, while commercial loans remained weak in line with market trends and soft demand conditions. By contrast, deposits have proven very resilient. In fact, individual demand deposits increased more than 20% thanks to our loyalty and customer acquisition strategy, while corporate demand deposits also grew double-digit, with companies favoring liquidity. Importantly, our prudence balance sheet strategy has allowed us to maintain ample levels of liquidity and capital, while our ROE for the years surpassed that of the system for the first time in the past five years, a result in which we are very well-satisfied. In terms of asset quality, we are pleased to report that 75% of the loan portfolio under the payment holiday program in support of retail and SME customers remains current. Only 9% have missed payments, and of that, 16% has been restructured already. Given this better-than-expected performance, we estimate that the preemptive loan provisions for 2.9 billion pesos that we made in the second quarter of last year are sufficient at this time. We will discuss our business environment shortly, but first, let me emphasize our conviction that Santander, Mexico remains very well positioned against the still adverse economic effects of the pandemic. Slide number four, please. The chart on slide four shows the full year impact of the pandemic on economic activity and employment. While it seems the worst is behind us, this year recovery is likely to be very gradual, and business activity is expected to remain well below pandemic pre-pandemic levels for some time. Although there has been a gradual turnaround in formal job creation, the annual trend remains negative. January normally shows a seasonal rebound in job creation, but the recent spike in COVID cases has resulted in renewed restrictions on economic activities that have reduced population mobility following a national recovery in prior months. These restrictions will likely impact the pace of their recovery in the first quarter of 21. It is important to note that most job losses have been concentrated among individuals who earn less than two minimum salaries, while approximately 86% of our customers earn more than two minimum salaries, meaning that the rise in unemployment has a limited impact on asset quality within our consumer loan portfolio thus far. Given current economic conditions, Inflation should remain within Bank of Mexico target range. We forecast inflation of 3.5 for 21, giving the central bank room for two more interest rate cuts of about 25 basis points each. We estimate that the reference rate could fall to 3.75% by year-end. The combination of modest economic growth, lower employment, and low interest rates present a challenging outlook for Mexico commercial and consumer environments, and therefore our business in 2021. On slide five, you can see that system loan volume contracted nearly 2% year over year. The weakest performance is 2002. The decline was mainly driven by consumer loans, which had not contracted this much since the 2009 crisis. We coincided with the gradual reduction in corporate loan demand, following high volumes in the first quarter of last year. By contrast, System deposit remains strong, expanding 11% year over year. We demand deposits up 17% year on year, likely reflecting a greater need for liquidity among households and companies, as well as lower rate environment. Moving to slide six, a brief update on our strategy. Our strategic priorities remain focused on building a stronger bank for the future. As we shift the business mix toward higher share of retail loans and deposits, thus attracting more retail customers and increasing loyalty remain the cornerstones of our strategy. Digitalization also remains a priority, and we continue investing in technology. This part of our strategy includes collaborating with fintechs and other tech companies to introduce faster and more convenient digital tools and functionalities that increase customer engagement and drive more transactions. For example, This year we plan to release a new integrated app that is simple, intuitive, and offers enhanced functionality. We expect the app to become a market benchmark and will be exported to other markets where Santander operates. Cloud technologies embedded in our everyday operations, as well as reinforced cybersecurity, are key to our delivering higher value to our customers, as well as increased operating efficiencies. Continually improving our customer journeys and service excellence excellence are also our aim. Being a top three player in terms of NPS is one of our strategic targets, and this indicator is already a relevant KPI in the variable compensation for all employees at the bank. Digital conversion is crucial to our goal of serving customers anytime, anywhere, and anyhow. Progress on this front includes expanding the number of digital customers by 20% to 5 million by year end. A critical part of our strategy has been driving digital adoption levels, as well as expanding our base of loyal customers, who now account for almost 40% of the total active customers. Helping drive digital adoption is our network of smart and agile branches, as well as new functionalities that we're introducing across our digital banking platforms, in addition to new digital products and services. It's our new digital onboarding platforms that are boosting our auto and mortgage loans, which represents 62% of our retail loan portfolio and continue performing extremely well even under these conditions. Importantly, we are growing our auto loan business organically and rapidly, achieving a 5.4 market share as of December. Our alliances with Mazda, Tesla, Suzuki, and Peugeot helped us gain nearly 400 basis points in market share during the last 12 months. We plan to at least double our market share over the next couple of years, with the goal of reaching our natural market share of 13.5% in the medium term. Our mortgage business broke our own production record against this product in December, as well as the banking system, originating 5.6 billion pesos of home loans, driving growth for our innovative Hipoteca Plus and Hipoteca Free products, boosted by our newest digital product, Hipoteca Online, the only mortgage platform in Mexico that connects to all end-to-end processes. Our customer acquisition and loyalty initiatives have been paying off over the past two years, with our mix of retail deposits improving 373 points to 35% of total demand deposits, which will contribute to lowering our cost of funding over time. Attracting retail customers and their low-cost deposits is core to our strategy. Our goal is to reach the average mix of 42% retail and 58% commercial demand deposits over time. Turning to slide seven, total loans contracted 1.5% year-on-year and 4.4% sequentially. in line with the market trends and mainly due to lower balances of corporate and consumer loans. Given the constraints of the current economic environment and with an eye on maintaining asset quality, we continue focusing on more defensive segments, such as mortgages, payroll, and auto loans, where we have been gaining a lot of market share and we have been a leader in the market. On slide 8, you can see that individual loans are growing above 7% year-on-year on the back of mortgages and auto loans, while credit cards and personal loans remained weak. Mortgages have proven defensive, despite current conditions. In fact, we grew mortgage loans over 18% year-on-year, again, organically. Also, by focusing on the middle and upper income segments, we have been able to increase our average ticket, which is 35% higher than the market, compared with 5% only four years ago. This approach has also allowed us to attract more high-quality customers that we then convert into loyal customers with a Hipoteca Plus offer that has been a huge success. In December, when we set our mortgage origination records, around 70% of originations came from our Hipoteca Plus, which helps drive cross-selling in other products as well as build customer loyalty. Our digital onboarding platform for mortgages, Hipoteca Online, has been critical during the pandemic and also helped drive originations around 2020. 70% of mortgages were processed through this digital process. Like mortgages, our auto loan origination reached a historically high level in December, nearly doubling auto loan production sequentially in the fourth quarter. Turning to slide nine, Growth in loyal and digital customers continues demonstrating solid progress in this key area of our strategy, with year-on-year increases of 14% and 20% respectively. As you can see on the slide, loyalty penetration continues to increase significantly. We have also focused on digital conversion while increasing digital transactions and sales. This quarter, product sales via digital channels accounted for almost 50% of total sales. a significant increase from a year-ago level. Digital monetary transactions also spiked, reaching almost one-third of our total, with mobile transactions accounting for 94% of total digital transactions versus 87% in 2019. Mobile customers also kept growing at a solid 23% annual rate, reaching 4.7 million at the end of the quarter. As shown on slide 10, Commercial loans decreased approximately 7% year-on-year and 9% respectively, and some corporates and the middle market firms continued to prepay some lines they tapped in the first quarter of 2020. Loans to government and financial entities also contracted, mostly driven by prepayments from PEMEX and CFE. Middle market companies continued showing a year-on-year expansion, although the segment declined sequentially. SME loans registered a six-sequential quarterly contraction, as this segment was weakening even before the pandemic. Putting this in perspective, our standing loans to SMEs is similar to our third quarter in 2016. The downward trend in this and other segments is also related to a reduced risk appetite in the current economic environment, particularly on SMEs, which are higher risk when the economies are weak. Comps will be difficult in the first quarter of 21, given the precautionary lines of credit that companies drew at the start of the pandemic. Moving on to total deposits on slide 11, this increased 10% year-on-year, while we saw a slight contraction sequentially. As in previous quarter, there was a shift between demand and time deposits due to lower interest rates that favored the former. Deposit growth for individuals stands out at 24% year-on-year, supported by our promotion campaigns to attract these types of deposits. Although this effort, we have been able to reduce the cost of our demand deposits by 110 basis points year-on-year, better than the market has decreased. Although we are satisfied with this result, we continue working to reduce our cost level further as we make additional headway improving our deposit mix while lowering the cost of our commercial deposits. With term deposits, there is also some room to improve our funding costs under the same strategy. I would like to conclude by highlighting that we finished the year better than we have expected due to our swift response to the negative market conditions, and although many challenges remain, we are well positioned with very strong capital and liquidity levels. Now let me pass the call over to Didier, who will review the quarter's most important trends and metrics. Thank you.

