MEXICO CITY — U.S. community banks would be worst hit if President Trump's threats to upend the North American Free Trade Agreement or impose a 35% tariff on Mexican imports sparks a trade war.

Lenders in the U.S. farming heartland and across Texas and California could face big losses if Mexico were to slap retaliatory tariffs on U.S. grains to counter Trump's protectionist policies, several bankers and analysts said.

The timing would be inauspicious as a U.S. money-laundering crackdown has forced many border banks to shut their business or close Mexican accounts since 2013 and sacrifice revenue in the process. The moves followed fines paid by Wachovia, HSBC and Banamex USA for allowing drug lords and criminals to funnel illicit funds.

Now, as the U.S. and Mexico haggle over the future of NAFTA and diplomatic and trade relations worsen, institutions are facing the specter of rising loan defaults from U.S. clients involved in the countries' $500 billion annual trade game.

"We are facing severe risks," said Karen Neely, general counsel at the Independent Bankers Association of Texas, adding that roughly $180 billion of annual exports south of the border leave from Texas.

"We have the Laredo inland port, which is the busiest in the country where billions of exports leave to Mexico and require financing," Neely said. Most Texas banks lend to U.S. firms involved in that commerce, but few fund Mexican businesses because it is difficult to seize collateral property, according to Neely.

As tensions rise, trade flows are diminishing with U.S. exports seen shrinking 2% this year. This is because a cooling Mexican economy and slumping peso are cutting demand for U.S. staples such as auto parts, electrical equipment, petroleum products and agriculture, said Alfredo Coutino, the Latin America director at Moody’s Analytics.

Mexican exports are also expected to be flat after declining 2% in 2016, he said. Mexico, which ships mainly auto components, cars, fruits and vegetables to the U.S., could see sales plunge as much as 50% if Trump and Mexico's president, Enrique Pena Nieto, fail to strike a win-win trade deal.

"The worst-case scenario is that our exports will be halved," said Delia Paredes, economic research director at the Mexican banking company Banorte.

Mexico is unlikely to sit on its hands while Trump wreaks havoc on its economy, she added.

"You can't assume we won't do anything; there are instruments we can use," including tariffs on key U.S. agricultural exports like corn, wheat or soy, which Mexico's economy minister, Ildefonso Guajardo, has said he would consider imposing.

If trade falls off a cliff, regional banks would be hit most, observers said, highlighting International Bank of Commerce, Commerce Bank, the Spanish-owned BBVA Compass, and other Laredo and Rio Grande firms as the biggest losers.

"The economic impact would be very dramatic, and 350,000 jobs could be lost," Neely said. Small lenders would have a harder time coping than large ones like Citigroup or Bank of America, which have huge exposures to Mexico but larger cash war chests and more diversified businesses, she said.

Firms focused on bankrolling Midwest grains could face even bigger challenges.

"The greatest impact from a NAFTA retreat would be felt by Midwestern banks because their exports could be more directly targeted" by the Mexican government, Neely said.

Some of that is already happening, with farmer default rates climbing 37% in the past six months, unnerving banks in the area, said Kent Olson, who oversees the University of Minnesota's farmer lending remediation program.

"There have been many more notices and more mediation proceedings" between farmers and bankers, he said.

Bankers on the front lines
In Texas, some banks are feeling the squeeze.

Gerard Schwebel, executive vice president of the Laredo-based International Bank of Commerce, said profits and revenues will likely be flat this year as a strong dollar hurts U.S. exports, offsetting gains from the Federal Reserve’s interest rate hikes.

IBC is also struggling with higher know-your-customer and compliance costs stemming from Washington's anti-laundering battle and Dodd-Frank.

"Our costs have risen because of the regulatory burden," Schwebel said. However, "we remain competitive by controlling our costs and expenses."

Tougher conditions have forced the firm to close as many as 75 branches in recent years, shrinking its network to 185, and to scotch plans to open new ones. The regulations have also restricted the depth and breadth of products it can offer to Mexican customers who have entrusted $2.5 billion of deposits.

Employing the marketing slogan "We Do More," IBC typically charges 5% to 7% interest for international trade and business loans, offering letters of credit, currency exchange and wire transfers.

IBC has stepped up investments in know-your-customer reviews, Schwebel said.

"We visit them at their businesses and go to their [debutante parties] or weddings to understand who they are," Schwebel said of his Mexican clients who can open a checking account regardless of their immigration status.

