Brazilian banks grow; foreigners stay marginalised

A glance at the mouth-watering first quarter results released by São Paulo-headquartered institutions Banco Bradesco and Banco Itaú show why Brazil is becoming such a keenly-watched banking market. Bradesco reported on May 8 that net income had jumped 27% in the first quarter over the same period of last year and that return on equity (ROE) stood at 34.6%. Itaú announced similar results the day after with a 28% increase in profits and ROE of 34.8%.

The two figures nearly illustrate both just how profitable the best run Brazilian banks are and how rapidly they are increasing profitability. When compared to the far lower figures seen in the developed world, the return on equity appears doubly appealing. Between 1992 to 2005, for example, the average US bank has posted an annual 14% return on equity.

The best Brazilian banks are making money hand over fist, then. But the attraction of the market is not only that profits are fat and growing fast, but the long-term potential of Brazil. The sheer size of the country and the many under-developed banking services mean that there’s plenty of scope for high levels of growth for years to come. The population is just shy of 190 million and yet less than a third of Brazilians have bank accounts. Even though the deposit figure is likely to grow only slowly, economic stability should encourage lower income customers to start accounts, providing banks with the opportunity to sell banking and related products to a host of new customers.

The story is particularly hot now for economic reasons. Brazil has long had many of the right ingredients for a profitable banking industry, but the key catalyst, economic stability and growth, have been missing in its boom-bust economy. That seems to be changing. More and more economists believe that the foundations for stronger and, most importantly, more consistent growth are now in place. Vinod Thomas, Director-General for the Independent Evaluation Group at the World Bank and former country director of Brazil, is one of these optimists. He has just written a book “From Inside Brazil” that outlines the case. In it, he argues that the country is one of the most promising of the developing countries thanks to its relatively strong institutions and entrepreneurial culture. He believes it is quite possible that Brazil will soon witness economic growth in the region of 6-8% per annum and stand along side China and India as the most attractive countries for foreign investment.

There are already signs that confidence in the economy is starting to translate into new opportunities for Brazilian banks. The key consumer lending market, especially through credit cards, is nascent but growing at a clip of more than 30% annually. Insurance and asset management are equally under-developed and growing quickly. And for foreigners, Brazil looks doubly enticing when evaluated as part of an overall Latin American strategy. You just need to glance at the instability and anti-foreign sentiment dogging many neighbours (Hugo Chavez’s Venezuela and Evo Morales’ Bolivia spring to mind) to see why Brazil is the number one priority for many foreign banks when considering their Latin strategy.

Foreign presence
Given the flowering of optimism on the Brazilian economy and the profitability of the banking sector, you would expect foreign banks to be all over the retail banking market through acquisitions. You’d be wrong. Instead, not only has the market for take-overs by foreign banks been eerily quiet but foreigners have actively been packing up and leaving Brazil. The trend started to reverse in 2003 when Spanish banking behemoth Banco Bilbao Vizcaya Argentaria (BBVA) sold its Brazilian business to Bradesco for $700 million and JP Morgan sold its asset management business to the same bank in the same year. That follows a period of aggressive foreign entry into the market predominantly through privatisation in the 1990s and into the early 2000s.

Analysts reason that foreign banks under-estimated the difficulties of doing business in Brazil and have left because of the market’s hidden pitfalls. Many of the difficulties that foreign banks have faced in Brazil stem from its peculiarities, including a system that has adapted over time to a volatile inflation rate and a very low deposit base, explains Catarina Pedrosa, an analyst covering banks at São Paulo-based Banif Investment Banking. Local banks understand and have adapted accordingly, implementing systems that are more sensitive to interest rates. Just to give one example, very high rates of inflation led local banks to create a wire transfer market that is outstandingly efficient. A transfer in Brazil happens overnight against a more typical three days worldwide. Most Brazilians do not have bank accounts so there is a limited deposit market. Banks have finessed paying monthly salaries to non-deposit holders at a low cost.

Foreign banks, on the other hand, came to Brazil and simply replicated the strategies they had used at home, getting bruised in the process. “One of the prime difficulties is that it is not possible to simply replicate the same structures that you have in your home market,” says Pedrosa. She points to the issue of branding and notes that Banco Santander, which bought Banco do Estado de São Paulo in 2000, wanted to be seen as a universal bank in the country. And yet as a foreign bank headquartered in a rich country, Brazilians consider it a high-end, foreign bank and consequently an alien institution. “They are using a low-end strategy for high-end customers. Foreign banks really need to understand the difference,” says Pedrosa.

Interestingly, the lower end of the market is where the most profitability is to be had, according to Pedrosa. Naturally, low income customers tend to be less financially savvy and therefore more tolerant of higher bank charges. That’s vital in a country with the highest real interest rates in the world at some 10% with the juicy profits that are to be had from high spreads on lending. The charges for low income customers are typically a 30-40% spread. Not only that, says Pedrosa, but the low income users tend to be the most determined to pay off their debts as they are highly dependent on credit, with many using it even for basics such as food shopping. Default levels within this group are a surprisingly low 5%. Wealthier customers tend both to have more clout and to shop around more when borrowing, reducing banks’ profitability.