Thank you very much, Hector, today, everybody. Turning to slide 12, we continue maintaining very strong capital and liquidity positions, as Hector just noted. Our liquidity coverage ratio stands above 300%, a substantial buffer, and well above the regulatory threshold. We also remain very comfortable with our debt profile, given multiple debt maturities. Our capitalization ratio increased to 19.01%, While our core equity tier one ratio increased 209 basis points to 14.35%, reflecting the recommendation made by the Banking Commission in March 2020 of not paying out dividends. As you can see on slide 13, our net interest margin contracted 89 basis points to 4.5% for the quarter. This was a result of lower interest rates along with lower balances within high yielding segments, partially offset by a significant increase in our securities portfolio during the second quarter. Please move to slide 14. In the fourth quarter of last year, net commissions and fees increased 9% year-on-year, supported by solid performance in insurance, credit cards, and cash management. For the full year, net commissions and fees increased approximately 4%, driven by the same items. Turning to slide 15, gross per year income declined 3.6% year-on-year due to a 50% decline in market-related income as we return to our quarterly average rate of 600 to 800 million pesos per quarter, partially upset by a solid 9% increase in fee income. Moving on to asset quality on slide 16, you will find an update on the evolution of our payment holidays program for customers. As of June of last year, 25% of our top portfolio was on the payment holidays, and by December, all of it had changed payments, showing a better-than-expected performance. 75% of the loans under the program remained current by year-end. 16% had already been structured, while only 9% missed the payments. As expected, most just had the best performance. 91% being current, our proactive and early strategy for recovery and restructuring proved effective, as we have already restructured around 30% of the mid-market and SME portfolios on the holiday payments and 13% of our consumer loans. On the next slide, you can see that our NPL ratio showed an 80 basis point year-over-year increase to 3.08% reflecting the effect of the loans that had missed payments and they become past due. The largest impact has been in credit cards and SMEs with increases of around 300 basis points year-on-year. We expect our NPL ratio to remain about 3% in the next couple of quarters as more of these customers will likely become past due. Given that we have anticipated this increase in NPLs, We have been able to implement strategies to mitigate and manage its impact on our results. Provisions in the quarter fell more than 30% year-on-year and sequentially, supported by recoveries and the usage of a fraction of the anticipated provisions made in the second quarter. Our cost of risk for the quarter and full year stood at 2.89%, 39 basis points, year-on-year increased, but 24 basis points lower on a sequential basis. Considering the behavior of our holiday payments portfolio to date and its expected evolution, we estimate that the level of additional reserves that we made in June of last year remains adequate and gives us a comfortable buffer for future losses. In any case, rest assured that we will continue focusing on mitigating the risk of credit losses through 2021. Turning to costs on slide 18, administrative and promotional expenses rose slightly over 7% year-on-year, mainly driven by higher IT-related expenses as we continue migrating our operations to the cloud, enhancing our ATM software, and reinforcing our cybersecurity tools, among other technology investments. To a lesser extent, EPUB and personal costs also contributed to the increase. It was partially offset by lower administrative expenses as we maintained cost controls. While the efficiency ratio has been increasing since the second quarter of this year, impacted by weaker income in light of a more challenging environment, we remained focused on controlling expenses. Moreover, as we continue investing in digitalizing the bank, And as digital adoption rises, this should make us more efficient through time. Turning to profitability on slide 19, net income increased 11.5% year-on-year to 5.5 billion pesos, mainly due to lower provisions and resilient free income. For the full year, net income declined nearly 6% year-on-year to 25%. A very positive result considering the challenges we faced in an unprecedented year. Return on average equity was 14.7%, 15 basis points below year-ago level, and up 86 basis points sequentially. Year-to-date, ROE contracted 259 basis points to 13.55%. Note, however, that we have been able to make a dividend payment in line with our usual distribution practice, which was paying the excess of a quarter-to-one ratio above 11%. And we, for the year, would have increased by 70 basis points. Let me turn the call back to Hector Ricci for some final remarks. Hector, please go ahead.

