BICRA Highlights

In our opinion, Brazil's low income levels and the government's weak fiscal position constrain the country's economic resilience.   We expect economic growth of 2.5% in 2022 and 0.6% in 2023, as tight monetary conditions and high inflation weaken domestic demand. Credit growth will likely moderate amid rising inflation, increasing interest rates, sluggish economic growth, and political uncertainty given the presidential elections in October. We think asset quality will slip as a result of the economic slowdown, low credit growth, and residual effect of the pandemic on certain economic sectors, but credit losses should be manageable because of the high provisioning coverage.

Although the banking industry's profitability has remained resilient, we expect it to slightly slip as provisioning needs increase.   Brazilian banks' profitability is high and has remained resilient thanks to the high provisioning coverage and diversified revenue mix. However, profitability will likely slip as provisioning needs rise, although net interest margins should mitigate the impact. Our industry risk assessment for Brazil also reflects its well-developed financial regulation that is broadly in line with international standards, and the regulator's good track record that has helped the financial system withstand the last economic downturn. The Brazilian banking system has an adequate funding mix with a large and stable core customer deposit base.

Economic Risk  |  7

Economic resilience: Low income levels and government's weak fiscal position

In 2021, Brazil's economic output modestly exceeded its pre-pandemic level. We expect the economy to grow 2.5% in 2022 and average less than 2.0% growth in 2023-2025-- below the growth rate of countries at similar development levels. We expect GDP per capita, at just below $9,000 in 2022, to rise to $9,800 by 2025. Resilient consumption (partly due to supportive countercyclical measures), high commodity prices, and rising export volumes continue to support economic growth.

Investment is recovering due to the government's efforts to improve its infrastructure concession programs and legal framework across sectors, with the aim of greater private-sector participation in the economy. We expect investment to remain about 18% of GDP in 2022-2025, compared with a 15% average in 2016-2020. Still, we continue to see elevated downside risks, given high inflation. A scenario of prolonged high inflation and restrictive monetary policy would dampen consumption and investment and worsen public finances.

The composition of Brazil's debt limits the risks of the high debt burden. The debt is mostly denominated in local currency, and the central government's strong liquidity position mitigates rollover risk. Nonresidents hold only about 9% of local currency central government debt as of July 2022, limiting the risk of potential adverse external shocks on debt rollover. The share of domestic lenders, including the banking sector, is high. On the other hand, the banking sector's high exposure to the government (which accounts for over 20% of its assets) will constrain the availability of credit to other economic sectors.

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Economic imbalances: House prices should stabilize due to increasing interest rates while credit growth will likely moderate

We expect real lending growth to slowly moderate in 2022-2023 due to the lower credit demand from the corporate sector and banks' lower risk appetites. Although during the first half of 2022 lending growth in nominal terms remained very high, we expect the second half of the year to return to normal because the soft economic performance and political uncertainty will curb credit growth. We expect the retail sector to mainly drive credit growth, in line with what occurred in the past 12 months. Last year, lending grew about 16% driven by consumer lending (21.5% growth) thanks to the rebound in economic activity, mortgage lending (14.3%) supported by the still low interest rates, and corporate lending (11%).

House prices have continued to increase due to the low interest rates, low stock of houses, and high demand for residential housing and investment. However, we expect house price growth to slow as interest rates remain high in the near term, and then to moderate in the coming years. The share of mortgages as a percentage of total loans rose during the past few years as banks focused on low-risk products. However, mortgages only account for about 18% of total lending as of March 30, 2022. On the other hand, we don't expect the asset quality of mortgages to worsen because underwriting standards have been adequate in the past few years. LTVs averaged 54% as of the end of 2021, with a very limited presence of home equity loans and no subprime lending. In addition, Caixa Economica Federal (Caixa; BB-/Stable/B) holds about 40% of total mortgages.

We expect a challenging business and operating conditions for Brazilian banks, which will likely lead to worsening asset quality metrics in the next 12-18 months, although manageable. We expect credit losses (estimated as new loan loss provisions to total loans) to be 2.7%-3.0% in 2022-2023 (from 2.3% in 2021). We estimate nonperforming assets (NPAs) in the banking system to be 2.9%-3.2% of total loans during this timeframe and that loan loss reserves will cover 170%-190% of nonperforming loans (NPLs).

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Credit risk in the economy: Asset quality metrics are likely to weaken, but we expect them to remain manageable

Credit growth in the past 12 months has been driven by consumer lending, with greater emphasis on loans with higher margins but also higher risk, namely credit cards and other consumer loans. Mortgage loans continue to have moderate growth due to the higher interest rates. Growth of loans to SMEs has slowed with the end of government programs, while larger companies have mainly accessed the capital markets, slowing their credit demand.

