Giant new Brazilian bank throws down size gauntlet

The merger of the two Brazilian giants, Banco Itaú and Unibanco, creates Brazil’s biggest bank and a leader in the Americas. The idea is for the bank to become a global player exploiting a moment when Brazil’s global stature is growing and the industry is in disarray. At home, though, the news is a mixed blessing. As customers seek safety in the strongest institutions, the merger has prompted the government to push state banks to keep up, using new powers. Consumers will pay a premium for the safety of size.

The announcement of the proposed merger of Itaú-Unibanco in early November took the Brazilian markets completely by surprise. Its audacity – the bank will be the largest in the southern hemisphere and become one of the largest 20 banks in the world by market capitalisation – makes the secret negotiations all the more surprising.

The ability of the CEO of Itaú, Roberto Setúbal, and his equivalent at Unibanco, Pedro Moreira Salles, to negotiate the deal over a clutch of meetings in an apartment in a posh southern suburb of São Paulo and keep it a secret from the banking community underlines the importance of family ownership in the structure of the Brazilian banking system. Ultimate control of both Itaú lies with the Egydio de Souza Aranha family while the Moreira Salles family controls Unibanco.

At a stroke, the estimated 26.5 billion reais ($12.5 billion) deal, creates one of the biggest, and most profitable, banks of the Americas. Itaú-Bradesco will dispose of 575 billion reais in assets, a branch network of 4,800, and 19% of the local credit market. If the deal is approved, the new bank will become the largest in Brazil, leapfrogging current top dog in the private sector Bradesco and even the country’s largest bank, the publicly-owned Banco do Brasil.

Itaú-Bradesco does not just have clout through size but performance too. By third quarter results, the combined Itaú and Unibanco entity would rank as the second most profitable bank in the Americas and be placed top among Brazilian banks with $1.33 billion in profits, according to investment analysis firm Economatica. Only Wells Fargo posted more profit at $1.637 billion.

Indeed, Economatica shows that of the 20 most profitable banks in the Americas, five are Brazilian. Stripping out the merger, Bradesco comes top among Brazilian banks with $977.9 million in the third quarter, followed by Banco do Brasil with $975.3 million, Itaú with $965.2 million and next in line Unibanco, which revealed profits of $367.5 million. The merger also opens up the gap between the Brazilian banks and the most important foreign competitor in the market, Santander which posted profits of $259.5 million.

Pros and Cons

There are a number of obvious advantages to scale in an era when clients are desperate for the security of a bank that is seen as too large to fail. A broader deposit base is also critical at a time of scarce credit.

The merger will also allow for some cost cutting, although both banks have painstakingly repeated that there are no plans to lose staff except through natural wastage. That said, the new entity may be able to squeeze out 3-4 billion reais in savings, including through tax and the ability to trim technology spend, according to Henrique Navarro, analyst at Santander Investment Securities. The new entity will also benefit from Unibanco’s strengths in consumer credit while enjoying Itau’s lower fund-raising costs, he points out.

The bank sees itself as becoming a Latin powerhouse, and indeed its own backyard is the first area for expansion. Mexico is a priority, according to Salles and Chile. Itaú does not have a substantial presence there making it high on the list of investment plans. “I always thought it strange that Brazil does not have a [banking] multinational, given its concentration of talent and developed financial system. Now this opportunity exists. We want to build a unique business in which the country can take great pride,” Salles adds.

The deal also opens up opportunities in secondary sectors, with the most obvious being insurance. Since the announcement of its merger with Itaú, Unibanco has said that it is buying out a 48% stake held by rescued US insurer AIG in an insurance joint venture between the two. Unibanco has agreed to pay $820 million in the deal, giving it full control over Brazil’s fourth-largest insurer with total assets of 12 billion reais. The sector has been booming on the back of areas including credit protection, private health care and life insurance.

Behind the bombast, the reasons for the merger often look more prosaic. The purchase by Santander of ABN Amro’s Brazilian operations had raised the uncomfortable spectre of a foreign bank competing for the top spot among private banks, long held by the duopoly of Itaú and Bradesco. There was the strong possibility that Santander and ABN, with European roots, could leverage their experience of domestic mortgage markets to capture a big slice of the next great opportunity in Brazilian banking, the flourishing of the nascent mortgage market. Already, Santander had shaken up the Brazilian credit market, for example introducing fee- free credit cards, which were quickly copied.

Unibanco, long the third private bank, had a franchise which had lost space in some critical areas, such as corporate banking. Its business was seen as being the clincher for either Itaú or Bradesco to take the final step to becoming the dominant bank and as such it had long been rumoured as a take-over target, although management constantly repeated that it was not up for grabs.

The financial crisis, which emphasised the importance of strong ratings and deep pockets, was already challenging Unibanco. Then rumours started swirling that the bank had been deeply involved in selling US dollar forward contracts to clients, which had gone sour as the real reversed its gains and slumped against the greenback.

Salles was clearly aware of what was pressuring the bank and looked to scotch those rumours. “We heard stories about our derivatives losses that were completely out of proportion.” In late October, he announced that bank clients would forfeit one billion reais to cancel leveraged positions and pointed out that this represented less than 0.5% of total assets. But the writing was already on the wall.

