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The Future Of Puerto Ricos Community Lenders
Stiff government regulations, loan caps, and competition from banks due to low interest rates are creating financial woes for the islands personal loan companies.
By LUIS A. RAMOS
December 9, 2004
Puerto Ricos financieras in a fix
Long the only option for high-risk borrowers, small loan companies have been struggling in recent years. Many say the remedy lies in reforming the Small Personal Loans Law and reducing regulatory oversight.
For decades, Puerto Ricos small-loan companies, known as financieras, have provided a quick financial fix for clients who wouldnt have access to loans through other lending institutions. In recent years, however, financieras have provided the only wrinkle in what has otherwise been a stellar performance by Puerto Ricos financial sector.
In 1999, financieras reported $2.1 billion in total assets, according to the Office of the Commissioner of Financial Institutions. By June 2004, their total assets had dropped to $1.2 billion, a decline of over 40% in the five-year period. The number of financieras has also been declining, from 57 in 1971 to just seven in 2003, while employment in financieras has dropped by nearly 50%, from 4,075 in 1996 to 2,108 in 2003. For decades, these small-loan companies have had a large presence throughout Puerto Rico, assisting their clients with financing for home improvements, cars, debt repayment, holiday shopping, schooling, and other purposes. Financieras have earned a widespread reputation for providing fast loans to clients who lack good credit, have no collateral, and are considered high-risk.
The high-interest rates that accompany these fast loans, however, have become the center of controversy and are generating doubt regarding the future of the small-loan industry in Puerto Rico. With commercial banks expanding their financial services, the small-loan industry has been losing ground at a steady pace for the past three decades, yet the demand for fast money among high-risk groups has remained constant.
In 1971, there were 57 financieras in Puerto Rico. By the end of 2004, only seven remained: Associates Finance, part of Citigroup; Island Finance, a subsidiary of Wells Fargo Financial; Expresso of Westernbank; Commoloco; Popular Finance of Banco Popular; Money Express, a subsidiary of First BanCorp, and Plaza Finance. The assets of these financieras add up to less than 1% of the total assets reported in Puerto Ricos financial system. According to the Office of the Commissioner of Financial Institutions, a decade ago, financieras total loan portfolio was $1.5 billion. By June 2004, it had declined to $1.1 billion.
Impact of stiff regulations and high-interest rates
Financial experts maintain that government regulation has become one of the financieras greatest obstacles, and Law No. 106 of June 28, 1965, the Small Personal Loans Law of Puerto Rico, seems to be at the heart of the issue. Law No. 106 establishes the maximum lending limit at $5,000. Loan originations over this limit would require financieras to access alternate legal venues that entail additional permits and offices, contributing to higher operational costs.
Although the average small loan is for $3,000, many blame the $5,000 lending ceiling for the industrys difficulties. Further complicating matters is the high-risk profile of the financieras client base. Industry experts estimate small-loan companies serve about 400,000 clients a year, a large portion of whom have annual incomes of $10,000 or less.
Providing lending services to a high-risk market is considered the driving force behind the higher-interest rates offered by financieras. In 2001, the Puerto Rico House Banking Committee indicated that 63% of all small loans carried interest rates of 30% or higher. The Small Loans Companies Association of Puerto Rico (Financo) points out, however, that the number of loans with a 30% interest rate has declined significantly since then.
But high interests are considered by many to be the financieras only protection from bad debts. High risk may equal high rewards, but it can also mean high losses. Bad debts represent one of the industrys main expenses. According to a study by H. Calero Consulting Group, in 2000, the amount of bad debt in the small-loan industry reached $100.7 million. Concerns over bad debts have forced many financieras to raise their credit standards, thereby reducing their client base. The number of small loans provided by financieras has declined by nearly 60% in recent years, from over 800,000 in 1996 to 334,841 in 2000, according to H. Calero Consulting Group.
Increased competition for the small-personal-loan business has also contributed to the greater challenges facing financieras. A combination of the Small Personal Loans Law of Puerto Rico and a different marketing approach has opened the door for new players to serve the small-loan market.
"Our industry has been a significant contributor to Puerto Ricos economy, but we have bumped into a crisis," said Oriol Segarra, senior vice president of Wells Fargo Financial, parent company of Island Finance. "Any industry that doesnt grow is in questionable shape, and ours has been stagnant for the past 20 months."
Nevertheless, the small-loan industry has continued to push forward with its risk-based community-lending effort. Specific consumers have also continued to sponsor financieras in their communities, benefiting from the lenders quick loan-approval process.
