Service, quality of products and services, price, social responsibility and deep commitment to the environment and ethics. Brazils high flyers are a picky lot when they opt for a bank, surveys find. Banco Itaú delivers on these eclectic areas and is managing to deliver income, profitability and share price growth for investors at the same time.
Itaús philosophy of listening to the market and giving it the products and services it wants together with its tenet of keeping a tight lid on costs is behind the banks ability to produce this balance. Its core philosophy is market-led expansion strategies, not grandiose, management-driven plans. Adaptability, an ability to spot good, organic commercial opportunities, together with a knack for buying and integrating companies flows from that market-driven mind set. Speed helps, particularly in a market where lumbering government-owned banks are still leading players.
What could trip the bank up? Itaú must continue to navigate its way through a rapidly-changing, uncertain landscape. Brazilian interest rates are declining fast, competition is getting steadily more aggressive with a consequent squeeze on spreads, and growing dependence on lending is likely to lead to the roll out of riskier credit products to a wider range of clients. Add to the mix the chronic instability that has plagued Brazil in the past and you see why only the tough survive and thrive.
The market revolution
Just five years ago, Itaú and its competitors operated in a completely different banking landscape. Banks centred operations around the safe, dull and highly lucrative business of government deposits, the profitability of which tended to strangle other business opportunities. The consumer credit market was stagnant, capital markets and active asset management were moribund, interest rates were as high as twice current levels and advanced management in risk and processes a dot on the horizon.
Since then, macroeconomic stability has enabled the Central Bank to cut interest rates from a high of 26% to todays 12%. Theres scope for further cuts as Brazil still has among the highest real interest rates in the world. If current trends continue, rates should be normalised by the end of next year by which time Brazil may well have an investment grade rating (it is one notch below with the three major rating agencies).
Brazilian banks are having to learn, or re-learn, a lot of skills as the industry undergoes this profound change. Profits on plonking assets in government bonds have tumbled and will continue to fall. Individuals and small businesses are leveraging and the release of this pent-up demand for credit means that first mover advantage and pricing are significant.
Clients in Brazil have suffered because of economic instability over the last 20 years, says Roberto Setúbal, who became CEO of Itaú in 1994. Many have bad memories of borrowing, particularly for mortgages. We have to rebuild confidence and distribution channels, he says. In the next few years, interest rates will be clearly much more attractive for borrowing and will push the industry to a new level, he says.
The danger in these conditions is that you miss out through over-caution or get over-exposed and build too much risk. That makes selectivity key.
Itaú reported another excellent set of results this May. Net income was just over R$1.9 billion, the highest level of first quarter net income achieved by any private Brazilian bank over the last 20 years. Key to achieving these consistent results is to pick and choose your business priorities wisely as the Brazilian market closes some doors and opens up others. Itaú has been careful not to let success go to its head and has eschewed some forms of expansion. For Setúbal, it is all about responding to market needs and not pushing products. Thats encapsulated in Itaús pithy, three-word slogan in Brazil, feito para você (made for you). Itaú has focused on loans to consumers and small- and medium-sized enterprises; development of its high-income segment, Itaú Personnalité; and creation of a strong investment banking franchise to take care of blue-chip clients as they fund more of their balance sheet through capital markets. It has focused less on building a universal footprint through branch openings and capturing current and savings accounts in the lower-income areas.
That pickiness has kept the banks cost-income ratios down. They were an impressive 44.1% in March this year, compared to 50.3% in December 2005. Setúbal understands the virtues of good housekeeping. We do keep a very close eye on efficiency ratio. We are improving it year after year and this is a key objective of the bank, he says. We aim to get [cost-to-income] to below 40% in three to five years, says Setúbal, who then adds that some banks have got the level down to under 40% and that this could be a new benchmark for banks globally. This is another sign that hes not content to rest on his many laurels. We still see room for improvement through investing in processes, technology and people. We are going to keep on doing that that as its a key aspect for our future growth, he says.
Setúbal is honest enough to admit some indicators may turn down. Itaú has had a consistently excellent performance in its return on equity (ROE), which in the last few years has been above 30%. It is expected to be above that level again this year. The numbers we presented in the first quarter (31.3%) will be sustainable for the whole year, according to Setúbal. And yet competition and consequent falling margins are two key factors that are set to erode returns slightly over the medium-term. Setúbal predicts: this is not a sustainable level over the long-term. He reasons that in as little as the next two to three years, the ROE number may start to fall, albeit slowly.
The emphasis on cost control should not be confused with a pathological tight-fistedness. When Itaú sees a business it likes, it goes for it. Internally, it has dedicated resources to investment banking, building up an impressive franchise, for example. Nor has it stinted in building up its lucrative credit business. It also continues to spend on interesting growth and last years acquisition of many of BankBostons Latin operations brought a book of high net worth clients and expansion into overseas markets.
