The executives of Brazil's small and medium-sized banks have been looking on with anguish as tortuous negotiations to rescue Banco Cruzeiro do Sul, which is under central bank administration, are concluded. The deadline for finding a buyer for the family-owned bank was set to expire as The Banker went to press, with harassed bondholders still searching for a solution.
Some industry-watchers are pondering just how deep-rooted the problems in Brazil's banking sector are. Central bank investigations into fraud at Cruzeiro do Sul, as well as Banco PanAmericano and the smaller Schahin and Morada banks, have caused the widespread withdrawal of foreign bond investor trusts, which is shutting off the already tight funding markets. Tougher competition in niche markets in Brazil’s rapidly maturing credit markets is emerging and government pressure to bring down rates has seen state-owned banks cutting spreads. All of this comes amid a weaker macroeconomic situation in Brazil, which is expected to grow by just 1.75% this year.
Álvaro Taiar, lead partner in financial services for Latin America at PricewaterhouseCoopers in São Paulo, cautions that the Brazilian consumer is starting to appear “tapped out in credit when you consider total liability as a percentage of salary". "We have lower economic growth and we need to learn how to manage this,” he says.
Funding problems
Reduced wholesale funding has hit the Brazilian small and medium-sized banking sector particularly hard. Banks need to meet Brazil’s high minimum total capital requirement of 11%, as well as facing complex rules and high levels of compulsory reserves.
Moreover, there is a chronic mismatch between assets and liabilities in the sector, with small and medium-sized banks accounting for just 5% of system deposits and a full 15% of credit, according to Clive Botelho, finance director at Banco BMG, which is headquartered in Belo Horizonte. The fall in the overnight rate, which has come down by 5% to 7.5% in one year, is less damaging for small and medium-sized banks, which do not benefit from high rates on deposits, than larger ones. However, lower rates are also forcing down spreads and cutting profits on lending, the core business for most small and medium-sized banks.
Technical issues are further dogging the sector. Brazil has adopted international accounting standards. Under Brazilian accounting standards, banks were able to book the full net present value of loans in portfolios, allowing them to move loans off the balance sheet, flattering numbers. Under international rules, Brazilian banks have to accrue loans as they are paid down by borrowers. Many banks are still making the accounting transition as existing portfolios mature.
That has hugely undermined a key business model: many small and medium-sized banks were hunter-gatherers in the credit space. One of the most common models was to build assets and sell portfolios to bigger banks. That model is now much less efficient. Jair Ribeiro, CEO at Banco Indusval in São Paulo, says: “The cost of generating consumer loans is high and the funding base incompatible. Banks selling out portfolios to large banks and appropriating returns upfront created a myopic view.” Banco BMG, in line with many other banks, is transiting its portfolio to the international system, and that is hurting earnings in the short term, adds Mr Botelho.
Playing safe
Given this combination of problems, foreign investors have been hesitant to invest in Brazil, as can be seen in international bond markets, a key funding source. Last year, even though investor appetite fluctuated, a large number of medium-sized bank issuers were able to place deals successfully, says Ceres Lisboa, senior bank analyst at Moody’s in São Paulo. This year, deals have come from the largest and highest-quality banks coming to market with large tickets. “You can count on your fingers the number of smaller and medium-sized banks [coming to market] this year,” she says. Domestic investors have long been seen as possible buyers of smaller bank certificates of deposit but they have tended to plump for issues from the safest banks.
If fixed-income investors are to return to these banks, they will need assurances that the recent cases of fraud among some Brazilian banks are a one-off. However, many analysts in the country say they cannot give such assurances.
Part of the problem is cultural, especially at the smaller end of the scale. Some of these banks were treated as the personal fiefdom of owners, and were run as status symbols instead of profit-making businesses. Banks such as Banco Fibra have been dogged by multiple changes in their business model, which has caused confusion among clients and staff. The rest of the sector has been tarred by the same brush, often unfairly.
Picking out positives
There is, however, a silver lining. The scandals have sensitised the Brazilian central bank to the issue of fraud and acted as a catalyst towards it helping out smaller banks. The central bank is keen to avoid further consolidation. As Mr Ribeiro at Banco Indusval points out: “The Brazilian banking system has six banks holding some 85% [of assets]. Not even Canada is that concentrated.” The top five banks in Brazil account for 80% of lending, according to central bank data.