Thank you, Olivier.

Before going into the Q&A session, let me share with you some final thoughts presented in the slide 20. Even though visibility has improved from a year ago, we continue to suspend hard guidance given the strong uncertainty regarding loan demands and other business indicators. On this slide, we share our current expectations for our market and business this year. Considering the current state of the pandemic and our assessment on the evolution of the vaccine program in Mexico, we anticipate a very gradual recovery of economic activity this year, mainly driven by the external sector, while private consumption and investment as well as the government spending will likely remain weak. With this in mind, we anticipate dynamic long demand through the year, likely accelerating to the second half as the effects of the vaccination program start having a positive impact in consumer and business confidence. Given the uneven pace at which households and companies will likely recover, we expect the various segments of our portfolio to show different dynamics. As we remain focused on favoring low-risk segments such as mortgage and auto loans, we expect that our attractive products offering will allow us to keep gaining market share driven by double-digit growth in these key products. Given the slow pace of job creation and marginal upturn in consumer confidence, we expect demand for payroll and personal loans to remain weak. On SMEs, highly impacted by the pandemic, we expect the portfolio to continue shrinking along the year. Given that 50% of our loan book are medium-sized companies, large corporates, and government loans, and their performance has been volatile since the onset of the pandemic but clearly losing steam recently, we remain cautious. Even though it is hard to predict the performance of this part of our total portfolio, we anticipate our total loan portfolio to show marginal growth in this year. While loan demand might take some time to recover, we remain focused on our strategy of attracting retail customers and further enhance loyalty. This focus is anticipated to contribute to high single-digit growth in total deposits. we will continue with our efforts to improve the mix, mainly growing retail demand deposits faster than commercial ones. In terms of asset quality, the better than expected performance of our portfolio following the expiration of the pending holiday period is quite encouraging. As I said earlier, considering the level of anticipated provisions, we made in June of last year, its allocation so far and the expected trend in the asset quality of the year, we anticipate around the level of provisions to decline slightly, allowing for a stabilization of cost of credit risk at the current levels with room to improve by year end. In terms of cost, although we intend to make additional investments in the bank transformation, mainly in IT and digitalization, we will continue to keep in a tight control of other expenses and to seek overall efficiencies in support of our bottom line. We estimate that cost should grow around inflation this year. With that said, we look forward to our questions. Operator, please open the call for Q&A session. Thank you very much.