The financial health of the corporate sector has remained resilient, even in a challenging economic scenario. Despite persistent high inflation and the tightening financial conditions, the increase in economic activity has strengthened domestic companies' payment capacity and the leverage of large companies has decreased. With respect to the consumer segment, borrowers' payment capacity has been relatively stable. Although the household debt service-to-income and debt-to-income ratios at aggregate levels have increased, when this measurement is carried out considering the operations in banks' portfolios, the central measures of these ratios indicate recent relative stability with a marginal increase.

On the other hand, because of the reduced supply of new vehicles, there has been an increase in the past four years of financing of vehicles over three years old, a loan type that tends to have weaker credit performance than new vehicle loans. We expect this to pressure asset quality metrics in this segment.

As of the end of 2021, household debt represented 31.2% of GDP (up from 30% the previous year) and 52.6% of household annual disposable income (up from 43.9%), while debt service accounted for 28.0% of household monthly revenue. The household portfolio's NPLs increased to 3.0% in 2021 from 2.8% in 2020, and net charge-offs were 2.6% in 2021.

Corporate NPLs slipped to 1.3% in 2021 from 1.2% in 2020. Corporate lending growth has decelerated from strong levels during the pandemic when companies increased their bank lending to have liquidity to cope with the lockdowns. However, in 2021 corporates shifted their funding from bank lending to the domestic capital markets.

Construction loans accounted for only 0.7% of corporate loans as of December 2021, and foreign currency lending accounted for just 4.1% of total loans of the system. In addition, these loans are adequately matched on the balance sheet. Banks have maintained low customer concentration; we estimate that top 20 borrowers account for 10%-12% of total loans or 0.4x-0.5x reported equity.

In our opinion, Brazil's payment culture and the rule of law are weak, weighing on credit risk. According to the Transparency International Corruption Perceptions Index 2020, Brazil ranks 94th out of 179. There's still significant room for improvement, but Brazil's ranking is above some other Latin American countries such as Mexico and Bolivia (124) and Paraguay (137), and is tied with Peru (94).

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Industry Risk  |  5

Institutional framework: Extensive regulatory coverage well aligned with international standards

In our opinion, Brazil's banking regulation has extensive coverage of financial institutions with a comprehensive set of tools to monitor risks in the system. The country's banking regulation is broadly in line with international standards in terms of accounting, capitalization, money laundering, related-party transactions, and financial statement disclosures. Brazil has fully implemented Basel III, in line with the international phase-in arrangements. The central bank supervises all banks, credit unions, nonbank financial companies, and other financial intermediaries (exchanges, securities brokers, etc.). Supervision is adequate and carried out on a risk-based basis, and coverage is extensive. There are specific rules for liquidity; derivative exposures; single-name and geographic concentrations; foreign currency operations; credit, market, and operational risks; capitalization; compensation; and information disclosure. In our view, regulatory minimum requirements are adequate, and authorities foster a preemptive risk culture.

BCB is committed to promoting environmental, social, and governance (ESG) awareness, reflected in the early adoption of a green protocol in 1995. Since then, the regulator has introduced several resolutions to support social and environmental responsibility, with special focus on agribusiness considering Brazil's exposure through the Amazon forest. In September 2020, the central bank issued an ESG agenda, which it has followed since. Among the measures announced, it recently published regulations that establish criteria for the treatment of ESG risks and opportunities by financial institutions under its supervision. It has also stated its commitment to conduct its first climate risk stress test for Brazilian banks, which we expect it to publish before the end of this year.

BCB has implemented a comprehensive framework for managing cyber security risk, which includes several requirements for financial institutions. Institutions must prepare an annual report on the implementation of their action plan, including:

• Actions to adapt the institution's organizational structures and policies ;
• The routines, procedures, controls, and technologies to be used in preventing and responding to incidents; and
• The area responsible for recording and controlling the effects of relevant incidents.

This report must be made available to the BCB, which will analyze it during the supervision process. BCB also requires institutions to have a classification policy for third-party services for data processing and storage, including

cloud computing, and they must inform contracting of relevant services to the BCB. With this information, the BCB can act when a risk is detected for a supplier, triggering closer monitoring and limiting the impact on other institutions.

BCB has a proactive approach toward regulation. Brazil's financial system has been resilient to the weak economy in the past few years, and the government's measures were effective in offsetting potential liquidity problems. The central bank was also successful in identifying potential risks among consumer lending products and took measures to reduce them (i.e. higher-risk capital charges on auto loans and long-dated consumer lending.) However, ten banks have failed since 2010, some of which were allegedly involved in unlawful activities. Still, these institutions were small and didn't cause systemic damage. In addition, authorities have taken steps to strengthen supervision to avoid unlawful practices in the system, such as requiring supervision for lower retail loan amounts. In our view, the central bank's biannual financial stability reports also contribute to effective monitoring of the financial system.