The central bank has powerful instruments to monitor banks, including a highly transparent system that gives the central bank access to real-time liquidity, according to Mr Lisboa. It is also looking more closely at smaller banks, even though they may not by systemically important. On funding, the central bank is keen to show that it is helping smaller banks, particularly through its Special Guaranteed Time Deposits (DPGEs), a funding instrument designed to help smaller lenders. An initial, temporary DPGE programme was launched in 2009, which offered banks guarantees up to 20m reais ($9.89m) per depositor compared to 70,000 reais for regular deposits.
Earlier this year, the central bank started a new and permanent programme which offers much cheaper guarantees, at 0.3% of deposits instead of to 1%, with demands that banks put up collateral. Smaller banks have reacted favourably to this. “The government needed to provide other sources of funding as smaller banks don’t have a retail base. It was intelligent in creating this,” says Mr Ribeiro.
Rating agencies agree that the instrument is a lifeline for smaller banks, but are concerned that banks will get hooked on what started off as a temporary aid that they will struggle to wean themselves off. According to Robert Stoll, director of Latin America financial institutions at Fitch in New York, there is “growing market discussion about moral hazard”.
In addition, the central bank is trying to twist the arm of larger banks to return to buying the portfolios of smaller banks by tweaking the rules on banking reserves, reducing larger banks’ payments on deposits and incentivising investing in buying loan portfolios of smaller banks. But still there is a limit to what the central bank can do. “It wants a healthy mid-sized bank sector but not at any cost,” says PwC's Mr Taiar.
Four bad apples?
The government’s timely intervention is propping up the sector and giving it some breathing space to deal with longer-term funding and competition issues.
Some banks are using the time to change their business strategies. Banco Indusval, which accounts for just 0.1% of the Brazilian banking system according to Fitch, is one. The bank has overhauled the management and professionalised staff, bringing in experienced big hitters to mobilise its transformation, including an ex-Bovespa president. As well as additional funding from shareholders, the bank brought in private equity house Warburg Pincus, which will supply 150m reais.
Mr Ribeiro says the new management is doing a number of things. It is moving away from its traditional focus on small businesses to larger, better rated companies. “In the past six months, 98% of new credits have gone to companies with ratings from AA to B,” he says.
Indusval is also moving away from lending to manufacturers in the south and south-east of Brazil, which have been hardest hit by the global economic slowdown, and stepping up lending to the booming agribusinesses sector, especially in the country’s centre-west region. New instruments, such as Agribusiness Letters of Credit (LCAs), backed by agro loans, are cheap and effective ways for the bank to raise money for such companies. Financial innovation is key: the bank is also looking to develop bond platforms as it bets on greater use of fixed-income instruments by Brazilian companies.
The larger Banco BMG, long the country’s leader in payroll-deducted credit, is also changing. State-owned banks have become more ferocious competitors, especially in the key public sector where there are economies of scale, says Mr Botelho. That has had a chilling effect on smaller banks. “There were nearly 60 small and medium-sized banks operating in this a few years ago. Nearly all of them have gone,” he warns.
To compete, BMG needed deep pockets, and to allow itself access to such funds it has launched a joint venture with Banco Itaú Unibanco. In July, the two banks announced a joint venture with Itaú holding 70% and BMG the balance with an initial capital stock of 1bn reais. BMG and the joint venture will share distribution channels. Itaú committed to invest up to 300m reais each month for five months and the portfolio is expected to reach 12bn reais in two years. Itaú had been struggling in the pay-roll space, with just a 6% market share, so the deal is crucial for the bank in this segment, says Mr Botelho.
Payroll importance
Mr Botelho says that the payroll-deducted sector continues to be attractive. Salaries have increased substantially and payroll-deducted credit is widely accepted in Brazil and cheaper for consumers than other forms of credit. Today, it is the most popular form of credit in the country, accounting for some 180bn reais, he says. Spreads are still attractive, with rates of 20% to 25%, and non-performing loans are minimal as the loan is deduced straight from the borrower’s pay cheque.
Still, spreads have fallen substantially from some 45% just five years ago, while the cost of securing loans through correspondent banks has increased substantially, says Mr Botelho. New models of co-operation between lenders and agents may change that and make access cheaper, he adds. Even so, Mr Botelho believes that efficiency and access to cheap funding have become prerequisites for operating in the payroll sector.
New funding from deep-pocketed investors, foreign and domestic, is likely to reinvigorate the best of the small and medium-sized banks in Brazil. Those that have strong niches and operate in new, attractive business areas or regions are likely to thrive, according to Mr Taiar. However, many will not make the cut, with Mr Stoll predicting that there will be fewer than 100 banks operational in Brazil in 10 years' time, down from today's 137.
