Brazil's Banks Facing Stiff Challenges to Profitability
06/25/2012| 12:46pm US/Eastern
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--Model based on high spreads and credit expansion ending
--Return on equity for Brazilian banks already declining
--Small players face major challenges in current climate
By Rogerio Jelmayer
SAO PAULO--Lower interest spreads and a slower pace for credit expansion loom as major challenges to profitability for Brazilian banks.
Although Brazil's largest banks do not suffer from problems such as high leveraging and insufficient capital--which are hitting their European peers--they do face a potentially drastic reduction in profitability.
In fact, Brazil's banks are already seeing a slide in return on equity, or ROE.
"Brazilian banks are set to experience the biggest decline in ROEs in over a decade; 15%-16% of ROE should be seen as a ceiling even for the most profitable players," Credit Suisse said in a recent report.
In recent years, most Brazilian banks have consistently reported ROEs in excess of 20%.
"The decline in ROE is structural, and although banks will certainly do their best to contain costs and boost the non-interest income lines, it will not be enough to compensate for the significant margin compression. In our view, the only way banks can go back to previous profitability levels is through structural reforms, mainly lower taxation and reduced labor costs," Credit Suisse added.
In recent years, Brazilian bank profitability was anchored by credit expansion, but this model is showing signs of wear as consumer and corporate debt increases.
"Measures of debt service cost suggest that high debt levels could be a problem. The fraction of GDP that households and firms in Brazil, China, India and Turkey are allocating to debt service stands at its highest level since the late 1990s, or close to it," said the International Settlements Bank, or BIS, in its annual report, released over the weekend.
Meanwhile, other sources of profit are under attack by Brazil's government.
This year, the administration of President Dilma Rousseff launched a campaign to cajole banks to lower their interest charges. To that end, the government obliged state-run banks to cut rates, with private banks following suit to remain competitive.
The negative scenario for the nation's banks is echoed by industry executives, although they highlight the fact that Brazilian institutions face a different set of problems from international players.
"Brazilian banks are starting with a higher capital base but will still need to examine their own businesses, as lower interest rates mean spreads will fall, and banks will have to focus on efficiency through the use of technology," said Roberto Setubal, president of Itau bank (ITUB, ITUB4.BR), earlier this year. "The only department at Itau which is expanding is technology. In other departments, we're looking for more efficiency."
Virtually all executives agree that bank lending in Brazil can't keep up the torrid pace of recent years.
"We need to be ready to operate in an environment of low rates in the coming years," said Marcial Portela, president of Banco Santander Brasil (BSBR, SANB11.BR), the Brazilian unit of the huge Spanish bank.
The negative scenario is reflected in share prices.
So far this year, shares of Brazil's two largest banks, Banco do Brasil SA (BBAS3.BR, BDORY) and Itau, have lost more than other banks in Latin America and the U.S. with assets above $100 billion, according to financial analysis firm Economatica.
Government-run Banco do Brasil was the biggest loser in the region through mid-June, down 11%. Brazil's largest private bank, Itau, suffered a 9% slide.
While even big players suffer, small ones face an even worse scenario. In recent years, one of the most often used funding tools by small players was the sale of their own credit portfolios to bigger banks.
But changes adopted by the central bank, including the assumption of non-performing loan costs by small banks, have reduced the attractiveness of this tool.
"The largest banks have the muscle to face negative scenarios, but the story is not the same for smaller players. We are already seeing problems in some banks and we can't rule out problems in others," said Joao Pedro Brugger, who manages about $90 million in assets for Leme Investimentos.
Earlier this month, the central bank took control of Banco Cruzeiro do Sul SA (CZRS4.BR), a medium-sized bank, after detecting inconsistencies in the bank's accounting.
It was the third seizure of a bank in two years. The central bank took control of Banco Morada in October 2011 and Banco PanAmericano SA in late 2010, both of them amid fraud allegations.
Write to Rogerio Jelmayer at rogerio.jelmayer@dowjones.com
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