Brazil: Where the Banks Grow

Crisis? What crisis?

Around the world, major financial institutions — at least those that are still standing — may be pulling in their horns, but in Brazil the biggest banks are still expanding as if the boom never stopped.

“Brazilian banks don’t have problems related to toxic assets,” proclaims a confident Roberto Setúbal. His Banco Itaú Holding Financeira, Brazil’s third-biggest bank, posted net income of 7.72 billion reis ($3.42 billion) last year, up from R$7.18 billion in 2007. “And we don’t have any bubbles.”

But they do have plenty of ambition, which Setúbal knows as well as anyone. In early November he engineered the merger of Itaú, where he was CEO, with Unibanco, Brazil’s sixth-biggest bank, to create Latin America’s largest lender, with combined assets in 2008 of R$552.8 billion. The new bank — Itaú Unibanco Banco Multiplo — reported combined net income last year of R$10 billion, a 16.1 percent drop from R$11.92 billion in 2007, which it attributed to loan-loss provisions and merger-related costs. The deal, Setúbal acknowledges, was sparked by the 2007 acquisition of Banco Real by Grupo Santander Brasil, now the country’s fourth-biggest bank.

Smarting from the loss of its top perch, government-controlled Banco do Brasil, formerly the country’s top bank, with 2008 assets of R$521 billion, quickly responded with two big deals of its own. In November it paid R$5.4 billion for a 71.25 percent stake in Banco Nossa Caixa, the savings and loan giant owned by the state of São Paulo, and in January it bought a 50 percent interest in private sector consumer finance specialist Banco Votorantim for R$4.2 billion.

“We are not trying desperately to regain the leadership,” insists Marco Geovanne, head of investor relations at Banco do Brasil, which is 77.6 percent–owned by state agencies. “We have a strategy that focuses on retail banking growth because this is where we are lagging behind our peers.” The bank had 2008 net income of R$8.8 billion, up 74 percent from the year before, thanks largely to a one-time boost from an accounting change to recognize actuarial gains in its retirement and pension plan. Excluding this and other extraordinary items, Banco do Brasil earnings were up a more modest 13.7 percent, at R$6.7 billion last year.

Also playing catch-up with Itaú is longtime rival Bradesco, which ended last year as Brazil’s largest private sector bank by assets. In 2008, Bradesco earned R$7.6 billion on its R$454.4 billion in assets, up from R$7.2 billion on assets of R$341.1 billion in 2007. “We are focusing on organic growth,” says Milton Vargas, Bradesco’s chief financial officer.

That may be because there are no large banks left to acquire. With the Itaú-Unibanco merger, the five biggest banks control 72 percent of the system’s assets. Citigroup’s Brazilian subsidiary — the country’s tenth-biggest bank by assets (R$39.4 billion) — could conceivably become available, given the U.S. parent’s dire straits.

Brazil has hardly been immune to the world’s deepening economic and financial woes. GDP growth is expected to fall below 2 percent this year, after expanding by 5.2 percent in 2008. Industrial output is sagging — it fell by 14.5 percent in December compared with a year before, and the December loss of 654,000 jobs was the biggest monthly drop since May 1999. After last year’s torrid 31 percent rise in bank lending, analysts forecast that credit growth will slow to 10 percent in 2009. That’s still an enviable pace compared with that of the U.S. and Europe, and the major banks remain profitable, well capitalized and optimistic.

“Of course, it all depends on how long and how deep the global crisis will be,” concedes Fabio Barbosa, CEO of Santander Brasil, which had assets of R$288.3 billion and earned R$2.94 billion last year, up from R$120.3 billion in assets and R$2.41 billion in net income in 2007. Santander’s Brazilian operations accounted for 12 percent of the group’s global earnings. Although profits rose for the year, signs of slowdown were evident in the fourth quarter, when Santander’s profits declined to R$517.54 million, from R$777.44 million in the third quarter. Itaú Unibanco and Bradesco also reported lower profits in the fourth quarter than in the third.

One reason for the health of Brazilian banks is the tough regulatory stance of the Banco Central do Brasil. Whereas the rest of the world’s banks aim to comply with the Basel II accord’s 8 percent minimum capital ratio, the Brazilian central bank requires at least 11 percent — and actual levels range from 13 percent (Unibanco) to 16 percent (Bradesco).

“The central bank has pushed Brazilian banks to the vanguard of Basel II,” says Antônio Delfim Netto, a former Finance minister who now does business consulting. “Their reserve requirements are much more stringent than for U.S. and European banks.”

A legacy of the hyperinflation era of the 1980s and ’90s, the reserve requirements were conceived as a tool to help the central bank control liquidity and inflation. “In moments of potential crisis like the current one, they work like a cushion,” says Milena Zaniboni, a São Paulo–based analyst for Standard & Poor’s.

The reserve requirements range from 35 to 50 percent, depending on the type of deposit, compared with less than 15 percent elsewhere in Latin America. “It means there is no funding problem in Brazil,” says Mario Pierry, a banking analyst at Deutsche Bank in New York. “You have all this money sitting in the central bank, which can reduce reserve requirements as needed.”

When the banking system showed signs of financial distress in October and November, the central bank increased liquidity by about R$84.6 billion, mainly by lowering some reserve requirements — levels for demand deposits, most notably, were reduced to 45 percent from 53 percent. “That gave the bigger banks incentives to buy assets from the smaller banks,” says Alberto Ramos, a New York–based economist who covers Latin America for Goldman, Sachs & Co.