Itaú has shown consistently that it is good at acquisitions and extracting synergies from them. The only big disappointment was its failure to buy Banespa, the state bank of São Paulo, the countrys wealthiest state, which went instead to Santander in 2001, albeit for what was considered a high price of $3.6 billion.
BankBoston promises to be another excellent acquisition in a consolidated banking market in which every sale is hotly contested. In an innovative, share swap deal, parent Itaú Holding paid Bank of America 7.44% of its share capital, using its beefed up share price as currency and giving the giant US bank a key shareholding. At a stroke, BankBoston provided Itaú with an additional base of high income, small and medium business and international corporate customers as well as an asset management business. It also realised Itaús other major ambition, to grow outside its home market
Theres further scope for synergies flowing from the BankBoston acquisition, believes Setúbal who sees this coming through the second half of this year. The consequences of the acquisition surprised some analysts who had expected Itaú to make significant lay-offs to capture cost reductions. Setúbal clarifies that although the number of staff will be slightly reduced, it will happen in an organic way with a strong emphasis on natural attrition and very few lay-offs. We are a very big group. We have 60,000 employees in Brazil. As people leave, we will be able to reposition BankBoston staff. That is possible as BankBostons upper crust focus means that its staff tend to have different skills.
After Itaú has fully digested BankBoston, whats next for its cherished plans to expand overseas? The risk perception attached to Brazil has been falling and: Our share price has been developing well and has increased, especially in the last two years, to new levels. It is coming into line with other similar institutions in the world, says Setúbal. Long-term, that should make it possible for Itaú to acquire banks outside Brazil through share-based acquisitions which was not possible before, says Setúbal. Still, he cautions that although Itaús share price has risen fast, many overseas financial sectors still enjoy higher P/E ratios. That means for now Itaús focus is to increase its presence in markets in which it already operates organically. The banks share price closed at R$77 on June 15, up from R$43.89 a year earlier.
In what is normally considered the bread-and-butter business of deposit growth, Itaú has grown its base from $36.4 billion up from $28.7 billion against a year. Much of this has come through the acquisition of BankBoston.
The US bank has a chichi reputation in Brazil and its predominantly high income client base has been folded into the upper income segment of the Brazilian bank, Itaú Personnalité. This customer base is Itaús prime target. Deposit and savings are much more concentrated within the high income segment and the basis of our deposits lies here, says Setúbal.
This sector is already proving receptive to value-added products that include the banks asset management business. In Brazil you have one of most developed asset management industries in the world compared to the size of the economy, says Setúbal. Itaú already offers multi-asset products with low risk and fund of hedge funds, a sector that has proved enormously successful in Brazil. We are considering developing our own hedge funds. Its part of the development of the industry. We are discussing how to label that now, says Setúbal. Given the possible reputational risk associated with hedge funds and performance, it will probably need to be powered by Itaús brand but labelled separately.
Although its deposit base has been growing, Itaú has not embarked on an expensive spree of massive branch openings to capture lower-income customers. At the end of March, it had 2,637 units up from the 2,408 recorded at the same time in the previous year. This year, Itaú is planning on opening 140 units, says Setúbal.
Its not to say that Itaú couldnt provide more deposit services: it is able to offer financial services to clients with incomes as low as $200 per month, says Setúbal. Rather, its that the deposit business for low-income clients does not make much sense. Fees on these accounts compared to countries at similar levels of development are low at an average of $3-4 per client per month, which does not make it an attractive business for the bank. Moreover, this client base is much more interested in gaining access to credit than opening deposit accounts, he says. We are not planning to get to clients using a bank platform but much more through credit products and consumer and credit cards. Itaú will focus more on technology to improve service for existing clients such as its ATM roll-out (it has some 20,000 machines) and Internet banking.
Technology is another example of where Itaú is spending in a focused way. Some banks over-spend on jazzy but unnecessary products pushed by vendors. Not Itaú. Technology has to be used very much in line with the business approach, says Setúbal: We believe that tech has to bring improvements either for the bank or our clients. For us, its about gaining productivity and efficiency. For clients, it must meet one of three criteria: convenience, new products or distribution. Each time we invest, we look for one of two items.
The spigot on credit has been well and truly turned in Brazil and a trickle is fast turning into a flood. Itaú is growing its credit business fast and in March loans, leasing operations and other credits reached R$91,180 million, up nearly 50% on a year earlier. Starting in 2004, but really taking off in the last couple of years, growth has been this high despite what many in developed countries would see as eye-watering rates, particularly for non-secured lending.
Setúbal points to some of the reasons that rates are high: Volatility in the economy, a bad track record on credit history, and lots of taxes on financial intermediation. Brazil is a poor country with low incomes so loans of $50 or $100 are usual, he explains. The cost of processing loans is the same as it would be for a loan of thousands of dollars. That pushes up charges, he says.
