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AmericasMarch 1 2016

Weathering the storm: Brazil's banks stay strong

Brazil’s banks have long experience of steering through choppy financial waters and were able to anticipate the country’s current difficulties with a range of pragmatic and forward-looking measures that have rewarded them with increased profits in a shrinking economy.
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Brazil is facing its worst economic crisis in a generation. Some analysts are predicting gross domestic product falls of nearly 4% in 2015 followed by a similar contraction this year and flat economic growth in 2017.

On top of this, interest rates of 14.25% are among the highest in the world, but this has not halted inflation, which is set to hit 7% this year. Government finances are deteriorating and there is continuing political fallout from the Petrobras corruption investigations. Most concerning of all, Brazil’s most impressive success story of the past decade – that of moving lower income families into the middle classes – risks being undone by rising unemployment and falling wages.

Given such a scenario, the leading banks in most countries would be going through their own matching crisis. But not in Brazil, where the leading private sector banks – Itaú, Bradesco and Santander – spotted the crisis early and took immediate action.

So while the next couple of years are hardly going to be stellar ones for Brazil’s economy, returns at the country’s bank are still set to be healthy, while damage to the balance sheet will be limited by high capital levels and ample provisioning.

Many Brazilian bankers grew up handling crises – such as past inflation rates of up to 5000% as well as sovereign debt defaults and military takeovers – so they are usually cautious in their business and well prepared for upheavals. This time is no exception, although there is a divergence between how the recession will affect the public sector banks as opposed to those in the private sector.

Cover chart 1

Bradesco’s quality growth

Bradesco is Brazil’s second largest private sector bank by Tier 1 capital, according to The Banker’s Top 1000 ranking, larger than foreign-owned Santander but not as large as Itaú.

Bradesco chief executive Luiz Carlos Trabuco Cappi says: “Over the past three years, our credit growth strategy has been very much focused on good risk management. We foresaw the scenario [of a stalled economy] and the strategy was to only grow with quality. In Brazil, when you make a loan you immediately take an upfront provision, so we have already taken a part of the cost upfront. The growth in the past three years was cautious and focused on taking the right amount of risk.”

Mr Trabuco adds that this cautious approach has been conditioned by the country’s turbulent economic history. “Brazil has a history of volatility and has had many different economic plans in the past before stabilising under the Real Plan [in 1994]. A lot of companies got into problems during these times and this taught the banks always to be cautious,” he says.

Past crises have also led to Brazil having tougher banking regulation than in many other jurisdictions, including high capital, reserve and provisioning requirements. 

“Given Brazil’s history of past crises with hyperinflation and also the banking crisis in the 1990s, our
central bank always requires high levels of solvency
in terms of capital and liquidity. The reserve requirements in Brazil are extremely high, in some cases approaching almost 50% as in the case of cash deposits. This liquidity provides extra protection to the banks,” says Mr Trabuco.

Itaú’s early warning

Itaú’s chief executive, Roberto Setubal, says that as far back as 2012 the bank recognised that the country’s economy was going to dip and that precautionary measures needed to be taken. “In 2012 we recognised that economic policy in Brazil was not going in the right direction and that growth would be reduced. We did not forecast that growth would be negative, the way it is turning out this year and last year, but we started reducing our risk appetite even back then,” he says.

This has meant, says Mr Setubal, focusing on higher rated borrowers among both consumers and companies, and working with more or better collateral. Indeed, the portfolio composition for the major Brazilian private sector banks has generally shifted away from higher risk assets such as auto and consumer loans and credit cards to less risky ones such as payroll lending and mortgages.

In Bradesco’s case, for example, auto loans as a percentage of individual lending have reduced from 43.5% of the individual lending portfolio in 2008 to 26.5% in 2012 and 15.5% in September 2015 (see chart 1). At the same time, the loan-to-value ratio of these loans has come down from 75% to 50%, thus reducing the risk in the remaining portfolio.

Taking up the slack has been much safer payroll-deductible loans and mortgages, which combined have grown from 12.8% of the portfolio in 2008 to 26.3% in 2012 and 37.9% by  September 2015.

