Fitch Ratings has affirmed Banco do Brasil S.A. (BdB)'s Long-Term Foreign and Local Currency Issuer Default Ratings (IDRs) at 'BB-' and National Rating at 'AA(bra)'.

The Rating Outlooks are Stable. In addition, Fitch has affirmed BdB's Viability Rating (VR) at 'bb-'. A full list of rating actions follows at the end of this rating action commentary.

Key Rating Drivers

Government Support Drives Ratings: BdB's IDRs are driven by potential government support and equalized with those of Brazil's sovereign (BB-/Stable), which is reflected in the banks' Government Support Rating (GSR) of 'bb-'. Fitch believes there is a moderate propensity of government support, if the need arises. This assessment balances Fitch's view that the Brazilian government's willingness to support BdB if needed is high given BdB's ownership structure, its key policy role in rural lending and BdB's systemic importance. However, the sovereign has limited financial flexibility and capacity to provide support as indicated by its 'BB-' IDRs.

Despite BdB's high linkage with the sovereign rating, substantive enhancements to the company's governance structure and efforts to isolate itself from government intervention have materially improved BdB's business and financial profile in recent years. While Fitch's base case assumes no structural change of the bank's overall strategy in the near term, Fitch will continue to monitor the potential for federal government interference that could materially affect BdB's role and financial metrics.

The National Ratings reflect the entities' creditworthiness in local currency relative to that of other Brazilian issuers.

Sound Standalone Profile: BdB's VR is driven by its leading and diversified banking franchise in Brazil, supporting consistently healthy profitability and a granular and stable funding franchise. The ratings also consider BdB's adequate capitalization and a well-balanced lending mix that results in good asset quality relative to industry averages.

However, the VR is one notch below the implied VR of 'bb' as the rating remains highly linked to the sovereign, given BdB's majority federal ownership, and could be constrained in the future if a change in its business model negatively affects the bank's risk profile.

Diversified Business Profile: BdB's strong and diversified franchise is a key rating strength and results in resilient structural profitability and access to large, stable deposit bases. BdB is the leading domestic bank, accounting for 15% and 16% of Brazilian banking system assets and deposits, respectively, and is particularly strong in the agricultural segment (56% market share). Revenue diversification is strong by income stream and has allowed the bank to generate capital consistently across economic cycles.

Adequate Asset Quality: BdB has maintained stable and stronger asset-quality indicators than domestic peers due to its improved underwriting standards, lower exposure to unsecured lending relative to its main peers and a large share of rural loans that benefits from better economic fundamentals than the national average. At end-March 2023, the 90-day nonperforming loan (NPL) ratio was a low 2.6% and its impaired loan ratio was 8%, roughly in line with the bank's four-year average despite macroeconomic challenges. Maintenance of high reserves support an NPL coverage of above 200% (impaired loan coverage of 70%) and provides a sound buffer against downside risks from asset quality deterioration.

Fitch expects some asset-quality deterioration in 2023 as the effects of high interest rates and high inflation will become more evident on borrowers' repayment capacity, in particular for some SMEs and unsecured lending. However, Fitch expects moderate deterioration, with BdB's impaired loan ratio remaining closely in line with current levels over the next two years, aided by a large share of well-performing rural and secured payroll loans.

Earnings Resilience: BdB's domestic franchise and diversified business model have led to resilient income through the cycle despite revenue pressures. Revenue quality is good, with significant contributions from fee and insurance income. The acceleration of efficiency and commercial measures has supported strong revenue growth and led to profitability metrics above historical averages.

The bank's operating profit/risk-weighted assets ratio of 4.0% in 1Q23 (2022: 2.9%) reflected higher lending revenues and business volumes, as well as higher yields on government bonds. Fitch expects the operating profit/risk-weighted assets ratio to remain above 3.5% in 2023, driven by the higher interest rate and growth environment.

Capitalization Commensurate with VR: BdB's common equity Tier 1 (CET1) ratio of 12.0% at end-March 2023 was in line with the previous year despite high balance-sheet growth, and was supported by BdB's sound capacity to generate earnings and the maintenance of adequate buffers above regulatory requirements. Fitch expects the bank to operate with a CET1 ratio at around or just above 12% over the rating horizon, including the repayment schedule of BRL8.1 billion in hybrid instruments that are currently accounted as CET1 capital and will be repaid in roughly equal eight instalments until 2029.

Furthermore, part of the resources provided by the Fundo Constitucional de Financiamento do Centro-Oeste - (FCO), which comprises the bank's entire Tier 2 capital, are subject to a 10% annual phase out between 2021 and 2029. Given the bank's good internal capital generation prospects, these reductions are likely to be manageable from a capital adequacy point of view.

Diversified Funding, Stable Liquidity: Fitch views BdB's funding and liquidity as stable and a positive driver for its VR, supported by its large deposit franchise with frequent access to secured and unsecured wholesale markets. The bank's liquidity position is sound and supported by large buffers of high-quality liquid securities. The core metric of loans to deposits of 118% increased slightly at YE22 from YE20 pre-pandemic level of 113% as loan growth accelerated and deposit growth moderated, but we expected the ratio to stabilize as loan growth decelerates in the coming years.

Rating Sensitivities

Factors that Could, Individually or Collectively, Lead to Negative Rating Action/Downgrade

IDRs, GSR and VR

Rating downside is primarily contingent on a downgrade of Brazil's IDRs, though this is not Fitch's base case given the Stable Outlook on the sovereign's Long-Term IDRs. BdB's ratings are also sensitive to changes in its strategic importance to the Brazilian government, which is not expected to change;

BdB's VR would be negatively affected if its CET1 ratio falls below 10% and/or its regulatory capital ratios approach the minimum requirements, due to a combination of asset quality deterioration, weakening of profitability or higher than expected growth.

National Ratings

BdB's National Long-Term Rating is also sensitive to a negative change in Fitch's opinion of the bank's creditworthiness relative to other Brazilian issuers'.

Factors that Could, Individually or Collectively, Lead to Positive Rating Action/Upgrade

IDRs, GSR and VR

An upgrade of the GSR and Long-Term IDRs would require a sovereign upgrade. In addition to a sovereign upgrade, the bank would have to maintain healthy financial metrics to upgrade the VR.

National Ratings

BdB's National ratings may be affected by a change in Fitch's perception of the bank's local relativities with respect to other Brazilian entities.

OTHER DEBT AND ISSUER RATINGS: KEY RATING DRIVERS

BdB's 'BB-' senior debt rating is in line with the bank's Long-Term Foreign Currency IDR, as default on senior obligations is equal to the default of the bank.

OTHER DEBT AND ISSUER RATINGS: RATING SENSITIVITIES

Factors that could, individually or collectively, lead to negative rating action/downgrade

BdB's senior unsecured debt ratings are sensitive to a change in its IDR.

Factors that could, individually or collectively, lead to positive rating action/upgrade

BdB's senior unsecured debt ratings are sensitive to a change in its IDR.

VR ADJUSTMENTS

The VR of 'bb-' has been assigned below the 'bb' implied VR due to the following adjustment reason: Risk Profile (negative)

The Asset Quality score of 'bb-' has been assigned above the 'b' category implied score due to the following adjustment reason: Collateral and Reserves.

Best/Worst Case Rating Scenario

International scale credit ratings of Financial Institutions and Covered Bond issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

Public Ratings with Credit Linkage to other ratings

Bdb's ratings are equalized with Brazil's sovereign rating.

ESG Considerations

Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg.

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