Multinational companies command a dominant position in several industrial sectors in Brazil, yet the big banking groups, such as Banco Itaú, are largely locally owned. Founded by a São Paulo lawyer in 1945 and controlled by the Villela and Setubal families, Itaú has been a leading shaper of the banking landscape during decades of steady organic growth and well-chosen acquisitions. Today it boasts a strong domestic franchise, a sound capital base, and a sparkling 35.6 percent return on equity—a level of performance that made it Latin America's most profitable bank in 2005.

High interest rates have historically provided a volatile and risky environment for Brazilian banks, though the successful ones have achieved wide margins between their cost of funds (mostly from deposits) and the rate they charge borrowers. The growing prospect of a more stable and sustainable economic environment, cheaper money, and rising consumer income thus represents a challenge as much as an opportunity for the leading players.

Itaú looks well positioned to take advantage of these changes. Its mid-2006 acquisition of Bank of America's BankBoston Brazil unit and other Latin American assets in exchange for a 5.8 percent stake in the bank was eloquent testimony to its reputation.

The bank's chief executive, Roberto Egydio Setubal, combines deep knowledge of the Brazilian market with broad experience in international finance. Educated at Stanford University and groomed at Citibank, he currently serves as a member of the international advisory committees of the Federal Reserve Bank of New York and the New York Stock Exchange.

In this conversation with McKinsey director Alexandre Gouvea, he talks about, among other things, the region's economic and political future and low-income consumers, as well as the bank's plans for continued growth.

The Quarterly: International investors seem to favor Latin America at the moment. Is the region really that healthy and robust?

Roberto Setubal: In the 1980s, we went through a major crisis as a result of hyperinflation and invented a number of economic prescriptions that did not work. In the 1990s, however, we returned to democracy and to sounder, more orthodox economic policies. In general, in Latin America we have learned how to control inflation. The fiscal situation is healthy, and the current account is also very much on track. Even countries with populist governments still have a responsible fiscal approach. The bad news is that the region has not been able to implement an effective growth strategy and lags behind other emerging markets in this regard. Brazil is now growing at close to 4 percent per annum—much better than the average 2 to 2.5 percent of the past 20 years, but not enough given the social problems we have to solve.

The Quarterly: What, in your view, explains this growth gap, and what can be done to close it?

Roberto Setubal: I believe that we need fundamental reforms in order to improve the efficiency of the country, notably in the judicial and political fields. In Brazil the law is not always clear, and the rule of law is therefore not something that in reality always applies as expected. The political process is desperately slow because the president and the government have to negotiate every new bit of legislation with every elected representative, not just with the political parties. That's one cause, in my view, of the corruption scandals over campaign funds and other issues. With Brazil's tax burden now at 40 percent, fiscal reform also needs to be considered—the money we raise from taxes is not being efficiently invested to make the economy grow more quickly and therefore represents a burden on the private sector.

The Quarterly: Is the failure to pursue institutional reform the biggest medium-term risk?

Roberto Setubal: Even if nothing happens, I think we can continue to grow at around 4 percent in a sustainable way, and that's very good. But with the reforms I mentioned, on top of what has already been achieved, I think the whole region could grow by something like 7 percent. Whatever happens, I do not believe we will go back to the bad days of economic and political crisis. Despite the problems, our institutions work much better than they did—we have an independent congress, a judiciary that is independent of the executive, and a free press. There is a new consciousness in the heads of most people about the importance of a good fiscal situation. Hyperinflation tended to obscure the numbers. Now it's becoming more and more clear that there is no miracle, that you have to save enough money in order to service your debt and to make new investments. There's no other way to do it.

The Quarterly: How do you assess the first presidential term of Lula,¹ and what do you expect from a second term?

Roberto Setubal: Many Brazilians—the business community in particular—were afraid of having Lula as president before the last election. Yet he has turned out to be good for the business community because he kept the orthodox economic policies of Cardoso.² He has not interfered in markets and has been more interested in collecting taxes so that there is enough money to solve the country's social problems. With this in mind, he wanted the economy to do well and companies to perform well. The problem has been that Lula and members of his cabinet have not spent the money raised from taxes efficiently. They had no idea about efficient management of the public sector, made a lot of errors, and some became involved in corruption. Lula himself, in a lot of ways, has been as frustrated as anyone by this.

In a second mandate, I think he will try to choose a better cabinet rather than relying on his close friends as he did last time. I don't share the view of those who expect him to turn to the Left, though. He is not an ideological man. He is very pragmatic, he is balanced, and he wants to see results. He is open and accessible to all segments of society, including the business community. He wants to help poor people, for sure, but he understands that this has to be done in a very sustainable way and that the economy needs to be strong. I really don't think that he'll do any crazy things.