Jason Mollin, the Latin American bank analyst at Bear Stearns in New York, believes that foreign banks are going to find it tough to make significant acquisitions in Brazil, despite the desire to do so. He argues that banks that already have a presence in the country can pay more for acquisitions given the economies of scale that domestic expansion implies, for example, in streamlining back-office functions. Newcomers cannot gain from these cost savings and revenue synergies.

They also face another significant hurdle, he believes. The banking system has already undergone tremendous consolidation, and that means there are few attractive national franchises that would give a buyer sufficient scale. Moreover, the three largest private sector banks: Itaú, Bradesco and Unibanco all have capital structures that mean that the banks “need to be sold, not bought.” There are voting and non-voting shares with the controlling shareholder owning more than 50% of the voting shares of the bank (compared to perhaps a more typical figure of 30% voting control in Europe and the US). There is no fear of losing control, for example, through a hostile takeover even if stock prices were to post significant declines. In addition, these shareholders can tap equity markets if they need capital and keep control of the company by diluting minority shareholders.

With the controlling shareholders of these large Brazilian banks already receiving high dividends, as well as the prospect of maintaining strong profitability levels and new business opportunities, there’s little incentive for them to part with their business. “There’s a lot of interest from foreigners, but majority shareholders are unlikely to want to sell such lucrative franchises. Why would they?” asks Mollin. One answer could be that “offer prices are just too good to say no.”

Two banks that have declared an interest in entering the Brazilian market but have not yet made a move are JP Morgan and Citibank. Last June, William Harrison, chairman and CEO of JPMorgan, said the bank was looking at expanding in the country either via a joint venture, or through taking a minority or majority stake of a local bank. At the time, he told Brazilian financial Valor Econômico that it would not make sense for JPMorgan to start opening branches and try to grow organically in Brazil. JPMorgan declined to provide an update on its acquisition strategy. It’s understood, however, that the bank is not considering any imminent deal to expand its presence in the country.

Gustavo Marin, CEO of Citibank in Brazil, announced May 10 that the bank would increase its credit card business, Credicard, by buying out the 17% stake held by Unibanco and bringing Citi’s share of the joint venture to 50%. The bank announced at the same time that it would seek to increase by nearly 100% the number of Citifinancial branches this year. That seems to mark a change of heart from last year when the bank indicated it would seek to expand through acquisitions in Brazil. Unibanco had often been cited in the market as a possible target.

The peculiarities of the Brazilian market, the very limited number of national banks that might be acquisition targets and the sheer size of the market explain why foreigners have been sidelined. That leaves the big domestic banks in a strong position to expand franchises and pick up where foreigners leave off. Mollin believes that Brazilian banks are actively squirreling away profits to enable them to pick up assets and they have clearly been successful in benefitting from the assets the retreating foreigners leave behind.

You need look no further than Banco Itaú’s deal to buy the Brazilian assets of Bank Boston (owned by Bank of America) to support this theory. The Brazilian bank announced the $2.2 billion deal May 1. The deal is just the latest example of Brazilian banks buying out foreign businesses (witness Bradesco’s acquisition of the BBVA and JPMorgan business back in 2003). And, in this instance, the price Itaú paid seems to be a snip. “The price that Itaú paid was fantastic,” says Pedrosa. “There was no cash element and the preference shares that were issued carry few advantages over common shares in Brazilian law.”

Future worries
Despite all the hoop-la, there’s a note of caution to be sounded with the Brazilian banking system. For now, the peculiarity of the world’s highest level of real interest rates (the benchmark Selic is 15.5% against an inflation level of under 5%) is a prime driver behind the extreme profitability of Brazilian banks. But most analysts believe they have become too dependent on this abnormally high interest rate as a source of profitability.

Indeed, it is already coming under threat. Competition in the lending market is already ferocious and getting more cut-throat by the day. In the short-term, that means that the cost of adding new customers is getting more expensive and that spreads are liable to come down as more and more banks compete to offer credit. And in the longer-term, Brazilian interest rates are bound to tumble. As it does, banks will have to adjust to thinner spreads and lower profitability. That may seem a long way off for now, but with Brazil striving to reach investment grade in the next couple of years and elections looming, rate cutting may come sooner and faster than most Brazilian banks might wish.

Investment Banking Shake-Up
The investment banking market has just got more interesting. The take-over by UBS of Rio de Janeiro-headquartered Banco Pactual, announced May 9, promises to shake up the market that has seen Credit Suisse in ascendancy since its take-over of Banca Garantia in 1998. At a stroke, Pactual has become a global player and will be able to go head-to-head with CS/Garantia when pitching for international mandates. Last year, CS advised on 10 equity deals worth $1.96 billion, putting it in prime place in Dealogic’s equity league tables and taking market share away from Pactual. The new UBS/Pactual link is likely to give CS/Garantia a run for their money.

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