OREANDA-NEWS. Rising loan impairment charges are reducing profitability in Brazil's banking sector and this will affect banks' ability to generate capital internally, says Fitch Ratings. If Brazilian banks strengthened their capacity to absorb unexpected losses, this would mitigate the impact of the country's deep recession, which is forcing up non-performing loans (NPL).

Sector-wide NPLs as a percentage of gross loans are rising, but the deterioration across loan portfolios is not as bad as might have been expected considering the weakness of the operating environment. At end-May 2016, NPLs represented 3.8% of total banking sector gross loans, up only slightly from the 3.4% reported at end-2015 and 2.7% at end-2014.

NPLs in Brazil are reported once they are 90 days overdue, as is the case in many countries, and reported figures provide a backward-looking indication of asset quality. Our base case, which uses our forecast for a 3.8% contraction in GDP and a rise in the unemployment rate to 12% from the current 11.2%, is that the NPL ratio rises to 4.2% by end-2016. A more stressed scenario, using a 4.5% contraction in GDP and unemployment climbing to 14%, indicates that NPLs would reach 4.9%. Our forecast is that GDP will return to modest 0.5% growth in 2017 but we expect banks' asset quality to continue to deteriorate even as economic growth returns.

Our base case assessment is that loan impairment charges will rise by about 20% in 2016 and continue to weigh on profitability. The system as a whole will, in our opinion, post modest profits in 2016 and 2017, but trends will diverge across the banks.