As Brazilian banking is in the middle of a long-term transition that will gather pace this year if, as expected, the country moves into a new economic era of moderate growth and less turbulence. Banks will need to change tactics to exploit this novel situation.
The old banking model, which has made the leading Brazilian banks among the strongest in the emerging markets, will no longer work. Its central philosophy is "better to be safe than sorry".
Under its strictures, banks lend mainly to the largest corporates, invest a huge proportion of the balance sheet in government bonds, and have capital adequacy ratios in excess of the central bank's 11% requirement, itself significantly above the Bank for International Settlements standard of 8%. In the past five years, they have made huge profits out of interest rates kept high (19% at the end of 2001) to prevent a return to hyperinflation or collapse of the currency, amid spells of both international and Brazilian volatility. Long US dollar positions, using offshore structures, provide further earnings, enabling banks to benefit from falls in the value of the real.
So adept have the banks become in managing these conditions that investors in Brazilian equities consider it to be highly defensive. Something is definitely afoot, therefore, when a leading research house turns bearish on the banks. The problem is this: the economic outlook for Brazil is the best for decades so who needs defensive stocks?
"This is the first time since the Second World War that we have had, at the same time, single-digit inflation, an adequate exchange rate and a concentration on putting an end to fiscal problems," says Fernao Bracher, chief executive of corporate bank BBA and a former central bank governor. "It gives us an opportunity we have never had before."
Boom is not best
BBA's analysts link the upturn in the medium-term economic outlook to the future fortunes of bank equities, but in a negative way. "Banking shares are likely to underperform in a boom market," says a recent market report written by banking analyst Tomas Awad. "Banking shares have proved to be defensive investments when the market is down but, after adjusting our target prices to the new macroeconomic assumptions, the upside potential looks extremely low."
Generally, the assumptions are:
– that Brazil will not experience widespread contagion from the Argentine crisis and that any spillover will be through loss of trade and not a financial crisis;
– that pre-election volatility will be minimal and even a win by the left-wing opposition candidate in this year's Presidential elections would not rupture Brazil's market-oriented development;
– that any economic slowdown caused by world events will not result in widescale bankruptcies or increases in non-performing loans and moderate growth of 2-3% can be expected in 2002;
– and that the central bank's safety conscious reform of the banking system will continue which, together with a more stable environment, will allow for cuts in interest rates as well as reserve and capital requirements allowing banks to expand and grow.
Decoupled from Argentina
"The Brazilian financial system is very strong and that is one of the reasons for the decoupling of the country from Argentina," says Banco do Brasil's managing director of international business, Osanan Lima Barros Filho.
BBA's Mr Bracher says: "We are no longer a good hedge for investors in Argentina [which previously shorted Brazil to protect themselves], something that caused us trouble in the past. This hedge no longer works. Argentina is important for us as a trading partner but no longer has an impact in the financial area."
Under these circumstances, a new kind of banking model is needed - Brazilian banks have been working towards changing their game. The new strategy will be to lend in volume to small and medium-sized companies (SMEs) as demand rockets and net interest margins of around 10% start to contract. Banks need to sell other services to their customers, both corporate and retail, to increase the proportion of fee income in revenues. They have to tap into cheap funding by spreading their retail networks to the 30-40 million Brazilians without bank accounts, while using the internet to cut the costs of servicing affluent customers. The new emphasis will be on credit skills rather than treasury skills, on popular marketing as much as reaching A- and B-grade clients and on successful leveraging of the balance sheet rather than building up capital buffers.
Winners and losers
Which Brazilian banks will win out in this scenario and which will lose? Will the leaders of the past decade continue at the helm in the first decade of the 21st century? Much will depend on how quickly they adapt to the new environment and how well they deal with the inevitable stop/go nature of the transition process.
Brazil's second largest private sector bank Ita™, for example, has long been the darling of analysts and is considered the ultimate defensive play by nervous investors. It has been the most adept at perfecting the old game: it is a cautious lender, with loans-to-earning assets of only 40% compared with 50% for its traditional private sector rivals Bradesco and Unibanco, and loans-to-deposits of 94% compared with 115% for Bradesco and 158% for Unibanco (all figures 2001 BBA estimates). But if corporate lending becomes the main show in town, Unibanco, with its segmented wholesale bank and aggressive approach, and Bradesco, with its strong SME franchise, may be better able to take advantage.
