Despite Lula's victory putting an end to uncertainty that gripped Brazil for months, it will take time for the new administration to flesh out its policies and how they will affect the domestic banking sector. S&P Global Ratings doesn't expect major changes in the industry in the coming months, and if they occur, they will do so later. In the meantime, Brazilian banks have to deal with challenges stemming from the country's weak economic growth and deteriorating global conditions.

The Election Won't Have An Immediate Impact On Banks

On Oct. 30, Brazil elected Lula da Silva as the new president. However, his party and left-leaning political coalitions are far from simple and qualified majorities in Brazil's Congress, limiting Lula's ability to advance an ambitious economic and social agenda such as his ability to raise taxes and increase government spending. As a result, we believe it will take time for investors to learn about the economic policies the new government will implement, leading to continued cautious business and investor sentiment, hurting investment. This could dent internal demand, which could slow lending growth and weaken banks' asset quality. Given these factors, financial institutions' operating performance could struggle.

Adding to the lack of majority in Congress, a new Lula presidential term will face a sputtering global economy. Tightening financing conditions, slower growth in China, weaker economic prospects in Europe, and a potentially deeper-than-projected recession in the U.S. signal tough times ahead for emerging markets (EMs). Moreover, a possible scenario of prolonged inflation and restrictive monetary policy would dampen consumption and investment.

We forecast lending growth in Brazil to moderate to about 10% in 2023, due to the corporate sector's waning credit demand and banks' lower risk appetite, as economic conditions weaken. The country's soft economic performance and political uncertainty, which limit investment and internal demand, will curb credit growth. We expect the retail sector to continue to account for the bulk of lending growth.

Chart 1

In our view, banks' profitability will be pressured in 2023, but will remain healthy. We expect provisioning needs to pick up as asset quality metrics worsen, while margins will take time to improve as loans take longer to reprice than funding sources. The shift toward higher-margin loans (such as consumer lending) and banks' ability to reprice their portfolios will support margins in the longer term.

Chart 2

We expect nonperforming loans (NPLs) to continue rising in 2023 while credit losses to remain manageable thanks to sufficient provisioning coverage. We forecast the likely weaker economic performance in 2023 and slower credit growth to push up the NPL ratio, but it should remain manageable thanks to banks' conservative growth strategy before and during the pandemic. We expect consumer loans, particularly credit cards and middle-market loans, to be the cause of the rising NPL ratio, which we expect to peak between 3.0% and 3.5% in the first half of 2023.

Chart 3

The financial health of the corporate sector has remained resilient, even in a challenging economic scenario. Despite persistently high inflation and tightening financing conditions, the increase in economic activity has strengthened the domestic companies' payment capacity, while leverage has decreased. In the consumer lending 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.

Government-Owned Banks' Improved Performance Could Be In Danger

We believe that the Brazilian financial system is exposed to the risk that the new administration could attempt to use government-owned banks to boost economic growth. This has occurred during previous administrations, when the state-owned banks' market share jumped to 56% in 2016 from just above 30% before 2007. If Lula's administration decides to take similar measures, they will blunt the benefit of improved performance among government-owned banks. However, we don't expect these banks to resume the aggressive strategies they had during the peak of their growth in 2016-2017.

Chart 4

We believe the implementation of the State-Owned Company Act in 2017 has significantly improved the Brazilian state-owned banks' governance, promoting greater transparency in decision-making processes, and limiting political appointments for the banks' executive positions. We think these measures reduce political risk and entrench the banks' long-term strategy, resulting in more stable revenues and bottom-line results. Moreover, the implementation of Basel III standards and the need to maintain satisfactory capitalization levels could also somewhat limit their extensive use as a policy tool. The government's fiscal restrictions will likely limit its appetite to inject capital into government-owned banks to compensate for the stronger growth, as it has done in the past. However, these banks' current capital ratios are well above the minimum requirements and as such, they can grow without needing to receive a capital injection.