Industry officials maintain financieras are providing vital community services to a segment of the population that otherwise wouldnt have access to loans. Financieras provide personal small loans, mortgage-guaranteed loans, and retail sales finance loans. Personal loans make up 71% of all financieras loans. Mortgage guarantees allow for loans higher than $5,000 secured by real estate; they also require a separate setup for the lending entity. Retail sales finance loans, which take place through island retailers, have recently shown the highest growth in the industry.
While some believe the industrys growth relies on expanding financieras niche, many others support deregulation. Despite all the financing activities of small-loan companies, including mortgage-guaranteed loans and retail sales finance loans, the industry has still shown lackluster results. Nevertheless, additional competition has emerged to vie for financieras market.
Meeting new realities
Many in the industry agree the past five to six years have been particularly difficult for financieras in Puerto Rico. Low interest rates are one of the reasons for their difficulties. They have enticed consumers to pursue home equity loans from commercial banks, further diluting financieras position in the market. But several years of this activity have caused personal debt and bankruptcy to mount, pushing credit limits and compromising consumers credit ratings.
As customers began calling on financieras again, the industry experienced an increase in loan demand, helping it to endure, even if just for the short term. While clients are being helped with their new debts, the small-loan industry continues to search for feasible solutions to advance its business in the long term.
Financieras havent reached consensus on a development blueprint. Financo and individual members of the small-loan industry have a number of pressing issues, particularly the interest rates charged on loans and the $5,000 lending limit.
According to Financo Executive Director Edgar Novoa, these issues have compromised financieras competitive flexibility. The reason is that financieras, as community-based lenders, have a higher number of clients with lower credit scores, increasing their exposure to risk. There is also concern that the traditional interest-rate range in which financieras operate may not be sufficient to counter nonperforming loans.
Some in the industry favor basing interest rates on open competition. Technically self-regulated, the small-loan industry has kept within the imposed interest-rate parameters for the benefit of its customers.
A changing market
Attempts to control transactions in Puerto Ricos small-loan industry can be traced to the early 1900s. From 1902 to 1965, Puerto Ricos Usury Law provided the framework for such contracts. It prohibited, for example, charging interest rates higher than 9% on personal loans of less than $3,000.
Legislative initiatives eventually gave shape to Puerto Rico Law No. 106. Small-loan companies, which claim to be serving about 80% of Puerto Ricos work force, including the unbanked population, have been operating under this law for nearly 40 years, during which time it has undergone several amendments. According to Gaither International, in 2002, 36% of Puerto Ricos population was classified as unbanked. Other players such as commercial banks and cooperatives have entered the small-loans market.
Accordingly, financieras share of the market has declined. With a total small-loans market of $5.1 billion in the first half of 2004, financieras share was 20.55%, a 0.9% decline since 2000. Meanwhile, commercial banks (including banks with financiera affiliates) garnered 42.29% and co-ops 37.16%.
Associates Finance and Island Finance have the lions share of the small-personal-loan market. They lead the industry in terms of total assets, giving them respective market shares of 32.5% and 30.9%.
The $5,000 lending limit has spurred Associates Finance, Island Finance, and other financieras to create separate entities to reach the market for loans over $5,000, mostly through mortgage-guaranteed loans. Statistics have shown that a large number of small-loan customers need to borrow over $5,000.
Also of concern to financieras are regulatory requirements that raise their overhead and limit cross-referral possibilities between related finance companies. "Required separate reporting and additional overhead are two relevant issues affecting our business. Restrictions on cross-referrals create another key limiting barrier on the deal flow," said Jose A. Diaz, president of Associates Finance.
Financieras have also suffered from the greater availability of alternative credit sources. Credit cards, even with interest rates in excess of 20%, have become more available to all sectors, reducing the number of potential customers seeking small loans.
Then there is the growing participation of commercial banks in the small-loan market. At the top of this new class of competitors is Expresso of Westernbank. Expresso has positioned itself in the above-$5,000 loan market by creating an individual branch image while operating under Westernbanks commercial-banking auspices. Expresso has focused on attracting customers who need to consolidate loans. It currently has an estimated 21,000 customers and 19 branches throughout Puerto Rico.
Backed by Westernbank, it can concentrate on small-loan customers presenting an acceptable risk. "Some of our traditional clientele may be at the top of the interest range, but our design allows us to start interest-rate offerings at 4.9%. A number of our customers are part of Westernbanks client base, while an estimated 3,000 are new to this sector," said Migdalia Rivera, president of Expresso of Westernbank.
Other participants in the small-loan industry are simply affiliates of commercial banks. FirstBanks Money Express and Banco Popular de Puerto Ricos Popular Finance, for example, are becoming a major force in the industry. Popular Finances growth in recent months can be attributed in part to its acquisition of Mendoza Finance.