At this time, we will be conducting a question and answer session. If you would like to ask a question, please press star 1 on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star two if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary for you to pick up your handset before pressing the star keys. Please limit yourself to two questions, and please jump back in the queue if you have further questions. One moment while we poll for questions. Our first question comes from the line of Jason Mojine with Scotiabank. You may proceed with your question.

Hi, thank you very much. I have two questions. First, on the dividend outlook, if you can give us an update on the expectations, I guess, given the operations and the muted growth that you're looking for, but also on the regulatory, the regulators outlook for or views on whether banks should be paying dividends in the current environment. And my second question is, is on the announcement that was made, I guess it's almost a year ago, that Santander Group was going to acquire Elevon Mexico, with Santander Mexico owning in the end, I guess, 49%, and the Santander Group company owning the other 51%. If you can tell us what's going on there and what's going on in that business and the prospects there, especially given what we're seeing Santander's subsidiaries announce in terms of payments elsewhere in the region. Thank you.

Hi, Jason. Good to talk to you. Regarding dividends, as you can imagine, there is an ongoing discussion with the regulators, and I think that from a banking association standpoint, we have made clear what our recommendation how we think regulators should look at this topic. Basically, what we have recommended is that rather than looking at potential payout ratios, as other regulators have done in other countries, I think it's more applicable in the Mexican market to look at capital ratios. Okay, you know, there are, in my opinion, two things that merit this approach. First, the Mexican banking system has a very healthy capital ratio, you know, north of what we can see in other geographies. That's one point. The other thing is that, you know, profitability, even with the impact of the pandemic, the ROE of the entire Mexican banking system is around 9%. So even in challenging environments, we have, you know, as a banking sector, the capacity to continue building up capital. And that's what, you know, most of the banks and clearly the largest players have been doing over the last year. So that's why we are recommending, you know, the banking commission to look at capital levels. What's the capital ratio that they will feel comfortable with? One of the exercises that is worth looking at is the most recent financial stability report published by the central bank a couple of weeks ago. They run three scenarios. well, actually six scenarios. And under all of them, you know, and obviously they're highly stressed scenarios, the Mexican banking system continues to be above the minimum levels. And I would say that in some cases, you know, within 14% to 16%. So in my opinion, that is a lot of capital tied up in the banks. Now, having said this, you know, that this is a recommendation, I'm concerned that what Mexican regulators will do is just follow what others are doing and that they might end up recommending the Mexican banks not to pay more than 15%, 20% of last year's earnings. That definitely is... It's something good, but I think that that's not the right approach. Let's see if we can be able, if we were successful in trying to convince them that it's more applicable, you know, having or setting a certain level of capital ratio and then allowing banks to pay out what is in excess of that, okay? Well, and finally, Regulators have mentioned to us that they expect to have a view and share that view with us during the first quarter of this year. So we expect that those conversations will continue happening and that we will have a final view coming from them relatively soon in the next couple of weeks. On your second question, I will turn the microphone to Hector. I think that he has a more comprehensive view of what's going on with Elabon Mexico.

Thank you, Didier. Hello, Jason. Let me tell you, we concluded the acquisition of Elabon last year. Actually, we finished that off around mid-year and Actually, Group took over the 51% and the bank in Mexico ended up with 49%. And now, basically, we are changing the system and we're changing the name from Elevon Mexico to GetNet Mexico, okay? As you know, GetNet is our name in Brazil, which has been very successful. And now, GetNet Mexico is a new reality. We are growing the business in a very healthy way. Now, we are the second largest acquirer in the country. We're growing rapidly. very well in that business, and we will continue to do so. Okay, this is one of the most important things that we're going to be concentrated on. As you know, Santander Group has announced the formation of a new subsidiary called PagoNext, which is basically our payment subsidiary, and PagoNext is the one that owns the 51% of now GetNet Mexico, okay? And this is a business that is going to be very important that will continue to grow We hope that we will be rolling out the new system and the new software for the system in probably the next couple of months, which, by the way, will be one of the most advanced in the Mexican market. And we hope to continue growing that business very fast, also with a huge SME penetration that we have.

