Latin America Equity Research Financials – Banks July 2012

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Financials – Banks Banking team Victor Galliano Analyst HSBC Securities (USA) Inc

+1 212 525 5418

[email protected]

Mariel Santiago Analyst HSBC Securities (USA) Inc

+1 212 525 5418

[email protected]

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Latin American Banks

Brazil Itau Unibanco Bradesco Banco do Brasil Santander Brasil Banrisul

Mexico Banorte Compartamos Findep

Perú Credicorp

Colombia Bancolombia

Argentina Grupo Fin. Galicia BBVA Banco Frances

Chile Banco de chile Santander Santiago Corpbanca

Latin America Equity Research Financials – Banks July 2012

Sector structure

ABC Brasil BIC Banco Daycoval Pine Source: HSBC

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Latin America Equity Research Financials – Banks July 2012

Latam banks price-to-book values

Source: Thomson Reuters Datastream, HSBC

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3

4

2 9%

2 7% C OM PAR C 2 5%

Latin America Equity Research Financials – Banks July 2012

PBVs versus ROEs Latam banks

2 3% B AP

2 1% BB D IT U

BR S R 2012e ROE

1 9%

AB C

1 7%

P IN E

C IB

DA Y C

B BA G FNO RTE

1 5%

BIC

1 3%

1 1%

F IN DEP SA N B

9% 0. 5

1.5

2. 0 2012 e P B V

2 .5

3. 0

3. 5

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Source: HSBC, consensus estimates

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Latin America Equity Research Financials – Banks July 2012

Sector description The banking sector functions as an intermediary between sources of capital (investors and depositors) and users of capital (individuals, corporations and government). Banks make money on the spread between interest paid to those from whom it raises funds, and interest charged to those who borrow from it, and for other services offered to depositors and lenders. Latam banks’ services and products include lending and deposit-taking, credit/debit card issuance, consortium management, insurance, leasing, payment collection and processing, pension plans, asset management, and brokerage services. Following consolidation of the financial services sector in Latin America in recent years, an increasing number of firms operate in more than one of these businesses. However, there do remain small banks that still derive the bulk of their income from one source.

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Victor Galliano Analyst HSBC Securities (USA), Inc. +1 212 525 5253 [email protected]

In providing these products and services, banks take on three major risks: credit risk (the risk that a borrower will not repay a loan), interest rate risk (changes in the yield curve may change funding costs and asset yields), and liquidity risk (the risk, usually in a crisis, that assets cannot be liquidated quickly enough to cover any short-term funding deficiency). The main revenue sources for banks are:  Net interest income, defined as the difference between the interest rate earned on assets and the interest rate paid on liabilities: typically 65%+ of revenues.  Fee and commission income, includes account fees, overdraft fees, payments, arrangement fees, guarantees as well as asset management and insurance: typically 25% of revenues.  Trading income, derived from transactions in securities/derivatives/FX. Also, banks hold securities to manage their liquidity. Banks need to mark-to-market their securities, leading to valuation gains/losses. Trading income is typically 10% of total revenue. Among the top publicly listed banks in Latin America are Banco do Brasil, Itaú-Unibanco, Bradesco, and Banco Santander Brasil in Brazil; Grupo Financiero Banorte in Mexico; Bancolombia in Colombia; and Credicorp in Perú.

Key themes A common feature during the recent financial crisis has been the ability of financial systems across Latin America to remain sound despite the global crisis and resulting recession in several industrialized economies. This reflects reforms put in place by many Latin American countries over the last five years to adopt sound macroeconomic measures and to strengthen financial sector supervision. In addition, Latam banks are well-capitalized and have benefited from stable domestic funding, even during periods of global liquidity constraints. Latam banks have been growing market share in their home markets, expanding their credit portfolios, as well as growing their deposit bases.

Margins and spreads in a low benchmark rate climate All Latam banks under our coverage are asset sensitive, meaning interest rate changes impact asset yields more than they impact funding costs which results in a margin decline when interest rates decrease. The recent economic downturn has led governments to lower interest rates to stimulate growth. This,

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Latin America Equity Research Financials – Banks July 2012

combined with historically low benchmark rates in the region, has resulted in spread erosion in the banking sector. If Latam economies maintain interest rates at low levels, there could be further margin pressure in the banking sector going forward. Latam banks do have some protection to margins and spreads from fixed rate portfolios, at least in the near term.

