OREANDA-NEWS. Investigations into allegations that Brazilian banks may have been involved in longstanding bribery of tax officials and members of the Tax Appeals Board to either waive or reduce tax payments could add to the pressures on the Brazilian banking sector, says Fitch Ratings.

The operating environment for banks has become increasingly difficult since 2014 and challenges are likely to persist, as suggested by the Negative Outlook on the sovereign's 'BB' rating and on several bank ratings. Performance indicators in the sector are down: net returns on average assets reached 0.9% in March 2016, against 1.3% in 2015; and the sector's impaired loans are rising, albeit slowly, to 3.5% of total loans at end-June 2016, against 3.3% at end-2015 and 2.7% in 2014.

Brazil's federal public-sector prosecutors are investigating allegations, codenamed Zelotes, that a large number of companies may have been involved in corruption schemes to lower their tax payments over many years. Media reports suggest that tax revenues lost through bribery could be as high as BRL19.95bn (USD6.3bn), equivalent to 0.5% of GDP. Zelotes comes on the heels of other corruption investigations underway, which could further create risks for investor confidence.

In March, Joseph Safra, the largest shareholder in Banco Safra, a prominent medium-sized bank with 2% market share, was charged with tax irregularities and in July, the CEO and other senior executives of Banco Bradesco, a leading, systemically important private bank, were also accused. In our view, neither bank has yet suffered financially as a result of the investigations nor have we seen evidence that reputation risk is spreading and damaging the franchise.

Bradesco's liquidity position is strong, held up by extensive and stable retail deposits and it operates with ample cash. In times of macroeconomic turbulence, Bradesco tends to see an inflow of deposits as it benefits from flight to quality. Its funding sources increased 10% in the 12 months ended June 2016. Media reports indicate that changes on the executive board are being considered but in our opinion, the bank's management team is deep. The tax investigations should not disrupt either the bank's day-to-day operations or the implementation of its strategy.

Safra's case is different and in our opinion, reputation risk from the investigation is higher for all companies associated with the Safra name. The bank carries the family name and if this were to suffer permanent tarnishing as a result of the investigations, its franchise could be significantly eroded.

When banks are closely associated with their key executives and/or shareholders, this can expose them to reputation risks, which can rapidly translate into other risks. For example, we downgraded Banco BTG Pactual in December 2015 following news that its CEO and largest shareholder had been arrested. This triggered reputation damage at the bank, leading to serious liquidity problems which have since stabilised. In our view, BTG Pactual, a wholesale-funded bank, was far more likely to experience liquidity problems than either Bradesco or Safra but the incident highlights potential reputation risks for this type of bank.

We do not expect the Zelotes investigations to interrupt the businesses of either Bradesco or Safra. Fines could be imposed on the banks and, if this is the case, we will assess the impact on their profitability and ratings.

Should the Zelotes investigations widen to include a larger number of banks, risks for smaller players with more unstable funding bases could be considerable.

Bradesco and Safra, are respectively rated 'BB+' and 'BB', and the Outlooks in both cases are Negative.