So are you waiting to grow that business? Are you waiting for the new software? Like standing by, are you just kind of treading water with the market share you have at this point? No, no, no.

We're not waiting for anything. We're growing very much. As I told you, now we overpassed Banamex as the second largest acquirer in the country. BBVA is the largest one. We're the second one. and we will continue to grow that business. The rollout of the new software will be in the next couple of months. Right now, we're still operating through Elebon, and the new software will be ready. We already have friends and family. We have a group of clients already working out the new software. We're just checking the last points, and the rollout will be completed in the first quarter.

That's very helpful. Thank you both.

Yeah, thank you.

Our next question comes from the line of Ernesto Gavilondo with Bank of America. You may proceed with your question.

Hi, good morning, Hector and Divier, and thanks for your presentation and for the opportunity to ask questions. My first question is on provision charges. We noticed that you used around 1.5 billion pesos out of the 3.9 billion pesos of the preventive provisions billed in June. And on the other hand, the research coverage declined to levels below pre-COVID. On the other hand, you mentioned that the behavior of the deferred portfolio has been better than expected and that there is 9% of your deferred portfolio that is delayed. So this represents around 15.7 billion pesos. So considering that you still have preventive provisions of around 2.4 billion pesos, how should we think about these 15.7 billions that are delayed? And how much do you think you can restructure considering you have probably collaterals in mortgages and SMEs? And what could be the worst case scenario for this delayed portfolio? And then my second question is related to your net income for the year. When incorporating your expectations for 2021, we are getting to a flat net income for 2021, so just want to know if that sounds reasonable on what you're expecting.

Thank you. Hi, Ernesto.

Good to talk to you. Regarding the provisions, you know, you know, something that is important to have in mind is how the different loan portfolios are performing, you know, in terms of one late payment, two late payments, three late payments, and comparing that to prior years, okay? And what we're seeing is that in some portfolios, you know, customers that are, you know, at three payments late are slightly above just for, you know, very, very selected portfolios. But most importantly, when you analyze or when you compare one and two payments late for the vast majority of a long portfolio, what we are seeing recently are levels below pre-COVID. If you compare December 2020 to December 2019, we are, you know, the performance is better than what the loan portfolios were performing back in 2019. So all this to say that, you know, there was clearly and increasing MPLs associated with the impact of the pandemic, that the level of provisions that we made in the second quarter of last year, we consider that are insufficient for the deterioration that we've seen already, and that we don't have evidence regarding a potential you know, for the deterioration of the loan portfolio that is not taken into account. Obviously, if there's any deterioration that is not well incorporated into our provisions, we'll definitely make those. I think that as we have shared with you over the last few quarters, the strategy that we laid out in terms of classifying customers, depending on the risk, on the performance, on how linked they are to the bank, what type of product that they have. All those strategies, I think, that have worked pretty well so that we have a good understanding of what the current standing, current exposure, and potential risks that we have with clients, particularly in SMEs. I think that those SMEs that have been restructured, we were able to increase the guarantees that we have with them, not the guarantees that come from from the government development banks, but guarantees that come from the clients. So probably around 75% of those SMEs that have been restructured have an additional guarantee to the one that we had prior to doing the restructuring. So we think we enhanced the collateral that we have relative to SMEs. So I would say, Ernesto, that we feel relatively comfortable. You rightly point out that there is a decrease in the coverage ratio, and I think that this is a temporary decrease. With the increase in MPLs, then you you know, going to write off a policy, we have to try to recover those loans. When we have a reasonable expectation that those loans will not be recovered, then we have to write those loans off. So an increase in MPLs recently, implies that during the following quarters, there will be an increase in loans that are written off. And when that happens, the coverage ratio will increase. So I think that most importantly, what is very important for us is to stress the fact that when we make provisions, we take into account expected losses, probability of default, severity of the loss, And according to that information and with different scenarios that we are analyzing, we don't see a compelling reason of why to increase or provide or make additional provisions, okay? So that's on provisions. Now, turning to your question on net income, I think that you're right in the sense of, you know, with the soft guidance that we are providing, with the key trends that we are seeing, Yes, you know, in the combination of different assumptions that we are sharing with you, it could get you to flattening income or slight contraction in net income. Those are things that we're seeing, you know, very clearly. Some potential downsides, and that has to do, obviously, mainly with with the continuous impact of the pandemic. Also, there's clearly an upside. And that has to do, in my opinion, with there's an accelerated rollout of the vaccination program from the government. Even the governor of the central bank, in their assumptions, they state that a successful and efficient implementation of the vaccination plan could imply a 200 basis points difference in terms of GDP growth for the Mexican economy this year, going from 3.3% to 5.3%. We think that most likely, if that happens, it's going to be more concentrated over the second half of the year. There's been a relatively slow implementation of the vaccination plan in Mexico. So the upside is that in Mexico. In my opinion, and if that happens, definitely we are very well positioned. We have the capital and the credit to continue providing support for our customers.

