Banking Through the Crises

Brazil’s bankers are staring into an abyss. They have done very nicely for years lending Brasília prodigious amounts of money at equally prodigious rates of interest. But the global credit crunch, political uncertainty at home and growing fear of a sovereign default have sent the value of their portfolios of federal bonds tumbling. Brazil’s banks look a lot less solid than they did only a few months ago. Shareholders who fear the banks could go the same way as Argentina’s did earlier this year have cut their losses. They have sold stock fearing that a government debt restructuring would have devastating consequence for the banks, which hold about one-third of their assets in government securities. The share prices of Brazil’s big three banks began crashing in July, hit by heavy sales of their ADRs in New York. They lost a quarter of their value that month alone.

In spite of the International Monetary Fund’s $30 billion bailout in August, the dangers remain considerable. Banco Bradesco, the largest private sector bank by assets, held $13.33 billion in securities – mainly government bonds – at the end of June. Bradesco’s securities portfolio was equivalent to nearly four times its $3.56 billion equity and one-third of its asset base. Its great rival Banco Itaú had a $6.97 billion securities portfolio at the end of the second quarter, equivalent to one-fifth of its assets and more than double its $2.91 billion equity. Banks are provisioning heavily, which has hit their profits. Bradesco posted second quarter net income of $168.4 million, a 38% fall in second quarter income in dollar terms. Itaú posted a 47% slide in net income to $191.3 million in dollars. Even so, both banks did better than many analysts expected.

Bradesco’s bosses are trying to keep their cool. Luis Carlos Trabuco Cappi, executive vice president at Bradesco, says “I do not see any problem theoretically with government risk. The crisis is in terms of the dollar and stock market. It is a temporary crisis of international liquidity that prevents refinancing. Brazil has never had any problem rolling over its debt on the local market.” Even so, he says “The big banks have spectacular volumes of liquidity that are going to the overnight market because this is the moment to have a great liquidity cushion.”

By taking long positions in the bond market, Bradesco is betting on relatively smooth political campaigning leading up to the October presidential election and a calm transition to the next government, which takes office on January 16. Brazilian bankers are past masters at managing risk. Over the years they even found ways to prosper as the country staggered through sovereign debt defaults, hyperinflation, currency devaluations, financial crises and a bewildering succession of economic plans. They achieved this by maintaining a highly liquid balance sheet, a solid capital base, and acquiring natural hedges against currency weakness such as overseas branches and investments. Itaú, for instance, has opened a brokerage in New York, which it will use to service its institutional and private clients many of whom were previously managed from São Paulo. Assets held there rise in local currency terms every time the real falls, offsetting the impact of currency weakness on the bank’s balance sheet.

However, if the government imposes a forced restructuring on its bondholders, the impact on the banking system could be dramatic. Bruno Pereira, a bank analyst at UBS Warburg in Rio de Janeiro, calculates that a 40% haircut would cost Bradesco 73% of its equity and Itaú would lose one-third of its equity. A 30% haircut would wipe out state-owned Banco do Brasil, the country’s biggest commercial bank. Destruction on this scale would be costly and take a long time to repair. Mexico’s banks have still not fully recovered from the financial crisis of 1994-95. Argentina’s bust banks may not survive in their present shape. Brazilian bankers are calm because they have already survived a state-orchestrated reorganization of the banking system and their balance sheets are sound. They remain confident that both the current and incoming administrations will honor the public debt.

Of course, scraping through the elections while certainly a relief, will not be enough to prevent another financial crisis erupting soon. The incoming government needs to bring the public finances under control, cut its deficit and lower the debt-to-GDP ratio. Without this, the risk premium on Brazilian bonds will remain prohibitively high and the country’s credit ratings low. This means borrowing costs will remain very high. The country’s banks need the international capital markets to finance their growth and so keep foreign competitors at bay. There is a lot banks can do to keep investors happy in spite of market volatility. Itaú has delivered sparkling results for years. Roberto Setúbal, the bank’s president, has made a point of making it Brazil’s most investor-friendly bank because an enthusiastic following in the US, where it has an ADR listing, will make it easier for the bank to raise money in the markets when the day comes for a major expansion in the fragmented local market or perhaps overseas.

A government debt default would be a critical setback in the battle to cut Brazil’s scorching interest rates. The central bank’s Selic benchmark interest rate has been in double digits for decades and individuals and companies have to pay four to five times more than that for their loans. It is natural, but not entirely fair, to blame the banks for these gargantuan spreads. Wide spreads conceal a multitude of sins. Selic is high because of the government’s appetite for money and the risk that it may indeed stop servicing its debts. The government defaulted twice in the 1980s and in 1989 froze bank accounts. Spreads must also include a large commercial credit risk premium. Seizing collateral, especially housing, for non-payment is difficult and takes time. Taxes and reserve requirements come next. Reserve requirements are 20% for savings accounts and 45% for current accounts. In addition, the government levies two financial transaction taxes. Last, but not least, comes a profit margin. The United Nations’ Economic Commission on Latin America says real interest rates in Brazil are 21.6% a year, a rate far higher than the revenue growth of most legitimate businesses. At the same time, interest paid to savers has now fallen to almost zero in real terms.