While in many countries, real estate lending has been a source of banking problems, in Brazil mortgage penetration is low and loan-to-value ratios are high – 50% in the case of Bradesco, resulting in losses of less than 1%. As a result, a shift away from car loans to mortgages leads to a safer portfolio.

Cover chart 2

Santander acts fast

With the sale of HSBC’s Brazil business to Bradesco last year for $5.2bn, this made Santander the only foreign-owned bank with a major retail presence in Brazil. (Citibank, for example, is more of a corporate bank and has only 71 branches in 26 cities whereas HSBC’s operation comprised 851 branches in 529 cities. Citi announced in February that it was selling its Brazilian retail and credit card operation.) Santander, which also bid for the HSBC business, as did Itaú, has mirrored the other private sector giants by spotting and preparing for the current economic malaise early.

Santander’s chief executive in Brazil, Sergio Rial, says: “Santander started anticipating a slowdown at the end of 2013 and in early 2014. We began cutting costs but not by closing branches. We have reduced the number of loss-making branches and brought 200 deficit branches back into profit by monitoring traffic and sizing headcount and other costs to these levels.

“We also put in place a strong preventative task force to approach customers before they got into difficulties and offer them different products and solutions. We have helped several millions of customers this way and kept our non-performing loans [NPLs] low in the process.”

But however well prepared and well regulated Brazilian banks are, they cannot perform miracles. While profits remain high and NPLs low at present, an economy contracting as significantly as Brazil’s will inevitably have some impact.

Itaú’s return on equity in 2015 was 23.9% but dipped to 22.3% in the fourth quarter – levels that most international banks can only dream about. Profits of 23.8bn reais ($5.88bn) were 15.6% up on 2014, although the final quarter saw a 5.6% drop over the previous quarter. NPLs in the fourth quarter ticked up to 3.5% from 3.3% the quarter before, and would have been 3.7% without the sale of a book of bad loans. But again, these are low numbers under the economic circumstances and low by Itaú’s standards. The bank’s NPLs hit 5.2% in June 2012. The coverage ratio is an ample 208%.

“[Itaú] produced record profits in 2015. The bank will stay fine although the environment will be more challenging. The bank is very strong. We have a very good franchise and a relatively low risk profile. We are not going to grow over the next two years and we will not be able to keep return on equity at 24%. It will reduce but we will stay in good shape and at good levels of profitability,” says Mr Setubal.

He notes that spreads have been rising due to higher interest rates and higher delinquency and that this has helped in keeping profitability high, adding: “Almost 50% of our revenues and 50% of our profits come from non-risk activities such as payments, private banking, asset management, cash management and deposit taking. It provides a big base to keep profits high and those activities also benefit from low levels of capital.”

Delinquency will increase but, according to Mr Setubal, the bank has increased provisioning beyond what it thinks it will need. “We have about 30bn reais in provisions. Of those, only 20bn reais is required by the central bank so we have 10bn reais of provisions because we do envisage some problems in the pipeline. A big proportion of this is for corporate loans,” he says.

Eduardo Ribas, financial institutions director for Fitch in Brazil, says: “With the privately owned [Brazilian] banks, their NPLs and asset quality have not deteriorated as fast as the economy has gone bad. This is because the banks were already cautious as far back as 2013 and no one was caught by surprise. They have reduced their risk by taking more collateral on the commercial side and moving to safer payroll and mortgages in the retail business.” He adds that some private sector banks were able to activate tax credits following a rise in the social contribution tax and used these funds to increase their provisions.

Cover chart 3

How deep is your recession?

But how things progress from here depends upon how deep the Brazilian recession becomes. Mr Ribas says: “In 2016, asset quality pressure is increasing as the economic recession continues and the Brazilian economy underperforms. Large corporate names are becoming problematic and on the retail side, unemployment and inflation bring additional pressure. It is true, though, that large private banks are better prepared to deal with this deterioration.”