Bradesco executive director Jose Guilherme Lembi de Faria says: "We are very conservative in granting credit but we love small tickets. Only 25% of our lending portfolio is to large companies. With our huge branch network, we have an advantage in growing and diversifying our SME base."
Unibanco's president of wholesale banking, Fernando Sotelino, says: "We were the first bank in Brazil to reorganise with very clear retail and wholesale groups and to perceive that the walls between commercial and investment banking were disappearing. The market now is like the Olympic Games, in which we have to be ready to play all kinds of sports."
Another of Ita™'s great strengths has been its holding of US dollar assets, a highly profitable strategy in the past but one that may prove difficult to repeat as the direction of the exchange rate becomes harder to predict. In recent months, for example, the real has strengthened against the dollar and some analysts believe it is still 20% undervalued. That is bad news for those holding dollar assets. At the time of the Real Plan in 1994 and devaluation in 1999, it was very easy for banks to be on the right side of currency movements; today it is much less obvious.
Along with other Brazilian banks, Ita™ is also highly capitalised (Tier 1 of 14.4% in 2000) and the bank will need to increase leverage to continue producing returns on average equity above 30%. (Its executives were unavailable to be interviewed for this article.)
All Brazil's leading banks have some advantages, as well as some disadvantages, in adapting to the new environment. On the plus side, Ita™ has the highest proportion of non-interest income to total revenues (25% in 2000 compared with Unibanco's 14% and Bradesco's 9%), which will help to reduce the impact of falling interest rates and declining net interest margins when they come.
Transition course is crucial
A crucial factor in how various banks fare will be their ability to assess correctly the non-linear transition to the new model. At the beginning of 2001, everything seemed to be moving ahead nicely, with interest rates moving downwards and positive prospects for growth. The time was right, perhaps, for the banks to relinquish their government bond portfolios and start lending more to companies.
Later in the year, however, the international environment deteriorated, a domestic energy crisis developed, New York and Washington were attacked by terrorists, and Argentina's economic situation went from serious to critical. Interest rates rose again and the banks were happy to stick to making higher net interest margins and putting strategy overhauls on hold.
"In the latter part of 2001, we have seen higher earnings but of a worse quality," says Mr Awad. "Net interest margins of 10-11% are not sustainable and, on top of this, Brazilian banks need to reduce their exposure to the government and increase their fee income. Since the devaluation, the sector has taken four or five steps forward but in 2001 it took a couple of steps backwards."
Special qualities
Where next? Having apparently survived the Argentine crisis (Brazilian central bank governor Arminio Fraga continues to proffer caution), optimism has returned. In stock market terms, that favours banks such as Unibanco and Bradesco, which suffer when country risk is high, over Ita™ with its defensive qualities. Yet it also clears the way for other banks to exploit the special qualities they have that are relevant to the new era. State-owned Banco do Brasil, for example, with its commanding 21% share of deposits, has been undergoing a restructuring programme for several years, with non-performing agricultural loans transferred to the government. Although Banco do Brasil's ratios do not yet match up to those of the leading private banks, investors have been impressed enough to bid up the share price by more than 50% in 2001 (most other bank shares fell) and to buy the paper of a securitisation of remittance flows launched even as protesters were out on the streets of Buenos Aires.
Banco do Brasil's international vice-president, Rossano Maranhao Pinto, says: "No matter whether or not we are government owned, we have to be the best and we have to be profitable. Otherwise, society pays the bill."
There has been a turn around for Banespa, too. For a long time, it represented the sorry side of state-owned banking with a hierarchical bureaucracy, a lack of sales culture and the indignity of government intervention. Now, however, it is getting the Santander treatment and, a year after purchase by the Spanish bank, is starting to look threatening.
Sudameris, which ranks 14th by assets among Brazilian banks and which Italy's Intesa, the indirect controller, wants to sell, looks like going to Ita™. The latter has an exclusivity agreement to negotiate until February 15 for a deal that includes the entire Latin American operation except Peru and Argentina. The price would be the sum of the book value plus $800m goodwill, related to the Brazilian operation, but not exceeding $1600m.
Along with its good parts, Sudameris Brasil also contains Banco America do Sul, a less than dynamic bank acquired in 1998 with historical links to Brazil's Japanese community and the agricultural sector.