Maybe over time, taxes can be reduced to increase the rate of growth, but I don't think this is on the agenda of Lula.

The Quarterly: Brazil looks set to achieve investment-grade status for its debt. That would be quite a watershed, wouldn't it?

Roberto Setubal: Yes, I agree. I believe the country is on the route to investment grade and that this will happen two to three years down the road, depending on the international economic outlook at the time. But Brazil will get there sooner or later. The most obvious impact will be that interest rates will decline a lot, facilitating a lot of investment, especially in real estate and housing. This will push investment and growth. At the moment, for instance, mortgages represent less than 2 percent of GDP, compared with some other emerging markets where they account for 25 to 30 percent of GDP, so the potential is huge. Already we are seeing IPOs of companies that are either directly or indirectly involved in real-estate development, housing, commercial property, and construction materials. Prices of their stocks are very high compared with historical levels as investors anticipate what will happen. Other segments that are also capital intensive will benefit from lower interest rates.

The Quarterly: Turning more specifically to Itaú—and looking back over recent years—to what do you attribute the bank's success?

Roberto Setubal: About 15 years ago, we established a vision around the idea of performance leadership that was not about being the biggest or most profitable bank but much more related to value creation. This was very important to us, encouraging us to be disciplined and consistent during the many discussions we have had about acquiring other banks. On occasion, we refused to match the price of competitors because we saw no value creation possibilities.

With a value strategy at the core, we started building a strategic backbone around segmentation, technology, and convenience for the client, which put us ahead of our competitors. Our focus during the period of consolidation that started in the 1990s was always on client acquisition rather than branch development; it's the former, not the latter, after all, who deliver revenues. Once we acquired a bank, we were always concerned to consolidate it quickly in order to capture synergies and reduce costs. I think we were also ahead of the game in cross-selling. Through our technology platform—the Internet and ATMs—we have been able to offer a large portfolio of products. Our clients are able to move money between investment alternatives, such as CDs and mutual funds; to access preapproved credit lines; to buy a credit card; or to invest in a pension plan. We invested a lot in technology because I believe convenience is highly valued by clients.

The Quarterly: But aren't your rivals catching up in this respect? And with fewer acquisition targets, won't you have to develop new competitive advantages?

Roberto Setubal: Yes. When you are just one of many players, and not a leader in the market, it takes time before competitors realize what you are doing. But once you are successful, everybody pays attention and starts benchmarking themselves against your every move. So building a sustainable advantage becomes much harder. You can always do things better, of course—more sophisticated segmentation and better technology delivery, for example—but competitors are still going to be much closer than they used to be.

The Quarterly: Will the advantage in the future come from investment in new markets or better execution in existing ones?

Roberto Setubal: In Brazil, there is a lot of potential in terms of credit growth, so the winners in five years' time will be those banks that best handle this opportunity. The mortgage market, as I've said, is one that everyone's looking at, and in a few years I think you'll see Brazilian banks becoming more international. The consolidation process in this country may not be finished, but it's certainly coming to an end. There may be only two or three more deals in the market, so the opportunities for further acquisitions will soon be gone.

On the other hand, the one thing that competitors can't copy is the culture of our company, and here you can create a sustainable advantage. At the moment, we are revisiting our culture through a top-down project, which started with the first layer of executives and has since moved down to the second and third tiers. It's partly related to leadership style but focused on the constant improvement of day-to-day activities. The results have been very powerful in terms of how people work together. It's about people—especially in the middle—taking more responsibility, more initiative, more leadership. If this works, I believe we will have not one big competitive advantage but a lot of little ones spread out through the business lines and across the organization. Over time, this can be very powerful and will be much harder to copy.

The Quarterly: Specifically, which banking segments offer the most exciting prospects in Brazil at the moment?

Roberto Setubal: In the corporate and wholesale arena, where we have organized our activities under a separate autonomous vehicle called Itaú BBA, we believe that investment banking will be the business line to develop, though it is still very small as a proportion of total revenues. On the retail side, we are expanding our consumer credit unit, which we started from scratch two years ago and which already has 4 million clients—people who mostly do not have a checking account and are in addition to the 15 million customers of the bank. We realized that this low end of the market is underserved and that there was a great opportunity to develop it in association with leading retailers. The challenge, however, is credit approval, which is very tricky in Brazil because there is not always enough reliable information for a good credit-scoring system. We are learning by experience, and we have also acquired expertise in this area from a company that used to sell credit cards to nonbank customers. But I believe this will be an important contributor to company profits in a few years.