In response to the COVID-19 pandemic and its economic impact, BCB introduced a comprehensive set of measures to limit the harm to the financial system. These include liquidity measures, loan moratoriums, a reduction in the capital conservation buffer, limits on dividend payments, and capital relief on restructured loans to SMEs. In addition, the interbank rate (Selic) was lowered to record low levels and the government offered guaranteed loans for SMEs. We think these measures have been key in containing the impact of the crises on financial institutions, which performed better than expected, and as the government lifted measures, the system's stability remained contained.

We assess governance and transparency as at least adequate. Brazil has adequate banking regulation that fosters satisfactory governance practices, and we think there's also satisfactory transparency in the system. Banks publish their financial statements on a quarterly basis and make them available online. Banks also prepare annual financial statements, which third parties audit. In addition, the central bank publishes a broad set of information on the financial system on a quarterly basis. Moreover, BCB publishes the minutes of the Financial Stability Committee that meets four times per year.

Investigations of the government-owned banks during 2015 and 2016 pointed to potential governance issues at these institutions. Investigations resulted in imprisonments of the involved individuals but haven't resulted in systemic drawbacks for the financial system. Moreover, the implementation of Law 13,303/16 (the State-Owned Company Act) in 2017 has significantly improved governance of state-owned banks, in our view, promoting greater transparency in the decision-making process and limiting political appointments to the banks' executive positions. We believe that the diligent execution of such measures could reduce political risk for banks while increasing their ability to perform their policy roles.

Competitive dynamics: Market distortions from government-owned banks has decreased, but they still have significant presence

We consider the Brazilian banking sector's risk appetite as moderate. Profitability has been sound and continued to benefit from its business diversification, which includes insurance and asset management. Banks' profitability, measured by return on equity (ROE), was 16.3% in 2021 (up from 12.8% in 2020) and has averaged at 15.8% for the past three years.

Our risk appetite assessment also incorporates the sector's low exposure to high-risk lending. There are no subprime loans, and the share of home equity loans is almost negligible. Additional exposures to other vulnerable sectors, such as agriculture, are limited, representing 7.7% of loans.

Chart 5

The Brazilian financial system consists of 136 banks, four development banks, and 1,181 other financial institutions (including credit unions, mortgage lenders, micro-financing, and consumer finance companies) as of Dec. 31, 2021. The ten largest banks control about 80% of the market in terms of deposits as of the same date. Market share among the largest players has been fairly stable in the past five years, and we don't expect major changes in the medium term. The three largest banks have controlled 50%-60% of the market in the past five years.

Demand for digitalized banking in Brazil is rising primarily because of the convenient and quick services, lower costs, and the relatively low access to credit, in our view. Moreover, we consider that a supportive regulatory framework has also prompted the boom in fintechs, fostering competition. We believe large banks' embrace of new technology, superior capacity to invest, and the universal banking model will help preserve their dominant market share. However, smaller banks will find it increasingly difficult to keep up with these trends. In the next few years, we expect competition to intensify and profitability to fall until the benefits from cost reduction through digitalization level off. This will likely lead to further consolidation among the struggling banks and fintechs.

Despite the government's efforts to reduce the market share of public banks, it remains high, almost 43% (see chart 6). This creates market distortions, given a still high spread differential between public and private banks. During the past years, there has been an effort to reduce distortions introduced by public banks and they've focused on improving operating performance and on their key roles. Banco Nacional de Desenvolvimento Economico e Social (BNDES; BB-/Stable/--) has focused on key infrastructure projects and key economic sectors for the country, Banco do Brasil S.A (BdB; BB-/Stable/B) on fostering the agricultural sector, and Caixa on granting financing to lower-income borrowers and promoting housing. In this sense, BNDES has divested large shareholdings in listed companies, while Caixa concluded the IPO of its insurance unit and raised about R$5 billion and sold its participation in Banco Pan with a R$2.0 billion net gain.

Historically, government-owned banks' strategic direction and risk appetite have changed according to the political parties in power. However, the implementation of the State-Owned Company Act in 2017 has significantly improved their governance, promoting greater transparency in decision-making processes and limiting political appointments for the banks' executive positions. We believe that the execution of these measures reduces political risk and improves the consistency of their long-term strategy, resulting in more stable revenues and bottom-line results. Finally, the implementation of Basel III and the need to maintain good capitalization levels could also limit market distortions from government-owned banks.

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Table 5

Systemwide funding: The banking sector benefits from a sizable and stable source of retail deposits.