Thank you, Vivian. Just a follow-up in terms of the provisions. So at the end, considering the potential expected losses, the restructures, and the collaterals, Do you think that the delayed portfolio of around 15.7 billion pesos could be reduced to around 2.4 billion pesos?

I think that the provisions that we have are sufficient for the deterioration that we're seeing. And it's not only about the portfolio that is in the payment holidays, but also the entire loan portfolios.

Okay, perfect. Thank you very much.

Our next question comes from the line of Jorge Cury with Morgan Stanley. You may proceed with your question.

Hi. Good morning, everyone. I hope everyone's doing well. Two questions, if I may. The first one is on trading market-related income. It's evidently been quite volatile in 2019 and 2020. Could you remind us what you think the per quarter normal level for trading should be? And I know it's very difficult to answer this second part, but do you think 2021 would look more normal and hence delivering on that normalized level? And my second question is on NII. Your comment about marginal growth in the loan book and falling interest rates in Mexico. Does that mean that we'll probably see another year with NII contraction similar to 2020, 1%, 2% contraction? Or is there anything that you see this year that would help you not deliver NII contraction? Thank you.

Let me tell you, on trading, what I believe is basically, I mean, as you have seen, we had a tremendous year this year. I think it's going to be highly difficult that we're going to be able to repeat this kind of year. We were very well positioned to the situation, and fortunately, we came out really well. The normal number should be between 3.3 and 3.7 billion per year. Okay, that's the normal thing that we should make. And I believe this year should be around between three and four. I don't think it's going to go beyond that, given the size of the book that we have and the size of the positions that we have at this point, unless there is an unexpected move or there is much more volatility. But otherwise, I don't think that it's going to be beyond that. And then second question, I would please ask Didier to follow on that.

Hi, Jorge.

I think that net interest income, in my opinion, should be relatively stable to what we are delivering in 2020. And there are obviously headwinds in terms of the expected growth in our loan portfolio. However, let me share with you some of the dynamics that we are seeing. If you look at how interest income and the interest expense are performing, what we've seen in the last quarter is that interest expense decreased almost 31% year-on-year, while interest income decreased only 15%. Given that we, when you compare what we've done relative to our most relevant years, we started, we were very cautious in terms of the potential impact of the pandemic in terms of Prior crisis had that deposit typically contracted as a consequence of the crisis, and we were somehow expecting that, and that hasn't happened. So for the first half of the year, we were monitoring closely the dynamic of the deposits and being not as aggressive as other countries. in terms of the reduction of interest rates. Now, at the end of August, when we had some stress scenarios, taking into account recent information of the performance on deposits, we realized that we had a very, very significant cushion in terms of liquidity, even on the very, very stressed periods scenarios. So we started a more aggressive campaign to reduce our cost of deposits. So that's why, you know, when we compare the reduction in interest expense relative to the third quarter of 2020, you know, in the fourth quarter we were able to reduce it twice as much as what we reduced in the third quarter of last year. So all this to say that you should probably look at what happened in the fourth quarter as some guidance, some guide to what could happen in the following year. And we still have some potential in terms of the benefit of what we have reduced recently in terms of deposit rates. and having the impact for the full year in 2021. Okay? So I think that that should be one of the most relevant factors that will make NII be relatively flat this year.

All right. Thanks, Hector and Didier. Be well.

Thank you.

Our next question comes from the line of Tito Labarda with Goldman Sachs. You may proceed with your question.

Hi. Good morning, Hector and Didier. Thank you for the call. My question, following up on the cost of risk, just want to understand a little bit the cost of risk this quarter. And given the rough guidance you mentioned for remaining more or less around current levels around 2.93%. But in the quarter, it did fall a lot to below 2%. So just to understand why the big decline this quarter, given that you expected to go back to that roughly 3% level. And, you know, we saw a big spike in MPLs this quarter, and you expect that to continue to deteriorate. I mean, you mentioned you benefit from recoveries. Maybe if you can give some color on what those level of recoveries were this quarter relative to other quarters, how that could evolve this year. I mean, just to get a sense of how we should think, at least like on a quarterly basis, how that costs the risk. should evolve from here because it looks like we should expect a big jump from what we saw just in the fourth quarter. Thank you.

