Brazilian Banks: The Worst Is Behind, But Caution Still Advised

Summary

  • A few specific corporate defaults along with the overly discouraging macro activity in Brazil have taken a toll on local banks’ profitability. This has endured for longer than many expected.
  • Looking ahead, loan loss provisioning is likely to trend down and political uncertainty will conceivably soon clear out, clearing the path for the awaited (though gradual) economic recovery in Brazil.
  • We expect Banco do Brasil and Bradesco to continue to gradually build up capital (mostly organically through earnings) and that should allow for a more competitive scenario.

 

 

In face of the still-challenging macro outlook in Brazil, investors still wonder whether the worst, in terms of loan provisioning, has indeed passed. They also question if lending will soon rebound ultimately supporting economic growth (currently, loan growth has been consistently down c.10% in real terms).

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Bank’s loan loss charges (‘LLC’) are extremely volatile and highly dependent on accounting treatment. That is, banks can often spread out the pain over many quarters with the intention of managing earnings to their best interest.

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On top of that, it is utterly hard accurately anticipating whether isolated corporate cases will materialize and, if so, the likely impact on banks. Nonetheless, obvious candidates for a Chapter 11 filing are many and include Petrobras (NYSE:PBR) and Odebrecht, one of Brazil’s largest conglomerates.

The key point is that sizable though isolated corporate defaults may still occur and that would most likely hurt banks profitability in the short term. In this sense, remaining cautious may come in handy. However, we see brighter skies going forward when it comes to recurring provisioning.

Has LLC peaked? Recurring LLC, likely yes. We have seen in the past quarters profits down for all banks in Brazil in the wake of the provisions spike coupled with the utterly challenging macro downturn and its direct impact on profitability.

In Brazil, unlike elsewhere, banks enjoy overwhelming market power in a highly concentrated market. This adds up to an excessively benevolent regulator as well as poorly financial educated loan takers. As a result, loan spreads are incredibly high vis-à-vis international peers and that opens room for risk-taking, which, at the end, leads to higher than usual provisioning.

In our view, however, the first half of this year marked the peak of recurring LLCs for the Brazilian banks. This is not only because banks have largely anticipated potential corporate cases by increasing provisioning but also due to a now better outlook for the economy as a whole (as shown below, leading indicators are already showing some progress). Also noteworthy, coverage ratios (NPL 90 days overdue) now sit at close to 200% for the four banks, confirming our thesis that provisioning may surprise us on the positive side.

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Despite the fact that banks are often overly optimistic in their projected peak of NPLs and LLCs, they seem to agree with us and have been indicating that the worse is now behind us. That said, and considering bank’s patent sensitivity to LLC, earnings revisions will likely lie on the positive side.

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Capital ratios: leaders and laggards. Currently, Itaú Unibanco (NYSE:ITUB) along with Santander Brasil (NYSE:BSBR) are understandably comfortable with their CET1 fully loaded ratios consistently trending above 10% (often the international benchmark, see figure below). On the other side of the spectrum, Banco do Brasil (BBAS3) and Bradesco (NYSE:BBDO) are still in their capital build-up phase – the latter had its capital impacted by the ill-advised HSBC Brasil acquisition, which cut its CET1 by nearly 300 bps.

Under this scenario, the two laggards are essentially unable to pick up the pace in loan growth while the two leaders feel naturally insecure to pursue countercyclical growth.

Going forward, as capital builds up for all players, competition will likely increase, setting the tone for declining net interest margins and more pronounced loan growth. All in, we presume a positive net impact on banks given the expected significant decline in provisioning, both for individuals and for corporates.

 

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LatAm PM’s Take: Going forward, we expect profitability to recover significantly as LLCs trend down despite the likely margin compression we expect to take place for all of the banks. We expect Banco do Brasil and Bradesco to continue to gradually build up capital (mostly organically through earnings) and that should allow for a more competitive scenario when it comes to lending margins as banks attempt to efficiently deploy capital. Banks’ projections already signal single-digit real loan growth for 2017, consumer and industry confidence keep on improving and foreign capital inflow have shown some signs of a potential rebound (in fact, carry trade is still to come). Overall, the outlook for Brazilian banks as well as the entire economy is slowly improving, and in our view financial stocks (particularly, banks) may be a great way to play the Brazilian recovery bet.

Analyst: Andre Villa 

https://br.linkedin.com/in/andrevillacabral

 

 

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