Specializing or scaling up

Brazil’s best banks make fabulous profits, whatever is going on in the markets. In spite of the collapse of the real and the Brazilian Central Bank’s aggressive monetary tightening, Brazil’s top three local private-sector banks raked in strong aggregate net profits of $1.27 billion in the second quarter, 8% more than in the same period a year ago in dollar terms.

Most of them did so by going long in dollars – investing in dollar-linked government paper, hedging their dollar liabilities – and making the most of high local currency interest rates. Last year, though, as interest rates fell, the economy grew strongly and demand for credit expanded, banks made money from lending to people and private-sector companies.

Banks can earn wide spreads on loans to even the best borrowers, including the government and blue-chip corporations. Lowlier borrowers like small-and medium-size enterprises or retail customers, pay even more for their loans. Indeed, Brazilian banks still behave more like hedge funds than real banks. Last year, loans made up about one-third of their total assets of $430.15 billion. The rest of their assets consisted mainly of government securities.

The average spread for the Brazilian banking system is almost 38%. This princely spread eflect a high cost base, the effect of taxes and the services banks are required to perform, such as acting as payment agencies for utilities. High spreads also compensate banks for the risk of lending in such a volatile environment. Yet the level of bad loans is not that high, with only 2.6% of loans in June more than 90 days past due. So there may well be some validity in the common criticism that Brazil’s bankers are making vast profits, but taking few risks.

Strong Management
Roberto Setúbal, president of Banco Itaú, the country’s second-largest private-sector bank, says profits are a reflection of successful management. Itaú is one of the country’s most profitable banks. He has hacked away at the bank’s expense ratio. He wants to cut the ratio to 50% from 54% and hired consultants from Accenture to advise on where to squeeze more costs out of the bank. The focus on profitability (see page 35) is unrelenting. Yet Itaú has increased lending. It lent $13.85 billion in the first quarter, a 20% increase from $11.58 billion in the same period last year. Bankers report similar growth, but say that expansion has ground to a halt in recent months.

Asset quality has also suffered as banks increase lending. Unibanco, the third-largest locally owned bank, has had strong loan expansion this year but suffered a sharp increase in its loan default rate. Management says most of the decline in asset quality affected lower-income groups. Unibanco’s loans rose 44% in local currency terms to R$24 billion.

Erivelto Rodrigues, director of Austin-Asis, a São Paulo banking consultancy, says the Brazilian banking system used to make a $10 billion annual profit from inflation and there was so no great emphasis on cost structure. When inflation was halted, they compensated for this loss with a brutal reduction in staff, branch closures and greater use of electronic systems. He says that before the Real Plan halted hyperinflation in 1994, the banking system had a 12% cost-to-asset ratio. It has since halved this ratio, but Rodrigues says banks still make more money from fat margins than from operating scale businesses.

The arrival of international banks on the scene since 1994 has done little to change this state of affairs. Spain’s Banco Santander Central Hispano, which has bought four Brazilian banking groups, is the only foreign bank to have made it into the upper reaches of the local banking system. Its purchase last year of Banco do Estado de São Paulo (Banespa) turned it into the third-largest private-sector bank.

However, BSCH is still too busy – and is likely to remain so for some time to come – digesting its acquisitions to put up much of a fight with the big three private-sector Brazilian banks: Banco Bradesco, Itaú and Unibanco.

ABN AMRO of the Netherlands, Britain’s HSBC, and BBVA of Spain have all bought local banks but they are all small franchises. ABN AMRO’s Banco Real is the largest of the lot, but its $13.78 billion in assets is only about one-quarter of Bradesco’s $48.52 billion asset base. Citibank and BankBoston, which have built up a retail and corporate banking franchise aimed at an elite clientele over decades, rarely compete head to head with Itaú or Bradesco.

No Fear
Israel Vainboim, president of Unibanco Holdings, says foreign competition holds no fear for him. “We have been competing with foreign banks for 80 years in the wholesale market and in the last 10 years we have been invaded by international banks,” he says. Yet, he claims, whenever the going gets tough in Brazil the foreign banks pull back, leaving their clients in the lurch and opening up fresh opportunities for local banks. Vainboim says foreign banks “Bid up costs and many had to reduce [exposure] with the volatility in Brazil and the 1999 devaluation. But we are here, using our balance sheet, capital. We are never closed.”