The Quarterly: Can you say more about the experience you have gained generally from serving low-income consumers?

Roberto Setubal: Brazil is a poor country, and many of our clients are on very low incomes, as is the case throughout Latin America. The average customer of Itaú earns perhaps $350 a month, much below the poverty line in the United States. It's a completely different type of retail banking from what goes on in OECD³ countries and requires a different type of approach. To make a loan of $100 or $200, for example, involves the same processing costs as a loan of $10,000, but the revenue you can earn is much lower. That means the margins have to be higher and costs have to be kept low. We have learned to offer credit in the most automated way possible—our systems in this area are very impressive—so that when you look at the number of loans rather than the overall volume, we are very efficient, even by US and European standards.

People look at Brazil from the outside and say, "Hey, the margins are high; it must be easy to make money." But the point is that losses are also much higher and tickets—the size of loans—much smaller. Recent performance proves this. On the whole, the local banks have increased their market share much more than have the international banks, which haven't really understood the different dynamics of this market.

That said, a very positive thing about Brazil is that people are generally open to new experiences in banking—to using technology and to buying products through ATMs and the Internet. In Europe, by contrast, my impression is that people are more conservative in the way they handle their relationship with a bank.

The Quarterly: You mentioned international expansion, which has been very modest at Banco Itaú up to now. Where are you looking?

Roberto Setubal: For the time being—the next two or three years—I believe the major focus is going to be on the local market. But at some point the international opportunities will have to be addressed. That said, it's not clear to me whether this will involve traditional retail banking or a concentration on a more specialized business, like credit cards or consumer credit. We have already acquired BankBoston's operations throughout Latin America, including Chile and Uruguay. Argentina is a complex situation because of the problems the country has faced in the past. Chile is very well organized, with a sound, very competitive financial system and a low-margin environment, but it will be a challenge for us to perform well there given the small size of our new operation. It will be a chance to learn and to try to transfer some of the good things we are doing here in Brazil. Even a bank with huge experience, such as HSBC, took a long time to turn around its operation in Brazil. It's very difficult to transfer a culture and competitive advantages.

The Quarterly: Would you consider any moves outside Latin America?

Roberto Setubal: I think the natural way forward for Itaú would be Latin America. But we have to be very careful with the next step because it's very easy to destroy value in a bank. If you make the wrong move, in too intensive a way, you can lose a lot of money. In general, I believe that our future is more related to emerging markets than to OECD countries. I believe we can compete with the international banks in emerging markets. We are accustomed to living with their volatility, among other things.

The Quarterly: The deal with BankBoston-Bank of America was not initially well received by investors. Can you explain how it fits into your strategy?

Roberto Setubal: This was one of the very few remaining acquisition opportunities in Brazil, but because the overall numbers are quite small—BankBoston's retail business is not big—it took the market some time to understand the significance. BankBoston, however, is very well positioned in corporate banking, in upscale retail consumers, and in the middle market, so the combination has made us number one in the first two of these segments. In the middle market, we have taken a major step forward in an area where we need to grow. The deal, incidentally, also makes us number one in asset management in Brazil, with $60 billion under management, more than 20 percent ahead of competitors. Once investors and analysts understood how good this acquisition was for Itaú in those important segments, they became supporters of the transaction. After the announcement, our stock price outperformed those of competitors.

By exchanging these Latin American activities for shares in Itaú, Bank of America has demonstrated that it wants to have a presence in Latin America, to keep a relationship with the region. It has a lot of clients in the United States with subsidiaries here, and in the future it will be able to offer them services through Itaú. That association will help us develop our lending to the large corporate market, though we realize this cross-company kind of arrangement is not easy.

The Quarterly: Brazilian banks, like many of their counterparts elsewhere, have faced popular hostility because of high profits and long queues. How do you deal with this?

Roberto Setubal: You're right. The image of banks in Brazil—and indeed in most countries of the world—is not the best one. There are several reasons for this. Banks have a tough role in society because they are there to extend credit but they have to say no to a lot of people. High interest rates do not help the image at all. In Brazil, banks are also very visible, being big and publicly owned, and unlike most of the multinationals that run the steel, automobile, chemical, or technology industries, they have to show their results to the public. So there is a perception, quite untrue, that only the banks make money. That problem apart, I do think banks in Brazil enjoy a lot of trust compared with those in other countries in Latin America. People are very comfortable about depositing their savings in a bank. You can see this trust too in the fast-growing pension companies owned by the banks, where there is a level of confidence in the financial system, which you wouldn't find in many other emerging markets. When you sit down and talk to clients, especially companies, they are satisfied with the level of services and products that the banks offer.