Our systemwide funding assessment reflects the Brazilian banking sector's low exposure to external funding and its large and stable core customer deposit base. The country's reported private sector loan-to-deposit ratio was 120% at year-end 2021. Core customer deposits (considering 100% of retail deposits and 50% of corporate deposits) accounted for 77% of total loans for the past five years. Deposit growth has stabilized after the strong growth during the pandemic.

The Brazilian banking sector's exposure to external funding is moderate, and refinancing risk is low. The sector's net external funding has averaged 12% of total loans for the past two years. Low reliance on external funding is mainly due to the sector's large customer deposit base and limited foreign currency lending.

In our view, Brazil's debt capital markets are moderately broad and deep. Market depth has been improving in the past five years as pension and mutual funds' appetite for private-sector debt increased. As of year-end 2021, pension and mutual funds held assets representing approximately 77% of GDP. Currently, a large percentage of these funds are invested in government securities; however, these entities are also looking for instruments with attractive returns and longer maturities. We expect that in the next three years, the appetite for higher returns will broaden available funds for banks and corporate issuers. In addition, we expect that longer-term maturities will become available because pension funds will also be looking to match their balance sheets.

The government has a satisfactory track record in providing liquidity to the financial system under stressful conditions, and the central bank serves as a lender of last resort. A deposit insurance entity, Fundo Garantidor de Créditos, covers up to R$250,000 per depositor per entity and up to R$1 million aggregated in all entities. This institution is also part of the financial system's safety net and plays a significant role in the various bank resolution mechanisms.

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Peer BICRA Scores

Countries in BICRA group '6' are very diverse. Compared with Colombia, Brazil has a stronger regulatory framework and alignment with international standards, but this is moderated by the distortions stemming from a large market share of government-owned banks, which isn't the case in Colombia. China continues to post much stronger (although moderating) GDP growth than Brazil, which supports the former's economic risk assessment, although leverage is much higher. On the industry risk side, China's banks have stronger funding profiles, while we consider the institutional framework to be stronger for Brazilian banks.

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Government Support

We classify the Brazilian government as supportive of the domestic banking sector. We believe the government will provide extraordinary support to systemically important banks (failure of which could compromise the country's payment system) in the event of a crisis. Brazil has defined various resolution mechanisms that include private-sector solutions.

Table 8

In December 2019, the administration sent Congress a draft of a resolution regime bill, but it has not yet been discussed. The bill would create two mechanisms to resolve financial institutions: the Stabilization Regime and the Compulsory Liquidation Regime. The regulator would apply the Stabilization Regime to institutions of systemic importance, but other banks could also be treated under that regime. Once the central bank decides on a regime, it will decide the extent of the bail-in: bailing in instruments or using the funds, or both (the bill provides the order of resources and bail in instruments to be used for loss absorption purposes). The regime would be executed by an administrator appointed by the regulators. The Stabilization Regime would immediately suspend the exercise of shareholder rights and remove the directors of the failing institution. The Compulsory Liquidation Regime would apply if the risk to financial stability is determined to be low. This regime involves closing the institution's activities, submission to the regime (which classifies creditors by order of priority), and selling assets. Situations that could lead to the enactment of the resolution regimes include insolvency, exposure to risk incompatible with equity, insufficient assets to cover losses, and repeated violations of legal and regulatory standards.

The draft would also create credit guarantee funds to pay out guaranteed deposits and provide liquidity to the system, and resolution funds to grant loans to and capitalize institutions under the Stabilization Regime. The resources for the capitalization of the funds will come from the financial system. For the Stabilization Regime, the resolution fund may constitute a transitional financial institution ("bridge bank") that would be capitalized to receive the institution's assets and liabilities under resolution until they are assumed by third parties or discontinued. If private resources aren't sufficient to ensure financial stability, the government may lend to resolution funds. In this case, some conditions must be met, such as the exhaustion of shareholder resources and the possibility of serious threat to the financial system. The government will be the first to be reimbursed when the institution recovers.

Related Criteria

• Banking Industry Country Risk Assessment Methodology And Assumptions, Dec. 9, 2021
• Financial Institutions Rating Methodology, Dec. 9, 2021
• Environmental, Social, And Governance Principles In Credit Ratings, Oct. 10, 2021
• Sovereign Rating Methodology, Dec. 18, 2017
• Country Risk Assessment Methodology And Assumptions, Nov. 20, 2013

Related Research

• Sector And Industry Variables Report Published For Banking Industry Country Risk Assessment Update For August 2022, Aug. 30, 2022
• Brazil 'BB-/B' Ratings Affirmed; Outlook Remains Stable, June 15, 2022