Although they also operate under Puerto Ricos Small Personal Loans Law and are limited to loans under $5,000, these entities seem better equipped to protect themselves from nonperforming loans. They also have the advantage of being able to provide other personal-loan products through their parent financial institutions.
"We are experiencing a certain level of affordability in our business right now," said Aurelio Aleman, FirstBanks senior executive vice president of consumer banking, who oversees Money Express. "The lending cap came from an original amount of $2,500 before hitting $5,000, and therefore we dont see that limit as critical."
Financieras try to maintain their market position
Concerned over the changing market, financieras have taken steps to maintain their position. One initiative has been to seek alternative venues to improve their lending opportunities.
They have recently begun working with retailers of consumer products as their financing agents, now a common practice among businesses such as retailers of furniture and home appliances. Operating under a separate legal umbrella from Law No. 106, financieras have also emphasized originations of mortgage-guaranteed loans with relative success, given the reduced proportion of small-loan customers that are homeowners.
Many financieras believe government regulations and oversight are limiting the industrys potential. Some say it is because the government may not fully understand the intricacies of small-loan companies. They note, for example, that Law No. 106 doesnt allow financieras to impose early cancellation fees, whereas other financing companies can impose such fees on loans of more than $5,000.
The latest attempt to amend Law No. 106 happened in 2001. It included an unsuccessful bid to establish an interest-rate guideline on small personal loans. Inaction by the Puerto Rico Legislature led the industry to seek an understanding with the Office of the Commissioner of Financial Institutions whereby consolidated interest rates on loan portfolios would generally not exceed a 30% weighted-average interest rate. This self-regulated approach is still applicable.
"Customers money needs have grown, but our compliance requirements have remained constant, limiting our expansion capability," said Diaz of Associates Finance. "We act professionally in trying to achieve a reasonable return given the risk involved. But the moment has arrived to inject substantial changes into the small-loan industry so it can truly grow and remain a feasible alternative for consumers."
"Lobbying for legislative changes could be on the industrys short-term agenda," said Financos Novoa, who insists the answer rests with deregulation at various levels. "Many members of the small-loan industry look forward to badly needed institutional changes. Simply put, we are overregulated, and it is unaffordable. The moment has arrived to review Law No. 106 carefully and reconcile it with the times we live in so our industry can define a growth alternative. Many issues would have to be looked at, but the heart of the solution is the removal of the $5,000 lending cap so we can compete on a fair and even basis in a changing marketplace."
Lifting financieras lending maximum may not be an easy task. It would require the Puerto Rico Legislature to examine this and other issues hindering the growth potential of small-loan companies. Some industry experts say that by maintaining the present status, financieras are at risk of being further diluted. They also note the irony that allowing financieras to make loans of more than $5,000 might serve only to put them in direct competition with affiliate entities.
Providing a community service
Despite their generally high interest rates, financieras are still perceived as a viable lending alternative. Their quick processing of loan applications is no doubt a key attraction. Financieras also retain customers loyalty because they promise more-personal service than is found in traditional commercial banks.
Financieras often engage their clients personally. It is perhaps this need for such personal contact and this familiarity that have forced financieras to open a large number of lending offices throughout the island.
According to the 2004 CARIBBEAN BUSINESS Book of Lists, small-loan companies operated 295 branches in 2003, up from 171 in 1996. The 73% increase is attributed primarily to the industrys need, as community-based lenders, to be close to the communities they serve.
During 2003, Associates Finance operated 81 branches with 982 employees, Island Finance 75 branches and 853 employees, Expresso of Westernbank 19 branches and 159 employees, Commoloco 47 branches and 248 employees, Popular Finance 30 branches with 258 employees, Money Express 37 branches and 200 employees, and Mendoza Finance 15 branches.
Jobs produced by the industry, however, have been declining despite the substantial increase in the number of branches. In 2003, financieras generated a total of 2,108 jobs, nearly half the 4,075 jobs generated in 1996. Among the main reasons for this reduction is financieras need to streamline their operations and reduce costs while remaining accessible to clients.
Diaz of Associates Finance said potential layoffs are a major concern, but he has faith the recent upswing in the small-loan industry will hold. He believes the continued expansion into home equity loans, mortgages, and retail sales financing will help the industry endure until major regulatory changes occur. Of course, he said, these regulatory changes need to be made as soon as possible.
Georgianne Ocasio-Teissonneire contributed to this story.
Employment in Small-Loan Companies in Puerto Rico
Sources: Office of the Commissioner of Financial Institutions, H. Calero Consulting Group Inc., and CB Book of Lists 2003
This Caribbean Business article appears courtesy of Casiano Communications.