Opportunities to acquire
Prior to the Ita™ announcement, Mr Sotelino said: "We will certainly look at it [Sudameris]. We look at every opportunity that comes up and we will continue to do so. On the other hand, we have reached a level and a scale with Fininvest [a consumer finance house acquired by Unibanco] that we are not worried about scale for the sake of survival."
Gustavo Marin, Citibank's president in Brazil, says: "The Mexican purchase [Banamex] shows that we have the appetite for acquisitions but the timing and the price have to be right. We analyse every opportunity that comes to the market to see if it would fill strategic gaps but we are not in a hurry. A bad decision on a problem bank can take years to sort out. I have a good life. I don't want to complicate it."
Citibank's strengths in Brazil are its corporate and investment banking, asset management and upscale retail; its weaknesses are consumer finance, insurance and the wider retail market. Against that background, the strategic fit of potential purchases must be judged.
While banks such as Citi, Unibanco and ABN Amro say they are satisfied that they can keep profits high at their current size, scale is undoubtedly an issue in Brazilian banking and there is considerable focus on growing banks by all means available. This is not a country suffering large-scale branch closures.
Branch growth
Bradesco, for example, with its enormous network of 2600 branches, was still motivated to bid R200m ($84.5m) to win an auction for the right to use post office counters to sell banking products. That will give Bradesco an additional 5300 points of sale and a vastly better penetration at the lower end of the market. In 3000 of these locations Bradesco, has no presence and in 1800 there are no banking services. Using post office counters is a more cost-effective way of reaching this target audience than opening new branches.
"We think the price paid was very cheap," says Bradesco's Mr Lembi. "We will amortise the premium in eight years, invest R10m each in technology and training, and add 3 million customers to our franchise."
Other banks have different strategies for growth. State savings bank Caixa Economica Federal has operations in lottery outlets, Banco do Brasil in supermarkets, Banespa has quadrupled its salesforce, Banco Real (owned by ABN Amro) is targeting specific groups, such as doctors, while Unibanco has focused on customer acquisition through consumer finance with the Fininvest full takeover and other similar deals (The Banker, 11/01, p.61).
Another favoured growth strategy is the purchase of state-owned banks in the regions. Ita™ is the leading player with four under its belt, including recently acquired Banco do Estado de Goias, a small bank by Brazilian standards but one that is in good shape and gives Ita™ the largest number of branches in Goias.
ABN Amro has also been busy in this direction with its purchase of banks in Paraiba and Pernambuco, neighbouring states in the north-east, allowing it to put the two back offices together.
ABN Amro's director of planning in Brazil, Marcos Matioli Vieira, says these banks bring with them the accounts of thousands of state employees, allowing lending against the payroll. "We did this with Bandepe [the former Pernambuco state bank] and loved the result. We intend to do the same with Paraiban," he says.
Customer growth
A proposed change in the law that would allow all employees to have their salary paid into the bank of their choice should not undermine the advantage these payroll deals give some banks, such as ABN Amro and Banespa, say bankers in Sao Paulo. They argue that improving service will deter large-scale defections.
On many other fronts, the Brazilian banking scene is modernising. For some time, banks have been required to classify their loans by risk according to national rules and provision for them even when performing. The long-awaited real-time payments system will come into effect in the middle of this year, reducing risk further. A change in the rules on subordinated debt has allowed Brazilian banks, Ita™ and Bradesco for example, to access this market in a similar way to their overseas competitors. Previously, if a bank failed to pay shareholders dividends, it was prevented from servicing subordinated debt, making this paper unattractive to investors.
Hopes for lighter burdens
As Brazil's economy stabilises, bankers are hoping stiff capital and reserve requirements may be eased. They are burdened by an 11% capital adequacy ratio and 45% reserve requirements for demand deposits. These were expected to be lowered last year until conditions worsened and interest rates rose. It would be surprising if there were not some loosening of the ropes in 2002.
Brazilian banks need to be ready for the changes. The critical question is whether increased lending volumes can compensate for narrowing interest margins sufficiently to protect profits. Citibank's Mr Marin - whose bank is not in the mid-sized corporate market - thinks not. On his reading of events, the players that are focused on consumer and small business lending face tough times. "The market will not grow 10 times, whereas spreads could come down that much and very quickly. Fortunately, we are not addicted to high spreads," he says.
As Brazil embraces stability, there is everything to play for in the banking market; and who will be the winners and losers is still undetermined.
