Brazilian banks faced strains on their asset quality metrics in 2022 and 2023, resulting in high credit losses due to a spike in delinquent unsecured retail loans--mostly credit cards and personal loans. The corporate sector also started to struggle largely because of persistently high interest rates. The number of large Brazilian companies' defaults peaked in 2023, while creditworthiness of SMEs_ deteriorated, hitting banks' profitability.

The three largest private banks in Brazil--Itau Unibanco, Bradesco, and Santander--charged off around R$92 billion in total, net of recoveries, of NPLs in 2023 (compared with R$47 billion in 2022). These charge-offs represented about 4.5% of the three banks' combined loan book (2.4% in 2022).

However, the impact was not the same for all the banks, and depended on exposure, obligor profile, exposure to relevant single-name defaults in Brazil last year, and ability to navigate rising NPLs on SME loans, credit cards, and personal loans. For instance, the default of a large Brazilian retailer in early 2023 led to higher NPLs through the year. Itau's NPLs remained on par with pre-pandemic levels, at about 2.8% as of December 2023, while its renegotiated credits remained fairly stable. Bradesco's NPLs, in turn, increased to about 5.2%, compared with 3.3% in 2019, and its renegotiated credits reached 6.2%. Santander's NPLs had a mild increase to 3.1% by December 2023 (from 2.9% in December 2019), but its renegotiated credits had increased to 7.1% of its gross credit portfolio by December-2023, against 4.6% in December 2019.

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Annual lending growth in Brazil's financial system was, on average, 15% in 2020-2022. A large portion of this growth was from credit cards that benefited from the quick recovery from consumption after the pandemic restrictions ended, and at its peak was growing by more than 50% year on year. Following the erosion in bank asset quality in the segment due to peaking inflation, banks have materially lowered their risk appetite, which reduced overall credit growth.

In response to the tough conditions, banks have tightened their underwriting practices to protect their balance sheets. Credit growth in 2023 was 8%. We expect credit growth to remain moderate in 2024, amid sluggish economic growth, while banks focus more on collateralized loans.

Overall, we do not expect relevant negative rating actions for Brazilian banks this year, as we believe that banks will face a more benign scenario than last year, and that losses will remain manageable.

Large Brazilian Private Banks Should See More Stability This Year After Uneven Performance In Credit Cards And Personal Loans

We expect Itau Unibanco, Bradesco, and Santander to have stable asset quality metrics in unsecured personal loans and credit cards this year--after facing deteriorating performance recently. This reflects our expectation that inflation and unemployment will remain controlled and large banks will continue to be cautious and avoid significantly growing those asset classes. However, we think it will be key for large banks to continue investing in technology and innovation to retain their retail clients amid more competition from digital banks.

Up until 2021, the three large private banks in Brazil had similar asset quality indicators for retail loans. Each reported NPL ratios between 3.5% and 4.0% in December 2021. Then, in 2022, credit cards and unsecured personal loans started to deteriorate in the Brazilian financial system. This deterioration resulted from high inflation and rising interest rates, which began to burden low-income individuals' creditworthiness.

However, some banks had steeper NPL increases than others. While Itau's and Santander's retail NPL increased to close to 5.0% in June 2023, Bradesco's increased to 6.7%. We think this contrast resulted mainly from the banks' different strategies and focus within the credit card and personal loans segments. Particularly, Bradesco had a higher focus on lower-income individuals than its peers.

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Moreover, Bradesco's credit card growth in the year that preceded the NPL deterioration was higher than peers, which we think also contributed to higher losses. Its credit card outstanding amount had grown at a compounded annual growth rate (CAGR) of 19.4% between the end of 2019 and end of 2022, while Itau's and Santander's CAGR for the same period were 14.1% and 10.3%, respectively. In turn, the system's credit card CAGR was 20.9% during the same period, as digital banks were expanding their credit card issuances faster than incumbent banks.

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SME Loans Deteriorated In 2023, And Downside Risks Remain

For the three largest Brazilian private banks, SME loan performance has been uneven, and we still see downside risks for this year. This reflects our view that, while interest rates have been declining, they will remain high, and their effects on loans will take longer to cease. Some banks like Bradesco seem to have reached the peak in SME delinquency in 2023. Nonetheless, other market indicators, like filings for judicial recovery or banking system's SME loans NPLs, don't seem to have peaked yet.