Fitch is also relatively unconcerned about the likely impact of any fallout from the Petrobras scandal – in which the state-run oil company is accused of corrupt practices – on the financial sector. “The agency does not expect a default,” says its 2016 outlook on Brazilian banks, adding: “However, even under a default scenario, losses would be absorbable. Fitch estimates that Petrobras’s total domestic debt represented a low 2.8% of the system’s total credit and about 15% of the system’s total equity in June 2015, although concentration may vary by bank.” Analysts point out that a major part of Petrobras’s funding comes from the capital markets and not directly from the banks.

Another worry for banks in emerging markets is that of currency mismatches, especially as the Brazilian real has fallen sharply against the US dollar. But here again, Brazilian banks seem to be in the clear with analysts estimating that only about 8% of credit in the system is dollar linked.

Santander on the rise

Last year was also a good one for Santander, with net profits of 6.6bn reais, up 13.2% on 2014, although with a 5.9% drop from the third to the final quarter of the year. Mr Rial says: “Santander Brasil’s revenues increased 7.2% to 41.5bn reais but expenses only increased 3.4%, so well below inflation. Over the past three years the bank has made 15% savings in real terms and brought the efficiency ratio down to 49.8%.

“Last year was one of the best for the bank in Brazil and we have grown top line about 7% on the credit side. We have done very well on costs and we have paid 6.2bn reais in dividends, partly due to extraordinary gains. This was the highest dividend payout ever. Total profits were 6.6bn reais, which is 13% higher than 2014. Net interest income grew at 7.2% and the other really good area was transactional banking, where we increased commissions by more than 7%.” Mr Rial says that NPLs are under control and in line with the market. Santander’s NPLs are currently 3.2% for loans not being paid over 90 days with a coverage ratio of almost 200%.

In Brazil, banks also use a 15- to 90-day NPL indicator as a way of flagging up problems early. In Santander’s case, this stood at 5% in December compared with Itaú’s 2.6% and Bradesco’s 4.1%.

“We hope to keep NPLs where they are. The level of resilience of Brazilian society in times of economic crisis is enormous and there is a can-do attitude that helps the nation to move forward,” says Mr Rial.

He points out that even after the dramatic falls in the value of the Brazilian currency, Santander’s Brazil earnings still represent about one-fifth of group profits, adding that the bank has picked up business with HSBC’s departure. “The Brazilian banking systems are very sound but being the only international player of size, we can be seen as a safe harbour and our liabilities have grown 14%. This was partly caused by HSBC’s departure and by institutional money, which is growing fast and needing new outlets,” says Mr Rial.

Cover chart 4

Bradesco’s HSBC boost

Bradesco estimates that its HSBC acquisition will add 3.1% in deposits and 2.1% in assets giving it a 13.8% total market share of deposits and 16% of assets (see charts 2 and 3). At the time of writing, Bradesco was still awaiting final approval from the competition authorities before the merger can go ahead. Mr Trabuco says the deal brings both cost and revenue synergies with the opportunity to sell insurance and credit cards to the HSBC client base, where penetration is lower than among Bradesco’s customers.

“We don’t see major costs in terms of adjusting the balance sheet as the bank has a healthy level of provisions. There are some integration costs but all of that has been considered in the pricing of the deal,” he says. “We used very conservative assumptions in making the acquisition so if the cycle turns we can even get better returns than forecast.”

So how does Bradesco forecast the impact of the crisis on the bank as a whole? “This is the third difficult year,” says Mr Trabuco. “We will maintain a good level of return. What we have been telling investors is that we believe our return on equity will remain close to 20%.  It was above 20% in 2015. It will still remain at a good level but it will be affected.”  Adjusted net income for 2015 was 17.8bn reais, an increase of 16.4% over the previous year.

Mr Trabuco continues: “In terms of NPLs, they have been going up and have reached 4.1%. We are not giving a specific target for the peak of the NPL cycle because it depends on the economy. They are likely to continue going up through 2016 but we expect them to stabilise at the beginning of 2017.”

Like other banks, Bradesco has made significant provisions for this kind of negative outlook over and above regulatory requirements. The guidance to the market is for 16.5bn reais to 18.5bn reais in provisions in 2016 compared with 15.2bn reais last year.

