Banking: Rate rise threat to sector

Brazilian banks are defying global trends by posting healthy increases in profitability and by oozing confidence about their long-term future. Bradesco and Itaú, the two leading private-sector banks, have shot past many large European and US counterparts in market capitalisation, and are rapidly growing credit portfolios just as the rest of the world frets over how to shrink their exposure to borrowers. Still, in the near-term, higher interest rates are set to challenge the new model, threatening to choke longer-term lending and cut off cheaper funding sources.

Marcio Cypriano, president of Bradesco, paints a picture of rude health. In a sign of long-term confidence, Bradesco is opening 194 branches this year, up from 140-150 last year, as well as increasing points of sale in a hodge-podge of outlets, such as supermarkets and pharmacies.

The bank’s highly valued shares and the strength of the real would make acquisitions overseas cheaper, but Mr Cypriano does not see any reason to consider buying abroad. It is not the right moment. “We don’t know where the crisis is going to end. We have been surprised by the recent turn of events and there could be more bad news,” he says. While there are such rich pickings in Brazil, diverting resources to expensive foreign acquisitions is unappealing.

For now, then, the bread and butter is domestic credit. Banks are targeting the kind of clients that a few years ago they would have thumbed their noses at, the lower-middle and working classes, Mr Cypriano says. In the past, these classes were clamouring for credit, but credit cards were considered elite products and were not issued, he says.

With consumer credit representing just 36 per cent of gross domestic product, the same level that it was in 1995, there is plenty of room for all-comers. A raft of smaller banks, that have used the more vibrant capital market scene to raise funds to on-lend, are mining the area with success, too.

Morris Dayan, executive director at São Paulo-based Banco Daycoval, says there is so much new business that the bank has not been fazed by the increasing focus of the larger operators on consumer finance. To keep ahead of the big boys, Daycoval has been rapidly expanding in niche areas, such as loans to second-hand car buyers.

Increases in consumer lending have been spectacular to date, but further business is threatened by a big rise in inflation and interest rates. “What we are seeing is an increase in inflation and this is a big preoccupation to which the central bank is very attentive,” says Mr Cypriano. He sees short-term rates increasing by as much as 3 percentage points from the current level of 12.25 per cent before the cycle turns and rates start to fall, probably in 2009.

The effect of higher rates is a double-edged sword. Banks are enjoying the extra yield on their investments and have passed on the central bank’s increased rates to borrowers – and added some extra jam for themselves in the form of higher spreads, says Celina Vansetti-Hutchins, senior analyst at Moody’s. The danger is that the increase in rates will lead to increased defaults and deter banks from expanding portfolios and making longer-term loans, she says.

That will slow the development of Brazil’s very new mortgage market in which high loan values make long payback periods a prerequisite. Mr Dayan acknowledges that his bank’s plans to roll out loan products in the housing sector have been put on hold thanks to the rise in rates. Mr Cypriano says Bradesco still has plans to triple lending to R$6bn ($3.7bn) this year from R$2bn in 2006. But the bank is requiring tougher credit scores and is reducing loan tenures.

Higher rates do not just hurt the banks’ ability to lend, but their ability to raise capital too. Access to cheap funding is the number one challenge for smaller operators such as Daycoval. Just as rates make borrowing less appealing, the bank has seen the price of its shares fall – from R$17 at the time of its IPO to R$12 today. That comes in spite of a doubling of profits in 2007.

The combination of more expensive borrowing, tougher conditions for lending and higher yields on government paper is likely to see the clock turn back. The next year is likely to see a reversion to the profitable but stodgy business of taking deposits and investing conservatively in government paper. That will slow down, but not stop, the trend to bring credit to small businesses and the masses.

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