The question now is what the effect will be on the overall banking system and its competitiveness. Brazil has a relatively concentrated banking system with the five largest Brazilian banks accounting for 65%. Concentration has been increasing and as recently as 1995, there were 240 banks in Brazil. That had fallen to 156 this June. Still, it is by no means the most concentrated in the region: the top five banks in Peru enjoy 86% market share, while the figure is 79% in Mexico and 75% in Chile.

The financial crisis means that customers are already suffering with higher fees. According to the Brazilian banking federation, Febraban, average spreads in September consumer lending were up by 3.6% year-over-year at a hefty 53.1% per annum. Even in the corporate sector, the average spread is up 2.1% in 12 months with an average charge of 28.3%. Further consolidation clearly does not bode well for customers and probably reduces the likelihood that attempts will be made to win market share through competitive pricing.

Smaller Banks

With the merger, Unibanco has avoided the fate of many of its admittedly much smaller brethren, which have had to slam the brakes on all expansion plans. The elimination of smaller banks is also effectively exacerbating the concentration in the Brazilian banking industry.

The last six months have been a grueling time for smaller banks. Many had thrived in the previous three years through moving swiftly into new areas of the credit boom. Starting in the payroll deducted credit market, they had spread out into niches including lower income credit, auto and motorbike loans, including for second hand purchases, as well as lending for small- and medium-sized enterprises. With ready capital through equity markets and securitization, they had been witnessing lending growth of more than 30% per annum.

The scale of the turn-around can already be seen. São Paulo-based Daycoval saw net profits fall 18.4% in the third quarter to 47.1 million reais and, more worrying still, a steep decline in deposits, which tumbled 10.8% between the second and third quarter to 2 billion reais.

The financial crisis has hit smaller banks hard for a number of reasons. The closing of equity and structured debt markets means that these banks no longer have access to new financing to grow and do not have sufficient balance sheet clout to sustain lending.

The inability to raise reasonably priced financing calls into question the very business model, according to Celina Vansetti-Hutchins, senior analyst at Moody’s in New York. At least until markets re-open, these banks will find themselves frozen out, adds Plinio Chapchap, professor of finance at Profins Business School and partner at Queluz Gestão de Ativos, a boutique asset manager and corporate advisor. He sees zero credit growth in Brazil next year.

Chapchap points out that one of the most dynamic credit segments, that of lending for car purchases, is likely to decline and points out that manufacturers are already idling plants for weeks as demand outstrips supply. Extremely long tenors for loans enabling lower income borrowers access to consumer goods has all but disappeared, he notes.

Chain Reaction

The predictable effect of the Itaú-Unibanco proposed merger has been to stimulate further moves towards conslidation in the belief that bigger is better. This comes at a time when the Brazilian government is desperate to ensure that the credit downturn does not exacerbate the economic slowdown already underway.

To seek to maintain credit growth, the government pushed through measures including a lowering of what have been very high reserve requirements. More controversially, it pushed through Congress a measure, MP 433, to allow public sector banks to take over other financial institutions. In the case of Caixa Econômica Federal, the giant mortgage bank, the government went a step further and allowed the bank to buy stakes in real estate companies.

Banco do Brasil has been on somewhat of a rampage. On November 21, the Federal bank announced that it had bought a 71.2% stake in Banco Nossa Caixa, a state bank owned by the government of São Paulo, for 5.39 billion reais, representing a premium of 38% over the previous trading day’s closing price. The subsequent reaction of the share price suggested that investors believed Banco do Brasil overpaid, with its shares tumbling 14% for a decline of over 60% year-to-date while Nossa Caixa shares ended up.

The acquisition spree has not stopped there. Banco do Brasil has also been negotiating to buy Banco de Brasilia, has already agreed to buy the state bank Banco do Estado de Santa Catarina for 685 million reais and more recently said it would pay 81.7 million reais for the Banco do Estado do Piaui. It has also been widely rumoured that the Federal bank is negotiating to buy a stake in Banco Votorantim, with a price tag of some seven billion reais, although there had been no official confirmation at press time.

Cinderellas

The big question now is how the mighty Bradesco and foreign Santander keep up in this more competitive environment in which Banco do Brasil seems willing to spend significant premiums to buy up banks. Marcio Cypriano, president of Bradesco, has been at pains to stress that the bank is not going to be bounced into making a precipitate acquisition to keep up. “What interests us is efficiency (and) returns for our shareholders,” he said. He added that the bank is not imminently going to look for expansion overseas to keep up with Itaú-Bradesco either. Bradesco is pessimistic about Brazil’s expansion next year, predicting anaemic growth of 2.5%.

Meanwhile, Spanish banking giant Banco Santander’s plans to become the most profitable bank in Brazil seem to have retreated further from reality. Santander Chairman Emilio Botín recently said his bank would invest 2.6 billion reais over two years to expand its business by 15% with 400 branch openings.

Customers may be thankful for the moment that the safe-keeper of their wealth is fortified. Down the line they may rue the day that the banking sector consolidated still further. As for Itaú-Bradesco, it is likely to find that the lower fees charged in Latin America make these markets less appetising than staying at home.

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