Sharks and Minnows

Brazil is the only country in Latin America where locally owned banks still dominate the financial industry. Just one foreign-owned bank – Santander Central Hispano – has managed to break into the ranks of the country’s five largest banks. It did so in 2000-2001 at a cost of over $5 billion when it took over Banespa, the São Paulo state bank.

The local banks, chief among them Banco Bradesco and Banco Itaú, have retained their independence because of their size, strong capitalization and sound management. These qualities have also put them beyond the reach – so far – of acquisitive Spanish and US banks. Furthermore, Brazil has three large and tolerably well-managed federally owned banks with assets that tower above their competitors in the private sector. Banco Nacional de Desenvolvimento Economico e Social (BNDES), Banco do Brasil and Caixa Econômica Federal are unlikely ever to be privatized and will probably continue to do the bidding of their political masters in Brasília.

Many of the foreign banks that have ventured into the Brazilian market in the last five years such as HSBC, Banco Bilbao Vizcaya Argentaria and ABN AMRO, are struggling with an identity crisis. They are too small to compete with the state banks or the two leading private-sector banks, Bradesco and Itaú. However, they are too large to become specialist banks, carving out in highly lucrative niches. As a result, it is Bradesco, Itaú and Unibanco, the third-largest Brazilian-owned private-sector bank, that are leading the consolidation process and not the foreigners.

Even Bigger
Since August, these three banks have spent $3.2 billion to acquire 10 banks, fund managers and finance companies. Bradesco alone recently made four acquisitions, three of them in January alone, opening the bank to accusations that its overriding concern is size, rather than improving its margins and making more money.

Márcio Cypriano, the bank’s president, says, “Leadership is important and we are used to it. We have been the market leaders since 1962. It has been in our blood for 40 years but we are not going to do anything crazy to keep the ranking.” In any case, Bradesco’s 2001 fourth quarter results, up 51% to R$610 million ($252 million), show that the bank is becoming a prodigious moneymaker.

Even so, Bradesco and Itaú seem to be locked in a race as each gobbled up one bank after another. In December, Itaú appeared to win a decisive advantage when it agreed to pay Banca Intesa of Italy up to $1.6 billion for Banque Sudameris, a middle-ranking bank with branches throughout South America and in Europe. The deal would increase Itaú’s assets by a fifth and would bring it within striking distance of Bradesco. In January, Bradesco struck back by buying 82.2% of Banco Mercantil de São Paulo for $570 million, bringing its assets to $48.13 billion, 15% more than Itaú’s.

Rumor has swept São Paulo that Unibanco and BBVA are negotiating a merger or acquisition, which if confirmed, would improve the survival prospects for the smallest and weakest of the big three Brazilian banks. Although Unibanco executives are fed up with denying the constant rumors surrounding the bank’s future, most observers agree that although it has excellent management and made some intelligent acquisitions last year, it is probably too small to survive in its present form with an asset base of only $14.53 billion.

The obvious catalyst for change in the banking industry is Citigroup. When Sandy Weill, Citigroup’s chairman, announced the company’s $12.83 billion acquisition last May of Mexico’s Grupo Financiero Banamex-Accival (Banacci), he said he would probably strike next in Brazil. Citigroup, which has run a highly profitable corporate banking business in Brazil for decades, had passed up many opportunities to buy failed Brazilian banks over the years.

Citigroup is large and strong enough to buy any Brazilian bank it choses, but is giving away nothing more about its likely next move. Says Gustavo Marín, the recently appointed president of Citibank in Brazil, “Our priority is organic growth to keep growing our businesses. We are in trade finance, foreign exchange, derivatives, corporate and investment banking and asset management. All of these businesses have room for growth.”

This does not mean that Citigroup will ignore possible acquisition deals in Brazil, but it does mean that it will not waste time trying to fix broken banks. “Our ambition is to be accretive from day one with our acquisitions,” says Marin. “We want businesses that are good businesses that add profits. We have learned the hard way that buying cheap is not cheap.”

However, decent Brazilian banks are becoming expensive. Bradesco has a market capitalization of $6.60 billion and the smaller Itaú, which trades at a premium because it is more profitable, has a market capitalization of $8.20 billion. Unibanco has market value of $4.7 billion.

There are more than 140 banks in Brazil, so there is still plenty of consolidation ahead. However, most of these banks are small. According to 2000 balance sheet data, the 10 biggest banks control three-quarters of the banking system’s $430.15 billion in assets. This suggests that the Brazilians will continue to lead the concentration process simply because the foreign banks lack the skill, management capacity or time required to continuously absorb so many small houses.

Winston Fritsch, president of Dresdner Bank in Brazil, expects the banking system to develop in two stages, or acts. “The end of first act will come with the creation of three big groups after privatization of the state banks and [acquisition of] medium-sized private sector banks,” he says. “The second act will depend on the capacity of Brazilian banks for international integration and defend themselves from internationalization.

