Brazil's banks are on track for their most profitable year in recent history, despite concerns about asset quality deterioration and political uncertainty around the upcoming presidential election.

Aggregate net income for the main banks in Latin America's largest economy is projected to total 106 billion Brazilian reais in 2022, surpassing last year's figure by nearly 20%, according to Capital IQ analyst consensus estimates.

The pace of economic growth has slowed from 2021, when GDP rebounded from the economic downturn of the COVID-19 pandemic, but it is still projected at about 2.5% for the year. Banks expanded their loan books agressively amid renewed demand for credit, although the current political and economic environment is likely to dampen growth.

Presidential election

Brazilians go to the polls in a general election on Oct. 2, with former President Luiz Inácio Lula da Silva leading President Jair Bolsonaro of the Liberal Party in the polls by a comfortable margin.

Uncertainty in the run-up to the elections is likely to have put pressure on investment and economic performance, which could mean weaker internal demand, lower lending growth and worsening asset quality at banks, according to S&P Global Ratings bank analyst Cynthia Cohen Freue.

"Soft economic performance would likely restrict the payment capacity of households and companies, and as a result, the quality of banks' assets, which in turn could prompt banks to increase provisions, which would squeeze profitability. Amid these factors, financial institutions' operating performance could deteriorate," Cohen Freue told S&P Global Market Intelligence.

Policy shocks are unlikely given that both Lula da Silva and Bolsonaro are familiar names to Brazilian politics and markets.

"Regardless of whether Luiz Inácio Lula da Silva becomes Brazil's next president or President Jair Bolsonaro wins reelection, general policy continuity, defined broadly, will remain in place in the country," Elijah Oliveros-Rosen, Latin America lead economist at S&P Global Ratings wrote in a Sept. 26 research report.

But some changes are expected. Under a new administration, there is a chance that government-owned banks could increase their market share, which is already nearly 45%, Cohen Freue said.

"This creates market distortions, given a still-high spread differential between public and private banks," she said. Subsidized state-owned banks are able to offer lower interest rates than private banks.

Bolsonaro's government and economy minister Paulo Guedes worked to reduce the prominent role that public banks had during former mandates under Lula da Silva and Dilma Rousseff, who was president between 2011 and 2016.

Lula, the favorite

Lula da Silva, the center-left leader of the Workers' Party and president of Brazil from 2003 to 2010, is the frontrunner with close to 50% of electoral support, according to recent polls. Some of the latest surveys even show Lula above the 50% mark, which would clinch the election for him in the first round. President Bolsonaro trails in second place with about 35% of votes, with other presidential hopefuls trailing far behind.

A potential second round is scheduled for Oct. 30 for the top two contenders. Brazilians will also choose more than a third of senators, all of the lower house representatives, and all 27 governors and state legislatures in the general elections. Despite the high turnover, analysts highlight the fact that the two leading candidates for president have already led the country, which mitigates the level of political and economic risk.

"Lula is a well-known person to the political and financial systems," said Luis Santacreu, a bank analyst at Austin Rating, a local rating agency. "I don't think there will be many changes if he becomes president." The São Paulo-based analyst recalled Lula da Silva's first terms in office: "This idea of Lula as a very radical threat ... it didn't happen."

Brazil has a solid financial system in place with an "almost independent" central bank, Santacreu said. Furthermore, Banco Central do Brasil has been successful in determining and carrying out its agenda throughout presidential mandates of different political parties, he added.

"There is stability, so there might be more intervention perhaps, but no radical changes," he added in reference to a probable return to power by former president Lula da Silva.

Systemic risks and monetary policy are managed from an institutional and stability perspective and not according to political party preferences, the bank analyst said.

"There is an awareness that inflation has to be combatted, and one of the instruments is monetary policy and interest rates. Lula has also said that the central bank chief will remain in office to fulfill his term," said Santacreu regarding the tenure of Banco Central do Brasil President Roberto Campos Neto, who was appointed in 2018 during Bolsonaro's administration.

"This generates an expectation of stability in financial markets, and this is very important," said Santacreu.

No matter what the outcome of the election is, challenges will remain for the Brazilian banking system. Bringing down the historically high spreads in Brazilian banks is one of them, but any real effort to make that happen will require legislation to go through Congress and will not hinge on the political whim of the new president.

Another challenge is the high level of indebtedness of Brazilian households. With high inflation and a money tightening cycle still underway, some candidates are calling for renegotiation of household debts with banks. But that might be more a case of campaign strategy, rather than a serious threat of state intervention in the sector, according to Santacreu.

Banks' profitability to remain resilient

Brazilian lenders such as Itaú Unibanco Holding SA, Banco Bradesco SA, Banco Santander (Brasil) SA and Banco do Brasil SA booked a sharp increase in net interest income during the first half of the year, primarily driven by a pivot to unsecured lending such as retail loans. The average net interest income gain for Brazilian banks rose to $2.36 billion in the second quarter, up 77% from $1.33 billion in the previous quarter.

"Brazilian banks' profitability is high and has remained resilient thanks to the high provisioning coverage, diversified revenue mix — which includes insurance and asset management — and still-high margins despite increasing competition," Cohen Freue said.

Although banks' profitability could be weakened as a result of depressed net interest margins and deteriorating asset quality leading to higher provisions, profitability will likely remain resilient, Cohen Freue said.

"The ongoing shift in product mix toward retail lending will help cushion margins, which we expect will remain relatively healthy," she said.

As of Sept. 27, US$1 was equivalent to 5.37 Brazilian reais.