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AmericasFebruary 27 2013

How will Brazil's private banks see off multiple challenges?

Increased competition from public sector banks, criticism from the president, a weakening economy and aggressive interest rate cuts are combining to make life difficult for Brazil's private banks. Will an efficiency drive see them emerge leaner, smarter and stronger?
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How will Brazil's private banks see off multiple challenges?

The Brazilian banking sector is no longer resembling an invincible, profit-making machine. The rate of growth in income among the country's private banks has slowed. The government has declared open season on private sector banks and spearheaded lending by public banks, accelerating a drop in spreads that was already happening thanks to lower interest rates. At the same time, the Brazilian economy is recovering worryingly slowly, meaning loan growth will not return to previous levels and low rates are here to stay. Is the share price rally a dead cat bounce or a more durable sign that the industry is poised to return to health?

Brazil’s largest private sector bank, Itaú Unibanco, reported mediocre if improving fourth-quarter 2012 results on February 5 with recurring profits up 2.6% over the previous quarter. The bank sought to emphasise that it was heading in the right direction. Bradesco, the country’s second largest private sector lender, which had reported results earlier than Itaú, posted a net income increase of 2.9% for 2012 on 2011's figures.

A slower year

Last year was one that Brazil's private banks would rather forget. The country's president, Dilma Rousseff, has been vocal and frequent in her criticism of the sector, referring to the spreads charged by private banks as “inadmissible” and saying they need to come down to “civil levels” in line with international norms. That has emboldened those working in private banks to call for a better share of profits, which has only served to heighten customer perceptions that the banks are self serving.

Itaú is optimistic, however, that 2013 will be a better year, marked by faster credit expansion, according to Rogério Calderón, the bank’s corporate controller, director and head of investor relations. Itaú started to notice higher delinquencies at the end of 2011 and start of 2012 on the back of higher consumer indebtedness, he says, and immediately restricted lending to better quality products and customers.

The bank slashed auto lending by 14.8% in 2012, reducing loans from up to 100% to a maximum of 70% of the value of the vehicles, and cut the maximum duration of the loans from 60 months to 45. “In 2012, we were curing asset quality,” says Mr Calderón. This year credit growth at Itaú should be 16%. Results started to improve in the third quarter of 2012, which marked an inflexion point, according to Mr Calderón. “There was a clear trend of improvement in 90-day arrears,” he adds.

State-owned challengers

But with government-owned banks Banco do Brasil and Caixa Econômica Federal increasingly flexing their muscles when it comes to credit, are Brazil's private banks losing their dominant position?

Alessandra Ribeiro, a partner at São Paulo-based economic consultants Tendências Consultoria, points to the astonishing growth in loans achieved by the public sector banks. Last year, public institutions held a 47% market share, domestic private banks were down to 36.5% and foreign private banks 16.5%. In 2008, national private banks accounted for a 42.8% market share, public banks just 36.3% and foreign private banks 21%. “These are remarkable numbers and as long as Ms Rousseff is in power, the presence of public banks is unlikely to diminish,” says Ms Ribeiro. Mr Calderón predicts that the gap in lending growth between public and private sector banks is likely to lessen this year as the latter step up lending, although he declined to estimate by how much.

Moral suasion might not have been enough to persuade banks to cut rates but the government has a more powerful tool in state-owned banks. The giant development bank BNDES dominates long-term credit and lent twice as much as the World Bank in 2011.

Public banks are pricing loans more aggressively too. At the end of 2012, for example, data from Brazil's central bank shows that the average cost of a car loan came in at below 16% at both Banco do Brasil and Caixa, while Itaú was up at 18.3% and Bradesco 17.18%. “One of the most worrying aspects about Brazil is these credit capital distortions,” says David Ross, director of international equity investing at investment management firm Chevy Chase Trust, who believes that public banks are going to continue to push into lending and force private banks to compete on their terms.  “We don’t like the amount of government control and interference in the way these banks are operated,” he adds.

Celina Vansetti-Hutchins, a senior analyst at Moody's Investors Service in New York, is particularly concerned by Caixa, which loaned out 43% more in the third-quarter of last year than 2011. Banco do Brasil has a long history in credit and has developed risk models and a team that can draw from experience. That is not the case with Caixa, she says. “There is less history, less discipline and it is brand new in consumer lending. [Caixa is] less capable of saying 'no thanks'.”

