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UNIBANCO UNION OF BRAZILIAN BANKS SA 20-F 2005
Commission file number:
1-14640-1
Indicate the number of outstanding shares of each of the issuers’ classes of capital or common stock as of the close of the period covered by the annual report.
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13
or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that
the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90
days:
Yes
No
 Indicate by check mark which financial
statement item the registrant has elected to follow:
Item 17
Item 18
* Not for trading purposes, but only in connection with the registration of Global Depositary Shares, pursuant to the requirements of the Securities and Exchange Commission. 1 2 EXPLANATORY NOTE This Form 20-F/A constitutes Amendment No. 1 to the Registrant's annual report on Form 20-F for the fiscal year ended December 31, 2004. This Form 20-F/A is being filed solely for the purpose of amending certain information contained in the Registrant's Form 20-F as explained below. We have revised the disclosure in:
There are no other changes to the Registrant's Form 20-F in addition to those set forth above. In addition, this Amendment No. 1 does not reflect events occurring after the filing of the original Form 20-F. This 20-F/A consists of the cover page, this explanatory note, all items of the Registrant´s annual report on Form 20-F, including the modified items described above, as well as the exhibits, signature page and certifications required to be included herein.
NOTE ON JOINT FILING This annual report on Form 20-F has been jointly filed with the permission of the Securities and Exchange Commission by Unibanco–União de Bancos Brasileiros S.A. and our parent company, Unibanco Holdings S.A. Unibanco Holdings holds 96.6% of our outstanding common shares and 15.7% of our outstanding preferred shares as of May 31, 2005. Unibanco Holdings engages in no activities other than holding our shares.
FORWARD-LOOKING STATEMENTS This annual report contains forward-looking statements relating to Unibanco’s business that are based on management’s current expectations, estimates and projections. Words such as “believes,” “expects,” “intends,” “plans,” “projects,” “estimates,” “anticipates” and similar expressions are used to identify such forward-looking statements. These statements are not guarantees of future performance and involve risks and uncertainties that are difficult to predict. Further, certain forward-looking statements are based upon assumptions as to future events that may not prove to be accurate. Therefore, actual outcomes and results may differ materially from those expressed or implied in such forward-looking statements. Factors that could cause actual results to differ materially include, but are not limited to, those discussed under “Item 3. Key Information-Risk Factors”, and under “Item 5. Operating and Financial Review and Prospects” and elsewhere in this Form 20-F. These factors include:
We do not assume, and specifically disclaim, any obligation to update any forward-looking statements, which speak only as of the date made.
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PRESENTATION OF FINANCIAL INFORMATION All references in this annual report to the real, reais, or R$ are to the Brazilian real, the official currency of the Federative Republic of Brazil since July 1, 1994. All references to U.S. dollars, dollars or US$ are to United States dollars. On June 24, 2005, the exchange rate for reais into U.S. dollars was R$ 2.3877 to US$1.00, based on the commercial selling rate as reported by the Central Bank of Brazil. The commercial rate was R$2.6544 to US$1.00 as of December 31, 2004. Our audited consolidated financial statements are included in Item 19 of this annual report. These financial statements include the assets, liabilities, results of operations and cash flows of our subsidiaries, as well as our branches outside Brazil. Unibanco Holdings, a corporation organized under the laws of Brazil, controls us through its ownership, as of May 31, 2005, of 96.6% of our outstanding common shares and 15.7% of our outstanding preferred shares. Unibanco Holdings engages in no activities other than holding shares in us. As a result, the financial statements of Unibanco Holdings are similar to ours in all material respects, except for the minority interest line of the balance sheet and income statement and the financing activities section of the cash flow statement. References herein to our consolidated financial statements also refer to the financial statements of Unibanco Holdings. Our audited consolidated balance sheets as of December 31, 2003 and 2004 and consolidated statements of income, changes in stockholders’ equity and cash flows for each of the three-years in the period ended December 31, 2004, including the notes thereto, included in this annual report are prepared in accordance with U.S. GAAP. For certain purposes, such as providing reports to our Brazilian stockholders, filing financial statements with the Comissão de Valores Mobiliários (CVM), the Brazilian Securities Commission and determining dividend payments and tax liabilities in Brazil, we have prepared and will continue to be required to prepare financial statements in accordance with applicable Brazilian accounting practices and the Brazilian Corporate Law. Prior to June 30, 1997, Brazil was considered to be a hyperinflationary environment, having experienced extremely high rates of inflation until then, which affected the comparability of financial performance on a period-to-period basis. As measured by the general price index, or IGP-DI, published by the Fundação Getúlio Vargas, a leading independent Brazilian economic research organization, the inflation rate was 26.4% for 2002, 7.7% for 2003 and 12.1% for 2004. Certain amounts (including percentages and totals) appearing herein have been rounded. Unless the context otherwise requires, all references to loans include leases. Certain industry data presented herein have been derived from sources which we believe to be reliable; however, we have not independently verified this data and we assume no responsibility for its accuracy or completeness. Sources include Sistema do Banco Central, a database of information provided by financial institutions to the Central Bank (SISBACEN); Federação Nacional das Empresas de Seguros Privados e de Capitalização - Fenaseg, the National Federation of Private Insurance and Capitalization Companies (Fenaseg); Superintendência de Seguros Privados, the Brazilian government insurance regulatory body (SUSEP); Associação Nacional de Bancos de Investimento e Distribuidoras, the National Association of Investment Banks and Security Dealers (ANBID); Fundação Getúlio Vargas, a leading Brazilian independent economic research organization; and Associação de Empresas de Cartão de Crédito e Serviços, the Brazilian Credit Cards Companies Association (ABECS). 4 PART 1 ITEM 1. IDENTITY OF DIRECTORS, SENIOR MANAGEMENT AND ADVISERS Not applicable. ITEM 2. OFFER STATISTICS AND EXPECTED TIMETABLE Not applicable. 5 ITEM 3. KEY INFORMATION 3.A. SELECTED FINANCIAL DATA Our consolidated financial statements are presented in reais. For more details related to the latest, high and low exchange rates for reais into U.S. dollars, including the high and low exchange rates for each month during the previous six months and for the five most recent financial years see “Item 10 D – Additional Information – Exchange Rates and Exchange Controls”. Our selected historical financial data as of December 31, 2003 and 2004 and for each of the three years in the period ended December 31, 2004 have been derived from, and should be read in conjunction with, our audited consolidated financial statements included in this annual report. The selected financial data as of December 31, 2000, 2001 and 2002 and for each of the two years in the period ended December 31, 2000 and 2001 are derived from our audited consolidated financial statements, which are not included in this annual report. Our consolidated financial statements as of and for the years ended December 31, 2000 and 2004 have been audited by PricewaterhouseCoopers Auditores Independentes. Our consolidated financial statements as of and for the years ended December 31, 2001, 2002 and 2003 have been audited by Deloitte Touche Tohmatsu Auditores Independentes. The reports of the independent registered public accounting firms as of December 31, 2004 and 2003 and for each of the three years in the period ended December 31, 2004 are filed as part of this annual report. In addition, our Brazilian GAAP selected historical financial data as of December 31, 2000 to 2004 and for the five years in the period ended December 31, 2004 are derived from, and should be read in conjuction with our audited consolidated financial statements not included in this annual report, but filed at the CVM. Because the consolidated financial statements of Unibanco are similar in all material respects to those of Unibanco Holdings except for minority interest, earnings per share and the cash flow statement, separate selected financial data for Unibanco Holdings have not been presented. The following selected financial data should be read in conjunction with “Presentation of Financial Information” and “Item 5. Operating and Financial Review and Prospects.”
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Risks Relating to Brazil Set forth below are certain risk factors that could materially adversely affect our future business, operating results or financial condition. You should carefully consider these risk factors and the other information in this document before making investment decisions involving our shares. Additional risks not currently known to us, or which we deem as of now immaterial, may also harm us and affect your investment. Our business, almost all of which is located in Brazil, may be adversely affected by actions of the Brazilian government Historically the Brazilian government has intervened from time to time in the Brazilian economy and in the financial services industry. Such intervention has included, until 1999, currency devaluation, the imposition of wage, price and capital controls, the freezing of bank accounts and limitation on exports, and, most recently, increases in regulatory capital and reserve requirements, imposition of lending limits and other credit restrictions and the imposition of taxes on financial transactions. We are not in a position to predict if the Brazilian government will intervene in the Brazilian economy and, in such case, the nature and extent of such intervention. The actions of the government may adversely affect our business by:
Moreover, social instability and other political or economic developments resulting from the Brazilian government’s imposition of new economic policies, or the Brazilian government’s response to those developments, could also adversely affect our operations. See “Item 5. Operating and Financial Review and Prospects”. Devaluation of the real against the U.S. dollar may harm our and our Brazilian borrowers’ ability to pay dollar-denominated or dollar-indexed obligations Our financial condition and results of operations have been affected in recent periods, and will likely continue to be affected, by the devaluation of the real that has followed the Brazilian government’s decision in January 1999 to allow the real to float freely. The exchange rate between the real and the U.S. dollar has varied significantly in recent years. For example, the real declined in value against the U.S. dollar by 18.7% in 2001 and by 52.3% in 2002, and recovered to some extent in 2003, appreciating 18.3% against the U.S. dollar. For the period ended December 31, 2004, the real appreciated 8.1% against the U.S. dollar. When we refer to a specific percentage depreciation or appreciation of the real against the U.S. dollar in any year, we have derived such percentage by comparing the number of reais exchangeable for one U.S. dollar at the beginning of such year to the number of reais exchangeable for one U.S. dollar at the end of such year, as reported by the Central Bank. Devaluation of the real against the U.S. dollar and other foreign currencies may impair our ability to pay our dollar-denominated or dollar-indexed liabilities, by making it more costly for us to obtain the foreign currency required to pay such obligations. Devaluation of the real may also affect us by impairing the ability of our Brazilian corporate borrowers to repay dollar-denominated or dollar-indexed liabilities to us. When the Brazilian currency is devalued, we incur losses on our liabilities 10 denominated in or indexed to foreign currencies, and experience gains on our monetary assets denominated in or indexed to foreign currencies, as the liabilities and assets are translated into reais. In addition, our lending and leasing operations depend significantly on our capacity to match the cost of funds indexed to the U.S. dollar with the rates charged to our customers. A significant devaluation of the real against the U.S. dollar will increase our cost of funds and require us to raise our rates on our loans, which, as a result, may affect our ability to attract new customers who might be deterred from paying such higher rates. Appreciation of the real against the U.S. dollar may adversely affect our income tax liability During periods when the real appreciates against the currencies in which we hold our investments in our non-Brazilian subsidiaries and branches, we may experience an increase in our income tax liability. This is because losses in real terms on our overseas investments are not deductible for Brazilian tax purposes, whereas gains in the value of the related real-denominated hedges we maintain generally are taxable. Volatility of currency exchange rates may lead to an uncertain economic climate in Brazil that could negatively affect our ability to finance our operations through the international capital markets Devaluation of the real relative to the U.S. dollar could create additional inflationary pressures in Brazil by generally increasing the price of imported products and instigating governmental policies to curb aggregate demand. On the other hand, appreciation of the real against the U.S. dollar may lead to a deterioration of the Brazilian current account and balance of payments, as well as dampening export-driven growth. The potential impact of the floating exchange rate and of measures of the Brazilian government aimed at stabilizing the real is uncertain. Imposition of exchange controls could restrict our access to the international capital markets and limit our ability to service our obligations that are denominated in foreign currencies The purchase and sale of foreign currency in Brazil is subject to governmental control. Historically, the Brazilian government has implemented a number of policies affecting exchange rates and the servicing of external debt by Brazilian borrowers. These policies have included sudden devaluation, periodic mini-devaluation (with the frequency of adjustments ranging from daily to monthly), floating exchange rate systems, exchange controls and the creation of a commercial rate exchange market and a floating rate exchange market, which have recently been combined into a single exchange rate market. The Brazilian government has not prevented the remittance of proceeds to foreign investors since 1990 and has never done so in respect of securities obligations. Currently, the government does not restrict the ability of Brazilian or foreign persons or entities to convert Brazilian currency into foreign currency provided that the transactions are legal and based on the economic factors and responsibilities of each of the parties as set forth in the underlying document for each transaction that must be entered or settled through the Central Bank. Since the foreign exchange market has been recently modified, certain operational procedures are still pending regulation by the Central Bank. The Central Bank has assumed responsibility for the external obligations in connection with the formal restructuring of Brazilian sovereign debt. We cannot be sure that the Brazilian government will not institute a more restrictive exchange control policy. Such a policy could impede our access to the international capital markets by making non-Brazilian lenders and investors reluctant to commit funds to Brazilian borrowers. Such a policy could also negatively affect the ability of Brazilian debtors (including us) to make payments outside of Brazil to meet their obligations under foreign currency-denominated liabilities. Many factors beyond our control might affect the likelihood of the government’s imposing exchange control restrictions. Among these factors are:
11 If Brazil experiences substantial inflation in the future, our results of operations may be negatively affected Brazil has in the past experienced high rates of inflation, with annual rates of inflation as high as 2,708% in 1993. More recently, Brazil’s rates of inflation were 9.8% in 2000, 10.4% in 2001, 26.4% in 2002, 7.7% in 2003, 12.1% in 2004, and 1.99% in the first five months of 2005, as measured by the general price index (IGP-DI). Inflation itself and governmental measures to combat inflation have in the past had significant negative effects on the Brazilian economy. Inflation, actions taken to combat inflation, and public speculation about possible future actions have also contributed to economic uncertainty in Brazil and to heightened volatility in the Brazilian securities markets. Substantial inflation in the future in Brazil may increase our costs and decrease our operating and net margins, if it is not accompanied by an increase in interest rates. Inflationary pressures may curtail our ability to access foreign financial markets and may lead to further government intervention in the economy, including the introduction of government policies that may adversely affect the overall performance of the Brazilian economy, which in turn could adversely affect our operations. Developments in other emerging market economies may negatively affect the Brazilian economy and have an adverse impact on our business Historically, adverse developments in the economies of other emerging market countries, especially those in Latin America, have had an adverse impact on the Brazilian securities markets and economy. These events have negatively affected Brazilian companies by:
Such events have included the devaluation of the Mexican peso in December 1994, the Asian economic crisis of 1997, the Russian currency crisis of 1998 and the Argentinean economic and political crisis in 2002. In recent periods, the international financial markets have experienced significant volatility, and a large number of market indices, including those in Brazil, have at times experienced significant declines. In the event of adverse developments in emerging market countries, the international capital markets may not remain open to Brazilian companies and prevailing interest rates in these markets may not be advantageous to us. Decreased foreign investment in Brazil could negatively affect growth and liquidity in the Brazilian economy, which in turn could have a negative impact on our business. Risks Relating to the Brazilian Banking IndustryChanges in regulation may negatively affect us Brazilian banks and insurance companies, including our banking and insurance operations, are subject to extensive and continuous regulatory review by the Brazilian government. We have no control over government regulations, which govern all facets of our operations, including regulations that impose:
The regulatory structure governing Brazilian financial institutions, including banks, broker-dealers, leasing companies, and insurance companies is continuously evolving. Existing laws and regulations could be amended, the manner in which laws and regulations are enforced or interpreted could be changed, and new laws or regulations could be adopted. Such changes could materially adversely affect our operations and our earnings. 12 Changes in reserve and compulsory deposit requirements may affect our profitability The Central Bank has periodically changed the level of reserves and compulsory deposits that financial institutions in Brazil are required to maintain with the Central Bank. The Central Bank may increase the reserve requirements in the future or impose new reserve or compulsory deposit requirements. As of May 31, 2005:
Our balance of demand, savings and time deposits reserve requirement was R$4,808 million as of December 31, 2004. See “Item 5. Operating and Financial Review and Prospects—Macroeconomic Factors Affecting Our Financial Condition and Results of Operations—Effects of Government Regulation on Our Financial Condition and Results of Operations.” Reserve and compulsory deposit requirements reduce our liquidity to make loans and other investments. In addition, compulsory deposits generally do not yield the same return as our other investments and deposits. This is a result of the following factors:
Changes in minimum levels for federal housing and rural sector loans may negatively affect our profitability Under the banking regulation framework, we are required to use an aggregate amount not less than a specified percentage of our savings deposits for federal housing financing and a minimum percentage of demand deposits for loans to the rural sector. These limits can directly influence the profitability of our business as a result of two different factors. If we do not achieve the minimum levels required for these loans, we must keep the difference as compulsory deposits with the Central Bank, which generally do not yield the same returns as our other investments and deposits. In addition, obligatory loans to these sectors might entail more risk and/or be less profitable than other lending opportunities available. In general, as of May 31, 2005:
To support its fiscal policies, the Brazilian government regularly enacts reforms to tax and other fiscal regimes which affect us and our customers. Such reforms include changes in tax rates and, occasionally, enactment of temporary taxes, the proceeds of which are earmarked for designated governmental purposes. The effects of these changes and any other changes that result from enactment of additional tax reforms have not been, and cannot be, quantified. There can be no assurance that these reforms will not, once implemented, have an adverse effect upon our business. Furthermore, such changes have produced uncertainty in the financial system, increased the cost of borrowing and contributed to the increase in our non-performing loan portfolio. See “Item 5. Operating and Financial Review and Prospects —Macroeconomic Factors Affecting Our Financial Condition and Results of Operations—Effects of Government Regulation Effects on our Financial Condition and Results or Operations—Other Taxes.” 13 Changes in base interest rates by the Central Bank could adversely affect our results of operations and profitability The Central Bank establishes the base interest rate for the Brazilian banking system, and uses changes in this rate as an instrument of monetary policy. The base interest rate is the benchmark interest rate payable to holders of some securities issued by the federal government and traded at the Special System for Settlement and Custody (Sistema Especial de Liquidação e Custódia), or SELIC. In recent years, the base interest rate has fluctuated, reaching approximately 45% per annum in March 1999 and falling to 15.25% per annum as of January 17, 2001. Since 2001, the Central Bank has frequently adjusted the base interest rate, increasing the rate numerous times in response to economic uncertainties. In response to economic developments, the Central Bank reduced the base interest rate during the second half of 2003 and the first half of 2004. Most recently, to control inflation, the Central Bank increased the base interest rate several times from 16% per annum on August 18, 2004 to 19.75% per annum on May 19, 2005. Although typically increases in the base interest rate enable us to increase margins, such increases could adversely affect our results of operations, among other ways, by reducing demand for our credit and investment products, increasing our cost of funds and increasing the risk of customer default. Decreases in the base interest rate could also adversely affect our results of operations, among other ways, by decreasing the interest income we earn on our interest-earning assets and lowering margins. See “ Item 5. Operating and Financial Review and Prospects—Macroeconomic Factors Affecting Our Financial Condition and Results of Operations—Effects of Government Regulation Effects on our Financial Condition and Results or Operations—Effects of Interest Rates on Our Financial Condition and Results of Operations.” The increasingly competitive environment and recent consolidations in the Brazilian financial services market may negatively affect our business prospects The Brazilian financial market, including the banking, insurance and asset management areas, is highly competitive. We face significant competition in all of our principal areas of operation from other large Brazilian and international banks, public and private, and insurance companies. The Brazilian banking industry experienced a consolidation period in the 1990s, when a number of Brazilian banks were liquidated and several important state-owned banks and private intermediate banks were sold. Competition increased during this period as foreign banks entered the Brazilian market through the acquisition of Brazilian financial institutions. The privatization of state-owned banks has also made the Brazilian markets for banking and other financial services more competitive. The acquisition of an insurance company or of a bank by one of our competitors would generally increase the acquirer’s market share and scale, and as a result we may face heightened competition. This increased competition may negatively affect our business results and prospects by, among other things:
The profile of our loan portfolio may change due to acquisitions we make or due to changes in Brazilian or international economic conditions As of December 31, 2004, our loan portfolio was R$31,377 million, compared to R$26,039 million as of December 31, 2003. Our allowance for loan losses was R$1,560 million, representing 5.0% of our total loan portfolio, as of December 31, 2004, compared to R$1,317 million, representing 5.1% of our total loan portfolio, as of December 31, 2003. See “Item 5. Operating and Financial Review and Prospects – Results of Operations for Year Ended December 31, 2004 Compared to Year Ended December 31, 2003”. The quality of our loan portfolio is subject to changes in the profile of the business resulting both from organic growth or acquisitions we make and is dependent on domestic and, to a lesser extent, international economic conditions. Our acquisitions of Banco Fininvest S.A., or Fininvest, in 2000, the 50% interest in each of Pontocred and LuizaCred in 2001, Creditec – Crédito Financiamento e Investimento S.A., or Creditec, and HiperCard Administradora de Cartão de Crédito Ltda., or Hipercard, in 2004 have affected the quality of our loan portfolio by significantly increasing our exposure to the lower income segment of the retail 14 market. This sector generally features a higher volume of transactions, higher margins and higher default rates than other sectors. Adverse changes affecting any of the sectors to which we have significant lending exposure, political events within and external to Brazil or the variability of economic activity may have an adverse impact on us. Accordingly, our historic loan loss experience may not indicate future loss experience. Our securities portfolio is subject to market fluctuations due to changes in Brazilian or international economic conditions As of December 31, 2004, marketable securities represented R$14,875 million, or 19.1%, of our assets, and realized investment gains and losses have had and will continue to have a significant impact on our results of operations. These amounts, which we record when investments in securities are sold or are marked to market on all trading securities, may fluctuate considerably from period to period. We cannot predict the amount of realized gains or losses for any future period, and variations from period to period have no practical analytical value in helping us to make such a prediction. Gains or losses on our investment portfolio may not continue to contribute to net income at levels consistent with recent periods or at all, and we may not successfully realize the appreciation or depreciation now existing in our consolidated investment portfolio or any portion thereof. Integration of businesses in future acquisitions may increase our risks Our business strategy includes growth through strategic acquisitions. In March 2004, we acquired HiperCard, a full independent credit card company. In May 2004, we concluded the acquisition of Creditec, a financing company which has significant presence in the Brazilian personal loans and consumer finance sector among middle and lower income consumers. We may engage in further acquisitions, as we seek to continue our growth in the consolidating Brazilian financial services industry. The integration of the businesses we have recently acquired and may acquire in the future entails significant risks, including the risks that:
Cancellation of Global Depositary Shares in exchange for Units could adversely affect the public market and value of Global Depositary Shares and impose further restrictions on Unit holders Under our Global Depositary Shares, or GDSs Program, GDS holders are entitled to cancel their GDS and receive the underlying Units in Brazil. In this case:
15 Restrictions on overseas remittances could adversely affect holders of Units and GDSs Brazilian law provides that, whenever there is a significant imbalance in Brazil’s balance of payments or reasons to foresee such an imbalance, the Brazilian Government may impose temporary restrictions on the remittance to foreign investors of the proceeds of their investment in Brazil, as it did for approximately six months in 1989 and early 1990, and on the conversion of Brazilian currency into foreign currencies. In addition, if the Brazilian government determines that the Brazilian foreign currency reserves need to be maintained, it may impose temporary charges on any overseas remittance of up to 50% of the value of the remittance. Such restrictions could hinder or prevent foreign investors from converting dividends, distributions or the proceeds from any sale of Units into U.S. dollars and remitting such U.S. dollars abroad. Holders of Units and GDSs who reside outside Brazil could be adversely affected by delays in, or refusals to grant, any required governmental approvals for conversion of Brazilian currency payments and remittances abroad in respect of the Units and GDSs. Absence of voting rights for the UnitsIn accordance with Brazilian Corporation Law, our by-laws and the by-laws of Unibanco Holdings, holders of our preferred shares and Unibanco Holdings’ Preferred Shares have no voting rights except in certain limited circumstances, and holders of Units, therefore, are generally not entitled to vote either at meetings of our shareholders or at meetings of Unibanco Holdings’shareholders. Shares eligible for future sale may adversely affect the market value of our Units and GDSs Certain of our principal shareholders and the principal shareholders of Unibanco Holdings have the ability, subject to applicable Brazilian laws and regulations and applicable securities laws in the relevant jurisdictions, to sell our shares, Unibanco Holdings Common shares, and Units. No prediction can be made as to the effect, if any, that future sales of the shares represented by Units or Units may have on the market price of the Units and GDSs. Future sales of substantial amounts of such shares, or the perception that such sales could occur, could adversely affect the market prices of the Units and GDSs. Limitations on exercise of preemptive rights by foreign shareholders Under Brazilian Corporation Law, except in the case of shares offered through a stock exchange or a public offering, a Brazilian company must offer its shareholders preemptive rights to purchase, by means of capital subscription in a private placement, a sufficient number of shares to maintain their existing ownership percentages prior to the offering and issuance of any new shares. However, the participation of foreign investors in the capital of financial institutions is subject to prior authorization by the Brazilian government, except for participation in non-voting capital, once a general authorization has already been granted for this purpose. Therefore, in the event voting securities are being offered, our foreign shareholders could be prevented from exercising their preemptive rights. In addition, foreign shareholders may not be able to exercise preemptive rights with respect to our shares represented by the Units, or with respect to any securities issued by us or by Unibanco Holdings as to which the holders of Units have preemptive rights unless a registration statement under the Securities Act is effective with respect to the shares relating to such rights or an exemption from the registration requirements thereunder is available. Unibanco Holdings and we are under no obligation to file a registration statement with respect to such preemptive rights and there can be no assurance that Unibanco Holdings and we will file any such registration statement. 16 ITEM 4. INFORMATION ON THE COMPANY 4.A. HISTORY AND DEVELOPMENT OF THE COMPANY OverviewFounded in 1924 as a correspondent bank, Unibanco is Brazil’s oldest private-sector bank. From our longstanding position as one of the nation’s leading wholesale banks, we have expanded our operations to become a full service financial institution providing a wide range of financial products and services to a diversified individual and corporate customer base throughout Brazil. Our businesses comprise the following segments: Retail, Wholesale, Insurance and Pension Plans and Wealth Management. See Note 32 to our consolidated financial statements in Item 19 for additional information on our four reportable segments. We are one of the largest private-sector financial institutions in Brazil and have grown substantially both through organic growth and acquisitions. As of December 31, 2004, on a consolidated basis, we had:
Our consolidated net income for the period ended December 31, 2004 was R$2,063 million, representing a return on average equity of 26.9% and a return on average assets of 2.8% . Our equity securities have been publicly traded on the São Paulo Stock Exchange (Bolsa de Valores de São Paulo), or BOVESPA, since 1968. In 1997, we became the first Brazilian bank to list its equity securities on the New York Stock Exchange, or NYSE. As of December 31, 2004, the total market value of our equity securities, based on the closing price of our GDSs, was R$11.7 billion. Our legal name is Unibanco - União de Bancos Brasileiros S.A. Our address is Avenida Eusébio Matoso 891, zip code 05423-901, São Paulo, SP, Brazil. Our telephone number is (5511) 3097-1980. Our web site is www.unibanco.com. We are a corporation (sociedade anônima) and were incorporated on May 27, 1967 in accordance with Brazilian law. Our agent in the United States of America is our Representative Office in New York, which is located at 65 East 55th Street, 29th Floor, New York, NY 10022; telephone number (212) 832-1700. Unibanco Holdings’ legal name is Unibanco Holdings S.A. Its address and telephone number are the same as ours. Unibanco Holdings is a corporation (sociedade anônima) and was incorporated on June 20, 1994 in accordance with Brazilian law. Unibanco Holdings’ agent in the United States of America is our Representative Office in New York. Recent Acquisitions, Joint Ventures, Alliances and Divestiture We have built our competitive position in the Brazilian financial services market and significantly increased our scale through organic growth and carefully chosen strategic transactions and alliances. We believe that each of our business segments provides a solid platform for carefully managed future growth. The following is a summary of our recent important acquisitions, joint ventures, alliances and restructuring. AcquisitionsRetail and Wholesale BNL Brasil. In June 2004, we announced the acquisition of the total capital of Banco BNL Brasil, or BNL Brasil, from Banca Nazionale del Lavoro S.p.A., or BNL, and BNL International Investments, or BNL Group. BNL Brasil’s total capital was valued at R$109.7 million and BNL received one billion of our Units (before the reverse stock split of Unibanco and Unibanco Holdings implemented in August 2004) representing 1.43% of Unibanco’s capital, in the transaction. BNL Brasil had a credit portfolio of R$715,9 million and a credit card and consumer finance operation with approximately 107,000 clients and 96,000 cards issued at the time of the acquisition. 17 Banco1.net. Banco1.net is a banking and financial services website established through a strategic alliance between us and Portugual Telecom Brasil S.A., or Portugal Telecom. During the third quarter of 2004, we announced the acquisition of 17,607,235 common and preferred shares of Banco1.net, mainly from Portugal Telecom for R$38 million. Banco1.net was fully integrated into our Retail business in November 2004. Consumer FinanceHiperCard. On March 1, 2004, we announced the acquisition of HiperCard Administradora de Cartão de Credito Ltda., or HiperCard, from Koninklijke Ahold N.V., or Royal Ahold, for R$630 million. HiperCard started as a private label credit card company for the Bompreço chain of supermarkets and is now a fully independent credit card company with cards presently accepted in more than 70,000 points-of-sale in Northeastern Brazil. As of December 31, 2004, HiperCard had 2.7 million cards issued and a loan portfolio of R$1,100 million. Simultaneously with this transaction, Royal Ahold sold the BomPreço Supermarket chain to Wal-Mart. Creditec. In May 2004, we concluded the acquisition of Creditec–Crédito Financiamento e Investimento S.A., or Creditec, from Grupo BBM for a purchase price of R$50 million. Creditec has a significant presence in the Brazilian personal loans and consumer finance sector among middle and lower income customers. Creditec had approximately 600,000 registered clients in May 2004 and operates throughout Brazil, with a strong presence in the states of Rio de Janeiro and São Paulo, as well as in Northeastern Brazil. The acquisition did not include Creditec’s credit portfolio. Creditec’s network, which consists of stores and inside retailers, was fully integrated into Fininvest network. Insurance and Pension PlansCigna. In March 2003, Unibanco AIG acquired the Cigna Seguradora S.A. private pension portfolio, adding 120 corporate plans with approximately 10,000 participants, and R$149 million in reserves. Phenix. In October, 2003, UASEG – Unibanco AIG Seguros entered into an agreement to acquire the insurance company Phenix Seguradora SA, or Phenix, from Toro Targa Assicurazioni SpA. and Fiat do Brasil S.A., or Fiat. The value of the transaction was R$13 million. In connection with this acquisition, UASEG entered into a strategic partnership with Fiat, a large automobile manufacturer in Brazil, that allowed access to Fiat’s customer base and corporate insurance customers. Additionally, UASEG began to manage Fiat’s employee pension plans. Unibanco AIG Warrant (UAW). In November 2004, we acquired from Multibrás S.A. Eletrodomésticos a 20% interest of the total capital of Unibanco AIG Warrant. As a result of this transaction, Unibanco owns an indirect interest of 70% of Unibanco AIG Warrant’s capital. Wealth ManagementUnicorp. In April 2002, the Central Bank approved the acquisition by our subsidiary, Unipart Participações Internacionais Ltd., of the remaining 24.5% of the total share capital of Unicorp from the Moreira Salles Group for US$36 million. Pictet Modal. In January 2003, we entered into an agreement pursuant to which the administration and management of the funds managed by Pictet Modal were transferred to Unibanco and Unibanco Asset Management, or UAM, respectively. The transfer involved nine fixed income funds and three equity funds with aggregate total assets under management of approximately R$267 million as of January 17, 2003. 18 Joint Ventures and Alliances Ford Credit Brazil. In January 2002, Unibanco-Rodobens, our consortium finance arm, and Ford Credit Brazil established a joint venture for the sale of cars and management of groups of the National Ford Consortium, a financing goods system based on installment plans. Grupo Martins/Tricard. In July 2003, our subsidiary Unicard and Tricard Administradora de Cartões Ltda, a subsidiary of Martins Group, one of Brazil’s largest wholesale distributors, entered into a partnership to manage the SuperCompras and FarmaPlus private label cards offered to the clients of retailers served by Martins Group. As of December 31, 2004, there were approximately 557,043 Tricard credit cards issued through a distribution network comprised of 4,302 retailers. Sonae. In August 2004, we announced the establishment of a new credit company with Sonae Distribuição Brasil S.A., or Sonae, a Portuguese group that owns the Big, Nacional, Mercadorama and Maxxi supermarkets chains. We will offer private label cards, consumer finance, personal lending and insurance, among other consumer credit products to Sonae customers. The value of the transaction was R$21 million, due to indentifiable intangible assets. The establishment of this credit company is subject to approval by the relevant authorities. DivestitureCredicard/Orbitall. On November 8, 2004, we, Citigroup and Itaú announced a shareholder reorganization of Credicard Banco, or Credicard. In connection with the reorganization, we sold our interest in Credicard to Banco Itaú S.A., or Itaú, and Citigroup. Each of the companies now holds 50% of Credicard’s capital stock. We and Citigroup also sold our interests in Orbitall to Itaú. The total sale price for the 33.3% ownership of Unibanco in Credicard and Orbitall was R$ 1.7 billion. This shareholder reorganization did not include any changes in Redecard’s shareholders’ structure. Redecard continues to be owned by us, Citigroup and Itaú, each with 31.9% and Mastercard with a 4.2% ownership. Recent DevelopmentsWal-Mart In February 2005, Unibanco and Wal-Mart announced that they will make the HiperCard credit card available for use in all Wal-Mart stores in Brazil. Customers who live in the states of São Paulo, Minas Gerais, Rio de Janeiro and Paraná will also have access to the HiperCard credit card, which was created in 1982 and is accepted in over 70,000 commercial establishments in the northeast of Brazil. Wal-Mart's approximately 500,000 credit cards will be gradually replaced by HiperCard credit cards. Unibanco’s New BrandOn March 21, 2005, we launched our new brand which includes new official colors and a new logo. The new brand has blue as the main color and green as the supporting color, replacing our former official colors, black and white. The Unibanco logo, which was created in the 1960s, has also been redesigned to provide more movement and lightness to the brand. DibensOn June 3, 2005, we signed an agreement to acquire the remaining 49% of the capital of Banco Dibens S.A., from Grupo Verdi. The value of the transactions was R$128 million. Capital ExpendituresDuring the period from 2002 to 2004, our capital expenditures consisted primarily of expenditures for data processing to automate our branch network and for computer systems, communication equipments and other technology tools designed to increase the efficiency of our operations, the services offered to our customers and our productivity. For further details regarding the amount and nature of our capital expenditures, see “Item 5.B. Liquidity & Capital Resources–Uses of Funding.” 19 4.B. BUSINESS OVERVIEW Our Businesses The following diagram shows our principal lines of business: 
See note 32 to our consolidated financial statements in Item 19 for information on our four business segments for the years ended December 31, 2004, 2003 and 2002. RetailOur Retail business provides a wide variety of credit and non-credit products and services, including:
20 We separate both individuals and companies into smaller groups according to income brackets to enable us to offer differentiated products and services to these clients. By doing this, we increase our competitiveness in the market. While we traditionally have focused on middle and upper income clients, we have begun to market services to lower-income individuals. We believe this market segment will be a significant source of future growth in our retail business. We have also developed a strong presence in the consumer finance sector through our subsidiaries Fininvest, Unicard, HiperCard and Banco Dibens S.A. and our strategic alliances with Magazine Luiza, or LuizaCred, Ponto Frio, or PontoCred, and Sonae. We believe we are one of Brazil’s largest credit card issuers in terms of cards issued, primarily through our subsidiaries Fininvest, Unicard and HiperCard. For the year ended December 31, 2004, we had total loans of R$15,653 million, fees and commissions of R$1,858 million, and net income of R$1,645 million from our Retail business. IndividualsWe provide our individual customers with fee-based products and services, including use of ATMs, phone and personal computer banking and fund transfers. We also make secured and unsecured personal loans in reais for overdraft short term lines of credit, loans for consumer purchases, leasing and individual lines of credit. Individuals are segmented into three different groups: those earning more than R$4,000 per month (UniClass), those earning from R$1,301 to R$4,000 per month (Exclusivo) and those earning from R$350 to R$1,300 per month (Especial). In the UniClass group, we believe we differentiate ourselves from competitors by providing our customers with:
In the Exclusivo group, we believe we differentiate ourselves from competitors by providing services and products which substantially reduce the time spent by our clients in their basic banking transactions, such as withdrawals and payment of bills, as well as personalized service inside the branch. In particular, we provide customers of this segment more convenient banking through access to our “30 Hours” services. In the Especial group, we face more intense competition. We focus on retired individuals and employees of companies to which we provide payroll services, and we believe that our relationships with companies in our Wholesale business give us a competitive advantage to offer payroll services. We offer retired individuals special treatment, such as special service hours and pre-approved credit lines. Consequently, these clients who would ordinarily only withdraw their monthly income may also take advantage of our products and services. Small and Medium CompaniesWe serve approximately 520,000 small and medium companies with annual sales of up to R$150 million, or SMEs, consisting primarily of retailers. As of December 31, 2004, we had outstanding loans to SMEs of approximately R$6.2 billion, or approximately 19.8% of our total loan portfolio. For companies with annual sales up to R$5 million, we offer products and services through branch account officers that are dedicated to this group. Companies with annual sales ranging from R$5 million to R$150 million, which tend to require customized products and services, are served by Unibanco Empresas, a separate group of account representatives. 21 Distribution Network As of December 31, 2004, we and our associated companies, Fininvest, LuizaCred, PontoCred and Tecban, and Banco 24 Horas, had a distribution network with over 15,000 points of distribution throughout Brazil, consisting of the following:
Our branch system serves as a distribution network for all products and services offered to our retail customers. Our 895 full-service branches accept deposits, provide cash withdrawals and offer the full range of our retail banking products, such as checking accounts, consumer loans, automobile financing, credit cards, loans to small-sized companies, leasing, insurance, asset management services and payment of bills, including bills for taxes and public services. Our search for alternative distribution channels led to our introduction of in-store banking in 1998, then a new concept in Brazil. To continue this project, we have entered into partnerships with retailers such as, Carrefour, Sendas, Wal-Mart, Sonae and others. The majority of our contracts gives us exclusivity with respect to these services. Corporate-Site BranchesWe offer retail banking services to corporate customers and their employees through special banking branches located in the premises of corporate customers. Our network consists of 380 corporate-site branches. In the case of retail and smaller corporate customers, corporate-site branches may consist solely of an automated branch. In the case of large corporate customers, corporate-site branches consist of an average of four employees dedicated to serving the corporation and its employees. ATMsWe operate approximately 7,500 ATMs for the use of our customers. In addition to our proprietary network, we participate in the shared ATM network operated by our affiliate, Tecnologia Bancária S.A. This network has approximately 2,750 machines throughout the country, and serves clients of approximately 50 banks, which makes it the largest ATM network in Brazil. Clients of banks associated with Tecnologia Bancária S.A. can withdraw cash through the ATM network for a fee, allowing us to increase our income and optimize our capabilities. “30 Hour” ServicesOver the last ten years, we have been innovative in the distribution and promotion of remote banking services. Initially, we used the telephone as an instrument for banking transactions and as a marketing tool. Our “30 Hour” services provide clients electronic banking services such as cash withdrawal, pre-printed checkbooks, account statements and investment services 24 hours a day. The “30 Hour” services are convenient for our clients and cost-efficient to us. The original concept of a call center was converted into a contact center, using the “30 Hour” telephone service as a customer relations and sales force platform. The majority of the calls are taken care of by an electronic voice reply system. This system identifies individuals as potential purchasers of products and transfers the call to an operator. This is possible due to the use of Customer Relationship Manager, or CRM, tools. 22 Internet Banking We provide a variety of retail banking services, including opening accounts, utility bill payment, wire transfers, and mutual funds, through our Internet banking services. Since April 2000, we have also offered a variety of mobile “30 Hour” services, enabling clients to access their banking information from their cellular phones, PDAs or e-mail. As of December 31, 2004, we had approximately 1.7 million registered users of our Internet banking services. During 2004, we processed approximately 170 million Internet transactions, an increase of 67% over 2003. FundingOur Retail business is an important source of funding for us. 45.1% of our total deposits (excluding mutual funds), as of December 31, 2004, were from retail customers. Our extensive distribution network and strong deposit base support our Retail operations. As of December 31, 2004, Retail deposits (excluding mutual funds) were R$15,222 million, an increase of 20.5% compared to December 31, 2003. This was supported by a balance of R$1,625 million in our Superpoupe portfolio as of December 31, 2004. LoansAs of December 31, 2004, retail loans including loans by our subsidiaries and affiliates, were 49.9% of our total loan portfolio and, our loans to small and medium companies and individuals were R$6.2 billion. Approximately 43.5% of our retail loans are to individuals and the remainder are to small and medium companies. We believe we are well positioned to expand our retail loan assets when Brazil’s trends include declining interest rates and unemployment. Consumer FinanceWe have developed a strong presence in the consumer finance sector through our subsidiaries Fininvest, HiperCard, Unicard and Banco Dibens S.A. and our strategic partnerships with LuizaCred, PontoCred, and Sonae. In Brazil, clients still use their credit cards more as a payment tool than as a credit instrument, although in recent years this behavior has been changing. The market for consumer credit has grown as declining inflation in Brazil has led to increased consumption and increased acceptance of credit cards by merchants. We believe we are one of Brazil’s largest credit card issuers in terms of cards issued, primarily through our subsidiaries Fininvest, Unicard, and HiperCard. We offer credit card products, including Visa, MasterCard and Diners Club cards, to our customers through these subsidiaries. All three subsidiaries employ modern credit review procedures. Each credit card application is reviewed based on credit scoring and consumer behavior scoring systems. Our associated credit card companies offer cardholders revolving lines of credit, requiring a minimum payment of the outstanding account balance as well as credit in installments. UnicardUnicard’s credit portfolio reached R$1,708 million as of December 31, 2004. As of December 31, 2004, we had 4.8 million cards issued, a 9.1% increase compared to December 31, 2003. We provide customers with a credit decision on-line, in real time, in all of our distribution networks, with a thirty-second response time from the initial credit request, since 2002, when the Capstone system was employed in our branch network. The Capstone system compiles business intelligence and analytical customer relationship management for a credit decision platform used widely in banks. Prior to 2002, this system was available only for sales realized through internet and telemarketing. FininvestFininvest provides loans mainly to lower-income individuals and also offers regular and private label credit cards. Fininvest’s credit portfolio was R$1,565 million as of December 31, 2004, a 30.5% growth from December 31, 2003. At the end of 2004, Fininvest had 253 stores, over 11,000 points-of-sale and 7.6 million private label accounts. 23 HiperCard HiperCard started as a private label credit card company for the Bompreço chain of supermarkets and is now a fully independent credit card company with cards presently accepted in over 70,000 points-of-sale in Northeastern Brazil. As of December 31, 2004, HiperCard had a credit portfolio of R$1,100 million, and 2.7 million cards issued. We and Wal-Mart announced in 2004 that we will make the HiperCard credit card available for use in all Wal-Mart stores throughout Brazil. Wal-Mart's almost 500,000 credit cards will be gradually replaced by the HiperCard credit card. Credicard GroupIn November 2004, we, Citigroup and Itaú announced a shareholder reorganization of Credicard in which we disposed of our approximately one-third interest in Credicard. This reorganization did not include any changes in Redecard’s structure, which remained the same. Established in 1996, Redecard is responsible for the processing of credit and debit transactions of the MasterCard, MasterCard Electronic, Maestro, Diners Club International and RedeShop brands in Brazil. Redecard also provides some products and services for their customers, such as leasing to retailers machines used for the processing of debit and credit transactions. Debit card use has been increasing in Brazil. We have a 31.9% interest in Redecard, and Citibank N.A., Banco Itaú and Mastercard also hold interests in the company. Savings and Annuity ProductsOur wholly owned subsidiary, Unibanco Companhia de Capitalização, or Unibanco Capitalização, offers savings and annuity products. Unibanco Capitalização’s products consist primarily of savings account-type products, which provide incentives to depositors through a special weekly lottery award. For the year ended December 31, 2004, Unibanco Capitalização’s net income was R$124 million. Mortgage LoansAs of December 31, 2004, we had approximately R$1,144 million in mortgage loans outstanding. Brazilian law requires banks to provide a minimum level of housing financing equal to at least 65% of the bank’s savings deposits. However, banks may reduce their minimum lending requirements with credits against the Brazilian government housing fund (Fundo Nacional de Compensação de Variações Salariais), or FCVS. Cash ManagementOur cash management unit provides the tools to optimize companies’ cash flow management, making payments and processing receivables more simple, efficient and productive. As of December 31, 2004, approximately 91,000 customers used our cash management services, including payments and collections, a 6.9% increase compared to 2003. WholesaleThrough our Wholesale business we provide a wide array of products and services, including: general and specialized corporate lending, trade finance, capital markets and investment banking services, investment and brokerage services, project finance, and mergers and acquisitions advice to approximately 400 institutional investors and 2,028 economic groups. We serve these clients through a network of regional offices combined with a presence in major financial centers throughout Brazil. For the year ended December 31, 2004, we had total loans of R$15,027 million, fees and commissions of R$282 million and net income of R$162 million from our Wholesale banking business. The Wholesale business experienced some structural changes in 2004 with a change in focus to domestic and multinational companies with sales greater than R$150 million and credit lines above R$6 million. Loans to large customers may be collateralized according to the guidelines of our internal credit rating system. 24 Wholesale Network We use our regional and international network to offer a variety of products to our clients. Our subsidiaries and branches located abroad raise capital for trade finance and lending to our clients. We have five regional offices (in São Paulo, Rio de Janeiro, Minas Gerais, São Paulo countryside / Mid-West and South) and 11 regional branches. Due to the reorganization that took place in June 2004, some branches were integrated into others, optimizing our distribution network in the Wholesale business. Each of our corporate customers is assigned a dedicated banker, who is responsible for the day-to-day relationship with the customer and for assisting our clients’ operations throughout Brazil. These customers also benefit from our offices abroad. Our international network consists of the following:
International Trade Finance and Correspondent Banking We provide import and export financing and services to our corporate customers. We receive funding from correspondent banks as well as export and import financing funded or insured by export credit agencies and multilateral agencies. Our extensive network of correspondent banks and our international operations help us provide our customers with foreign exchange and international trade support worldwide. CommercialWe supply services to a diverse group of Brazilian companies. We have structured our operations so as to identify synergies among the different product areas. For instance, account managers or executives are in charge of developing and maintaining the strong relationship with our corporate clients. Investment Bank ProductsOur equity, fixed income and mergers and acquisitions groups supply product expertise and innovation focused on the ever-changing needs of Brazilian companies. Our brokerage and distribution groups are responsible for understanding the needs of Brazilian and international investors, in order to offer suitable investment options. BrokerageOur Brazilian brokerage operation offers equity and debt securities and derivatives products and provides trading services on Brazilian exchanges for institutional customers. It also provides research on over 60 listed companies. Project Finance and PrivatizationOur project finance group is responsible for structuring and financing infrastructure and industrial projects, such as projects related to toll roads, ports, railroads, energy and telecommunications. Our activities include advising our corporate customers about the economic and financial feasibility of proposed projects, as well as project structuring and long-term financing. Treasury, Trading and Derivative ActivitiesOur treasury unit conducts financial transactions for our corporate customers as well as for our proprietary portfolio. Our treasury group trades fixed income Brazilian government securities, derivative financial instruments and bank and corporate debt securities, prices loans and investment products for the Retail and Wholesale business segments, engages in foreign currency trading and enters into derivative transactions, such as swaps for global hedging and arbitrage purposes. Since March, 2005 it has been operating as an independent business unit. 25 Insurance and Pension Plans In October 1997, we established a partnership with AIG. We acquired approximately 50% of the equity of each of the AIG Brasil companies, each of which have been merged into AIG Brasil Companhia de Seguros, or AIG Brasil, and AIG acquired approximately 50% of the equity of UASEG. While AIG holds a slight majority of the total equity of UASEG, we have managerial control of UASEG, subject to approval of AIG on certain strategic issues. AIG has control of AIG Brasil, similarly subject to our approval on certain strategic issues. We offer individual life, automobile, personal accident, personal property and warranty insurance among other corporate insurance products as well as individual and corporate pension plans. Our insurance and pension fund companies ranked fourth in Brazil in consolidated terms of total premiums, as of December 2004, according to the Brazilian Private Insurance Superintendency (Superintendência de Seguros Privados), or SUSEP, the National Association of Private Pension Plans (Associação Nacional de Planos de Previdência Privada), or ANAPP, and the National Health Agency (Agência Nacional de Saúde Suplementar), or ANS, with a 7.9% market share (which does not include extended warranties). In 2004, insurance, insurance private retirement plans and pension investment contract income was R$1,775 million and total net income of the insurance segment was R$153 million, based on our proportionate share of the joint venture. InsuranceUASEG has the exclusive right to distribute insurance products through our branch network to our Retail and Wholesale customers. We believe that this distribution channel gives us a competitive advantage over many insurance companies that are not affiliated with financial institutions. Because approximately half of UASEG’s insurance premiums are generated through customers of our network, we benefit from significant cost savings and marketing synergies. UASEG also markets its insurance products through approximately 12,000 independent brokers and Unibanco’s call center, website and in-store branches. AIG Brasil distributes products through banks, financial institutions and mass marketing programs to affiliated groups. We also offer an extended warranty program for household appliances, marketed by Unibanco AIG Warranty S.A, or UAW, our joint venture with Multibrás, the largest Brazilian home appliance manufacturer. Pension and Retirement PlansUnibanco AIG Vida e Previdência S.A., or Prever, our subsidiary, manages reserves that consist of pension and retirement contributions made by institutional clients and individuals and serves approximately 1,231 corporate clients and 733,000 individual customers, of which approximately 217,000 come from corporate clients. As of December 31, 2004, Prever ranked fourth in Brazilian pension plan revenues with an 8.1% market share, according to ANAPP’s official data. Wealth ManagementIn March 2002, the private banking and asset management businesses were combined to form the Wealth Management business. The asset management business is conducted primarily through our subsidiary Unibanco Asset Management, or UAM. UAM offers fixed income and equity mutual funds to individual customers and manages portfolios on behalf of corporations, pension funds and private banking clients. Through Unibanco Private Bank, we provide wealth management services targeted to high net worth individuals with potential investment portfolios over R$3 million. In 2004 we directed our efforts towards strengthening our position both in the Asset Management and Private Bank markets by focusing on funds and portfolio performance enhancement and consistency. In addition, we made some changes in our organizational structure in order to further explore synergies within the unit. 26
Assets under Management as of December 31, 2004
UAM usually charges fees for its mutual funds based on the average net asset value of the funds, which is calculated on a daily basis. UAM also manages portfolios for pension funds, corporations, private banking customers and foreign investors. For these services, UAM usually negotiates fees that are based on a percentage of assets under management and on performance. As of December 31, 2004, UAM had R$27,765 million in assets under management and fees and commissions of R$321 million. Net income from our Wealth Management segment was R$104 million in 2004. As of December 31, 2004, UAM was ranked fourth in the Investment Banks and Distributors National Association’s (Associação Nacional de Bancos de Investimento e Distribuidoras), or ANBID’s, ranking of private third parties’ assets under management with a market share of 4.0% . Private BankingOur private banking unit targets high net worth individuals with potential investment portfolios over R$3 million. Many of our private banking clients are major shareholders or senior executives of our corporate clients. R$4.9 billion of the assets under management came from investment in funds and managed portfolios, representing a market share of 9.3%, holding the second position in the segment’s ranking published by ANBID in December 2004. Business StrategySince the second quarter of 2004, we implemented important changes to our internal structure. Our new business model focuses on (i) increasing business return; (ii) fostering a collaborative environment; (iii) continuing excellence in human resources; and(iv) reinforcing our focus on our Retail and Wholesale businesses. The main changes include:
27
Our objective is to maintain and enhance our position as a leading Brazilian full service financial institution operating in all business segments. To achieve this objective, we have developed strategies tailored to each of our business areas based on the Balanced Scorecard Methodology, a model designed to translate strategy into operational terms. Our business strategy is to add economic value through continuous pursuit of scale, profitability and efficiency maximization. We seek to increase our client base, including through cross-selling among our different businesses and to achieve high client satisfaction in all products and services, through excellence in internal procedures, such as customer relationship, optimized distribution, credit quality and sinergy processes. In order to achieve this, our aim is to excel in human resources, promote a cooperative culture, meritocracy, and a stimulating, challenging and pleasant work environment. In August 2003 we became the first Latin American institution to appear in the Balanced Scorecard Hall of Fame, which recognizes companies that excel in the implementation of the Balanced Scorecard model. Continuous Pursuit of Scale and ProfitabilityWe believe that to maintain competitive scale we must grow our customer base, expand our product and service offerings in each of our business segments and identify additional sources of revenue. We seek to accomplish this through organic growth, acquisitions, strategic alliances and partnerships. Continuous Efficiency MaximizationWe focus on controlling our costs as well as our investments across all areas of our business to help maximize returns. For example:
28 Retail Strategy Increase Scale We believe that our ability to maintain our position as a leading full service financial institution depends, in part, on maintaining and increasing scale in our retail business. We have increased scale through organic growth, strategic transactions initiatives, and several new cross-selling opportunities through our subsidiaries and strategic partners. As of December 2004, our total retail portfolio stood at R$15,653 million, representing 49.9% of our total loans, compared to 38.3% in December 2003. We seek to increase our scale through carefully chosen acquisitions and strategic alliances. We believe the consumer finance sector is one of the most rapidly growing and profitable segments of the Brazilian retail financial services market. Achieving a strong presence in consumer finance is central to our strategy of gaining scale in our retail business and reaching the lower income segment of the market. In March 2004, we announced our acquisition of HiperCard. HiperCard started as a private label credit card company for the Bompreço chain of supermarkets and it is now an independent credit card company with cards presently accepted at more than 70,000 points of sale in Northeastern Brazil. As of December 31, 2004, HiperCard had 2.7 million cards issued. Enhance sales to existing customer base through innovative products and service offerings We view scale not only in terms of the size of our customer base, but also as a function of the number of products we are able to sell per customer. Improving our product-per-client ratio has a positive impact on profitability, since it is less expensive to sell an additional product to an existing customer than to acquire a new customer. We believe that continually developing and marketing tailored and innovative products to serve the needs of specifically identified customer segments increases our ability to sell multiple products per client. An example of this is our Superpoupe portfolio, which had a balance of R$1,625 million as of December 31, 2004. Superpoupe is a time deposit certificate offered to Unibanco customers with a cost of funding that is less than the cost of a traditional time deposit certificate. We have increased our market penetration through cross-selling and new products and offers such as Tarifa Zero, in which fees are based on the client’s historical relationship with Unibanco; Plano Único, a letter of credit issued in connection with the purchase of real estate which permits clients to repay the credit over an extended period of time with guaranteed delivery on 36 months from the first installment and the remaining balance could be paid on 100 monthly installments; and consignment credit offerings to private or government employees with credit card usage and personal credit lines. Wholesale StrategyEnhance Our Market Position in Brazilian Wholesale Through our Wholesale business, we seek to be the bank of choice for corporations and investors with interests in Brazil. Our strategy combines the strength of a commercial bank with the agility of a leading investment bank. Our deep knowledge of our clients and their business coupled with our financial capabilities allow us to establish credit limits and structure transactions in a differentiated way. Throughout 2004, we have developed a new regional coverage strategy maintaining a close relationship with our clients and supplying them, in their day-to-day financial needs, with diversified products and services, including working capital credit lines, foreign exchange lending, banking services, corporate finance, advisory services and derivative products. We are one of the leading Brazilian banks participating in the Brazilian Development Bank (Banco Nacional de Desenvolvimento Econômico e Social), or BNDES, programs. As of December 2004, Unibanco ranked third among private-sector banks in terms of total BNDES disbursements, with a 7.52% market share, according to the official BNDES ranking list. Insurance StrategyFocus on Offering High Profitability Insurance Products and keeping corporate leadership We believe that Brazilian economic growth will present opportunities for the country’s insurance industry, as Brazilians’ spending on insurance products currently lags behind that of many other countries. We intend to take advantage of this growing market by using our sophisticated product development capability to focus our insurance offerings on value-added products. Maintaining high levels for our underwriting criteria, our products are more profitable than the relatively commoditized, market-standard products offered by many of our competitors. We believe that our Insurance business has the best mix of products among the five largest insurers in Brazil. In developing insurance products for corporate clients, we have achieved leading market positions in a variety of specialized areas, including directors and officers (D&O) insurance, and insurance and coverage products for the petrochemical, transportation, property and aeronautic sectors. Our focus on developing and offering value-added insurance products is supported by our joint venture with AIG, which gives Unibanco access to AIG’s expertise in product development and reinsurance, as well as a valuable brand name. 29 Enhance Profitability in Our Insurance Business through Cost Control and Underwriting Expertise The profitability of our Insurance business depends in part on our ability to minimize expenses and losses. We have taken significant steps to reduce expenses in our Insurance operations, including the merger of several companies into Unibanco AIG Seguros, and the introduction of an Internet portal to communicate with our brokerage force. Pension Plan StrategyOur primary strategy is to improve sales of corporate pension plans by adding new companies to our pension plan portfolio and increasing the size of our portfolio of individual plans. We offer several innovative investment contract products including Vida Gerador de Beneficio Livre, or VGBL, which combines life insurance with investment, enabling the insured party to redeem the invested amount at any time, while still offering coverage in case of death, accident or disability and Plano Gerador de Beneficios Livres, or PGBL, which enables customers to save for retirement with a tax-deductible feature and may include insurance coverage for death, accident or disability. These pension products are mainly sold in Unibanco branches. Increasing sales and controlling expenses are the key drivers for the profitability of our pension plan business Wealth Management StrategyBe the leading provider of Wealth Management services in Brazil The mission of our Wealth Management business is to provide proactive advice to help our clients accumulate, preserve and transfer their wealth. We offer integrated financial solutions through our three main areas of expertise: asset management, private banking and advisory services. Our tailored and value-added products are targeted to companies and individuals positioned in the top end of the wealth pyramid distribution, typically middle to large companies, pension funds and affluent to high net worth individuals, thus leveraging our unique position in those market segments. In order to provide these differentiated services we have developed a strong local and international network of wealth management specialists in the areas of succession advice, tax advice and real estate, among others. In the area of financial investments we developed an open architecture model that further differentiates our offerings. Through this model, our clients have access to our best investment products and also to the best investment products of third party asset managers. As of December 31, 2004, UAM had R$27,765 million in assets under management and was ranked fourth in ANBID’s ranking of private third parties’ assets under management with a market share of 4.0% . R$4.9 billion of the assets under management came from investment in funds and managed portfolios, representing a market share of 9.3%, holding the second position in the segment’s ranking published by ANBID in December 2004. During the second quarter of 2004, we created a new approach exclusively for customers with investment portfolios greater than R$ 200,000, which consists of management of their investments by offering specific services and products to this segment. Other Information about UnibancoRisk Management Risk management is an independent unit responsible for identifying, measuring and managing market, credit and operational risk on an institution-wide basis. Through the development and use of tools based on the best practices adopted in the market, we seek to optimize our risk-return relation, as well as to assure the continuous improvement of risk management in all organizational levels. Risk Management at Unibanco is based on tools and parameters associated with risk/return optimization, taking into account, among others, risk diversification and maximum exposure limits. See “Item 11. Quantitative and Qualitative Disclosures About Market Risk - Risk Management” for a more detailed discussion of our risk management policies. 30 Funding Our principal source of funding is deposits from the Brazilian public, including individuals and businesses. At December 31, 2004, our total deposits were R$33,775 million, representing 49.3% of our total liabilities. We provide four types of deposit accounts:
Savings deposits with banks in Brazil typically only pay interest after funds have been left on deposit for at least one calendar month by individuals and 90 days by corporations. Interest earned by individuals on all savings accounts is income tax free. Time deposits either pay a fixed interest rate or a floating rate. The breakdown between fixed and floating rate deposits varies from time to time, depending on the interest rate expectations of the market. At December 31, 2004, most of our time deposits carried a floating interest rate. The following table sets forth our total deposits, by type and source, as of December 31, 2002, 2003 and 2004:
The following table sets forth the mix of the retail and wholesale deposits as of December 31, 2002, 2003 and 2004:
Other Sources We have obtained US dollar-denominated lines of credit with our correspondent banks to provide a source of trade finance funding for Brazilian companies. As of December 31, 2004, our total import and export funding was approximately R$2.0 billion, compared to R$2.5 billion as of December 31, 2003. We borrow foreign currency in the international markets either by borrowing privately or issuing debt securities for the specific purpose of onlending such funds in Brazil to Brazilian corporations and financial institutions. These onlendings take the form of loans denominated in Brazilian currency indexed to the U.S. dollar. We believe we are one of the most active Brazilian financial institutions in the Eurobond market. As of December 31, 2004, we had approximately R$1.2 billion of securities outstanding in the Eurobond market, compared to R$2.6 billion as of December 31, 2003. 31 In 2003, Unibanco raised approximately US$1.4 billion in funding abroad through eight Eurobond issues, two securitization transactions, and one Tier II subordinate note offering. In 2004, we raised approximately US$625 million in funding abroad through two Eurobond issues, two securitization transactions, and one subordinate note debt. At December 31, 2004, we had R$5.4 billion outstanding in local and foreign onlendings, which consist primarily of real-denominated amounts borrowed from BNDES and FINAME, for loans extended to Brazilian clients for investments mainly in fixed assets, such as premises and equipment. TechnologyTechnology is important to the execution of several components of our business strategy. We have invested heavily in technology, and we will continue to invest in new technology to enable us to retain and enhance our competitive position in various markets, and improve the quality of our services and controlling costs. During 2004, we invested a total of R$193 million on technology. Principal projects included:
32 Competition The market for financial services in Brazil, including banking, insurance and asset management, remains highly competitive. Since 1990, the banking industry in Brazil has experienced a period of consolidation. A number of banks were liquidated, many important state banks were privatized and many medium-sized private-sector banks were sold. As of December 31, 2004, there were 139 multiple-service banks, 24 commercial banks, 21 investment banks and numerous savings and loan, brokerage, leasing and other financial institutions in Brazil. Through the past years, the Brazilian industry banks have begun to face competition from foreign banks. Some U.S. banks, such as Citibank and Bank Boston, are becoming increasingly active in Brazil. Other foreign banks such as HSBC, ABN-AMRO, Banco Santander Centro Hispano have also entered the Brazilian market through acquisitions. Banco Bradesco and Banco Itaú are the two largest private-sector banks in Brazil in terms of assets, followed by Unibanco, Banco Santander-Banespa, Banco ABN AMRO Real, Banco Safra and HSBC Bamerindus. We expect that the recent acquisition and partnership in the Brazilian banking market will increase competition in the retail sector , mainly in the consumer finance segment. We also face competition from public sector banks, some of which have a larger distribution network and larger customer base than the private-sector competitors. Public sector banks, the largest of which are Banco do Brasil and Caixa Econômica Federal, accounted for 36.3% of total lending in the Brazilian banking system as of December 31, 2004, compared to 38.9% as of December 31, 2003. Public-sector banks operate within the same legal and regulatory framework as the private-sector banks and have a strong presence as private-sector banks in the retail sector. 33 Credit Cards and Consumer Finance The Brazilian credit card market is highly competitive, consisting of approximately 33 credit card issuers of varying sizes. The primary competitors of Unicard and HiperCard are Credicard, Banco Itaú, Banco do Brasil, Banco Bradesco, Santander and Banco ABN AMRO Real. We believe that the primary competitive factors are price (interest rate, cardholder fees and merchant fees), card distribution network, card acceptance and name recognition. Co-branded cards, particularly with companies that offer rewards, discounts or mileage programs, such as airline companies, are increasingly being adopted by credit card companies to expand their client base. Post-dated checks also compete with credit cards. They are a popular mean of term payment in Brazil by which customers pay for merchandise and services with future dated bank checks, effectively allowing payment over a longer term. However, we believe that credit cards will gradually replace post-dated checks as the primary method of term payment because of their convenience, safety and growing acceptance. Consumer finance companies, while targeting different economic segments of the population than banks generally do, are likely to continue expanding their credit card activities. We believe the majors competitors for Fininvest are Losango, a company acquired by HSBC, Banco Zogbi and Finasa, both acquired by Bradesco, Taií, Itaú`s consumer finance division, and many small independent companies. Asset Management and Private BankThe asset management industry in Brazil has been dominated by commercial banks offering fixed-income funds to retail bank customers. Competition in the sector includes such traditional competitors as Banco do Brasil, Banco Itaú, Banco Bradesco, HSBC, Citibank, CEF and BankBoston. Unibanco Asset Management has several competitive advantages, particularly its ability to offer a wide product range and a strong brand. In addition, UAM has differentiated itself due to the quality of its investment process, which includes credit analysis, macroeconomic and company research, asset allocation models and risk control. The Private Bank industry is also dominated by the largest commercial banks with some competition coming from both family offices and investment management boutiques. In Brazil, our key competitors are Citibank, Banco Itaú, Banco Bradesco, Banco Safra, HSBC, ABN, BankBoston and Banco Santander, while in our offshore operations, in addition to the local competitors, banks such as JP Morgan Chase, UBS, Merrill Lynch, Morgan Stanley, Crédit Suisse First Boston and the Swiss private banks (Lombard Odier Darier Hentsch, Mirabaud, Julius Baeur, Pictet, among others) also have a strong presence. 34 Insurance and Pension Plans The Brazilian insurance and pension plans market is highly competitive. The total insurance and pension plans market in 2004 represented R$53.8 billion in premiums written and pension contribution. The ten largest insurance groups represented 79.1% of the insurance market as of December 2004. As of December 2004, UASEG and AIG Brasil, on a combined basis, had a 7.8% share of the insurance market, and Prever had a 8.1% share of the pension plans market, representing a total market share of 7.9% in insurance and pension plans. Although companies that operate nationwide underwrite the majority of the business, we also face competition from certain local or regional companies in various markets that may have a relatively cheaper cost structure or specialization in certain niches. We believe that our main competitive advantages are our strength, strong partnership with international company brand name recognition, quality of services and competitive rates. THE BRAZILIAN BANKING INDUSTRYGeneral The Brazilian government controls some commercial banks and other financial institutions which play an important role in the Brazilian banking industry. These institutions hold a significant portion of the banking system’s total deposits and total assets and they have a stronger presence in markets such as residential mortgage and agricultural lending than private sector banks. In addition, the development banks act as regional development agencies. Public SectorThe three main public financial institutions controlled by the Brazilian government are:
Private Sector The following are the most important types of private sector financial institutions:
35 REGULATION AND SUPERVISION Principal Regulatory Bodies The National Financial System is composed of the following regulatory and inspection bodies:
The CMN, the Central Bank and the CVM regulate the Brazilian banking industry. We summarize below the main functions and powers of each of these regulatory bodies:
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Legal Reform of the Brazilian Financial System - Amendment to the 1988 Brazilian Constitution In May 2003, an Amendment to the Brazilian Constitution, or EC 40/03, was enacted to replace the existing restrictive constitutional provisions with a general permission to regulate the Brazilian financial system through specific laws. The enactment of EC 40/03 will allow the legislature to focus more closely on the different issues affecting the regulation of the financial system, which will hopefully lead to greater efficiencies within the financial system. The Brazilian Congress may now vote on several bills dealing with the regulation of the financial system. Congress would have been unable to do this absent the enactment of this constitutional amendment. 37 Principal Limitations and Restrictions on Activities Restrictions on the Extension of Credit Financial institutions may not grant loans to, or guarantee the transactions of, their affiliates, except in some limited circumstances. For this purpose, the law defines an affiliate as:
Moreover, there are currently certain restrictions imposed on financial institutions limiting the extension of credit to public-sector entities, such as government-owned companies and governmental agencies, which are in addition to certain limits on indebtedness to which these public sector entities are already subject. Restrictions on Risk ConcentrationBrazilian law prevents financial institutions from concentrating risks in only one person or group of related persons. The law prohibits a financial institution from extending credit to any person or group of related persons in an aggregate amount equivalent to 25% or more of the financial institution’s adjusted shareholders’ equity. This limitation applies to all transactions involving extension of credit, including those involving:
Financial institutions may not:
When a bank receives real estate in satisfaction of a debt, such property must be sold within one year. Such one-year limit may be extended for two additional periods of one year, subject to the Central Bank’s approval. Repurchase TransactionsRepurchase transactions (operações compromissadas) are transactions involving assets that are sold or purchased subject to the occurrence of certain conditions. Upon the occurrence of any such conditions, and depending on the terms of the particular agreement, the seller or the buyer may be obligated to repurchase, or resell the assets, as the case may be. The conditions triggering the repurchase or resale obligation vary from one transaction to the other, and typically must occur within a particular time frame. Repurchase transactions executed in Brazil are subject to operational capital limits based on the financial institution’s shareholders’ equity, as adjusted in accordance with Central Bank regulations. A financial institution may only hold repurchase transactions in an amount up to 30 times its adjusted shareholders’ equity. Within that limit, repurchase transactions involving private securities may not exceed twice the amount of adjusted shareholders’ equity. Limits on repurchase transactions involving securities backed by Brazilian governmental authorities vary in accordance with the type of security involved in the transaction and the perceived risk of the issuer as established by the Central Bank. 38 Foreign Currency Loans Upon registering with the Central Bank, financial institutions may borrow foreign currency-denominated funds in the international markets for any reason whatsoever without the prior written consent of the Central Bank, including on-lending such funds in Brazil to Brazilian corporations and other financial institutions. Banks make those on-lending transactions through loans denominated in Brazilian currency and indexed to the foreign currency in which the original loan was denominated. The Central Bank may establish limitations on the term, interest rate and general conditions of foreign-currency loans. It frequently changes these limitations in accordance with the economic environment and the monetary policy of the Brazilian government. Foreign Currency PositionOnly those institutions authorized by the Central Bank to operate in the foreign exchange markets may purchase and sell foreign currency in Brazil. The Central Bank imposes a limit on the net exposure of Brazilian financial institutions and their affiliates to assets and debt subject to foreign currency and gold fluctuation. The limit is currently equivalent to 30% of the institution’s adjusted shareholders’ equity. Management of Third Party AssetsAsset management was historically regulated by the Central Bank and the CVM. In 2001, the regulation and supervision of both financial investment funds and variable income funds was transferred to the CVM. In 2002, the CVM and the Central Bank entered into a memorandum of understanding under which they agreed on the general terms and conditions for the transfer of such duties to the CVM. In 2004, the CVM enacted certain regulations which set out, on a consolidated basis, the rules applicable to financial investment funds and variable funds. Only individuals or entities authorized by the CVM may act as managers of third party assets. Financial institutions must segregate the management of third party assets from their other activities. These institutions must appoint an officer as the agent responsible for the management and supervision of the third party assets. The Central Bank, except in very specific circumstances, has prohibited institutions that manage third party assets and their affiliated companies from investing in fixed rate income funds which they also manage. The CVM allows investments in equity funds. There are some rules regarding mutual funds portfolio diversification and composition, which aim to reduce exposure to certain types of risk. Fund managers are required to mark their fixed-income securities to market and results in such fund’s portfolio assets must be accounted for at their fair market value. Micro-credit RegulationThe Brazilian government has taken several measures intended to encourage lower-income individuals to have greater access to the Brazilian financial system. Such measures include the requirement for credit allocation, the simplification of banking procedures, and the liberalization of credit union (cooperativas de crédito) regulations. Since 2003, commercial banks, full service banks licensed to provide commercial banking services, the Caixa Econômica Federal and credit unions must allocate 2% of their cash deposits to low-interest-rate loan transactions designated for lower-income individuals, small companies and informal entrepreneurships, following a specific methodology. Interest rates on these loans cannot exceed 2% per month, the repayment term cannot be less than 120 days, and the principal amount of the loan cannot exceed R$600 for individuals and R$1,000 for micro-enterprises. 39 Credit upon Payroll Discount Since December 2003, employees regulated by the Consolidation of Labor Laws, or CLT, are entitled to authorize employers to discount directly from employees’ payroll amounts due under loans, financing and lease transactions, when the respective agreements permit such procedure. The employers shall transfer the amounts discounted from employees’ payroll to the institutions which have granted the credits to the employees, in accordance with the terms and conditions set forth in the respective loan, financing and/or lease agreements. New Bankruptcy LawIn 2005 the Brazilian Congress enacted the new bankruptcy law, or New Bankruptcy Law, which regulates judicial recuperation, extrajudicial recuperation and bankruptcy of enterprises. The New Bankruptcy Law shall be effective as of June 10, 2005 and shall apply to financial institutions only with respect to the matters not specifically regulated by the intervention and extrajudicial liquidation regimes. It will not directly affect financial institutions, which continue to be subject to intervention and extrajudicial liquidation regimes according to specific legislation. See “- Bank Failure.” Under the New Bankruptcy Law, in the event of bankruptcy, creditors’ credits shall rank, in order of repayment, as follows (a) labor credits, up to a certain limit for each employee and credits derived from labor accidents, (b) credits guaranteed by collateral, up to the value of such collateral, (c) tax credits, (d) credits with special privilege under Brazilian laws, (e) credits with general privilege under Brazilian laws, (f) other credits, (g) any penalties derived from agreements, taxes or criminal laws, and (h) subordinated credits. The changes in the creditors ranking in the event of a bankruptcy is deemed to be favorable to Brazilian creditors, to the extent that the fiscal credits no longer have preference over financial institutions credits guaranteed by collateral. It is expected that such changes shall increase the granting of credit and promote further development in the Brazilian financial sector. Furthermore, the Brazilian Tax Code has been amended to establish that in the event a person under bankruptcy or judicial recuperation proceeding disposes of its assets, the successor shall not be responsible for the tax debts incurred before the disposal. It is expected that such modification shall be favorable for the recuperation of the enterprises by means of the sale or disposal of part of their assets. Regulations Intended to Ensure the Safety and Soundness of Financial Institutions and the Financial System Internal Compliance ProceduresAll financial institutions must establish internal policies and procedures to control their:
The board of executive officers of a financial institution is responsible for implementing an effective structure of internal controls by defining responsibilities and control procedures and establishing corresponding goals at all levels of the institution. The board of executive officers is also responsible for verifying compliance with internal procedures. Either an internal audit department, which reports directly to the board of directors of the institution, or the institution’s external auditors, must be responsible for monitoring the internal control system. Independent Accountants and Audit CommitteeAll financial institutions must be audited by independent accountants. Independent accountants can only be hired if they are registered with the CVM, certified in specialized banking analysis by the Federal Board of Accounting (Conselho Federal de Contabilidade) and the Institution of Brazilian Independent Auditors (Instituto dos Auditores Independentes do Brasil) and if they meet several strict requirements that assure their independence. Moreover, financial institutions must replace their independent accounting firm at least every five consecutive fiscal years and former accountants can be rehired only after three complete fiscal years have passed since their prior service. Financial institutions must designate a senior manager to be responsible for compliance with all regulations regarding financial statements and auditing. 40 In addition to preparing an audit report, the independent accountants must report:
All financial institutions (i) with a reference capital or a consolidated reference capital equal to or greater than R$1 billion, (ii) managing third parties assets in an amount equal to or greater than R$ 1 billion or (iii) managing third parties assets and deposits in an aggregate amount equal to or greater than R$ 5 billion must have created, by July 1, 2004, an internal audit committee. The audit committee must be created pursuant to the financial institution’s by-laws and must be composed of, at a minimum, 3 individuals, at least one of whom is an expert in accounting and auditing. In accordance with the Brazilian law, the members of the audit committee may also be members of the board of directors of the institution and must meet certain requirements that ensure their independence. The audit committee must report directly to the board of directors and its main functions include:
Furthermore, it is permitted under Brazilian law, to create a sole audit committee for the whole group of companies. In this particular case, the audit committee shall be responsible for every and each financial institution pertaining to the same group which falls within the requirements set forth in the paragraph above. The independent accountants and the audit committee must immediately communicate to the Central Bank any event that may materially adversely affect the financial institution’s status, including material non-compliance with applicable regulation and fraud. See “Item 16.C. Audit Committee Financial Expert”. 41 Auditing Requirements Brazilian law requires financial institutions to prepare their financial statements in accordance with certain standards set forth by Brazilian corporation law and other applicable regulations. Capital Adequacy GuidelinesBrazilian financial institutions must comply with guidelines similar to those of the Basle Accord on risk-based capital adequacy. The requirements imposed by the Central Bank differ from the Basle Accord in a few aspects. Among other differences, the Central Bank:
Under the Central Bank regulation, the net worth, or Reference Capital, of Brazilian financial institutions is represented by the sum of Tier 1 and Tier 2 capital and is taken into consideration for the purposes of defining their capital adequacy.