Credit quality: structural developments One crucial factor in the structural improvement for credit quality is, we believe, the deepening of credit data – as provided by credit bureaus – in the region. There are broadly three types of credit bureaus: negative bureaus track historical default data, and share the data with banks; segmental positive bureaus share default and payment data with entities of the same segment (banks with banks, retailers with retailers); comprehensive positive bureaus share positive data across separate segments, so entities get the broadest view of the potential credit risk. The creation and full implementation of comprehensive positive credit bureaus should result in structurally lower delinquency rates – good for banks – as well as potentially lower borrowing rates – good for borrowers – as more complete credit quality data reduce credit risk. Colombia has a comprehensive credit bureau in operation, as has Mexico. Brazil is in the process of shifting from negative to positive, and Chile has a negative credit bureau only, although there are regulatory moves in Chile to transition to a positive credit bureau. Successful implementation should depend on maximum participation of lenders as well as borrowers. If we look at the case of Mexico, there has been both a positive and negative credit bureau established since 1997. However, the effectiveness of the positive credit bureau was limited by two of the largest banks in Mexico. They did not allow the bureau to share their information on borrowers with the rest of the sector, maintaining the barriers on asymmetry of borrower information. In 2009, the CNBV, the Mexican banks’ regulator, required mandatory sharing of all positive credit data in the bureau, including non-bank providers of data, which has resulted in a fuller, more representative picture of credit quality data available to lenders. This development has likely contributed to lower delinquency rates. Brazil is in the process of adapting from negative to positive credit bureau, which may be in place by 4Q 2012. One catch in Brazil is that the consent of the potential borrower is required in order to be included in the positive credit bureau, yet the attraction of potentially lower borrowing rates in, for example, credit cards and other unsecured credit could help to accelerate the process. In addition, the successful Brazilian implementation of the positive credit bureau is likely to require a catalyst like the mandatory disclosure of positive credit data for all banks; this could lead to some delay to the full implementation of the positive credit bureau for at least a couple of years in Brazil.

Capital adequacy: balancing credit growth with Basel III implementation Bank regulators have created common international bank capital standards, called the Basel rules. Basel II guidelines set in 2004 laid out international standards for banking regulators to control how much capital banks needed to put aside. Deficiencies in these rules were revealed during the 2008 financial crisis, and have resulted in an updated set of bank regulation guidelines called Basel III, which focus on quality as well as quantity of capital and liquidity levels. Basel III requires stricter regulatory adjustments against the highest quality form of capital, Tier 1 capital, which is composed of common shares and retained earnings and also raises capital requirements for banks. Banks will have to comply gradually with the new, stricter rules, as the full implementation of Basel III is expected by the end of 2019. Latam banks

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Latin America Equity Research Financials – Banks July 2012

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have capital ratios usually well above the minimum industry requirements. After adjustment for compliance with the definition of capital under Basel III, Latam banks capital ratios should see some capital adjustments; however, the long implementation timeline and the fact that many Latam banks’ capital ratios are above the Basel III minimum standards should limit the impact of the new regulation on lending, particularly for big-cap players, and so minimize the need for raising additional equity capital.

Funding in a liquidity-constrained world Funding remains one of the key issues in the banking sector in the current economic environment. This relates to both internal (pertinent to a specific bank) and external factors, such as perceived country risk, for example. Domestic funding remains available in Latam at relatively attractive cost. In Brazil for example, the primary retail funding instrument of banks is the CDB (certificates of deposits), with the average maturity of a CDB being less than one year; yet deposits can be redeemed by customers prior to maturity. Foreign markets issuance is an alternative in the case of longer maturity funding, but under current market conditions and given scarcer liquidity, this source has become more expensive. This tougher funding climate motivated the creation of domestic instruments to meet the increasing demand for long-term funding for financial institutions. Brazil, for instance, launched in 2009 one important funding instrument, Financial Debentures (Letras Financeiras), which has a minimum term of two years. In less than two years, Brazilian banks have raised nearly BRL200bn via Letras Financeiras, equivalent to 16% of total core funding at the end of April 2012. In general, Latam banks have healthy capital ratios and liquidity positions that should allow stable credit growth.

Sector drivers The Latam banking sector has been resilient in the face of recent global financial turmoil. However, the structural profitability of the regional banking industry has been adversely impacted, reflecting more conservative structuring of balance sheets, greater regulatory oversight, and a historically low interest rate environment. Looking ahead, loan growth, credit quality, and interest spread improvement are the key drivers of banks’ earnings. Loans/deposits growth: These are mainly related to GDP growth, as lending demand is normally positively correlated to expanding economic conditions and vice-versa. Deposit growth is more a function of market yield, alternative investment opportunities and gearing ratios but is, again, correlated to economic conditions. Interest rates: Cost of money is based on a spread banks apply to interest rates. Although spreads are controlled to a large extent by banks, the level of interest rate is given by the market. Banks tend to prosper in a high interest rate environment (when the spreads between assets and liabilities tend to be wider) and vice versa. The steepness of the yield curve is also a key factor, as banks normally tend to spread their financing according to the different rate levels along the curve – for example making the spread the differential between short rates (lending or borrowing) and long rates (borrowing or lending). Asset quality and loan loss provisions (LLPs): Non-performing loans (NPLs) tend to increase in periods of economic difficulty, when there is low GDP growth and rising unemployment for example, thereby forcing banks to increase LLPs and write-offs. NPLs and unemployment growth are closely correlated. Empirical analysis also suggests that LLPs and GDP growth are relatively well correlated.