Until a few years ago, Caixa was focused almost purely on mortgages. Now it is talking about setting up an investment bank. Ms Ribeiro agrees that Caixa is making a foray into the unknown and may unwittingly be taking on troubled consumers that private banks do not want on their books.

Monetary cuts

If the situation with the growth of public sector lending were not bad enough already, there is another factor affecting bank profits. On top of government criticism and increased lending from public sector banks, aggressive interest rate cuts have caused a reduction in spreads. The overnight Sistema Especial de Liquidação e Custodia, or Selic, rate fell from 12.5% in August 2011 to 7.25% at the start of 2013. The government wants rates to remain low to stimulate the economy, an issue the central bank remains dovish about.

Ms Ribeiro says that for individuals, average spreads came down to 27.4% from 34.7% in the 12 months to the end of last year. Lower rates have helped banks raise financing more cheaply. In August 2011, banks were paying an average 12.3% for funds whereas by November last year they were paying 7.3%, she says.

“There’s no doubt about it: net interest margins will continue to fall,” says Mr Calderón. But when looked at on a risk-adjusted basis, the picture is brighter. Lower loan provisioning of 19bn reais ($9.63bn) to 22bn reais against 24bn reais last year offsets the lower margins, he adds.

Credit slowdown

After years of rapid growth, private banks have somewhat stepped on the brakes. That is not only down to competition from the public sector and lower spreads, but is also because of a rise in defaults due to Brazil's weaker economy. Gross domestic product (GDP) growth for 2012 is forecast to be 0.98%.

“Individuals are using a high percentage of income to service debt and this means there is not much space to increase credit as fast as in the past,” says Mr Ross. Corporate lending, however, is more attractive because of traditionally low borrowing rates, he adds. Ms Ribeiro estimates family consumption will rise just 2.9% this year. Bradesco managed to expand its loan portfolio by 12%, which seems healthy, but is still below the bank’s original 14% to 18% expectations. Itaú increased lending by just 9% in 2012, though the bank predicts loan growth will amount to a more healthy 16% this year.

There will still be a lot of selectiveness in credit and private sector banks will be especially cautious, according to Ms Vansetti-Hutchins. Even so, she expects the improving economy to drive growth to between 10% and 15%. This is a cause for concern, says Ms Vansetti-Hutchins, as deposit growth has been relatively weak in Brazil, which is an outlier in depending on funding from overseas. “Banks in Brazil and the developing world are leveraging up just as banks in the developed world deleverage,” she adds.

Defaults were rising, although there have been recent signs of improvement. Ms Ribeiro says that individual defaults reached 7.9% in 2012 while businesses recorded 4%, a figure that has doubled over four years. She expects improvements in 2013, with the year-end figure for individuals being 6.3%.

The distribution of bad loans across the banks has been somewhat uneven. Bradesco reported a relatively modest 4.1% in arrears and Itaú’s final quarter results showed that the bank was getting to grips with delinquencies, which came down to 4.8% from 5.1% in the previous quarter. The operations of Banco Santander in Brazil have been particularly badly affected, with late payments increasing to 5.5% in the fourth quarter of 2012.

Better growth

Higher GDP growth looks set to take some of the pressure off banks. In general, Brazilian banks are well capitalised, with Bradesco's capital adequacy ratio standing at 16.1%, of which 11% is classified as Tier 1. An improvement in Brazil's economy will allow banks to reduce provisioning, according to Álvaro Taiar, a partner at PricewaterhouseCoopers in São Paulo. If Brazilian GDP accelerates to 3% this year and 4% in 2014 on the back of the country's hosting of football's World Cup, that would produce a good tailwind for banks, he says.

But banks may be relying too heavily on the improving economy to help boost their profits. Economists have been cutting GDP forecasts for the full year. Back in November, a central bank poll of economists showed an expected 4% GDP growth for 2013. The figure had been cut to 3.1% at the end of January as a recovery in manufacturing continued to elude Brazil. “Industry is not showing a clear dynamic of recovery and there is a risk that current predictions on the level of the recovery will not materialise,” says Ms Ribeiro. Mr Calderón predicts growth of 3.1% but agrees it may be revised downwards.