In 2022 and 2023, Itau kept relatively stable NPL metrics for SMEs, while Bradesco experienced deterioration in its SME portfolio. The banking system's total SME loans also suffered during that period, but less so than Bradesco's. In addition, while we don't have SME NPL rates data for Santander prior to 2022, the level of NPLs as of 2023, at about 4.0%, suggests it deteriorated less than Bradesco's. Also, the NPL rates that we used for SMEs were extracted from the banks' earnings release and, as so, may not be fully comparable due to differences in their construction (for example, Itau considered personal loans to agribusiness within its SME loans, while this doesn't seem to be the case for Bradesco).

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According to data from the Brazilian central bank, Bradesco was the SME loans market leader as of June 2023, holding about 15% of those loans. Itau was second, with 12%-13% as of June 2023. Santander, in turn, held between 8% and 9% of SME loans.

The Brazilian Central Bank (BCB) defines SMEs as companies that either have annual revenues of up to R$300 million or total assets amounting to up to R$240 million. However, if the company has up to R$4.8 million of annual revenues, it is considered a small or micro company.

Micro or small companies represented roughly 45% of Bradesco's SME portfolio as of June 2023, according to data from the BCB, similar to Santander's, but higher than Itau's, which was about 30%. We think that Bradesco's sizable share of smaller companies within its SME loan book could be one of the reasons for its lagging performance recently. Smaller companies tend to be more sensitive to economic cycles.

Some Large Banks Have Continued To Report Sound Profits, Albeit Below Historical Average

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The three largest private Brazilian banks all reported profits in 2023. However, while Banco Santander's and Bradesco's were close to 10%, below their historical average, Itau's was close to 20%, slightly higher than its five-year average. A significant part of that difference in profitability came from rising NPL levels.

Banco Santander's ROE for 2023 was 11.8%. Banco Santander (Brasil)'s asset quality ratios worsened in 2022. Since then, the bank has tightened its underwriting practices, expecting a tougher credit cycle. As a result, the loan portfolio grew slower, but with stronger clients and a greater focus on collateralized loans like payroll deductible loans, car loans, and mortgages.

The analysis of new vintages of credit performance indicates stronger credit quality that should support profitability in the longer term, but currently the more conservative strategy has undermined the bank's margins.

Bradesco's annualized return on average common equity (ROAE) was around 10% in 2023, below its 10-year average of about 16%. While the cost of risk continued to drag Bradesco's results in 2023, we believe the insurance unit partially cushioned the hit. Net income remained subpar in 2023, markedly dragged by banking results, and loan loss provisions continued to lower its profitability. While credit cards' NPLs started to improve after peaking midyear 2023, SMEs continued to deteriorate. In addition, market margin results remained timid.

Conversely, Bradesco's life and property/casualty insurance units generated healthy profits, partially offsetting the impact of the lower banking results on the group's profitability.

Itau's ROE was 19.5% in 2023, which is above its peers. Its operating performance benefited from strong net interest income despite lower credit portfolio growth. Despite higher provisions for credit losses from risks associated with the weaker economy in Brazil, Itau reported 15% growth in adjusted net income compared with the same period in 2022. The resilient operating performance was a result of strong net interest margins amid decreasing interest rates. Moreover, Itau was able to sustain its lending growth at just 3.1% year over year, led by growth in personal loans, residential mortgages, and large corporates.

2024 Looks Somewhat Brighter For Top Private Banks, But There Are Challenges Ahead

Overall, we think that 2024 will be somewhat better to large banks. Banking system's return on average equity (ROE) should be at 14%-16% this year. We predict that credit costs will moderate in 2024, as asset quality stabilizes, particularly for the large banks that were hit harder. We predict that the banking system's NPLs will end 2024 somewhere between 3.0% and 3.5%, and we expect lending growth to remain contained this year, at 6.0%-10.0%, as banks should continue being cautious as they seek to protect their balance sheets.

However, we still see pressure for SME exposures. While interest rates have been declining, they remain high, and their effects on loans will take longer to cease. Additionally, while net interest margins (NIMs) should continue supporting the banks' capacity to absorb losses, they could be strained this year. Large banks' NIMs could be contained by the competition from digital banks and fintechs, which are gradually gaining scale, improving their cost structure, and widening their scope of activity. Moreover, margins could face pressure from regulatory interest caps, like the interest rate limit for payroll-deductible loans and interest accumulation limit for credit cards loans.