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Latin America Equity Research Financials – Banks July 2012

Valuation Implied PE Banking stocks are generally valued on PE multiples, although book value multiples dominates in periods of low earnings/recession. We value our stock universe using a core valuation methodology of implied PE, as we believe this best captures both growth potential and return on equity (ROE). This valuation metric takes into account the most critical factors highlighting the financial performance of a banking institution (ROE, COE, growth and BV). The implied – or target – PE multiple is defined as ROE less long term growth (ROE-g) divided by ROE times cost of capital less long-term growth (k-g). In essence, implied PE is implied PBV (Gordon’s Growth Model) divided by ROE. Implied or Target P/E = [ ( ROE – g ) / (ROE * (k-g )) ] “g”: reflects the prospective growth of the bank in the long term. It is estimated by taking into account net profit CAGR (for historic as well as future periods). Many analysts assume this rate above the long term GDP growth of a country, when the latter is under-banked and vice versa. Cost of capital “k”: calculated as the sum of risk free rate and market risk premium (adjusted for beta). Based on the level of disclosure transparency, the free float, and the market cap, the equity risk premium can be adjusted accordingly. “ROE”: reflects the bank’s ability to deliver profitability under stable market conditions in the long term. Over the past five years the sector has experienced more consolidation (eg, in Brazil, Banco Itaú and Banco Unibanco merged in 2008; in Mexico, GFNorte merged with Ixe in 2011) and this has boosted intangibles on the balance sheets such as goodwill; as a result, investors are increasingly using valuation metrics based on tangible book values (PTBV) and return on tangible equity (ROTE).

Latam banking sector

Brazil (BRLbn) Loans Deposits Asset Quality (90 day) Net Interest margin (%) Mexico (MXNbn) Loans Deposits Asset Quality (90 day) Net Interest margin (%) Colombia (COPbn) Loans Deposits Asset Quality (30 day) Peru (SOLbn) Loans Deposits Asset Quality (30 day) Note: based on banking sector data for each country. Source: HSBC estimates

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2007

2008

2009

2010

2011

734 865 3.2% 5.9%

934 1,201 3.2% 5.8%

1,077 1,252 4.3% 5.6%

1,325 1,366 3.2% 5.3%

1,679 1,610 3.6% 5.5%

1,654 2,020 2.5% 5.0%

1,871 2,340 3.2% 4.6%

1,969 2,394 3.1% 2.7%

2,127 2,628 2.3% 3.6%

2,460 2,814 2.5% 3.7%

125,062 144,559 3.3%

147,174 40,384 4.1%

150,574 153,726 4.2%

175,904 167,935 2.9%

215,305 200,871 2.5%

66.8 69.0 1.3%

91.9 91.1 1.3%

92.4 93.7 1.6%

109.7 112.3 1.5%

128.4 126.1 1.5%

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Latin America Equity Research Financials – Banks July 2012

Sector snapshot

Bradesco Top 10 stocks

1Q12

3Q11

1Q11

3Q10

1Q10

Banco do Brasil

Itau Un

Source: Company reports, HSBC

Stock rank

Stocks

1 2 3 4 5 6 7 8 9 10

ITAU UNIBANCO PN BRADESCO PN ITAUSA PN BMF BOVESPA ON GFNORTE 'O' CREDICORP SANTANDER BR UNT BANCO BRASIL ON PFBCOLOM PF. BSANTANDER

Index weight 4.33% 3.86% 1.47% 1.29% 1.26% 1.14% 0.78% 0.75% 0.68% 0.66%

Latam banks PE band chart

19 17 15 13 11 9

Source: HSBC, Thomson Reuters Datastream, MSCI, I/B/E/S, At June 30, 2012

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Country breakdown

Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12

Weights (%)

COLOMBIA PERU BRAZIL CHILE MEXICO Source: HSBC, Thomson Reuters Datastream, MSCI, I/B/E/S, At June 30, 2012

38.88 36.72 24.02 15.78 8.87

MSCI Latam banks PE band Source: Thomson Reuters Datastream, MSCI, HSBC

PB vs. ROE 29% 27%

COMPARC

25% 23%

BAP

21% 2012e ROE

Country

3Q09

*Performance includes dividends Source: HSBC, Thomson Reuters Datastream, MSCI, I/B/E/S, At June 30, 2012

1Q09

0.93

3Q08

878.30% 40.28% ITUB4.SA, BBDC4.SA, ITSA4.SA

1Q08

686.84 169.63

70% 60% 50% 40% 30% 20% 10% 0% -10% -20%

3Q07

Trading data ADTV (5 Year) (USD mn) Free float market cap (USD bn) Performance since 1 Jul 2002* Absolute Relative to MSCI EM Latam 3 largest stocks Correlations (5-year) with MSCI EM Latam

1Q07

21.28% of MSCI EM Latam

3Q06

Financials

1Q06

Core industry driver: Loan growth

Key sector stats

BRSR

19% ABC

PINE

17%

ITU

CIB

DAYC

BBA 15%

BBD

GFNORTE

BIC

13% 11%

FINDEP SANB

9% 0.5

1.0

1.5

2.0 2012e PBV

2.5

3.0

3.5

Source: Thomson Reuters Datastream, HSBC, consensus estimates

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