Hi, Pinto. Regarding cost of risk, you have to take into account that the spike that we saw in the second quarter was mainly to make additional provisions. So when you compare the fourth quarter relative to the prior quarters, then that's why you see that decrease. But at the end of the day, in my opinion, the way we have to look at it is to analyze whether the provisions that we're making are enough cover for the potential losses that we expect in our loan portfolio. And what we have analyzed is that we respect the level of, you know, cost of risk being around 3%. You know, so it's clearly higher than what we had in pre-pandemic. And it's not as high, you know, but it's like 15, 20 basis points lower than the numbers that we were getting in the second and the third quarter of last year. In terms of recoveries, Hector, would you like to expand on that?

Yes. I mean, first of all, let me tell you, I mean, what we did on the last quarter is we sold a lot of the portfolio. We sold a big piece of it, around $1.2 billion. That was a big part of the portfolio that we sold. That's why the numbers basically came down. What we have seen also is that the deterioration on the portfolio, mainly in credit cards and in SMEs, is not growing. It grew into the forequarter, but basically the deterioration has stopped over the past, I would say, 45 to 60 days. Okay, so with that, we feel confident that at this point it's not going to get worse. Now, I mean, we are being a little cautious in the sense with this second lockup, what's going to happen, okay? What we have seen is that our portfolio is resilient. And if you take a deep look at what we've been doing, we were cautious not since the pandemic started, but a long time before then, since the new government came in, because we were a little bit concerned about the investment and a little bit concerned about what's going on. So we were already cautious. So our portfolio in that sense was already not growing as much as it was growing before before the new government came in. So on that regard, I feel very confident that the portafolio that we have left is very resilient at this point, okay? But, I mean, nevertheless, it's very difficult to prove, I mean, to see if the vaccine's coming before then the situation could be better. But at this point, I could tell you that... not extremely but comfortable enough with the portfolio and the levels we have of PASUS, okay?

Okay, thanks, Hector and Didier. And can you give some color on the recoveries?

Yeah, the recoveries are going well. As you have seen the numbers, I mean, they are actually much better than expected. What we did, and I'm going to give you a little detail, we divided our clients into clusters, okay? Okay? And we defined the clusters that were a little bit more dangerous in the sense that we believe that had a little bit more probability of not getting paid. So we actually went a little ahead of the market, and we were negotiating with those clients in the beginning. And we reviewed the portfolio, and also we were very aggressive basically in SMEs in buying warranties from Nafinsa. So our portfolio is one of the best secure portfolios in the market. I mean, best warrantied, sorry, portfolios in the market. We were very, very aggressive on that even before the crisis started. So I believe that we're going to come in a very good position in that way.

This is Hector Chavez.

And just in addition to what Hector Greasy just mentioned on the strategy of recoveries, the actual number on the fourth quarter of reserves of 3.1 billion, there we did sell a portfolio of bad loans for 1.2 billion pesos. Without that sale, the level of provisions would have been 4.3, which is very much in line with the average normal level of provisions that we put every quarter. That's another reason why you saw an important sequential reduction of provisions quarter over quarter.

Okay, that's very helpful. Thank you, both actors and Didier.

Our next question comes from the line of Carlos Gomez with HSBC. You may proceed with your question.

Thank you very much. Hello to everybody. My first question is about interest rates and sensitivity of margin. I noticed that everybody's expectations is changing and yours has changed to 3.75% for the year. Can you remind us about your sensitivity in terms of basis points for the margin for every 100 or every 50 basis points change in the interest rate. And second, in terms of risks, we have seen the proposed energy reform that is now being discussed in Congress. Could this have any impact on private producers and would that have any effect on your portfolio? Thank you.

Hi, Carlos. Great talking to you. Regarding interest rates, I think that given how inflation has come over the last few weeks in terms of being closer to the midpoint of the range that the central bank has been I think that that provides us with certain confidence that there's still some room to reduce the interest rate by 50 basis points. We expect that to happen within the next two meetings of the board of directors of the central bank. We have reduced insensitivity in our debt interest margin associated With the power and production in interest rates, 100 basis points contraction implies close to 300 million pesos of impact. That's the most recent sensitivity that we have. Then on what's going on on the energy reform, I'll let Tergizi to comment on that. would you like to comment on the energy outlook that you see?

Sure, sure, sure. Okay. On that look, I mean, we have taken a close look at the portfolio. Even though we have risk to the sector, we have one of the most important, most of the risk basically has been put into bonds and to some other securities. We will have probably an impact, but it will not be material to the portfolio, okay? So we're not worried in that sense.

Thank you, Hector.