Cheap funding is a crucial advantage for the big Brazilian-owned banks – Banco do Brasil, Bradesco, Itaú and Unibanco – which have large branch networks. Foreign loans and interbank lines provide less than 20% of funding for the main Brazilian banks and the rest comes from the local markets. Unibanco is an exception, with its smaller branch system and it must raise 27% of its funding in the market. This also means that the local banks have been less aggressive in cutting back lending to their corporate clients, while foreign banks have had to comply with orders from headquarters in New York, London or Madrid to reduce Brazilian exposure. Nearly all the international banks operating in Brazil – BBVA and Santander Central Hispano of Spain, Citibank and Fleet Boston of the US and Britain’s HSBC – have lost billions in Argentina and do not want to repeat the experience in Brazil. These and other international banks have slashed interbank and trade finance lines by over 50%, local bankers say. Luiz Carlos Aguiar, executive manager at Banco do Brasil, says “there is little international liquidity. The US banks are cutting interbank lines before they cut lines to Brazilian corporates, but they are cutting.” Bradesco’s Trabuco says local banks have also had to cut back lending. “The bank is being very conservative. We know this is a temporary phenomenon and with rates this high we have to be conservative.”

Breaking into Retail
Santander is the only foreign bank to have succeeded in building a large Brazilian retail franchise. It is the fifth largest bank in Brazil by assets, with a 6% market-share. Most other foreign banks have balked at the cost of building a banking franchise in Brazil, since this would require acquiring a big and expensive local bank. Brazil remains one of the few remaining Latin American countries in which foreign banks have yet to gain much of a foothold. Sandy Weill, chairman and CEO of Citigroup, stated last year after paying $12.5 billion for Banamex, Mexico’s second bank, that he wanted his next acquisition to be in Brazil. He and other bankers are attracted by the country’s large and underbanked market of 170 million people. Loans account for 27% of GDP. This has not prevented Citibank from building up a strong, highly profitable wholesale and investment banking business in Brazil, but its retail business is a minnow.

Unibanco, the smallest of the big four Brazilian banks is often thought of as a target. But Pedro Moreira Salles, the bank’s president and son of the founder, says he is not selling. And the big international banks would have a hard time convincing their shareholders that this is the right time to buy a bank in Latin America even though Brazilian assets are looking cheap these days. The market capitalization of Unibanco, with its highly regarded management, peaked at $4.28 billion in January 2001 and plummeted to $1.5 billion in August.

Erivelto Rodrigues, a São Paulo banking consultant, says that to succeed, banks need to be big enough to reap scale economies. “No foreign-owned bank, not even Santander, can compete without buying a larger bank. Otherwise, I don’t see how they can be successful here,” he says. “Foreign banks entered Chile, Mexico and Argentina at a time when the [local] banks were weak. But the Brazilian banks are still strong.” Merely suggesting that the giant Spanish twins – Santander Central Hispano and BBVA – expand their Latin American franchise by acquiring a large Brazilian bank would seem in bad taste these days. SCH has spent $15 billion setting up a network of Latin American banks, topped off with its memorable December 2000 purchase of Banespa, the São Paulo state bank. It paid $3.6 billion for the bank at a privatization auction and later paid a further $1.3 billion to buy out minority shareholders. Yet Santander has successfully fought to bring the bank back into profit, posting a $238.2 million profit in the second quarter, more than Bradesco or Itaú. Santander’s Brazilian subsidiary provided a quarter of the group’s first half net profit of €1.2 billion in spite of a collapsing currency.

Foreigners Can’t Compete
Foreign banks entered Brazil in force in the 1990s, and many hoped at the time that their advanced management and technology would shake up the local banking system by injecting more competition. This would bring borrowing costs down and ensure better standards of service. However, spreads have not diminished in recent years. Neither have the foreigners brought much of an improvement in service. Although banks offer remarkably sophisticated online services and their branches are highly automated, service still leaves much to be desired. Brazilians put up with this because it is so difficult and time consuming to switch banks. In any case, local banks tend to provide better service than foreign-owned ones. British-owned HSBC ranks second in a Central Bank list of customer complaints, after small state-owned Banco de Brasília. Santander comes third, followed by ABN AMRO. Complaints may be higher at foreign banks because they have wealthier and possibly more discriminating clients. Even so, the list indicates that the foreigners have yet to crack the Brazilian market.

Brazilian bankers are jubilant that some foreigners are quitting Brazil just as the going begins to get tough. Paris-based Banque Sudameris is selling out to Itaú for $1.45 billion. Itaú has also bought the asset management business of Britain’s Lloyds TSB. Bradesco has bought up the asset management arm of Deutsche Bank and taken over Ford Motor Co.’s finance business. It also snapped up a few state banks and bought out the owners of Banco Cidade and Banco Mercantil, two small São Paulo banks. Consolidating the fragmented banking industry – Brazil had 138 banks last year – has become cheaper and easier now that the foreigners are staying away. Ctibank had bid for Mercantil but later dropped out. Rumors abound over which bank will throw in the towel next. Will it be BBVA, which has a market share of only 1.3%? How about HSBC with its classy upscale image but a return on equity of only 4% in 2001? And there is always ABN AMRO’s Banco Real franchise, which it acquired so expensively only a few years ago yet posted a loss last year.

Although Santander is in the black in Brazil, its profits are tiny compared to its investment in Banespa and the losses it has suffered in Argentina, where it had invested $2.15 billion to buy the country’s fourth-biggest bank. The damage in Latin America has dented the credit rating of Santander’s Spanish parent, when Standard&Poor’s lowered its long-term debt rating to A from A+ on June, citing deepening risk in Brazil.