The renaissance of Brazils credit markets has been sparking off a host of innovative, new products. Itaú, along with other Brazilian banks, was slower off the mark than smaller local banks that kicked off the market through loans that are deducted from payroll. It has caught up fast. Currently, it is working a new and rich seam in auto loans where it has carved out a leading role. This has been one of the fastest growing markets in Brazil thanks to pent-up demand and changes in legislation that make repossessing in the event of a default easier. Itaú has a 23.3% market share. Thats close to double to its 12.8% deposit share. The key to the auto business? You need to be close to dealers and very fast, says Setúbal.
The acquisition of BankBoston has opened up new opportunities too and brought Itaú a well-balanced, attractive new range of clients. BankBoston had a well-diversified portfolio across three attractive areas for the bank. One third of its business was with high income clients, one third small and medium business and the balance in large corporations, says Silvio de Carvalho, chief accounting officer. The small- and medium-sized business segment is particularly important: We are growing faster than the market and are gaining market share. The new dimension that BankBoston has bought has been very important for our strategy, he says. The Chilean and Uruguayan operations have helped it grow lending abroad, he adds. Operating in investment grade Chile is also helping Itaú understand the different dynamics of these markets, he notes.
For now, the build-up of consumer finance arm Taií, whose employees bright turquoise and orange uniforms can be seen all over the country as they seek to drum up business, will not be a priority. This year we are not going to be opening many Taií branches. We want to make it profitable before we start opening stores. We will have the necessary scale to be profitable next year, Setúbal predicts.
The headlong rush into credit has been a big profit driver, but a tougher environment is emerging. Competition is ever fiercer and state-owned giant Banco do Brasil is limbering up and likely to pressure margins further. That is likely to be offset by volume growth to some extent. Delinquency rates are a further cause for concern. A rise in problem loans in 2005 made Brazilian banks tighten lending standards in the last couple of years and default rates have levelled off. Delinquency rates have come down a bit especially since the Central Bank started cutting rates, says Setúbal. Still, this is such a new market that it is difficult to predict the level of default as the new, longer tenor loans season.
Itaús determination to be ready for the advanced implementation of Basel II should help it to continue to grow credit as the more sophisticated approach should enable it to reduce reserving. We are investing heavily to be ready with our own system of allocating capital and our estimate is that it will reduce our capital needs, in particular for retail operations. That will allow us to increase lending, predicts Setúbal.
Finally, capital market funding is becoming more important in areas such as auto loans, notes Setúbal. This points to the wider development of capital markets in Brazil, an area where Itaú has focused on building a strong business. Its franchise is both highly lucrative and, as always for a retail bank, fraught with danger. To do nothing would be dangerous. Theres a keen awareness that as markets open up, tomorrows large corporate clients will desert bank loans.
The current boom in investment banking in Brazil, thanks primarily to equity markets that are up 500% over four years in dollar terms, has led to giant packages and murderous competition for staff. Itaú Holding has managed to keep a step ahead by allowing its investment banking arm, Itaú BBA, a rare degree of autonomy and the ability to determine its own packages, says Jean-Marc Etlin, VP of investment banking and head of the group. One of the hallmarks here too is the ability to move fast and, again, to take advantage of changing market conditions. Weve taken the business in different directions in the last three or four years. The bank has moved away from large loans into investment banking, offering a sophisticated M&A advisory business while continuing to offer an array of the bread-and-butter of cash management. Banks need to move fast to launch products as the markets open such as and new markets such as equity-linked products and mezzanine financing, notes Etlin. Itaú BBA is already number three in the equity book running business in the country. Last year, the bank was a book-runner on 11 transactions totalling $3.4 billion, he says.
Planning for the long-term
Itaú has also shown bold leadership in two other key areas which should pay long-term dividends: investor relations and social and ethical responsibility. These are areas where Brazil has been a global leader, as it has in alternative fuels.
We have put a lot of effort into investor relations and pay a lot of attention to what analysts and investors say, says Setúbal. Itaú has one of the highest levels of transparency among institutions in the world, not just in Latin America and Brazil, he says, adding that: were very proud of that. Its very positive for the institution and adds to our share price. Its a constant process of updating and anticipating what the market needs. We keep increasing transparency by releasing new kinds of information. I dont think that analysts can really read it all. I know that because they often ask us things that we have already disclosed, he quips.
Itaú is also in the vanguard on sustainable development. Setúbal starts talking about this as he does about so many subjects, insisting that this is client- and not bank-driven. Consumers are more and more demanding about social responsibility and cultural aspects, he says. Then he moves to acknowledge that it works for the bank too. To be sustainable and profitable and growing company, you do have to have social responsibility and ethical attitudes. The banks foundation has been very active in supporting programmes and initiatives. We want to do this for the very long term, he says.
Itaú seems to be getting the balance between satisfying its stakeholders broadly right: focusing on delivering customers what they want, enabling investors to look deeply into its books and delivering consistent, strong growth and topping it off with long-term policies on social, ethical and environmental responsibility. It will be interesting to watch in coming years to see if it can successfully replicate this model in other markets in Latin America and possibly further afield.