Nagging doubts on a country's economy deter investors. Mr Ross at Chevy Chase Trust, who has no positions in Brazilian banks, preferring Colombian and other Latin financial institutions instead, was close to investing in Itaú in January. However, the rally in bank stocks, weak economic growth and low interest rates deterred him from making such a move. “There is lots of inflation pressure, slow GDP growth and we think that will keep interest rates lower for longer and pressure bank margins,” he says. He also questions the central bank´s monetary policy and believes the bank may be behind the curve in dealing with inflation.

Mr Ross continues to wait for a good moment to buy into Itaú. “It is the one that is at the top of our list because it is the best operator in the system. Bradesco is more of a value play. As a rough comparison, I’d say Itaú is JPMorgan and Bradesco is Bank of America,” he says, adding that the improvement in Bradesco’s share price gives less scope for further upside.

Housing and infrastructure

Investors and analysts believe private banks will have to diversify more rapidly to maintain profitability. Housing and infrastructure are two areas where this could happen.

The mortgage market is still in its early stages in Brazil but is starting to grow fast. Real estate loans in Brazil represent just 4.8% of GDP, according to data from the central bank. However, the data must be treated with caution as it excludes many of the loans made to developers, who tend to finance consumer purchases.

Mortgages have been a growth area for Itaú, which considers the sector low risk. It grew mortgage lending by 34% last year to 8% of its loan portfolio, according to Mr Calderón. The bank limits loans to 60% of value and delinquencies have been low, trending at about 3% while the assets financed are undervalued in the bank’s view. 

Mr Taiar says that the Brazilian market looks much less vulnerable to the kind of bubbles that emerged in parts of Europe and the US. One reason for this is that Brazilian banks have strict reserve requirements. Moreover, Brazilians tend to take out mortgages for new builds which they buy off-plan. Often they have paid 30% or more of the deposit with the construction company financing plan before they need to turn to a bank. Values of properties have increased but are not at the levels seen in problem markets, he says. This is an area, though, where Caixa really does have the advantages of experience and huge firepower. Its presence is likely to keep down rates in the mortgage market.

The other big talking point is infrastructure, which not only connected to Brazil's hosting of both the World Cup and the Olympic Games, but also more widely to improving the country’s logistics. The government has emphasised its desire to see the private sector play a role in this improvement. Mr Ross says that infrastructure financing has been a boon for banks in countries such as Chile and the Philippines, and he sees potential in Brazil. Ms Ribeiro sounds a more sceptical note, however, pointing out that there are still many question marks over the models for concessions.

The BNDES will continue to play a dominant role and as debt capital markets develop, the role of banks will probably be limited, according to Ms Vansetti-Hutchins. There will be space for banks to operate in short-term financing but they have proven reluctant to lend on long tenors and have little experience.

Efficiency drive

All is not lost, however. Brazilian banks have plenty of scope for cutting some of the flab, a process they have started with good results, but where there is plenty more to come. Cushioned for years by high interest rates, they traditionally had poor efficiency ratios. “It’s a necessity in this environment for Brazilian banks,” says Mr Ross. “They could hide expense growth in the past with high spreads and volume growth. But top line growth is not going to be there going forward.”

Mr Calderón believes that Itaú has made strides in operational efficiency. The completion of the merger with Unibanco has seen efficiency gains in everything from communications to back- and mid-office costs. But there is little flexibility in the key costs of salaries: in a collective bargaining agreement they went up 7.5% last year, or 2% in real terms, he says. 

Banks will seek efficiencies through internet services and reducing branches, says Mr Taiar, while Ms Vansetti-Hutchins points to Chile as a regional benchmark where efficiency has been running at 38%. “Brazil was at 70% and has gradually reduced that to 50% and less, so there is room for further improvement,” she says.

Ms Vansetti-Hutchins believes that Itaú is more prepared for this, due to its quantitative metric-based approach, and wonders how well equipped Bradesco is to make a big impact on costs. Bradesco’s fourth-quarter financial report shows that its efficiency ratio improved by 1.5% year-on-year, but it remains poor by international standards at 41.5%.

Brazilian banks are still living the luxurious life, at least compared to most international banks, and Ms Vansetti-Hutchins is keen to stress that they provide impressive return on equities. Moreover, they are showing signs of recovery. But it is unlikely that they will see a return of their heyday, those years after inflation was brought under control in 1994. “You did not have to be bright to make money as a banker in Brazil. Now these banks have to be more intelligent. They need to focus more on returns on equity and assets as opposed to just highlighting credit growth,” says Mr Ross. 

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