Despite Trump's plan to expel more immigrants, Schwebel said he doesn't expect the U.S. to pass a law barring Mexicans from opening accounts north of the border.

Trump "can't ban a foreigner from opening a U.S. account," Schwebel said. "He is the president, not the king. In this country, our laws are passed by Congress, not the president."

Since the 1994 enactment of NAFTA, IBC's business has grown twelvefold to $12 billion in assets, Schwebel said, adding that killing the agreement would spell disaster for Texas banks and the state's economy where many communities have flourished from booming trade with Mexico.

IBC lends to industrial parks, warehouse and freight operators serving such commerce, counting Killam Industrial Park, the freight forwarder Panalpina logistics and the customs broker Daniel B. Hastings as top clients.

Meanwhile, California bankers expressed concern Mexicans in Tijuana, Mexicali and other border cities could stop shopping in Southern California, hurting retailers and their banks.

"A 35% or any other tariff is going to make it less interesting for Mexicans to do business or shop here, and we are already hearing murmurings of people opting to stay home or taking a stance against buying U.S. goods," said a senior banker at a midsize San Diego bank.

Enrique Hernandez, a lawyer at Procopio, Cory, Hargreaves & Savitch, said Mexicans are paring shopping and banking crossings to the San Diego area, causing businesses to worry.

Due to the tougher anti-laundering provisions, dozens of banks have shut down along the border since 2014, forcing Mexicans to travel up to 10 miles inland to do their banking and hurting business in both countries, Hernandez said.

"There used to be banks right on the border where people could just walk in over the border and walk back to Mexico, but that's over now," Hernandez said. He added Citibank, Bank of America and others shut many branches. Rabobank, under pressure from a laundering investigation, also closed its Colexico, Calif., branch in January 2015.

Big-bank preparations
While small lenders fret, big ones are reducing their Mexican presence.

"In 2014, exposure to Mexico was about 3.5% and now is 2.5%," said Standard & Poor's research manager Neil Powell, who included 11 U.S. banks with more than $1 billion of assets in Mexico to tally the statistics.

Citigroup has withdrawn the most, slashing its exposure 9% in the 12 months leading to September 2016, the latest available data, according to Powell.

This is despite repeated assurances that it continues to invest in its troubled Mexican unit Citibanamex and has no plans to sell it.

Citi has $65.8 billion in exposure to Mexico, followed by HSBC North America with $5.5 billion, Powell said.

American Express has $2.2 billion while, Mizuho Americas holds $600 million of so-called outstanding claims, including interest and non-interest-bearing loans, deposits, securities, subsidiary investments and derivatives, Powell said.

The U.S. arm of the Spanish bank Santander also has $310 million, while BAC Florida, belonging to Costa Rica’s BAC Credomatic, has $137 million.

If trade relations deteriorate further, the trend will accelerate, analysts said.

However, Citigroup and the other big banks could weather the storm as their Mexican operations account for a small piece of their global banking operations.

"While Citi has the most exposure, at the end of the day, $66 billion of $2 trillion in assets is a small percentage of the business," Powell said.

Optimistic voices
Some analysts said Trump jitters are being overhyped.

"There is a commercial war risk, but I don't see it that possible," said Enrique Mendoza, an analyst with the brokerage Actinver.

He said U.S. banks likely have enough collateral (through inventory or real estate assets) to survive a more turbulent trade scenario. And even if defaults increase rapidly, they could accelerate provisions, sell bad debts in the secondary market, strike debt-for-equity swaps or merge with rivals.

U.S. banks, which have cut their correspondent and other financing lines to Mexican counterparts, will closely monitor the performance of banks linked to export manufacturers, or maquiladoras, Mendoza said.

Three such banks are Inbursa, owned by the Mexican billionaire Carlos Slim, which has a 6% exposure to maquiladoras, and Banco del Bajio and Investabank, which also hold big credits with these firms.

Lester Parker, the CEO of United Bank of El Paso del Norte, predicted reason will prevail. The likelihood of a trade war "is very remote," he said.

"Mexico and Canada are our principal trading partners and we would be cutting off our nose if we did" start a trade war, Parker said.

White House National Economic Council Director Peter Navarro this week said he wants the U.S., Canada and Mexico to create a regional "manufacturing powerhouse."

To forge it, stricter rule-of-origin regulations will be needed to force the three partners to source more manufacturing raw-materials from each other and ban such purchases from Asian and other rivals, he said.

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