Having revelled in the economic growth that characterised the past few years, Brazil's banks are now struggling to adapt to a less favourable environment. In response to stalling gross domestic product and disposable income growth, many lenders are curbing their lending, leaving gaps, particularly in the small and medium-sized enterprise segment, for other players to step in.

Brazil’s near-term economic forecast is disappointing, with gross domestic product growth that, at best, may just exceed 1% in 2015. This has had a dramatic impact on its banks' expansion plans. Private sector lenders, such as Itaú Unibanco and Bradesco, have tightened their lending policy, while state-run institutions Caixa Economica Federal and Banco do Brasil, which are tasked with supporting the economy through the extension of credit lines, are expected to relax their previously aggressive margins on loans and are braced for rising non-performing loans (NPLs).

Upcoming presidential elections have added a further layer of difficulty to the market in recent months, with most in the finance community adopting a wait-and-see policy. Banks have put the brakes on lending, but this may open up opportunities to less conventional financiers, such as private equity funds.

Worse than expected

On reflection, banks started 2014 in an overly optimistic mood, and now many are finding that they have not met their expectations for loan growth.

Itaú Unibanco, the country’s largest private sector bank, is one such lender that has seen slower than anticipated loan growth this year. Its loan book expanded by 9% in the second quarter of the year, slower than its February forecasts, which predicted growth in the 10% to 13% range.

Bank lending for the whole system rose 11.4% to 2800bn reais ($1200bn) in the 12 months to July 2014, according to Brazil’s central bank. Analysts expect private sector loans to grow 5% and state-owned lenders' loans to grow by 15% in 2014.

Average loan growth for the system could hover at about 10% next year, says Mauricio Molan, chief economist at Santander Brasil, the country’s third largest private sector bank by Tier 1 capital. But, while average growth will hold steady, the convergence towards safer assets will affect loan book composition, which “will continue to change from less to more secure lending”, says Mr Molan.

This means that products that are perceived to be more risky will be sidelined, such as certain consumer loans and financing to small and medium-sized enterprises (SMEs). This represents a U-turn from the interest which private sector banks have shown to smaller corporate clients in previous, more buoyant years.

“I don’t see much appetite for private sector banks to finance SMEs if the economy stagnates,” says Franklin Santarelli, head of the Latin American financial institutions team at ratings agency Fitch Ratings. “Banks, mostly private, have tried to shift the composition of their portfolios away from unsecured consumer lending, as it was five or six years ago, [and have gone] in different directions: in the consumer segment, towards payroll lending or auto finance or, [in the case of state-owned] Caixa, into mortgages.”

Changing tactics

Fast-growing levels of personal debt in recent years have raised concerns, so a slowdown in consumer credit would be welcome, according to analysts. But financing to SMEs is a different story, as these companies employ an estimated 80% of the total workforce in Brazil.

Itaú Unibanco plans to focus on large corporate clients and infrastructure-related projects, which it hopes the government will instigate. It will also continue to reduce its exposure to consumer lending and the financing of small businesses, says Marcelo Kopel, a former finance director of the bank's credit card processing business, Redecard, who is now head of Itaú’s investor relations.

“At Itaú, we’re very keen to grow large corporate [products] related to infrastructure and investment; we will grow in the consumer finance space only if disposable income is growing,” he says. “The environment is quite competitive among large corporates. In terms of SMEs, the market is competitive for mid-sized companies; for the smaller ones, it is less competitive, because banks are more risk averse. In our case, our policy is that even if we could charge more to compensate for larger losses, the risk appetite is not there. There are banks that may be willing to do this, but we are not.”

Brazil's second largest private sector lender, Bradesco, is of a similar view. It has also found that the stagnant economy has diminished loan demand.

“Our best product is the loan [portfolio], but we need to have quality in those operations,” says Luiz Angelotti, an executive board member and head of investor relations at Bradesco. “We try to approve the majority of [loan requests] but we need to maintain quality and margins. The demand that we have now is not enough to maintain the growth that we had expected at the beginning of the year. [Corporate] clients are not fully using their pre-approved lines.”

Middle ground

Brazil's medium-sized banks, which had traditionally been the natural fit for serving SME clients, have found themselves priced out by the larger lenders. Traditionally, SMEs were served almost entirely by mid-sized banks until larger players, encouraged in past years by a better macroeconomic backdrop, decided to target the market. Now, with leading banks preferring larger clients, and smaller banks dealing with rising funding costs, it seems the SME market is, once again, underserved.

“What we’re seeing, generally speaking, is that banks that were active with SMEs, mostly mid-sized banks – Indusval, Pine and others – have a competitive advantage because of their [long standing relationship with] the customers,” says Mr Santarelli at Fitch. “Having said that, once larger banks identify a segment, they’re in a better position than medium-sized banks because their funding is cheaper. They can go to the same client and offer an interest rate that is a bit lower, because their funding cost is a fraction of the funding cost for a medium-sized bank.”

Banco Indusval and Banco Pine did not respond to The Banker’s requests to comment.