However, Citigroup has hinted that its next acquisition in Latin America will be in Brazil. It is in the process of taking over Mexico’s second-largest bank after offering $12. 5 billion in cash and stock for 100% of Grupo Financiero Banamex-Accival last May. That deal has changed the way the world looks at the region’s banking industry. Banks in Brazil that once looked too big to be taken over, even by Citi, now look less impregnable. Unibanco, considered the most vulnerable of Brazil’s big banks, is often seen as a natural target for Citi, although its president, Pedro Moreira Salles, denies his bank is up for sale (see facing page).

For the time being, though, the foreign banks are unlikely to grab market share from their big Brazilian competitors because they lack scale. BSCH is the only possible exception, once it has completed absorbing Banespa.

Instead, the foreigners are aiming for less risky high-end customers whom they hope will buy more sophisticated, and more profitable, financial products than the majority of Brazil’s low-income bank clients ever would. HSBC has decided to settle down for the long haul and grow organically. Michael Geoghan, the bank’s president in Brazil, says “We are going to be here for 100 years. “He says there is no need to be big to be successful. The bank may have had a 2% share of the loan market in 2000, but its 21.5% return on equity was double the national average. Geoghan says that the bank’s natural market is the two million people who constitute the upper crust of Brazilian society.

The trouble is of course, that most other large banks have had the same idea of peddling high-margin services and loans to the richest Brazilians. Citibank and BankBoston have already carved out most of this upper-class market for themselves and Itaú and Bradesco are also muscling in. Unibanco has always claimed to be a classier bank than its two bigger competitors, although it has bought a finance company that caters to the mass-market and has expanded the number of its in-store branches and mini branches at factories and office buildings.

Pursuing specialization or scale are obvious strategies but neither offers a guarantee of survival. The market is already highly concentrated: the 10 largest banks have 70% of the country’s assets. Brazil has 150 banks and many are fated to disappear. However, some niche banks and boutiques are very, very lucrative. Among them are Banco Santos, a regional bank based in the port city of Santos, which posted a 45% return on equity last year. BBA Creditanstalt, a wholesale bank in São Paulo, earned a 40% ROE in 2000. Returns of 26% at Itaú and 21% at Bradesco look modest in comparison.

Growth Halted
The sudden economic slowdown this year has brought development of mass-market banking in Brazil to a halt. Loans are so expensive – average spreads on personal loans are 50% – that it is hard to see much growth in retail banking until the economy stabilizes and benchmark interest rates fall.

Brazilian banks have become less liquid as they lend more, but loans still make up a remarkably small part of their balance sheets. Indeed, loans last year made up only 39% of bank assets, down from almost 50% in 1999. Ultimately, though, development of a broad-based banking market is essential for the industry itself to develop. Loans in Brazil account for little more than a quarter of GDP, indicating vast untapped demand for financial services from a population of 170 million. For the time being, most of these people are not bankable risks because their incomes are so low. With time, price stability and economic growth should bring more and more of the C and D socioeconomic groups into the banking system.

This is what happened in 1994, when inflation subsided and credit became available to vast numbers of people. Indeed, last year saw the strongest growth in lending to the C and D group. Finance companies, which service this segment of the market, have spreads of 100%. Fininvest and Banco Mercantil/Finasa, owned by Unibanco and Citibank respectively, earned a return on equity of 80% and 88% each last year.

Bankers now insist that lending practices are more rigorous than in the past, when excessive credit expansion, coinciding with the loss of the banks’ $10 billion annual profits from inflation, caused a major crisis in the banking industry. In the mid-1990s, the government had to inject $50 billion into the banking system, and closed, privatized or sold off most of the failing banks. As a result, Brazilian banks are today well-capitalized and well-managed, making the current period of financial market turbulence less likely to lead to a generalized economic crisis.

Rodrigues, of Austin-Asis, says the banks must continue to gain efficiency by lowering costs, increasing revenues and gaining scale economies. The Internet and electronic systems are useful tools to cut costs but Brazilian banks are already among the world’s most successful users of technology already. Clients can perform just about any banking operation on ATMs as well as on the Internet. They need to continue raising fee income from new services such as asset management, insurance and pension funds.

One of the more notable characteristics of Brazilian bankers is an ability to change tack in a remarkably short period of time. Those that have survived the rigors of the last 20 years, which have brought hyperinflation, confiscation of the country’s entire banking deposits by the state and innumerable economic crises and currency devaluations, should be able to withstand just about anything the world – and Brasília – can throw at them and still make a tidy profit.