And again, congratulations. This is Rodrigo Brand. If you let me add to the electoral reform, I think it's very important what happened yesterday with the Supreme Court, which will, I think, it's very uncertain what will happen with this reform, given that the Supreme Court has ruled against normative changes that were in the same sense. So I think it is going to be a very long run for this reform in order for all the amparos and rulings from the Supreme Court in the long term.

Thank you very much.

Our next question comes from the line of Gilberto Garcia with Barclays. You may proceed with your question.

Hi, good morning. Thank you for the call. A couple of questions. First, just to clarify, the loans coming out of the holiday programs that you disclosed had to be restructured. Are those restructured loans making payments regularly or did some of them enter a sort of second holiday program? And secondly, one of your competitors has stated that they intend to be rather aggressive in the mortgage sector. Do you believe there's room, given that rates continue to go down, to be even more aggressive there? Thank you.

Thank you, Gilberto. Let me tell you, I mean, in terms of loans on holiday, the second loans that we basically did were giving grace on capital, not on interest. And the majority of the portfolio is performing well, as Didier explained. So in that regard, I mean, and some of the portfolio, as I discussed, we have not seen that the portfolio past due is increasing beyond three months and is behaving properly in a proper way, okay? So in that sense, we're not worried about that. And the holiday payment basically is just, as I said, on capital. In terms of the mortgage, we'll see. I think that the levels we have at this point in the market were very comfortable. The portfolio and the trend is continuing to grow, and the demand is continuing to grow. I don't see at this point that we will be lowering rates still, but I mean, still, I mean, we need to see and see how the market evolves. But at this point, I wouldn't be seeing that we will be lowering the rates at this point.

One thing to have in mind, Gilberto, is the fact that relative to our peers, we are positioned in higher income segment. As we noted in our comments, in our remarks, when you compare the average ticket that we have in our loan portfolio, that's close to 35% higher than the average of the loan ticket, the mortgage ticket that we see in our peers. So I think that, you know, we need less number of customers or loans to have to reach to a similar balance that our competitors. And probably most importantly, but we also comment on the remarks, is that unfortunately, the pandemic has impacted more low-income individuals. We are not that exposed. to low-income individuals. And within our customer base, the vast majority make more than two minimum wages that are the ones that individuals that make less than two minimum wages are the ones that have suffered more losing their jobs. So we think that the way that we are positioning the product and the strategy is relatively safe you know, aiming at the higher income individuals that are less vulnerable to the impact of the pandemic.

Our next question comes from the line of Brian Flores with Citibank. You may proceed with your question.

Hi, thank you for the opportunity. Just a couple of questions. The first one is, would you be comfortable going below the level of coverage of 100%? And the second one is, if you see the regulator approving the potential for booking write-offs of the pandemic directly against capital, as this happened some time ago with some specific real estate portfolios.

Thank you.

Sorry, can you repeat the last part of the question because you broke up a little bit?

Sure. The second question was if you see the regulator approving the potential for booking write-offs directly from against capital, as it has happened before with some specific real estate portfolios.

Okay. I mean, to your first question, I mean, I don't feel comfortable going below 100% coverage. I mean, what we will see is we will see how the portfolio evolves, and depending upon that, we will create more reserves if needed, okay? So we'll be taking a really close look at the portfolio. At this point, I think we're a comfortable way the way we are, given the portfolio that we sold and also the size of the portfolio that we have at this point, I mean, under observation, okay? But no, I would feel comfortable below 100. And in terms of the regulator, we have not discussed that particular with the regulator to going against capital. I don't think that's going to be... Okay, that will depend on how they – I mean, as Didier basically exposed to you, the amount of capital that we have is big, and also the return on equity on the different banks is also important. I mean, we're still generating a huge amount of money, so I don't believe that at this point would be needed. I don't know about the smaller banks. But the big seven, I don't think they will have to be in that situation. I don't think it's the time for that. Okay, perfect. And also, I don't think it would be a healthy thing because it would create a difference to the market, and I think that wouldn't be the right thing to do. I mean, when I'm talking about the international market, okay? Okay.

Okay, and just a quick follow-up. You mentioned to my colleague, Carlos, the sensitivity to a decrease in 100 bps in the interest rate.

Could you please repeat that figure?

Yes, would you please?

Absolutely. It's around 300 million pesos. That's 100 basis per month. Thank you very much.

Okay.

Thank you. There are no further questions at this time. I'd like to turn the floor back over to Mr. Hector-Travis for closing comments.

Thank you, operator. And thanks, everyone, once again, for joining Santander, Mexico on this call. As always, we wish to maintain an open dialogue with all of you. If you have any additional questions, please don't hesitate to call or email us directly. Until next earnings call, please stay safe.

This concludes today's conference call. You may disconnect your lines at this time, and thank you for your participation.