Mr Santarelli acknowledges the difficulties in lending to SMEs, however, and adds that not all large lenders have got their strategy right. “Five years ago, [private sector] banks discovered that the SME segment was a significant portion of the market and that it was underbanked. But this is a sector that can bring some grief,” he says, pointing out that lending to SMEs involves dealing with “customers that have never been attended to before. You don’t know exactly their paying patterns and how volatile they can be on the asset quality. [A leading bank] tried to serve SMEs using [what turned out to be the wrong] approach and quite quickly realised that the asset quality was not what they were expecting.”

Gap in the market

If banks are at a loss about how to continue their SME strategy, other players are becoming increasingly aware of the potential of this market.

Darby Overseas Investments, a Washington, DC-based fund that forms part of global investment firm Franklin Templeton Investments, has started to provide mezzanine financing to Brazilian SMEs. Unlike a bank, because of its natural risk appetite, Darby would not consider collateral a pre-requisite to financing.

Darby’s most recent investment in the country involves ethanol producer Vital Renewable Energy Company (VREC), for which Darby provided $15m-worth of financing that will allow the company to complete the next phase of an industrial and agricultural expansion of its ethanol facility. Darby provided equity as well as a senior loan with a tenor of more than five years – something that few local lenders would be prepared to do.

“Banks are very hesitant in terms of how long they will extend the tenors of their loans,” says Richard Frank Junior, Darby's managing director. “[Their] interest rates are probably less than what our ultimate returns would be, but we’re going out several years [on the loan] and banks don’t have the appetite to go that far. I think that will continue. What banks generally want is assets. VREC actually had some good assets, but there are other companies we were able to invest in that were asset-light – banks won’t touch those.”

Central bank steps in

In an effort to boost bank appetite for lending in general, in August Brazil’s central bank went so far as to reduce capital requirements, in a move that it hoped would raise loans by 150bn reais. Earlier this year, the central bank sought to control inflation with higher interest rates and increased its overnight rate to 11%, which central bank president Alexandre Tombini insists is not at odds with measures to free up credit. Analysts, however, expects a rate cut as inflation appears to be tamed at 6.5%.

Regardless, the central bank move left the market lukewarm. “Banks don’t want to lend. Putting more money into the inter-banking system is not going to do anything,” Tony Volpon, head of emerging markets research for the Americas at Nomura Securities International, told news agency Bloomberg in August this year. “There is too much policy and political uncertainty," he added.

The uncertainty is likely to continue in the months following the country's presidential election, which will be held at the end of October. The two candidates left in the race as The Banker went to press were incumbent president Dilma Rousseff, and pro-business challenger Aécio Neves, who has the endorsement of environmentalist candidate Marina Silva, who did not advance to the final run-off. Whatever the outcome of the election, the market will no doubt need a few months to adjust.

Among the challenges facing the incoming government will be the rising NPLs in state-run banks, where asset quality in consumer lending quickly deteriorated this year. To ensure that Caixa’s capital position was sufficiently strong, the central bank authorised the lender to book 28bn reais in hybrid securities as common equity.

Investors had voiced concerns that the rapid growth of the bank's loan book on the back of government pressure to boost access to credit, had weighed down Caixa's capital position. In the 12 months to June 2014, the bank said that its loan book had grown by 28%; this compares with average growth of 1% among private banks in the same period, according to Fitch Ratings.

Mr Molan at Santander, for one, is not particularly concerned about the rise of bad loans. “Public banks’ NPLs will grow, but won’t be critical; at the end of the day [if necessary] we’d see the government increase [public] banks’ capital so that they can improve their balance sheets,” he says. He also acknowledges, however, that the government will not have much room to manoeuvre, as it will have to engage in fiscal adjustments given the macroeconomic environment. According to Santander, flat economic growth will likely push unemployment to 7% next year, from the current 5.5%.

Shape of things to come

Some are convinced that SMEs, despite the difficult backdrop, will continue to do well and benefit, in particular, from expected government investment in infrastructure, as they can potentially provide services to large constructors, says Fitch’s Mr Santarelli.

At the same time, new investors are looking at this space. Mr Frank says that Darby is one of the very few funds providing mezzanine finance in Latin America using a regional strategy; it also invests in Mexico and Colombia. But, he adds that a number of local private equity firms have started to show interest in this type of deal. Because fundraising is currently done in US dollars, the fund needs to scout for companies that have exposure to the currency. A growing local network may galvanise this process.

“The challenge is to find the right fit [for a] US dollar investment with a mezzanine structure,” says Mr Frank. “We have to do our homework and find the right fit for companies that have a natural hedge or have very little debt where they can mange fluctuations on the exchange rate. We see a lot of opportunity for mezzanine investments in Brazil. The market has now cooled down a bit. In fact, we don’t see much activity right now because everyone is holding on before the final rounds of the elections, but in terms of mid-sized companies, Brazil is a huge market.”

If Brazil’s economic and political uncertainties continue, even after the elections, banks can be expected to stay on the safer side of lending for some more time. It may be that non-banks will be the ones that take on the riskier assets.


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