Fitch has affirmed Banco BMG S.A.'s (BMG). Foreign and Local Currency Long-Term Issuer Default Ratings (IDR) at 'B+', Viability Rating (VR) at 'b+' and National Long-Term Rating at 'A(bra)'.

The Rating Outlook on the Long-Term IDRs and National Rating is Stable.

Fitch has withdrawn BMG's Support Rating of '5' and the Support Rating Floor of 'NF'; as these are no longer relevant to the agency's coverage following the publication of its updated Bank Rating Criteria on Nov. 12, 2021. In line with the updated criteria, Fitch has assigned BMG a Government Support Rating (GSR) of 'ns' (No Support). This is based on Fitch's belief that the bank is not considered to be a significant financial institution locally because of the size of its market share. Thus, it is unlikely to receive external support from the Brazilian sovereign.

Key Rating Drivers

Despite the challenges the pandemic posed to the domestic environment, given the financial system's historical resilience and stable performance in times of stress, Fitch has revised the Operating Environment (OE) score mid-point to 'bb-' from 'b+', in line with the implied score as per Fitch's criteria. However, the score has a Negative Outlook, as risks tied to high inflation, increased household indebtedness and electoral uncertainty in Brazil remain as main downside risks of banks' performance and risk profiles in the medium term. The revision of the OE midpoint resulted in a change to the benchmark ranges used by Fitch to determine the implied rating scores.

BMG's intrinsic creditworthiness, as expressed by its VR of 'b+' underpins its IDRs. The VR is in line with the implied VR and takes into account the bank's business risk and financial profiles. BMG's national ratings reflect its creditworthiness relative to Brazilian peers. The Outlook on the Long-Term ratings is Stable as Fitch expects the bank's performance to remain within the benchmarks of its current ratings.

The bank's company profile remains satisfactory as BMG has continued to grow its traditional, lower risk, pension/payroll-backed (consignado) credit portfolio. This portfolio consists primarily of its payroll credit card product, followed by its payroll loan product, together accounting for 64% of the total credit portfolio and the bulk of its of revenues, of which the great majority have the risk of the federal government.

To diversify its sources of revenues, the bank has also enhanced a handful of other retail and wholesale products and invested heavily to grow its digital bank capabilities, which has already seen its number of digital account holders reach 7.4 million as of June 30, 2022.

Following credit portfolio growth of 14% during 2021, the bank was able to increase the size of the credit portfolio by nearly 30% during the first half of 2022. Fitch believes the growth is sustainable if asset quality continues to remain satisfactory and further deterioration in capital ratios is not very relevant. BMG has also been active at growing a variety of other revenue sources such as its insurance products and the FGTS lending product. BMG's focus is 90% retail-oriented. The bank also has a wholesale portfolio that is managed conservatively, favoring secured transactions.

Achieving consistent, recurring operating profitability over the past few years continues to be a challenge for BMG. Operating profitability was near break-even (0.2% for full-year 2021 and for the first half of 2022). This was due in part to rising funding costs and the continued regulatory caps on interest rates, notably in the payroll businesses. In addition, operating expenses, such as investments in new products and systems, and personnel costs remain high as the bank added new employees. Credit costs have also remained high due to conservative provisioning.

Furthermore, the bank also maintained a high level of liquidity which adds to carrying cost expenses. The bank's return on average assets and return on average equity at June 30, 2022 was only 0.55% and 5.23% respectively. Management expects stronger profitability ratios in the coming quarters as it begins to benefit from the various investments to reduce costs and credit impairments and benefits from the increased volume of clients and the resulting cross-selling opportunities.

BMG's capitalization ratios remain adequate despite a recent reduction driven in part by an increase in risk-weighted assets and other capital reductions. As of June 30, 2022, the bank's Common Equity Tier I ratio was slightly under 12% and the total capital ratio was 13.4%. Over the medium term, Fitch expects a strengthening of these ratios.

Asset quality remains satisfactory as BMG's impaired loans (BACEN D-H) to gross loan ratio remained on a generally a positive trend over the past five years, coming in at 5.6% at June 30, 2022 down from 6.4% at Dec. 31, 2021. Based on non-performing loans over 90 days, (BACEN E-H) the impairment ratio improved to 4.4% and the loan loss coverage ratio is at a satisfactory 104%.

Management expects asset quality to continue to improve as the bank maintains its main focus on secured lending, which usually has a lower level of impairment. For instance, the impairment level of the bank's largest credit product segment, the payroll/pension-backed credit card product at June 2022 was only 2.3% compared with 3.3% at June 2021. It is also worth noting that some of the less representative, unsecured credit products have, as expected, much higher average NPL ratios, but this is mitigated by premium pricing. The fact that the vast majority of the payroll-backed credit product is tied to federal government risk (85%) serves as a mitigation to asset quality deterioration.

For the past few years BMG has been operating with a comfortable liquidity position, which was partially enhanced by securitizations of receivables, funding from diversified customer deposits and the strategic downsizing of its commercial portfolios. The bank's loans to customer deposits ratio at June 30, 2022 was at a conservative level of approximately 92%. The bank's liquid asset position also remained high at BRL 3.8 billion. These levels are expected to decrease during the next few quarters to support credit growth and improve profitability.

Rating Sensitivities

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

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

Weak financial performance (negative trend in operating profit-to-risk-weighted assets from current low levels);

A sustained deterioration in its asset quality (non-performing loans over 90 days remaining above 8%);

A deterioration in capitalization (CET I ratio falling below 9%).

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

Positive trends in its credit metrics (notably asset quality and operating profits) could result in IDR and National Rating Outlook revisions to Positive within the next 12 to 18 months;

A consolidation of the bank's business model, including a relevant and sustained improvement in its operating profitability, especially if coupled with further and sustained declines in its impaired loan ratio (D-H) to below 5% of total loans, without deteriorating charge-offs and foreclosed assets;

Maintenance of CET 1 ratio above 12%.

VR ADJUSTMENTS

The Earnings and Profitability Score of 'b' has been assigned below the implied 'bb' Earnings and Profitability Score due to the following adjustment reason: Revenue Diversification (negative).

The Funding and Liquidity Score of 'b+' has been assigned below the implied 'bb' Funding and Liquidity Score due to the following adjustment reason: Deposit Structure (negative).

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.

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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