Shooting for Scale
Although the big Brazilian banks are quite large by the region’s standards, they are look like minnows compared with the giant banks being created around the world. Banking in Brazil, as elsewhere, is becoming a scale business, where low operating costs and advanced systems really matter. The Brazilians clearly have an advantage over the foreign banks because they better understand the idiosyncrasies of their local market.

The big three should have little trouble financing further acquisitions. Itaú’s senior management has said that one reason the bank has courted the local and international capital markets so diligently is to create an investor base willing to finance a large investment. Itaú and Bradesco have financed their spending spree from their cash reserves or by issuing subordinated debt. Unibanco has paid cash for its acquisitions and in the recent past, has even paid for acquisitions in stock. These banks remain well capitalized and highly profitable.

The Brazilians have perhaps wisely avoided foreign entanglements since there are no markets in the region as large or as lucrative as their own. Itaú bought Banco del Buen Ayre, a small Argentine bank, in 1998 for $213.5 million, an investment that is probably worth nothing now. Although Itaú recently acquired the branch network of Sudameris in South America – with the exception of Peru and Argentina – it may decide to dispose of its non-Brazilian assets. Itaú has indicated that it might keep the bank’s branches in Monte Carlo, Miami and Uruguay to help it beef up its private banking business.

Still Underbanked
These days, the international banks may be smarting from the horrors of the collapse of Argentina’s financial system and may be wary of making large commitments of capital to Latin America. However, memories are short and Brazil has so far avoided much contamination from the trouble in Argentina. So the time will come when global giants will look at Brazil again. They will see a large market where incomes are growing but where the population remains remarkably underbanked. Little more than one-quarter of Brazilian adults possess a bank account and fewer still are consumers of more than the most basic banking products.

Furthermore, the margins on retail lending are mouthwatering. Consumers pay almost 100% a year in interest on some personal loans. Credit has always been scarce, and therefore expensive in Brazil, so the financial sector should look forward to many years of strong profits. The big three Brazilian banks have recognized this trend and built up large consumer credit portfolios.

Unibanco in particular, bought up several of these mainly downscale finance companies last year or struck exclusive deals with retail chains to provide finance to their consumers. Although this is a risky business, returns can be great. Bradesco in January paid Ford Motor Co. $420 million for its financing arm, Banco Ford.

The banks are also buying into the asset management business, another growth industry in Brazil. In January, Bradesco paid Deutsche Bank between $20 million and $25 million for its asset management arm. Last year, Itaú took over the asset management and leasing divisions of Lloyds Bank in Brazil for $61 million. The beauty of operations like consumer credit and asset management is that they are annuity-type businesses that generate reliable streams of cash for extended, predictable periods of time. This matters more and more, now that the triple-digit inflation of the 1980s and 1990s is a thing of the past.

“Brazil’s culture is changing,” says Bradesco’s Cypriano. “Before, 90 days was considered long-term and now we can raise money and lend at longer and longer maturities. We are selling three-year CDs. With time, we will sell paper with fixed interest rates.” This has made banking a safer activity. “Six or seven years ago, you would get liabilities for 30 days at most, or as cash to match against 10-12 year assets, so it was a nightmare,” he says.

The likes of Bradesco and Itaú do not have the market to themselves. They need to carefully watch the mid-sized banks like the privately held Brazilian Banco Safra or Banco Real, ABN AMRO’s Brazilian bank. A newly resurgent Banco do Brasil, the biggest commercial bank in Latin America with $59.5 billion in assets, is also becoming a more serious competitor. Banco do Brasil, majority-owned by the government, was crippled for years by a large bad-loan portfolio and abnormally low capitalization ratios. It nearly went bust on several occasions in the 1990s, forcing the government to inject fresh capital to keep it alive.

Banco do Brasil Revival
The government has now recapitalized and reorganized the bank, turning it into a more streamlined organization. In previous years, Banco do Brasil suffered from poor management, political meddling and a considerable degree of corruption. Remarkably, it has managed to preserve a certain esprit de corps throughout the dark years of the past decade. Like BNDES, Banco do Brasil has succeeded in attracting well-qualified technical staff by offering them job security that only the public sector can provide with good salaries and promotion prospects. And since recruitment is by competitive examination, Banco do Brasil offers plenty of prestige as well. Still, neither bank is entirely free from political interference, bureaucratic inefficiency or low-level corruption.

Banco do Brasil has developed some groundbreaking financing techniques in Brazil. Last year it raised $300 million in bonds backed by wire transfers from Brazilians working in Japan.

This transaction highlights the principal weakness of Brazil’s banks. Their cost of funds is far higher than their European or US competitors that have access to cheaper capital. Although all banks in Brazil must still pay the price for being located in a risky country, locally owned banks must pay higher spreads for loans in the international market than competitors with rich parent companies. Ultimately, their only advantage is their intimate understanding of the Brazilian market, an ability to take decisions quickly and a willingness to take risks that foreign banks would hesitate over.