Mr Trabuco says: “We have built additional provisions as an extra buffer in case of a shock. We started with that strategy back in 2000 and never gave it up. We normally take advantage of extraordinary gains to build those reserves and last quarter we increased our provisions more after gains from the revaluation of tax credits due to an increase in taxes. We always take advantage of these opportunities to build up our reserves.”

Private versus public

For all the efforts of Brazil’s private sector banks, however, the country still has a very large state-owned banking sector. Their market share in loans currently stands at about 56% of the country’s total, up from 34% at the end of December 2007. This increase is largely due to the government using the state-owned banks as a policy instrument in order to channel loans to favoured sectors. In doing so, the state-owned banks have often undercut the private sector banks and the rapid expansion of their own balance sheets was, ironically, one of the indicators that warned the private sector banks a downturn was in the offing.

Caixa Economic Federal, for example, expanded its loan book by 37% a year between 2010 and 2014; the equivalent figure at Banco do Brasil was 18.1% and at the development bank BNDES 17.9%. To put this into perspective, the private sector annual loan growth for the same period was 11%.

Esin Celasun, who covers public-sector banks for Fitch, says: “In 2015, all three banks [Caixa, Banco do Brasil, BNDES] started tightening their underwriting standards but still increased their loans above the system average. The consequence of their higher risk appetite [compared with the privately owned banks] is that they are more vulnerable in the downturn.”

At present, NPL levels at the state-owned banks are actually mostly below those at the private sector banks but this may change as the recession takes its toll on balance sheets.  

In BNDES’s case, much of its lending is to other financial institutions for lending on to the wider economy. As a consequence, its NPLs are very low. Under the central bank’s credit classification system, which rates loans depending on how long they have been in arrears, BNDES’s  loans in the critical D to H segments (60 to 180 days overdue) only account for 0.6% of total loans. This is a stricter classification than the standard 90 days overdue.

Policy quotes

Banco do Brasil has less of a policy role than BNDES and Caixa, but does have a strong focus on the agricultural sector with much of the lending subsidised by government. As of September 2015, Banco do Brasil’s NPL ratio measured by the standard 90-day method was 2.2% with a 212.9% coverage ratio, which is slightly better than the private banks although its coverage of the D to H segment is less favourable.

Banker Mar Cover 5

Ms Celasun says: “The weakness at Banco do Brasil is in its provisioning levels of the loans in the D to H segment. Total [loan loss] reserves are lower than the average of private banks. It may need to make more provisions and this could hit profitability.”

Since Banco do Brasil is listed and has shareholders (the free float is roughly 30%) it is used less as a policy bank by the government than Caixa. With Caixa, the focus is on mortgages (see chart 4) and its market share is about 70%, with approximately one-third originated under the government’s housing programme, Minha Casa Minha Vida (My House, My Life). The bank also lends significantly to small businesses and lower income individuals at preferential rates. Even so, its NPL ratio is still low at 3.3% with a coverage ratio of 147.7%. While mortgage losses can be expected to remain low, unsecured parts of the portfolio to individuals and small and medium-sized enterprises may experience more strain.

Profits at the state-owned banks are lower than at the private sector banks but, as they have other aims than maximising returns, this is to be expected. While the private sector banks will welcome a pull-back by the public sector banks, their apparent largesse must be put into perspective. Even though portfolio quality may deteriorate, analysts do not expect losses at the public sector banks and consider them adequately capitalised. On top of this, they always have government support to fall back on.

Under Basel III capital ratios, both public and private sector banks in Brazil are comparable – above 16% at Banco do Brasil and Itaú (see chart 5), just below 16% at Santander and at about 14% for Bradesco and Caixa.

Well prepared

Brazil is dominated by its large banks and together they hold 70% of system-wide assets. This shows why HSBC, with a much smaller franchise, was unable to make an impact and decided to sell up.

This strong market position also allows the banks the potential to work together in terms of credit intelligence on borrowers, something they have now decided to do. The five banks announced in January just such an initiative for borrowers who agree to sign up. While it may be too late for this recession, this should help keep credit well monitored and flowing in the years ahead. On this basis, Brazilian banks are prepared for this recession and the next one too. 

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