The Brazilian central bank’s decision to cut the country’s Selic rate for a 10th consecutive time takes the benchmark to an historic low of 6.75% and creates notable challenges for Brazil’s banks to maintain profitability, according to analysts.
Most economists think the central bank will hold at the 6.75%, but the fall in the policy rate has been steep and will hit banks’ margins.
The Selic rate was 14.25% in October 2016 and Brazil’s banks enjoyed a boost to earnings in 2017 from the fact that funding costs are predominantly floating rate and therefore fall faster than the fixed interest rates charged to their borrowers.
However, a prolonged period of historically low interest rates will lower net interest margins (NIMs) and, as a result, will pressure profitability.
“Sharp monetary easing has created a new paradigm for Brazilian banks,” according to Ceres Lisboa, senior vice-president in Moody’s financial institutions group in São Paulo, and head of a new report about Brazil’s banking industry.
“Although the economy is growing, such an extended period of low rates is new for Brazil and will strain earnings at the country’s largest listed banks.”
Data from the central bank support this: in its most recent report, which covers December 2017, it showed credit spreads across the industry falling by 120 basis points month-on-month, with consumer spreads falling 130bp and corporate spreads by 90bp.
On a year-on-year basis, spreads have fallen by 380bp compared with the benchmark rate’s decline of 660bp, which suggests the nominal spread, currently 18.9%, has further to fall.
Lisboa highlights that the slower decline in spreads compared with the Selic was a boon to the banks last year, but this cannot continue.
“The sharp drop in interest rates has already lowered funding costs on the banks’ predominantly floating rate liabilities, supporting profitability in 2017,” she says. “But with rates likely at the bottom of the easing cycle, we see limited room for additional savings in 2018.”
The NIM reported by the three main private banks – Itaú, Bradesco and Santander Brasil – has been falling in recent quarters, particularly at Bradesco, whose merger with HSBC led it to take on lower yielding assets. The NIM at Banco do Brasil has remained stable, though, at lower levels.
Lower NIMs mean the banks will have to look for improved performance elsewhere to maintain recent profitability. Improved asset quality might help, but provisioning has already been declining across the banks last year as non-performing loans fell.
However, there are bright spots. First, the economic recovery in the country is gaining space and augurs well for credit growth. Increased credit volumes would offset a fall in NIMs and the banks are positioning for increased demand.
Data from the central bank show that this uptick seems to have begun: total loans in December grew by 0.7% over the previous month, although they still fell on an annual basis. Encouragingly, corporate loans posted a first positive result in five years – up 0.9% for the month, although down 7.0% for the year.
Although these numbers are still weak, Deutsche Bank’s financial analyst Tito Labarta points out that the private banks are rebuilding market share as the credit cycle and asset quality improve. In the last month of 2017, the private sector increased loan portfolios by 2.2% month-on-month and by 2.7% year-on-year.
Meanwhile, UBS bank analyst Philip Finch believes Brazil’s banks remain an attractive investment due to the country’s position in the credit cycle.
He expects “mid-single-digit” credit growth in 2018 and also points to other factors that should support the profitability of the large banks this year, including better technology adoption.
A greater reliance on fees will also offset falling margins.
Credit Suisse analyst Marcelo Telles points to Santander Brasil’s ability to outperform on fee generation – the bank increased fees by 8.9% in the fourth quarter of 2017, beating expectations – as a key part of the bank’s improved profitability.
According to Telles, the bank’s performance, with return on equity of 18.1% in Q4 2017, “would have been unthinkable a couple of years ago”.
'Soft' loan growth
However, Moody’s Lisboa is less convinced by the banks’ ability to compensate for an environment of structurally lower interest rates. Moody’s believes that loan growth will remain “soft” despite the economic recovery.
Most economists agree: unemployment is still high, though falling, which will suppress consumers’ demand for credit. And the political uncertainty stemming from this year’s presidential election is likely to lead to the postponement of the investment plans that would have led to substantial growth in corporate credit demand.
The rating agency also points out that investment income will also be a negative factor for all the leading banks. Banco do Brasil, Bradesco and Santander have around 70% of their securities and investments in Brazilian government bonds that pay the Selic rate, while Itaú has around 50%.
“All four banks obtain a risk-free spread on these holdings because all benefit from funding costs that are below 100% of Selic,” writes Lisboa.
“Now that the official rate is just 6.75%, this income stream has fallen and it is unclear how the banks can compensate for lower investment income.”