OREANDA-NEWS. August 11, 2015. Brazil's challenging macro environment increases the potential for mergers and acquisitions among midsize Brazilian banks, says Fitch Ratings.

High inflation, high interest rates, GDP contraction and rising unemployment hinders bank profits and increases the challenge of boosting capital to meet the Basel III phase in, among other challenges, opening the door for more M&A potential for midsize banks, in Fitch's view.

Even though Brazil's midsize banks do not face the magnitude of regulatory burdens of large banks, challenging regulatory constraints overseas and the scrutiny of international banks in regards to their correspondent banking has reduced the relative value of Brazil's midsize banks. Lower valuations on Brazil's midsize banks make them more attractive to those foreign banks that are less constrained by regulations in growing overseas. Furthermore, many of Brazil's small and midsize banks generally demonstrate the willingness to preserve good asset quality, thus the credit impact of the challenging macroeconomic environment has been relatively modest on these banks.

Around 80% of the assets in Brazil's banking sector are concentrated in the country's 10 largest banks, with a large number of small and midsize banks playing smaller roles. Such concentration will further increase when the acquisition of HSBC's Brazilian operation by Bradesco, announced this week, is concluded.

Given the concentration of the Brazilian banking system, the largest private banks, Itau, Bradesco and Santander, already count on a broad range of products and have access to cheap source of funding, thus the acquisition of a midsize or small bank would not bring relevant synergies. Because of that, a more likely scenario is that midsize banks are targeted by new entrants, such as foreign banking groups with appetite for investing in the country.

Among possible suitors are Chinese banks, which have already made a couple of acquisitions in the country (CCB and Bicbanco: October 2013 and Bank of Communications and BBM: May 2015), in addition to others that have already obtained banking licenses to operate in the country, such as ICBC and Bank of China.

A possible, yet less likely scenario would be mergers between small and midsize Brazilian banks. Most small and midsize banks in the country are family-owned, which generally increases the challenges of integrating the operations and aligning the corporate cultures of managers and controlling shareholders. Also, such mergers would still tend to not result in access to cheaper funding and capital, which can be a key benefit to merging to gain better competitiveness with the larger Brazilian banks.