Even though COVID-19 has reached Latin America later than other regions of the world, its impact was already evident in the largest Brazilian banks' first-quarter 2020 results. The weakening asset quality led them to increase substantially provisions for credit losses, jeopardizing bottom-line results. On the other hand, the coronavirus outbreak had mixed effects on credit growth, given that demand in the corporate sector spiked, while that for consumer products such as credit cards and auto loans stagnated. Banks withdrew their growth projections for 2020 due to a high uncertainty.

We expect banks' asset quality to continue slipping and most likely increase risk of credit in the second quarter of the year, as some government officials estimate the pandemic will peak between June and August in Brazil. We believe companies in vulnerable sectors will likely continue to take a hit, including importers due to Brazil's sharply weaker currency. Moreover, the local authorities continue adopting measures to contain the virus, including quarantine and social-distancing measures, which impair economic activity. This comes as economic conditions were already shaky in the region prior to the global outbreak of coronavirus, while the Brazilian government still has limited fiscal capacity to help the ailing economy. As a result, we now forecast a recession this year with GDP shrinking about 4.6%.

Provisioning Approaching The 2015-2016 Peak

Since 2017, Brazilian banks had been recovering from the domestic financial system's severe slump between late 2014 and 2016, during which provisions for bad loans peaked and caused banks' bottom-line results to decrease. Moreover, loan-loss reserves in 2019 fell to nearly a half of the amount provisioned at the depth of Brazil's recession. This drop was a direct result of improving conditions in the corporate sector and banks' tighter loan underwriting standards and shift away from riskier borrowers. Their portfolio mix also has gradually shifted to less risky products, such as payroll loans and residential mortgages. In addition, banks increased the use of guarantees for corporate and small to midsize enterprise loans.

However, in the first quarter of 2020, combined loan-loss reserves of large banks were around 50% higher than in the quarter a year earlier amid the deteriorating credit conditions in Brazil, because of the COVID-19 pandemic and the pernicious economic impact from its containment measures. This figure was the second largest these banks posted in a single quarter, just behind the September 2015 peak.

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Credit Growth Also Picked Up In 2020

Lending growth among Brazil's largest banks reached around 13% year over year in the first quarter of 2020. This was the first time large banks had posted double-digit growth on aggregate since 2015. This was mostly due to the rising volume of corporate loans as companies seek to strengthen working capital cash positions amid the pandemic. Banks, on the other hand, had regulatory incentives to increase lending, given that the central bank approved many measures to increase funding and capital availability through lower reserve deposits and capital requirements. Another important regulatory measure enabled banks to renegotiate existing loans for up to six months without requiring additional provisions that helped maintain the loan portfolio. Retail lending, on the other hand, posted modest growth as demand for some products such as mortgages, credit cards, and auto loans vehicles decreased.

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Efficiency Gains And Fee Income To Mitigate The Widening Credit Losses

Efficiency gains bolstered large banks' profitability in the past few years. Stronger efficiency, in turn, stemmed from higher revenues and tight cost control resulted on better efficiency metrics since 2018. Banks continue to focus on cutting administrative expenses, while shrinking their branch networks and expanding digital platforms. Moreover, since 2018, large banks have been increasing the fees and commissions revenue base, which we believe to be more stable than interest income. In our view, despite stalling business activities that require further credit provisions, the high proportion of fees and commissions from non-lending activities will continue to mitigate the likely increase in credit losses among large banks in 2020. Moreover, these entities have a diversified and resilient earnings base, given that they offer a broad spectrum of retail and wholesale banking, asset and wealth management, and insurance services.

Credit Costs Should Continue Depressing Profitability, And Impact Will Likely Be Higher Than In Past Financial Crisis

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Large Brazilian banks' profitability already took a big hit in the first quarter of 2020 due to heavy provisioning. However, a sustained drop in economic activity due to the need to maintain a quarantine for a long time could increase the volume of problematic loans sharply and continue to hurt banks' asset quality. If credit losses continue widen beyond the first-quarter levels, we believe the loan-loss reserves to total loans ratio could increase to around 8.5% by year-end. This would be higher than during the 2008-2009 and 2015-2016 financial crises. As a result, return on assets would likely remain below 1%, which is also lower than historical figures. Nevertheless, despite a potential deterioration in stand-alone financial profiles, large banks still have a buffer compared with the sovereign in the form of higher SACPs. Therefore, we expect our ratings on these banks to continue to reflect that on Brazil. The ratings on the sovereign constrain those on the banks given their high exposure in the domestic market. Therefore, we expect their ratings to move in tandem with the sovereign ratings.

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