State-owned entities have been the most voracious acquirers of those assets. In December, Caixa Econômica Federal, the federal government savings bank, purchased R$1.1 billion in small-bank loan portfolios, while Nossa Caixa, the São Paulo state savings bank, acquired R$540 million.

If anything, the global crisis and domestic economic slowdown are being felt more in retail banking than in corporate banking. Automobile sales, whose financing has been the fastest-growing sector of retail lending, are expected to decline 15 percent this year. The overall nonperforming loan ratio in the last quarter of 2008 rose to 4.4 percent — a 40-basis-point increase over the third quarter. But in consumer loans, the ratio rose 80 basis points in the same period, to 8.1 percent. Corporate NPLs increased by only 20 basis points, reaching 1.8 percent.

Higher growth in corporate loans is expected to compensate the bigger banks for the slowdown in consumer lending. “Companies that were funding themselves through global financial markets can no longer do so, and they have had to turn more to Brazilian banks,” says Santander’s Barbosa.

Although the corporate NPL ratio remains low, there are asset quality concerns linked to Brazilian companies’ exposure to foreign currency and target forward derivatives — agreements that lock in the price of a currency against the Brazilian real at a specified date. The derivative strategy backfired when the real declined by 30 percent against the dollar in the 12 months through early February. Banks — Itaú, UBS and Citibank, among them — that structured these products to generate fees may be forced to acknowledge that some of these derivatives will end up on their books as NPLs. A December 2008 report by HSBC Global Research estimated that total outstanding corporate exposure to these derivatives was R$49 billion to R$74 billion — equivalent to 11 to 16 percent of total corporate debt outstanding at the end of October 2008.

Another area of asset quality concern has been the agrarian sector. One of the world’s great bread baskets, Brazil achieved a record $71.9 billion in farm exports last year, up 23 percent from $58.5 billion in 2007. But prices for soybeans, wheat and corn have fallen sharply, and credit is tight.

The government has asked Banco do Brasil to pick up the slack, but it is resisting. The state-controlled bank already accounts for 60 percent of the country’s farm credit, largely because of its subsidized lending — for which it is compensated by the government. According to investor relations chief Geovanne, Banco do Brasil hasn’t yet seen a worrisome rise in agribusiness NPLs, which currently stand at approximately 1.4 percent of loans. But the bank isn’t about to expand its farm lending. “Our strategy is to maintain our current market share,” he says.

Although the global crisis may cut into Brazilian banking loan and profit growth this year, it has also been a big stimulus to consolidation in the financial industry. This was especially apparent in the case of the Itaú-Unibanco merger. The two banks, which are still controlled by their founding families, came close to merging a decade ago. Their current patriarchs — Itaú CEO Setúbal, 57, and Unibanco CEO Pedro Moreira Salles, 49 — restarted negotiations in mid-2007 and sped up the pace after Santander’s acquisition of Banco Real that October. The onset of the global crisis gave the talks more urgency.

“The merger would have happened in any case,” says Setúbal. “But a crisis always helps you to make decisions quickly. Pedro and I thought it would take a stronger bank to face any possible problems ahead of us.”

Under the merger terms, Unibanco shareholders will receive 27.4 percent of Itaú’s stock — equivalent to R$26.1 billion, based on the closing price on October 31 (the Friday before the November 3 announcement of the deal). Shareholders of both banks approved the merger on November 28, and on February 18 it received regulatory approvals from the central bank. Setúbal became the CEO of the new entity, Itaú Unibanco Banco Multiplo, while Moreira Salles was appointed chairman. Setúbal estimates that it will take at least two years for the merger to become fully operational, about as long as it is taking Santander to integrate Real.

Together, Itaú and Unibanco today have 20.3 percent of the system’s assets, 21 percent of deposits and 19 percent of loans. They also have a 17 percent share of the insurance market, thanks in part to Unibanco’s $820 million acquisition in November of the 49 percent stake that it did not yet own in Unibanco AIG Seguros, a 12-year joint venture with American International Group that is the fourth-largest insurance operation owned by AIG outside the U.S. Insurance in Brazil has long been dominated by Bradesco, which claimed 25 percent of premiums last year and drew 35 percent of its 2008 net income from insurance operations.

Underlying the Itaú-Unibanco merger is the assumption that retail banking will reemerge as the main growth driver. The same reasoning pushed Banco do Brasil to make its recent acquisitions. “We are looking to attain leadership in the consumer loan market,” says Geovanne.

Banco do Brasil is paying cash for its 71.25 percent stake in Nossa Caixa, which will finally give it a major presence in greater São Paulo, the region with the largest concentration of retail banking in the country. Meanwhile, Banco do Brasil is acquiring its 50 percent stake in Banco Votorantim with a R$3 billion cash purchase of the shares and a R$1.2 billion capital infusion in the bank. “Our main focus here will be increasing our automobile lending,” says Geovanne. Votorantim has a 12 percent share of the car financing market; Banco do Brasil has only 4 percent.

Neither acquisition is likely to be the last for Banco do Brasil. Although Geovanne insists management is more interested in dominating the retail banking market than it is with its position in the overall banking market, Brazil’s president, Luiz Inácio Lula da Silva, made it clear that he believes the state behemoth shouldn’t accept being dislodged from its accustomed leadership position by the merger of private sector Itaú and Unibanco. “We want Banco do Brasil to be much larger than any other bank in Brazil,” said Lula in a December press conference.

Meanwhile, Itaú’s Setúbal says the merger hasn’t dimmed his ambitions to turn his bank into a retail giant in Latin America. “If opportunities arise — and the assets are good ones at the right price — we will look at them closely,” he says. “We will not look for something outside Latin America — for now.”