From 2012 to 2014, government-owned banks in Brazil received about R$90 billion of perpetual bonds issued by the country's treasury. During this period, lending among these banks surged, because the government used these institutions as a countercyclical tool while the country's economy was stagnating. This took a toll on banks' capital adequacy--they required capital injections from the government, which did so through hybrid instruments for the banks' subsidiaries. However, during Bolsonaro's administration, state-owned banks implemented measures that included divesting noncore assets in order to repay this debt because of fiscal constraints and the government need to use these resources to reduce public debt.

Tight Global Financing Conditions Have Raised Concerns About Banks' Financing Needs

With the U.S. Federal Reserve pledging to do whatever it takes to bring persistent inflation under control, there's a growing risk of interest rates staying higher for longer. This could not only heighten market volatility but also make overall financing conditions tougher for issuers across EMs. Furthermore, the U.S. could experience a deeper recession than we currently expect. This would hamper economic conditions across many EMs, particularly those with high trade links with the U.S. or receive substantial remittances from the U.S. It could also cause financing conditions to deteriorate further, and likely depress investors' appetible for EM debt, while continued dollar strengthening could trigger an increase in capital outflows and lead to a sharp rise in refinancing risk for issuers with dollar-denominated debt. Lower-rated borrowers would be first to feel the impact of tighter financing conditions.

We believe major Brazilian banks are well positioned to cope with a prolonged scenario of monetary tightening. The banking sector's dependence on 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 scale of foreign currency lending.

Midsize banks don't benefit from large and stable retail deposit funding that major banks have. However, in recent years, they took advantage of issuing time deposits to retail investors through third-party brokers that have grown significantly in recent years, thanks to the insurance provided by the Credit Guarantee Fund (Fondo Garantidor De Credito [FGC]). The fund boosts confidence to retail investors. FGC is a private, non-profit organization that manages the safety net mechanism for depositors and investors in the Brazilian financial system up to the limits established by regulation in the event of the central bank's intervention and extrajudicial liquidation and recognition of the insolvency of the member institution.

As such, midsize banks in Brazil no longer, in our view, heavily depend on wholesale funding. In contrast, the risk has now shifted to having a heavy reliance on third-party brokers that can at some point decide unilaterally not to continue distributing deposits from an institution. However, we haven't seen many cases of this happening so far.

Another risk we see in this funding scheme are concerns over fees that banks pay to the FGC relative to the issuance size. Complaints about the scheme may prompt a change in the framework that could negatively affect some banks. Finally, although the FGC has the capacity to support individual banks, it may not be able to withstand a systemic risk if many institutions experience financial distress.

Rising Interest Rates Pose Doubt Over Hybrid Instruments

Some hybrid instruments issued by major Brazilian banks are approaching the call date, and amid the current high global interest rates, we think the call option might not be exercised because a new issuance might be too expensive. If a bank chooses not to do so on an optional call date, this wouldn't constitute a default according to our criteria. Moreover, it wouldn't have, by itself, any impact on the banks' stand-alone credit profiles or our ratings on them. The optional nature of the call (and the ability not to call) is a key feature of hybrid debt, which enhances an issuer's flexibility in how it uses the hybrid instrument to manage its capital. Recently, several European banks decided to not call AT1 instruments on a call date (e.g. Sabadell, Deutsche Bank AG, and Standard Chartered Bank). Given rising interest rates, we don't exclude the possibility of more banks following the same route. We believe the market viewed these events as economically rational behavior by the respective issuers, given rising interest rates, and we don't believe such actions hampered banks' ability to tap debt markets in the future.

Investors have asked what the implications are for banks that don't exercise the call option, given financing constraints. Despite having no obligation to do so, issuers around the world have typically called (and replaced) a hybrid instrument sold to institutional investors on their first optional call date. In addition, if the instrument has a step-up clause on the call date, the incentives to call the instrument are even stronger than for those instruments that don't have such a clause, because the servicing cost will generally rise after the call date. Tier 1 hybrid instruments among Brazilian banks have no step-up clauses; therefore, banks have lower incentives to call the instruments.