The Reference Capital shall be taken into consideration for the purpose of defining the capital adequacy of financial institutions, except for the permanent assets limit, which is defined pursuant to certain legal provisions. Capital StructureFinancial institutions must be organized as corporations. As corporations, they are subject to all the provisions of Brazilian Corporate Law and, if they are registered as public companies, to the supervision of the CVM. Financial institutions may divide their capital into voting and non-voting shares, although, non-voting shares may only represent up to 50% of their total capital. Treatment of Overdue DebtsUnder Central Bank regulations, banks have to classify their loan transactions with companies into 9 (nine) categories, ranging from AA to H, in accordance with their risk. Risk assessment includes an evaluation of the borrower, the guarantor and the relevant loans. Credit classifications are determined in accordance with Central Bank criteria relating to:
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The regulations specify, for each category of loans, a minimum provision, as follows:
In general, banks must review the loan classifications annually. However, banks must review loans:
A loan may be upgraded if it has a credit support or downgraded if in default. Banks must write-off loans six months after they are ranked H. In the case of loan transactions with individuals, there is a similar nine-category ranking system. The loan is graded based on data including the individual's income, net worth and credit history (as well as other personal data). For loans that are past due, the regulations establish maximum classifications, as follows:
Banks are required to determine, on a monthly basis, whether any loans must be reclassified as a result of these maximum classifications, and, if so, must adjust their provisions accordingly. Finally, banks are required to make their lending and loan ranking policies available to the Central Bank and to their independent accountants. They must also provide information relating to their loan portfolio along with their financial statements, including:
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Financial institutions are required to provide information to the Central Bank concerning the extension of credit and guarantees rendered to clients. The information is used to:
If the aggregate amount of a client’s transactions exceeds R$5,000.00 or in case of transactions of a single client in an amount equal to or greater than US$ 5,000,000.00, the financial institution must provide the Central Bank with:
For transactions that, in the aggregate, are below or equal to R$5,000.00, the financial institution must only report the total amount of transactions per client. Anti-Money Laundering LawPursuant to the Brazilian anti-money laundering law, financial institutions must:
In addition, the Brazilian anti-money laundering law created the Financial Activity Control Council. The main role of the Council is to promote cooperation among the Brazilian governmental bodies responsible for implementing national anti-money laundering policies, in order to avoid the performance of illegal acts and frauds. 44 Anti-Tax Evasion Law The Brazilian Central Bank is authorized to require financial institutions to provide information generally protected by bank secrecy without judicial authorization, as long as they have strong circumstantial evidence that a customer has engaged in tax evasion. Such evidence may be represented by, among others:
Other than in the circumstances described above, information protected by bank secrecy laws can only be furnished in compliance with a court order or an order by a Congress Inquiry Committee , or CPI. Regulations Affecting Liquidity in the Financial MarketReserve Requirements The Central Bank currently imposes several compulsory reserve requirements on financial institutions. Financial institutions must deposit those reserves with the Central Bank. The Central Bank uses reserve requirements as a mechanism to control the liquidity of the financial system. The reserves imposed on demand deposits, savings deposits and time deposits account for substantially all amounts required to be deposited with the Central Bank. For further discussion of reserve requirements, please see “Item 5. Operating and Financial Review and Prospects – Macroeconomic Factors Affecting Our Financial Condition and Result of Operations – Effect of Government Regulation on Our Financial Condition and Results of Operations – Compulsory Deposit Requirements”. Taxation of Financial TransactionsTemporary Contribution on Financial Transactions (CPMF) The Temporary Contribution on Financial Transactions (Contribuição Provisória sobre Movimentações Financeiras), or CPMF, is a tax imposed on any type of financial transaction, with certain limited exemptions. The current rate of the CPMF is 0.38% and shall be in effect until December 31, 2007. On 2004, the law 10.892/04 created the so called “Investment Deposit Accounts”, which are investment accounts that allow investors to handle their investments with funds existing in such accounts without paying CPMF. The Brazilian government may change the applicable rate at any time, subject to the limits established by the Federal Constitution. The CPMF is generally levied upon any debit to bank accounts. This creates an incentive for clients to reduce transactions in the financial system and short-term investments. Increases in PIS and COFINS Tax RatesIn May 2003, the Brazilian Congress approved an increase in the rate of the Contribuição para Financiamento da Seguridade Social, or COFINS, payable by the financial services sector. The Programa de Integração Social, or PIS, and COFINS were previously imposed on our gross revenues at a combined rate of 4.65%. As part of the Brazilian tax reform, in February 2004, the COFINS rate for non-financial companies has increased from 3% to 7.6%, resulting in a combined rate of 9.25%. These increases affect us less directly, as only certain of our consumer finance subsidiaries are considered to be non-financial institutions for the purposes of COFINS and PIS. The Brazilian government recently reduced to zero the rate of the PIS and COFINS on the revenues resulting from financial intermediation received by legal entities which are subject to the non-cumulative PIS and COFINS regime. The reduction of this rate is not applicable to revenues derived from interest over capital. 45 resulting from financial intermediation received by legal entities which are subject to the non-cumulative PIS and COFINS regime. The elimination of this rate is not applicable to revenues derived from interest over capital. Tax on Financial Transactions (IOF)The Tax on Financial Transactions (Imposto sobre Operações Financeiras), or IOF, taxes four different types of transactions at different rates. At present, actual rates are much lower than their legal limit. Generally the IOF is imposed upon the following transactions, at the following rates:
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Regulations Affecting Our Relationship with Our Clients The relationship between financial institutions and their clients is regulated in general by laws applicable to all commercial transactions, and by the Brazilian Civil Code in particular. However, regulations established by the CMN and the Central Bank address specific issues relating to banking activity and contracts, complementing the general regulation. 46 The Consumer Defense Code and the Banking Client Defense Code In 1990, the Brazilian Consumer Defense Code was enacted to establish rigid rules to govern the relationship between product and service providers and consumers and to protect final consumers. In May, 2004 the Brazilian Supreme Court of Justice ruled that the Brazilian Consumer Defense Code also applies to transactions between financial institutions and their clients. We are not in a position, at this stage, to predict the impact that this will have on the Brazilian banking system. Financial institutions are also subject to specific regulation of the CMN, which specifically regulates the relationship between financial institutions and their clients. The New Civil CodeA new Brazilian Civil Code, or the New Civil Code, took effect on January 11, 2003 and replaced the prior Civil Code and substantial parts of the Commercial Code. The New Civil Code is wide-ranging in application, governing individuals, corporations and other legal entities, and has provisions which affect, among others, contracts, including guarantees, property, family and succession law. Contractual obligations and guarantees entered into before January 11, 2003 will continue to be governed by the prior Civil Code solely in relation to their existence and validity; although the effects of such agreements as of January 11, 2003 are governed by the New Civil Code. The changes under the New Civil Code have not had a material impact on our business. Banking SecrecyFinancial institutions must maintain the secrecy of their banking operations and services provided to their customers. Certain exceptions apply to this obligation, however, such as the sharing of information on credit history, criminal activity and violation of bank regulations or disclosure of information authorized by interested parties. Bank secrecy may also be breached when necessary for the investigation of any illegal act. Bank FailureIntervention, Administrative Liquidation and Bankruptcy The Central Bank may intervene in the operations of a bank if there is a material risk for creditors. The Central Bank may intervene if liquidation can be avoided or it may perform administrative liquidation or, in some circumstances, require the bankruptcy of any financial institution except those controlled by the federal government. Extrajudicial LiquidationAn extrajudicial liquidation of any financial institution (with the exception of public financial institutions controlled by the Federal Government) may be carried out by the Central Bank if it can be established that:
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In addition to the aforesaid procedures, the Central Bank may also establish the Temporary Special Administration Regime (Regime de Administração Especial Temporária), or RAET, which is a less severe form of Central Bank intervention in private and non-federal public financial institutions and which allows institutions to continue to operate normally. The RAET may be imposed by the Central Bank in the following circumstances:
The main object of the RAET is to assist with the recovery of the financial conditions of the institution under special administration. Therefore, the RAET does not affect the day-to-day business operations, liabilities or rights of the financial institution, which continues to operate in its ordinary course. Repayment of Creditors in a LiquidationIn the liquidation of a financial institution, employees’ wages and indemnities and tax claims enjoy the highest priority of any claims against the bankrupt estate. The Credit Insurance Fund is a deposit insurance system which guarantees a maximum amount of R$20,000 of deposits and credit instruments held by an individual against a financial institution (or against financial institutions of the same financial group). The Credit Insurance Fund is funded principally by mandatory contributions from all Brazilian financial institutions that work with customer deposits. The payment of unsecured credit and customer deposits not payable under the Credit Insurance Fund is subject to the prior payment of all secured credits and other credits to which specific laws may grant special privileges. Brazilian Payment and Settlement SystemThe rules for the settlement of payments in Brazil are based on the guidelines adopted by the Bank of International Settlements, or BIS, and the Brazilian Payment and Settlement System began operating in April 2002. The Central Bank and CVM have the power to regulate and supervise this system. Pursuant to these rules, all clearing houses are required to adopt procedures designed to reduce the possibility of systemic crises and to reduce the risks previously borne by the Central Bank. The most important principles of the Brazilian Payment and Settlement System are:
48 Foreign Investment and the Federal Constitution Foreign Banks The Federal Constitution prohibits foreign financial institutions from establishing new branches in Brazil, except when duly authorized by the Brazilian government. A foreign financial institution duly authorized to operate in Brazil through a branch or a subsidiary is subject to the same rules, regulations and requirements that are applicable to any Brazilian financial institution. Foreign Investment in Brazilian Financial InstitutionsThe Federal Constitution permits foreign individuals or companies to invest in the voting shares of Brazilian financial institutions only if they have specific authorization from the Brazilian government. Foreign investors may acquire publicly traded non-voting shares of Brazilian financial institutions or depositary receipts offered abroad representing non-voting shares without specific authorization. Supervision in Other JurisdictionsWe have branches, subsidiaries and representative offices in several foreign jurisdictions, including New York, Miami, Luxembourg, Paraguay and the Cayman Islands. The Central Bank exercises global consolidated supervision over such branches, subsidiaries and representative offices. Furthermore, in most cases, we had to obtain governmental approvals from local central banks and monetary authorities in such jurisdictions before commencing business and in all cases we are subject to local authorities’ supervision. Insurance MarketPrincipal Regulatory Entities Two regulatory agencies oversee the Brazilian insurance system: the National Private Insurance Council (Conselho Nacional de Seguros Privados), or CNSP, and the SUSEP. The SUSEP is responsible for implementing and supervising the CNSP’s policies and ensuring compliance by insurance companies and brokers. InsuranceInsurance companies require government approval to operate, as well as specific approval from the SUSEP for each of their products. Insurance companies may sell policies only through qualified brokers. Insurance companies must set aside reserves, funds and provisions in accordance with the criteria established by the CNSP. The investments backing up the reserves must be diversified. Securities comprise a substantial portion of the assets in which insurance companies can invest. As a result, insurance companies are major investors in the Brazilian financial markets and are subject to a series of rules and conditions imposed by the CMN regarding the investment of technical reserves. Insurance companies, subject to certain specific exceptions, are prohibited from:
49 Insurance companies must operate within technical limits set forth by SUSEP pursuant to rules established by the CNSP. The rules take into account the economic and financial situation of the insurance companies, the technical conditions of their respective portfolios and the results of their operations with IRB (as defined below). Insurance companies (i) with adjusted net worth greater than R$ 500 million disclosed in the financial statements for each of the two previous years, or (ii) technical provisions greater than R$ 700 million as disclosed in the financial statements for each of the two previous years must appoint internal audit committees. Insurance companies which are part of financial groups, such conditions are applied considering all of the insurance companies under the same group. Additionally, insurance companies which are part of a financial group may have a single audit committee for the group, in order to comply with the responsibilities of the insurance companies. ReinsuranceThe regulation of reinsurance transactions in Brazil has traditionally been the domain of IRB-Brasil Resseguros S.A., or IRB, a government-controlled entity which enjoyed a monopoly over the Brazilian reinsurance market from 1932 through 1996. In 1996, the monopoly was formally eliminated. Pursuant to a law enacted in 1999, the IRB was to be privatized and its regulatory powers transferred to SUSEP. However, the constitutionality of this law is being challenged before the Supreme Court. As a result, until the Supreme Court renders a final decision in this matter, the IRB will not be privatized and shall remain as the reinsurance regulatory body in Brazil. All risks in excess of the companies’ maximum retention limits established by the SUSEP must be compulsorily reinsured or co-insured. According to industry practice, insurance companies also voluntarily reinsure or co-insure a portion of their exposure, regardless of whether they meet the maximum retention limits. Reporting RequirementsInsurance companies must file unaudited monthly and audited semiannual and annual reports with the SUSEP. LiquidationInsurance companies are exempt from ordinary bankruptcy procedures and instead follow a special procedure administered by the SUSEP. Liquidation may be either voluntary or compulsory. The Minister of Finance has the authority to institute compulsory liquidation. Foreign Participation in the Insurance MarketThere is currently no rule restricting foreign investment in insurance companies. The direct participation of foreign companies (as well as those of private Brazilian companies) in the reinsurance market may be regulated by a pending implementing law. Securities MarketThe Brazilian securities market is regulated by the CMN and the CVM. Current regulations impose several obligations on publicly traded corporations, such as:
For a discussion of the main provisions of Brazilian Corporate Law regarding protection to minority shareholders and requirements on publicly traded corporations, see “Item 10.B. Memorandum and Articles of Association”. 50 4.C. ORGANIZATIONAL STRUCTURE The following chart sets forth information, as of April 30, 2005, regarding our significant subsidiaries and affiliates or Group(1) (2):
51 4.D. PROPERTY, PLANT AND EQUIPMENT Our principal executive offices are located in São Paulo, Brazil. We own a portion of these offices and lease the remainder. The main offices, which we own, and the main activities carried on in each of them are:
We also have a number of other administrative offices in the main Brazilian cities, most of which are leased. Of our total branches, 5.2% are owned by Unibanco and 94.8% are leased. We lease most of our branches under renewable leases with terms averaging five years. 52 ITEM 5. OPERATING AND FINANCIAL REVIEW AND PROSPECTS The following discussion and analysis should be read in conjunction with our audited consolidated financial statements as of and for the years ended December 31, 2002, 2003, and 2004 and the related notes thereto included in Item 19 of this Form 20-F, on which we have based this discussion and analysis. Our consolidated financial statements for the year ended December 31, 2004 have been audited by PricewaterhouseCoopers Auditores Independentes and for the years ended December 31, 2003 and 2002 have been audited by Deloitte Touche Tohmatsu, as described in their reports included herein. OverviewIn 2004, we celebrated our 80th anniversary with a solid position as the third largest Brazilian private financial group according to the Central Bank’s ranking of total assets. We are a full service financial institution with assets of R$77,858 million as of December 31, 2004, providing a wide range of financial products and services to more than 18 million individual and corporate clients primarily throughout Brazil and also in foreign countries. Our mission is to actively contribute to Brazil’s economic development, fulfilling in a balanced manner the expectations, needs and interests of our clients, employees and shareholders. Our objective is to be a leading provider of services in each segment in which we operate, focusing on continuous pursuit of scale, profitability, efficiency maximization and excellence in human resources. We operate our business in four segments: Retail, Wholesale, Insurance and Pension Plans and Wealth Management. Our primary sources of revenues and expenses are:
In 2004, we continued to grow organically and also engaged in new strategic transactions to expand our businesses. 53 In our Retail business segment, in May 2004, we acquired Crédito Financiamento e Investimento S.A., or Creditec, a consumer finance company with a significant presence in the Brazilian personal loans and consumer finance sector among middle and lower income customers, and with approximately 600,000 active clients at the time of the acquisition. By the end of 2004, we had converted all of the former 64 Creditec points of sale into Fininvest stores, increasing Fininvest’s distribution network. In March 2004, we acquired HiperCard Administradora de Cartão de Crédito Ltda, or Hipercard, a credit card company created in 1982 to extend private label credit services to Supermercados Bompreço. In August 2004, we established a partnership agreement with Sonae Distribuição Brasil S.A., or Sonae, a supermarket chain, for the creation of a financing company that will offer financial services to Sonae customers. In the same month, we acquired Lev Cred Serviços de Crédito e Cobrança S.A. and two months later, in October 2004, we acquired a customer database from Credicerto, both related to the consumer finance business. In November 2004, we increased our ownership of Banco1.net to 99.999% of the total equity and a month later we decided to discontinue the business, bringing approximately 72,000 clients of former Banco1.net to Unibanco. In December 2004, we sold our equity interests in Credicard, a credit card issuer, as well as in Orbitall, a credit card processor. We sold our 33.3% interest in Credicard to Itaú and Citigroup, which each currently own 50% of Credicard’s capital stock. Citigroup and us also sold our respective 33.3% interests in Orbitall to Itaú. In connection with the sale of both equity interests, we received R$1,727 million in cash at the end of December 2004, generating earnings before taxes of R$1,574 million. After the transaction, we maintained our strong position in the credit card market with 17.5 million cards issued, including 8 million issued by our wholly-owned subsidiaries and 9.5 million private label cards. We also maintained our 31.9% equity interest in Redecard, a credit and processing company which contributed R$48 million to our net income in 2004. In February 2005, we entered into an agreement with Wal-Mart to make Hipercard credit cards available for use in all Wal-Mart stores in Brazil. In our Wholesale business segment, we announced, in June 2004, the acquisition of 99.98% of Banco BNL do Brasil, or BNL Brasil, from Banca Nazionale del Lavoro S.p.A., or BNL. At that time, BNL held a R$715.9 million credit portfolio and had 107,000 individual clients, 96,000 credit cards and 400 corporate clients. This transaction improved our ability to offer business opportunities and services to Italian companies in Brazil. In our Insurance and Pension Plans business segment, in January 2004, we concluded the acquisition of Phenix Seguradora S.A., or Phenix, the insurance business of Fiat do Brasil S.A. In addition, in November 2004, we increased our indirect interest in Unibanco AIG Warranty S.A., or Unibanco AIG Warranty, to 70% by acquiring the 20% interest held by Multibrás S.A. Eletrodomésticos. Unibanco AIG Warranty offers extended warranty contracts for household appliances, among other things. In addition to the acquisitions and partnerships mentioned above, since the second quarter of 2004 we have implemented important changes to our internal structure in order to enhance our business model. These changes include the election of a single CEO, the establishment of an Audit Committee, the creation of a Corporate Communications area, the installation of an independent Risk Management and Treasury department, the addition of new members to the Board of Directors, the restructuring of our Retail business (which now includes the middle market and cash management areas), and the assignment of new responsibilities to the CFO, such as operational back office and information technology. On August 30, 2004, we effected a 100-to-1 reverse stock split of our and Unibanco Holdings’ common and preferred shares, including the preferred shares that comprise the Units. We believe that the reverse stock split will reduce operational costs and increase stock liquidity. 54 On March 21, 2005, we revitalized our brand with new colors and a new logo. Our logo, created in the 1960s, was redesigned to provide more movement and lightness to the brand. The new logo is primarily blue with some green, replacing our former official colors, black and white. The following table shows our financial performance highlights for the years ended 2002, 2003 and 2004:
The year of 2004 had two distinct phases. During the first half of the year, the Brazilian economy demonstrated signs of recovery and the downward spiral in interest rates was interrupted. The base interest rate for the Brazilian banking system established by the Central Bank, or SELIC base interest rate, was stabilized at 16.00% . The base interest rate is the benchmark interest rate payable to holders of certain securities issued by the federal government and traded at the SELIC. However, during the second half of the year, despite the consolidation of the economic recovery, particularly in industrial activity, concerns with increasing inflation initiated a new cycle of increases in the SELIC base interest rate, which reached 17.75% in December 2004. Over the year, the real appreciated by 8.1% against the U.S. dollar, closing at R$ 2.6544 per U.S. dollar on December 31, 2004. Inflation measured by the Consumer Price Index, or IPCA, and published by the Brazilian Institute of Geography and Statistics, or IBGE, in the twelve-month period ended December 31, 2004 was 7.6%, lower than the 9.3% posted in the previous year. Industrial production, as measured by the IBGE, was 8.3% higher in the twelve months of 2004 compared to the same period of 2003. Brazil’s indicative cost of sovereign borrowing, as measured by JP Morgan’s Emerging Market Bond Index, or EMBI Brazil index, closed December 2004 at 383 basis points, 80 basis points down from the end of December 2003, reflecting an improvement of the Brazil sovereign risk. Our income before taxes and minority interest increased 82% in 2004 compared to 2003, mainly due to the sale of our equity interests in Credicard and Orbitall, which generated earnings of R$1,574 million before taxes, partially offset by higher level of non-interest expenses. Consequently, our net income grew by 136% in 2004 compared to 2003, also as a result of tax benefits and a lower tax impact, primarily attributable to different tax treatment of our gains (losses) from exchange variations on our investments in branches and subsidiaries offshore denominated in foreign currencies, or investments abroad, in which gains are not taxable and losses are non tax-deductible. In 2004, each of our business segments contributed to our net income as follows: 80% from Retail, 8% from Wholesale, 7% from Insurance and Pension Plans and 5% from Wealth Management. 55 In July 2004, the Retail business segment joined the corporate restructuring, and began to implement a new business model intended to create greater synergy amongst different activities and businesses, covering products, distribution network, and consumers in the segment’s many sub-segments. Middle-market companies with sales of between R$40 million and R$150 million, which previously had been assigned to the Wholesale business segment, were added to the Retail’s portfolio of clients. In addition to synergy objectives, focusing on higher profitability and efficiency, the new business model aims to maintain the growth of various business lines including:
As part of the new business model, we introduced four significant Retail products in 2004: Tarifa Zero, in which service fee discounts are given depending on clients’ historical affiliation; Plano Único, a product combining the advantages of a traditional mortgage and the flexibility of a purchasing pool; consignment credit offerings to private or government employees with credit card usage and personal credit lines; and Superpoupe, a certificate of deposit first offered in May 2004 with a cost of funding that is lower than the cost of a traditional time deposit certificate. Our Superpoupe portfolio amounted to R$1,625 million as of December 31, 2004. In our consumer and credit card business lines, our credit card company Unicard achieved a loan portfolio of R$1,708 million as of December 31, 2004, an increase of 60.4% compared to December 31, 2003, and 4.8 million cards issued, an increase of 9.1% compared to 2003. Hipercard posted a loan portfolio of R$1,100 million as of December 31, 2004 and had 2.7 million cards issued. Fininvest posted a loan portfolio of R$1,565 million as of December 31, 2004. During 2004, 142 new stores were opened, increasing the Fininvest distribution network to 253 stores and reaching over 11,000 points of sale. Our auto financing business had R$3,682 million in its loan portfolio as of December 31, 2004. In addition to auto financing, we offer, in our branch network, vehicle purchasing pools managed by Unibanco-Rodobens and Consórcio Nacional Ford. In 2004, we sold over R$700 million of these purchasing pools. Our Wholesale business segment continued to handle the business of large corporate clients with annual sales greater than R$150 million. In 2004, we integrated some branches of our domestic Wholesale network in order to optimize our distribution and better serve our clients, offering a higher level of customization and regionalization without interrupting the integration of our new products offerings, such as derivative products. On December 31, 2004 we had a balance of US$1.6 billion in foreign trade finance transactions, resulting from import, export and international financing warranties. R$857 million was disbursed for BNDES export and/or import transactions, giving us the leading position in BNDES-exim ranking. Our Wholesale capital markets, project finance, and financial advisory businesses were very active in 2004 and participated in the following major deals:
56
In our Insurance and Pension Plans business segment, UASEG and Unibanco AIG Vida e Previdência ranked fourth in consolidated terms, according to SUSEP, ANAPP and ANS, with a 7.8% market share, including extended warranty, according to ANS data as of December 2004. We also maintained our leadership in the property risks, D&O (Directors & Officers), aviation, petrochemical risks and extended warranty products. Unibanco AIG Vida e Previdência ranked fourth in pension plan revenues, with a 9.1% market share, according to ANAPP, and reached the second highest position in accumulated sales on corporate pension plans, with total sales of R$936 million in 2004. In our Wealth Management business segment, our subsidiary UAM ended December 2004 with R$27,765 million in assets under management and custody, 19.8% higher than in 2003. The year accounted for positive flow mainly from corporate, institutional and private clients. As of December 31, 2004 UAM held the sixth position in ANBID’s ranking of assets under management for third parties, with a market share of 4.0%. In December 2004, our Private Banking segment posted a 9.9% increase in its assets under management compared to December 2003, leading it to the second highest position in the ANBID’s ranking and reaching a market share of 9.3% . In 2005, we expect a positive outlook for Brazil with economic growth which could generate larger credit operations. Net interest spreads in banking operations tend to fall in this type of environment, since sustained economic growth leads to higher payment capacity of borrowers and lower credit risk for creditors. However, we believe the diversification of our products and services, as well as the growth of our individual and corporate client base, particularly in the consumer finance and middle market segments, should enable us to increase economies of scale and cross-selling opportunities among our different business segments, and thus enhance our profitability in the future. 57 Macroeconomic Factors Affecting Our Financial Condition and Results of Operations Our earnings and businesses are affected by general economic conditions, performance of financial markets, interest rates, currency exchange rates, changes in laws, regulations and policies of the Central Bank, and competitive factors on a global, national and regional basis. Since the majority of our customers are Brazilian, our financial condition and results of operations are mainly dependent on Brazilian economic conditions. For example, changes in the Brazilian economy, which adversely affect the ability of customers to repay their credits, such as high levels of inflation and consequently interest rates, may affect our financial condition and results of operations. Moreover, we are also affected by changes in the value of the real relative to the U.S. dollar and other foreign currencies, since we have assets and liabilities denominated in or indexed to foreign currencies, primarily the U.S. dollar. For additional information, see “Item 5. Operating and Financial Review and Prospects - Macroeconomic Factors Affecting Our Financial Condition and Results of Operations -Effects of Depreciation or Appreciation of the Real on Our Financial Condition and Results of Operations” and “Item 5. Operating and Financial Review and Prospects - Macroeconomic Factors Affecting Our Financial Condition and Results of Operations - Effects of Interest Rates on Our Financial Condition and Results of Operations”. Brazilian Economic EnvironmentThe following table shows, for the periods indicated, the main Brazilian macroeconomic indicators:
58 The following charts show, for the periods indicated, the real/U.S. dollar currency rate and the SELIC base interest rate: 
2002. The Brazilian economy deteriorated in 2002, primarily due to the political uncertainty relating to the Brazilian presidential election. During 2002, the real/U.S. dollar exchange rate fluctuated between a high of R$3.8949 per U.S. dollar and a low of R$2.2709 per U.S. dollar. In October 2002, the Central Bank began to increase the SELIC base interest rate from 18% in September 2002 to a high of 25% in December 2002. After the new government elections in November 2002, signs that the economic policy guidelines of the previous government would be maintained led to a decrease in the perception of Brazilian country risk as indicated by the drop in Brazil’s indicative cost of sovereign borrowing, according to JP Morgan’s Emerging Market Bond Index, or EMBI, from a high of approximately 2,400 basis points in October 2002 to approximately 1,500 basis points in December 2002. Inflation for 2002 was 26.4% and 12.5%, as measured by the IGP-DI and IPCA, respectively. GDP growth for 2002 was 1.5% . At December 31, 2002, the exchange rate was R$ 3.533 per U.S. dollar. 2003. Following the new government's taking office in January 2003, the Brazilian economy stabilized as it became more certain that the new government would maintain the primary economic policy guidelines of the previous government. The stabilization of the economy was partly due to the government’s decision to shift the primary surplus from 3.75% of GDP in 2002 to 4.25% in 2003, alleviating concerns about fiscal irresponsibility, as well as the Central Bank's decision to temporarily increase interest rates. The Central Bank increased the SELIC base interest rate to a high of 26.5% in February 2003 and subsequently reduced the SELIC base interest rate eight times to 16.5% in December 2003. During 2003, the government advanced proposals to reform the tax and social security systems, contributing to a decrease in the perception of Brazilian country risk. The Brazilian EMBI decreased from 1,500 basis points in December 2002 to 463 basis points at December 31, 2003. The Brazilian inflation rate, as measured by the IPCA, dropped from 12.5% in 2002 to 9.3% in 2003. Also measured by the IGP-DI, the Brazilian inflation rate declined from 26.4% in 2002 to 7.7% in 2003. The real appreciated against the U.S. dollar by 18.2% for the year ended December 31, 2003, compared to a depreciation of the real by 52.3% in 2002. At December 31, 2003, the exchange rate was R$2.8892 per U.S. dollar. 2004. The year of 2004 had two distinct phases. During the first half of the year, the downward cycle in interest rates ceased and the SELIC base interest rate stabilized at 16.00% . During the second half of the year, there was a new cycle of increases in the SELIC base interest rate. The risk of increasing inflation again became a concern in the first half of the year, due to the supply shock generated by the upward trend in international commodity prices. There was also the impact of foreign exchange pressure on expectations of inflation. The foreign accounts of the Brazilian economy, boosted by the very strong trade balance, helped maintain strong liquidity in the foreign exchange market. 59 The trend in the second half of 2004 was the consolidation of the economic recovery, especially in industrial activity. At the same time, inflation concerns continued to grow, leading the Central Bank to increase the SELIC base interest rate gradually, from 16.00% in September 2004 to 17.75% in the December 2004 meeting of the Monetary Policy Committee, or COPOM. In September 2004 the government announced an increase in the consolidated primary surplus target, from 4.25% to 4.5% of GDP, and the Central Bank adjusted the 2005 IPCA inflation target from 4.5% to 5.1%. The primary surplus is the difference between government revenue and government spending excluding the payment of interest on public debt. The internal situation created by the ongoing external adjustment was intensified by the powerful fiscal result for the first ten months of the year, with a primary surplus of 5.59% of GDP, strengthening the credibility of Brazil’s fiscal policy. These results in the public accounts were sufficient to keep the debt/GDP ratio declining over the course of the year, reaching 51.8% on December 31, 2004, compared with 57.2% on December 31, 2003. Exports produced growing monthly trade surpluses. In the twelve-month period ending in December 2004, Brazil posted a trade surplus of US$33.7 billion. The combination of vigorous exports, the continuously increasing credibility of fiscal policy and improvements in external and domestic solvency indicators helped reduce the perception of Brazilian sovereign risk: the EMBI Brazil index closed December 2004 at 383 basis points, a decrease of 80 basis points from the end of December 2003. In spite of this, rollovers of private sector external debt remained at modest levels as companies voluntarily reduced their external liabilities. The accompanying outflow of foreign currency did not adversely affect the liquidity of the foreign exchange market, with foreign exchange trade flows keeping their strength over the whole year. During 2004, the real appreciated by 8.1% against the U.S. dollar, closing at R$2.6544 per U.S. dollar on December 31, 2004. IPCA inflation in the twelve-month period ended December 31, 2004 was 7.6%, lower than the 9.3% posted in 2003. Industrial production, as measured by the IBGE, was 8.3% higher in the twelve-month period ended December 31, 2004 compared to 2003. 2005 through the end of May. The Central Bank continued to increase the SELIC base interest rate from 17.75% at the end of 2004 to 19.75% in May 2005. The IPCA index posted inflation of 2.7% through May of 2005, compared with 2.2% in the same period of 2004. Industrial production in the first quarter of 2005 was 6.26% lower than in the first quarter of 2004. The public accounts continued to post a primary surplus, totaling 7.26% of GDP from January to May of 2005. At the end of May 2005, the real had depreciated by 9.44% from the end of 2004. The trade balance continued to be strong, with a surplus of US$8.3 billion over the first quarter of 2005 compared to a surplus of US$6.2 billion during the same period of 2004. In addition, perception of Brazil’s sovereign risk deteriorated slightly: the EMBI Brazil index at the end of May of 2005 was 418 basis points, or 35 basis points higher than at the end of 2004. In spite of the increase of the SELIC base interest rate by 325 basis points from September 2004 through March 2005, we believe the outlook for the Brazilian economy is positive, with continuing economic growth, which will generate an attractive environment for new investments and improvements in the payment capacity of economic agents, consequently reducing risk for creditors, which we expect will provide a favorable environment to expand credit volume, albeit with lower spreads. In recent years, we have made several acquisitions and investments to expand our client base and develop a strong distribution network throughout the country, which has helped us consolidate our competitive position in the Brazilian market and prepare to face future challenges. 60 Effects of Depreciation or Appreciation of the Real on Our Financial Condition and Results of Operations The depreciation or appreciation of the real affects our net income, since substantial portions of our assets and liabilities are denominated in or indexed to foreign currencies, primarily the U.S. dollar. When the real depreciates, we incur losses on net income from our liabilities that are denominated in or indexed to foreign currencies, such as U.S. dollar-denominated short-term borrowings and long-term debt, as the carrying value and interest expense measured in reais increases. At the same time, we experience gains from our assets that are denominated in or indexed to foreign currencies, such as U.S. dollar-indexed marketable securities and loans, as the carrying value and interest income measured in reais also increases. On the other hand, when the real appreciates, we incur gains on net income from our liabilities that are denominated in or indexed to foreign currencies, as the carrying value and interest expense measured in reais decreases. At the same time, we experience losses from our assets that are denominated in or indexed to foreign currencies, as the carrying value and interest income measured in reais also decreases. Effects of Interest Rates on Our Financial Condition and Results of Operations Increases in the Brazilian interest rate may affect our interest income as interest rates on our interest-earning assets also increase. On the other hand, our interest expense may also be affected as interest rates on our interest-bearing liabilities increase. Typically, increases in the interest rate enable us to increase our revenues from credit operations due to higher net interest spreads on these operations. However, increases in the interest rate could adversely affect our results and loan portfolios by reducing demand for credit and increasing the risk of customer default. On the other hand, decreases in the interest rate could decrease our revenues from credit operations due to lower spreads. This decrease in revenues may be offset by an increase in the volume of credit due to increased demand for credit. Effects of Inflation on Our Financial Condition and Results of Operations Increases in the Brazilian inflation rate may affect our net income by increasing our costs and decreasing our operating margins if such inflation is not accompanied by an increase in interest rates. Moreover, inflation may contribute to increases in volatility in the market due to economic uncertainty, decreases in spending, lower real income growth and decreases in consumer confidence, which in turn could adversely affect our results of operations. 61 Effects of Government Regulation on Our Financial Condition and Results of Operations Compulsory Deposit RequirementsThe Central Bank imposes several compulsory deposit requirements on financial institutions, as a mechanism to control the liquidity of the Brazilian financial system. By changing the compulsory deposit requirements, the Central Bank is able to effect changes in the amount of our interest-earning assets and interest-bearing liabilities, and consequently our interest income and interest expense. Percentages of compulsory requirements are applied over the amount of our deposits and the funds resulted are deposited in the Central Bank. As of December 31, 2002, 2003 and 2004, respectively, the compulsory deposit requirements were as follows:
The Central Bank applied the following changes on the compulsory deposit requirements over the last three years:
The compulsory deposits earn interest, except for the one required on demand deposits. On December 31, 2004, our reserve requirement on time deposits in the form of Brazilian government securities deposited with the Central Bank totaled R$108 million, our reserve requirement on demand deposits totaled R$955 million, our reserve requirement on savings deposits totaled R$1,258 million and our additional reserve requirements on demand, savings and time deposits totaled R$2,487 million. 62 Capital Adequacy The Central Bank requires banks to comply with its regulations, which currently are similar to the Basel Accord with respect to capital adequacy, with a requirement of a minimum capital adequacy ratio of 11% of total capital to total risk-adjusted assets. The Central Bank also applies capital requirements on foreign currency exposure, on interest rate market risk and on credit swap risk, which are part of the determination of our capital adequacy ratio, or Basel ratio. In October 2002, the Central Bank imposed higher capital requirements for banks’ foreign currency exposure, which is the net position of assets, liabilities and derivatives denominated in or indexed to foreign currency as a percentage of the bank’s adjusted capital. This regulation required us to allocate 100% of our capital for foreign currency exposure exceeding 5% of adjusted capital. Furthermore, the Central Bank reduced the maximum allowed foreign currency exposure from 60% to 30% of adjusted capital. In July 2003, the allocation of capital for foreign currency exposure was reduced from 100% to 50%. In summary, there is no requirement to allocate capital for exposure from 0% to 5% of adjusted capital; 50% of capital must be allocated for exposure between 5% and 30% of adjusted capital; and an exposure above 30% is not permitted and is subject to penalties imposed by the Central Bank. In June 2004, the Bank for International Settlements Committee on Banking Supervision, or BIS, endorsed the publication of the International Convergence of Capital Measurement and Capital Standards: a Revised Framework, commonly known as Basel II. On December 9, 2004, the Central Bank, in Communication No. 12,746, expressed its intention on how to adopt Basel II in Brazil. The Communication indicates that the Central Bank intends to adopt Basel II gradually, with caution and appropriate adaptation to Brazilian needs in the coming years. Loan Charge-offsOur practice has been to charge off loans 360 days after the due date. As a result, our allowance for loan losses related to any loan remains on our books for that period until the loan is charged off. Income TaxesOur income taxes expenses consist of two components: the federal income tax and the social contribution. For the years of 2002, 2003 and 2004, the federal income tax was assessed at a rate of 25% and the social contribution at a rate of 9%. Other TaxesSince February 1999, the rate of contribution to the Programa de Integração Social, or PIS, relating to the promotion of the integration of employees in companies’ life and development, has been 0.65% of gross revenues. From February 1999 to September 2003, the rate of the Contribuição para Financiamento de Seguridade Social, or COFINS, relating to tax for social security financing, was 3% of gross revenues. In September 2003, the COFINS rate was increased to 4% of gross revenues for the financial services sector. For non-financial companies and pursuant to Law No. 10,637, of December 30, 2002, the PIS rate increased from 0.65% to 1.65% . In addition, pursuant to Law No. 10,833 of December 29, 2003, in February 2004, the COFINS rate for non-financial companies increased from 3.0% to 7.6% and became non-cumulative. These increases affected a few of our consumer finance subsidiaries that are considered non-financial companies. 63
The Contribuição Provisória sobre Movimentações Financeiras, or CPMF, has been charged at the rate of 0.38% on certain financial transactions since June 1999. Critical Accounting EstimatesIn preparing our consolidated financial statements, we use management estimates, assumptions and judgments to account for certain assets, liabilities, revenues, expenses and other transactions, in accordance with U.S. GAAP. Actual results in future periods could differ from those estimates, assumptions and judgments, and consequently our reported results of operations may be affected. The following is a brief description of the more critical estimates, assumptions and judgments in the application of our accounting policies under U.S. GAAP. Allowance for Loan LossesWe establish allowances for expected credit losses on a monthly basis by determining reserves through estimates and judgements. For each client rating, we determine a minimum allowance for corresponding expected losses using forecast models that consider, among other things, recent loss experience, current economic conditions, the risk characteristics of the various classifications of loans, the fair value of the underlying collateral, the probability of default and the loss given default rates in making this evaluation, as well as the size and diversity of individual credits. Our Wholesale loans have distinctive characteristics and therefore are not evaluated as a homogeneous portfolio. Instead, the allowances are currently calculated based on the risk profile of each individual borrower, including, among other factors, financial history, cash flows, quality of management, relationship history, market conditions and other factors relating to credit risk. Small-balance loans such as overdrafts, credit card loans, mortgage loans and consumer finance loans have similar characteristics and are managed using specialized systems and processes. We use a wide range of statistical tools to evaluate loans requests and client’s performance, which include credit and behavior scoring models. For additional information see Note 2(h) to our consolidated financial statements. The volatility of the Brazilian economy may lead to greater uncertainty in our models than would be expected in more stable macroeconomic environments. Consequently, the actual loan losses could differ from our forecast models results or the allowance for loan losses may not be indicative of future charge-offs. The methodology for calculating the allowances for expected credit losses based on forecast models involves significant judgment and is dependent on the quality of the information available. Our forecast models results are influenced by the risk profile of each credit operation that is classified within nine different levels of risk. For hypothetical sensitivity purposes, if our performing loans would be classified one level below in our forecast models, our allowance for loan losses would be increased by, approximately, R$76 million as of December 31, 2004. The analysis should not be considered as a reflection of our expectations for future determinations of risk classification or for future changes in the severity of losses. 64 Fair Value of Financial Instruments Our financial instruments include fixed rate securities, equity securities, derivatives and other financial instruments. We carry our investments at fair value if they are considered to be available for sale or trading securities. For the majority of our portfolios, fair value is determined based on externally quoted prices. If externally quoted prices are not available, we determine the fair value by reference to the quoted market price of comparable instruments, or we discount the expected cash flows using market interest rates commensurate with the credit quality and maturity of the investments on internally developed pricing models based on independent sources of market information. We believe we have a conservative policy regarding market risk exposure. The market risk exposure of our portfolio is independently supervised and controlled. Changes in the fair value of available for sale securities are recognized and included as a component of stockholders’ equity, unless the loss is considered to be other than temporary. Impairment losses that are considered other than temporary are recognized as losses in the period in which they occur. We conduct regular reviews to assess whether other than temporary impairment exists. For additional information see Notes 2(f), 7 and 8 to our consolidated financial statements. Deterioration in economic conditions could adversely affect these values. Changes in the fair value of trading assets and liabilities, including our derivatives for trading purposes with our customers, derivatives qualified as fair value hedges, and derivatives not qualified as hedges (primarily derivatives used to manage our overall exposure to changes in interest rates and foreign currencies), are recognized in earnings. Changes in the fair value of derivatives qualified as cash-flow hedges are recognized as a component of stockholders’ equity. Insurance ReservesReserves for insurance claims and claims expenses are charged as incurred. The reserves for claims and claims expenses represent the accumulation of estimates for reported claims and include provisions for claims incurred but not reported. The methods of determining such estimates and establishing the reserves, including unrecoverable reinsurance, are reviewed and updated regularly. Adjustments resulting thereof are recognized in earnings for the respective period. For additional information see Note 22(b) to our consolidated financial statements. Income TaxesIn preparing our consolidated financial statements we are required to estimate income taxes, which involve an estimation of current tax expense together with an assessment of temporary differences. Temporary differences result from the temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes, and this difference generates net deferred tax assets. Net deferred tax assets may also comprise tax loss carry forwards. Our carrying value of net deferred tax assets assumes that we will be able to generate sufficient future taxable income based on an internal forecast model that uses estimates and assumptions. We evaluate the reliability of the deferred tax assets frequently. If these estimates and assumptions change in the future, we may be required to record valuation allowances against our deferred tax assets resulting in additional income tax expense in the consolidated statements. During the year ended December 31, 2002, 2003 and 2004, we recorded no valuation allowances related to our net deferred tax assets. For additional information concerning income taxes see Notes 2(q) and 18 to our consolidated financial statements. 65 Impairment of Long-lived Assets, Goodwill and Intangible Assets Our balance sheet includes long-lived assets related to our premises and equipment, goodwill and intangible assets. Premises and equipment and intangible assets with finite useful lives are depreciated or amortized over their estimated useful lives. Useful lives are estimated based on the period that the assets will generate revenue. If circumstances and conditions indicate deterioration in the value of tangible or intangible assets, the book value will be adjusted and a loss will be recognized in earnings. Statement of Financial Accounting Standards 142 “Goodwill and Other Intangible Assets”, or SFAS 142, provides that goodwill and identified intangible assets with indefinite useful lives shall not be amortized but shall be tested for impairment at least on an annual basis. In assessing the recoverability of goodwill and other intangible assets we must make assumptions regarding estimated future cash flows and other factors to determine the fair value of the respective assets. If these estimates or their related assumptions change in the future, we may be required to record impairment charges for these assets not previously recorded based on the difference between the fair value and the book value. Goodwill was tested for impairment at December 31, 2002, 2003 and 2004, and no impairment charges were recorded in 2002 and 2003. In 2004, however, we recorded an impairment of R$35 million, mainly as a consequence of our decision to discontinue the reporting business unit of Banco1.net. In addition, we evaluated the useful lives of intangible assets at December 31, 2002, 2003, and 2004, and no impairment was recognized. We assess impairment of our long-lived assets and intangible assets with finite useful lives in accordance with the requirements of SFAS 144 “Accounting for the Impairment or Disposal of Long-Lived Assets” when events and circumstances indicate that such impairment may exist. No impairment was recognized in 2002, 2003 or 2004. Provisions for LitigationWe are subject to proceedings, lawsuits and other claims related to tax, labor and civil matters. We are required to assess the likelihood of any adverse judgments or outcomes to these matters as well as potential ranges of probable losses. A determination of the amount of reserves required, if any, for these contingencies is made after careful analysis of each individual matter (in the case of tax and civil matters) or is based on average amounts paid during the immediately preceding 36 months (in the case of labor matters), in accordance with advice of counsel. We record provisions for contingencies only when we believe that it is likely that we will incur a loss in connection with the matter in dispute. Our policy is not to record a provision for litigation for administrative proceedings other than lawsuits in which our evaluation of loss is considered remote or possible. For administrative proceedings in which a loss is considered probable, our policy is to pay or, where we have opted to defend the claim, record a provision. The required reserves for these contingencies may change in the future due to new developments in each matter or changes in approach, such as a change in settlement strategy in dealing with these matters. These changes could result in a negative impact on future results and cash flows. Accounting for Results of Unconsolidated AffiliatesIn accordance with U.S. GAAP, our equity in results of unconsolidated companies consists primarily of our proportionate interest in the results of affiliated companies whose results of operations are not consolidated. Under U.S. GAAP, we only consolidate the results of companies in which we have a controlling interest (either through a majority voting interest, or through the existence of other control factors). 66
Our most significant unconsolidated companies during 2004 were:
For additional information concerning the contributions to our net income generated by unconsolidated companies, see “5.A. Operating Results - Results of Operations for the Year Ended December 31, 2004 Compared to the Year Ended December 31, 2003 - Non-Interest Income” and “5.A. Operating Results - Results of Operations for the Year Ended December 31, 2003 Compared to the Year Ended December 31, 2002 - Non-Interest Income” and Notes 2(j) and 11 to our consolidated financial statements. 5.A. OPERATING RESULTSOverview Unibanco Holdings, a corporation organized under Brazilian laws, controls Unibanco through its ownership of Unibanco shares. As of December 31, 2004, Unibanco Holdings held 96.6% of Unibanco outstanding common shares and 15.6% of Unibanco outstanding preferred shares, owning 59.4% of Unibanco’s total outstanding equity. Unibanco Holdings engages in no activities other than holding shares in Unibanco. As a result, the financial statements of Unibanco Holdings are similar to those of Unibanco in all material respects, except for the minority interest line of the balance sheet and income statement and the financing activities section of the cash flow statement. References herein to Unibanco consolidated financial statements also refer to the financial statements of Unibanco Holdings. In our discussion of our operating results for 2004 compared to 2003 and 2003 compared to 2002 below, when we refer to changes from year to year being due to the “appreciation of the real”, we are referring primarily to the effects of the appreciation of the real described under “Item 5. Operating and Financial Review and Prospects - Macroeconomic Factors Affecting Our Financial Condition and Results of Operations - Effects of Depreciation or Appreciation of the Real on Our Financial Condition and Results of Operations”, as applicable. When we refer to changes from year to year being due to the “lower appreciation of the real”, we are referring to the fact that although we experienced in 2004 effects of appreciation that were similar to those we experienced in 2003, such effects were less pronounced because the percentage appreciation was lower in 2004. In addition, we refer in our discussion of our operating results below to “average interest earned” and “average interest paid” on our interest-earning assets and interest-bearing liabilities, respectively. Average interest earned on assets denominated in or indexed to foreign currency is the yield on such assets, taking into account the effect of the depreciation or appreciation of the real on the carrying value of and interest on such assets when measured in reais. Average interest paid on liabilities denominated in or indexed to foreign currency is the yield on such liabilities, taking into account the effect of the depreciation or appreciation of the real on the carrying value of and interest on such liabilities when measured in reais. 67 During the years ended December 31, 2002, 2003 and 2004, respectively, the real depreciated by approximately 52.3%, appreciated by approximately 18.2% and appreciated by approximately 8.1%, against the U.S. dollar. When we refer to a specific percentage depreciation or appreciation of the real against the U.S. dollar in any year, we have derived such percentage by comparing the number of reais exchangeable for one U.S. dollar at the end of the given year to the number of reais exchangeable for one U.S. dollar at the end of the previous year, as reported by the Central Bank. Results of Operations for the Year Ended December 31, 2004 Compared to the Year Ended December 31, 2003 The following table shows the principal components of our consolidated net income for 2003 and 2004:
Our income before taxes and minority interest increased 82.0% in 2004 compared to 2003, mainly due to the sale of our equity interests in Credicard and Orbitall, which generated an income before taxes of R$1,574 million, partially offset by higher level of non-interest expenses. Our net interest income increased 14.9% mainly due to a better credit portfolio mix, with growth in loans to individuals and SMEs, which generate higher interest income. We also reached a better funding mix with the growth of the volume of deposits through Superpoupe. Our fee and commission income also increased mainly from banking tariffs and credit card fees. In addition, we implemented efficiency improvement actions to better control costs. The net income increase of 136.3% was a result of the effect of growth in income before taxes and minority interest, as mentioned above, which was not followed by an increase in income tax expenses in 2004 due to Brazilian tax laws. Our income tax expenses decreased R$59 million or 16.7% in 2004 compared to 2003, mainly due to non-deductible foreign exchange losses on our investments abroad and tax benefits. Our Retail business segment net income increased 250% in 2004 compared to 2003, mainly impacted by the sale of our equity interests in Credicard and Orbitall, which generated earnings of R$1,574 million before taxes, partially offset by higher level of non-interest expenses. Net interest income increased mainly due to the 57% growth in our loan portfolio, which was mostly driven by the acquisition of Hipercard and the growth of our loan portfolio to small companies, individuals and consumer finance. Fee and commission income increased, mainly as a result of the acquisition of Hipercard, which contributed to the total credit card fees increase of 29%. Our Retail provision for loan losses did not match the increase of our loan portfolio, which indicates an improvement in the credit quality of our borrowers. Personnel and administrative expenses increased 13.9%, mainly due to acquisitions, provisions for labor claims, bargaining agreements, annual adjustments of utilities expenses, and the expansion of our branches and Fininvest stores. 68 Our Wholesale business segment net income amounted to R$162 million, posting a decrease of 5.8% in 2004 compared to 2003, mainly as a result of additional provision for loan losses due to the increased credit risk of the communication and media sector clients. Our Insurance and Pension Plans business segment net income increased 22% in 2004 compared to 2003, mainly as a result of changes in our portfolio mix due to the launching of and focusing on higher profitability products, and also as a result of tax benefits. The insurance, private retirement plans and pension investment contracts income amounted to R$1,775 million in 2004 compared to R$1,468 million in 2003, representing a 21% growth. Insurance and Pension Plans business segment expenses grew by 15.5% as a result of higher business activity. Insurance claims grew by 6% in 2004 compared to 2003, however the claims ratio (insurance claims over insurance, private retirement plan and pension investment contract income) decreased from 56% to 49% in 2004 due to better underwriting practices and a more rigorous expense control. Our Wealth Management business segment net income amounted to R$104 million in 2004, maintaining the same level as 2003. The 20% increase of assets under management, from R$23,168 million in 2003 to R$27,765 million in 2004, compensated the reduction of fee income average rate from 1.3% in 2003 to 1.1% in 2004. Net Interest IncomeThe following table shows the principal components of our net interest income for 2003 and 2004:
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69 Interest Income The following table shows the principal components of our average interest-earning assets and the average interest rate earned in 2003 and 2004:
The following table shows how much of the increase in our interest income was attributable to changes in the average volume of interest-earning assets and how much was attributable to changes in the average interest earned, including the effects of the appreciation of the real, for 2004 as compared to 2003:
The increase in interest income was composed of the following primary components:
70 Interest on Securities. Interest income on securities (including trading, available for sale and held to maturity securities) increased from R$975 million in 2003 to R$2,422 million in 2004. During 2004, our average volume of securities was R$16,506 million, or 22.2% of total average assets, maintaining approximately the same level of 2003. On December 31, 2004, 32.8% of our securities portfolio was denominated in or indexed to foreign currencies, primarily the U.S. dollar, compared to 43.7% on December 31, 2003. As a result of lower appreciation of the real in 2004 compared to 2003, average interest earned changed as follows:
Interest and Fees on Loans. Interest income and fees on loans increased 5.8%, from R$6,138 million in 2003 to R$6,495 million in 2004, primarily as a result of an increase in the volume of our credit portfolio of R$5,338 million, or 20.5%, mainly from increases in Retail as a result of organic growth and strategic acquisitions in the consumer finance segment. This increase, combined with a lower volume of loans denominated in or indexed to foreign currencies, offset the effect of the appreciation of the real on average interest earned. Average interest earned decreased from 25.8% in 2003 to 24% in 2004. On December 31, 2004, 19.3% of our loan portfolio was denominated in or indexed to foreign currencies, primarily the U.S. dollar, compared to 22.9% on December 31, 2003. Interest on Deposits in Other Banks. Despite the slight growth of 40 basis points on the average interest rate earned, interest income on deposits in other banks increased 50% from R$166 million in 2003 to R$249 million in 2004, as a result of a growth of 41.2% in the average volume of deposits in 2004. Interest on Central Bank Compulsory Deposits. Despite an increase of 10.3% in the average volume of compulsory deposits in 2004, interest income decreased from R$512 million in 2003 to R$404 million in 2004, or 21.1%, primarily as a result of the lower average interest rate earned in 2004 compared to 2003. The average interest rate earned declined from 16.7% in 2003 to 12.0% in 2004, mainly due to the correlation with the SELIC base interest rate, which on average also declined in 2004. Interest on Federal Funds Sold and Securities Purchased under Resale Agreements. Although the average volume of federal funds sold and securities purchased under resale agreements increased by 32.3% in 2004, interest income decreased from R$1,554 million in 2003 to R$1,538 million in 2004. This was a result of a decrease in the average interest rate earned from 19.5% to 14.6% respectively, mainly due to the correlation with the SELIC base interest rate, which on average also declined in 2004. 71 Interest Expense The following table shows the principal components of our average interest-bearing liabilities and the average interest rate paid on those liabilities in 2003 and 2004:
The following table shows how much of the increase in our interest expense in 2004 was attributable to changes in the average volume of interest-bearing liabilities and how much was attributable to changes in average interest paid, including the appreciation of the real, in each case for 2004 as compared to 2003:
In summary, interest expense for 2004 increased R$1,009 million, or 23.3%, compared to 2003, principally as a result of:
The increase in interest expense was composed of the following primary components:
Interest on Long-term Debt. Interest expense on our long-term debt increased from R$(302) million in 2003 to R$949 million in 2004, mainly due to the lower appreciation of the real in 2004 compared to 2003. As a result of the lower appreciation of the real, the average interest rate paid in 2004 on our long-term debt was a positive 7.5%, compared to a negative 2.5% in 2003. Additionally, the average volume of our long-term debt increased by 4.3% in 2004, with approximately 50% denominated in or indexed to foreign currencies. Lower gains on a portion of our long-term debt denominated in or indexed to foreign currency that acted as a global hedge to our investments abroad also contributed to the increase in interest expense. On these hedges we realized gains of R$154 million in 2004 compared to R$397 million in 2003. 72 Interest on Short-term Borrowings. Interest expense on our short-term borrowings increased from R$(444) million in 2003 to R$(36) million in 2004, despite a decrease in the average volume of short-term borrowings of 24.9% in 2004. The decrease in short-term borrowings was mainly due to the lower appreciation of the real in 2004 compared to 2003, which increased average interest paid from negative 9.8% in 2003 to negative 1.1% in 2004. The absence of gains on short-term borrowings, which acted as a global hedge to our investments abroad, compared to gains of R$101 million in 2003, also contributed to the interest expense increase. Interest on Federal Funds Purchased and Securities Sold under Repurchase Agreements. The average volume of these liabilities increased R$2,448 million and the interest expense increased R$25 million in 2004. The increase in interest expense, resulting from the increase in volume of liabilities, was partially offset by a decrease in average interest rates paid, from 17.8% in 2003 to 13.2% in 2004, mainly due to the correlation with the SELIC base interest rate, which on average also declined in 2004.
Interest on Time and Savings Deposits. Interest expense on time and savings deposits decreased as follows:
73 Provision for Loan Losses The following table shows the loan portfolio and provision for loan losses by segment for 2003 and 2004:
Despite an increase in our provision for loan loss expenses in 2004, the credit quality of our portfolio improved in 2004, with a ratio non-performing loans/total loans of 4.1% compared to 4.5% in 2003. This decrease was primarily a result of the recovery of the Brazilian economy, and improvements in our policies and procedures of credit and collection. The increase of R$67 million, or 7.6%, of our provision for loan loss expenses was primarily a result of the following:
In 2004, loan charge-offs decreased R$213 million, or 16.0%, due primarily to the improvement in the macroeconomic environment and to the administration of collection practices. Wholesale’s loan charge-offs decreased R$20 million, or 29.9% . In Retail, Fininvest’s loan charge-offs increased R$12 million, or 3.7%, and Unicard loan charge-offs increased R$26 million, or 13.6% . Commercial bank and other retail loan charge-offs were reduced by R$232 million, or 31.3%, compared to 2003. Allowances increased R$243 million, or 18.5%, compared to 2003. Wholesale allowances increased R$194 million, or 35.2%, mainly due to provison for loan loss expenses of R$139 million in 2004, which was 167.3% higher than 2003. Unicard’s allowance decreased R$9 million, or 7.4%, and Fininvest’s allowance decreased R$8 million, or 7.1%. Commercial bank and other retail allowances posted an increase of R$66 million, or 13.3% . Non-performing loans increased R$113 million, or 9.7%, compared to 2003. Wholesale non-performing loans decreased R$6 million, or 2.4% . Fininvest reduced its non-performing loans by R$27 million, or 13.8%. Unicard’s non-performing loans increased R$13 million, or 9.8% . Commercial bank and other retail non-performing loans posted an increase of R$132 million, or 23.5%, also due to administration of collection practices. 74
Fee and Commission Income. Fee and commission income increased R$230 million, or 10.7%, in 2004 compared to 2003. In 2004, 60.5% of this source of income was originated from banking tariffs and other fees and commissions, 22.1% from credit card fees mainly attributable to the acquisition of Hipercard, 11.4% from asset management fees and 6% from collection fees, with income variations of 7%, 29.5%, 7.9% and (2.7%) respectively, compared to 2003. Trading Income (Expenses). Trading income decreased from R$691 million in 2003 to R$221 million in 2004 as a result of lower appreciation of the real in 2004 compared to 2003. In 2004, we recognized net earnings of R$15 million from realized gains on securities, R$308 million from realized gains on derivatives, and R$102 million from unrealized losses on securities and derivatives. In 2003, we recognized net earnings of R$205 million from realized gains on securities, R$408 million from realized gains on derivatives, and R$78 million from unrealized gains on securities and derivatives. In general, we use derivatives to hedge our treasury and commercial client portfolios, as well as our investments abroad. In 2004, we recognized R$117 million in earnings from our global hedges of investments abroad, compared to R$138 million in 2003. Net Gains (Losses) on Securities and Non-trading Derivatives. The net gain on securities decreased from an income of R$191 million in 2003 to an expense of R$150 million in 2004, mainly as a result of:
Net Gains on Foreign Currency Transactions. The net gain on foreign currency transactions increased from R$93 million in 2003 to R$108 million in 2004, mainly as a result of our continued participation in foreign currency operations. 75 Equity in Results of Unconsolidated Companies. The equity in results of unconsolidated companies increased from R$199 million in 2003 to R$220 million in 2004, mainly due to:
Insurance, Private Retirement Plan and Pension Investment Contracts. In 2004, insurance premiums increased R$229 million, or 16.2%, compared to 2003. The growth in insurance premiums was primarily a result of the consolidation of our leadership, as measured by SUSEP as of December 2004, in the corporate segment of the insurance industry, which includes segments such as: Property, Aviation, D&O, Commercial Lines and Energy. This was driven by our partnership with AIG, which has significant experience as insurer and reinsurer in the international market. In the retail segment, customers demanded greater protection against credit card theft and fraud, further contributing to increases in our retained premiums. In addition, our product marketing TV campaigns and launch of new products, such as environmental insurance, and the re-launch of a specialized insurance product targeting women contributed to the improved performance in 2004. In 2004, private retirement plan and pensions investment contracts fee increased R$51 million compared to 2003, as a result of new corporate plan contracts and strong sales on individual pension investment contracts, such as PGBL and VGBL plans. Other Non-Interest Income. Other non-interest income increased from R$709 million in 2003 to R$2,285 million in 2004, mainly due to earnings before taxes of R$1,574 million originated by the sale of our equity interests in Credicard and Orbitall. Non-Interest ExpenseThe following table shows the principal components of our non-interest expense for 2003 and 2004:
76 Salaries and Benefits. Salaries and benefits increased 14.6% in 2004 compared to 2003 principally due to:
We had 27,408 employees on December 31, 2004 compared to 27,625 employees on December 31, 2003. The decrease in employees due to our internal restructuring was partially offset by an increase of approximately 1,400 employees as a result of our strategic acquisitions and addition of new sales force employees to support the expansion of branches and Fininvest stores. Administrative Expenses. Administrative expenses increased 10.3% in 2004 compared to 2003, primarily due to:
Amortization of Intangibles and Impairment of Goodwill. The amortization of intangibles and impairment on goodwill increased R$61 million, or 67%, in 2004. This increase was driven by a R$35 million increase in the impairment of goodwill, mostly resulting from the discontinuation of the reporting business unit of Banco1.net, and a R$26 million increase in the amortization of intangible assets, mainly as a result of recent acquisitions, such as Hipercard. Insurance, Private Retirement Plan and Pension Investment Contracts. Insurance reserves for claims increased R$48 million in 2004, while claims incurred increased R$46 million in the same period. Both expenses were higher due to increases in our underwritten portfolio during the year of 2004. Pension investment contracts expenses increased R$70 million in 2004 as a result of sales growth. Selling expenses increased R$74 million in 2004 also in conjunction with the sales growth. Good underwriting practices contributed to the reduction in the loss ratio in 2004. 77 Other Non-Interest Expenses. Our other non-interest expenses are mainly composed of the negative exchange variation on investments abroad, contingent provisions and taxes related to services, revenues and others. The increase of R$31 million, or 1.6%, in other non-interest expenses from R$1,974 million in 2003 to R$2,005 million in 2004 was primarily due to:
The increase of non-interest expenses was partially offset by a decrease in exchange losses on investments abroad of R$548 million in 2004, as a result of a lower appreciation of the real compared to 2003. In 2004, we incurred in exchange losses of R$83 million in 2004 compared to R$631 million in 2003. Income TaxIncome taxes and social contribution decreased from R$354 million in 2003 to R$295 million in 2004. At the statutory rate, tax expenses would have increased R$378 million in 2004 compared to 2003, as a result of income increase for tax basis in 2004. However, the increase in tax expenses was offset by tax benefits on interest attributed to stockholders’ equity, by tax on non deductible exchange losses on our investments abroad, and by tax benefits on non-taxable income from sale of investments in unconsolidated companies. According to Brazilian tax laws, the exchange variation gains on investments abroad are not taxable and the exchange variation losses on investments abroad are not tax-deductible for income tax purposes. In 2004, we had losses of R$83 million from exchange variations on our investments abroad, which created a tax effect of R$28 million. In 2003, we had losses of R$631 million from exchange variations on our investments abroad, which created a tax effect of R$215 million. Both years were influenced by the appreciation of the real. 78 Results of Operations for Year Ended December 31, 2003 Compared to Year Ended December 31, 2002 The following table shows the principal components of our consolidated net income for 2002 and 2003:
A highlight of 2003 is the 115.1% growth in income before taxes and minority interest in 2003 compared to 2002. This increase is mainly due to better performance in trading income attributable to more favorable market conditions, reduction of provision for loan losses due to the improvement in the credit quality of our borrowers and growth of fee and commission income, consisting principally of banking tariffs and advisory fees. The net income increase of 8.7% is a result of the growth in income before taxes and minority interest, as mentioned above, offset by a R$630 million increase in income tax expense in 2003. The increase in income tax expense resulted principally from the effect of the appreciation of the real on our economic hedging of our investments abroad. During 2003, we fully hedged our investments abroad, incurring a loss of R$631 million as a result of the appreciation of the real on our investments abroad that was offset by gains of R$636 million on our economic hedges. Since under Brazilian tax law, gains or losses on economic hedges are taxable, whereas foreign exchange losses on our investments abroad are not deductible and gains are not taxable, we incurred higher income tax expense of R$216 million. By contrast, in 2002, when the real depreciated by 52.3%, we partially hedged our investments abroad and experienced foreign exchange gains of R$1,187 million on our investments abroad and losses of R$794 million on the economic hedge, which contributed to an income tax benefit of R$270 million.
Each of our four business segments posted pre-tax growth in 2003 compared to 2002 as follows: 79 The Wholesale business segment income before taxes and minority interest increased, from a negative to a positive result, in 2003 compared to 2002, due to unfavorable market conditions that occurred in 2002. This increase is mainly attributable to growth in trading income, as a consequence of the favorable market conditions in 2003. Fees and commissions increased 12.7%, principally in the capital markets, investment banking and mergers and acquisitions sectors. The provision for loan losses decreased 80.7% demonstrating the improvement in the risk rating profile of our loan portfolio and the positive impact of real appreciation. Personnel and administrative expenses in this segment increased 16.2% for essentially the same reasons described in the Retail business segment paragraph above, other than the reserve for labor claims and sales force. The Insurance and Pension Plan business segment income before taxes and minority interest increased 30.7% in 2003 compared to 2002. The net interest income increased 31.3% mainly due to financial results, as a consequence of higher interest rates. The insurance, premiums amounted to R$1,468 million in 2003 compared to R$1,291 million in 2002, representing a 13.7% growth. We closed the year with a 7.1% market share for total premiums as per the official data of SUSEP compared to a 6.3% market share in 2002. The insurance, private retirement plan and pension investment contract expenses grew 31.1% due to an increase in insurance claims and changes in the provisions of pension investment contracts. Despite an increase of 9.4% in insurance claims in 2003 compared to 2002, the ratio (insurance claims over insurance premiums) fell from 58.0% in 2002 to 55.8% in 2003 due to the increase in insurance premiums in 2003. The Wealth Management business segment income before taxes and minority interest increased 4.1% in 2003 compared to 2002. In 2002, the volume of assets under management was negatively affected by the new rules for marking assets to market and by the challenging economic environment created by the presidential elections. During 2003, we showed a significant volume growth of assets under management from R$18,384 million to R$23,168 million, although fee income and average volume remained at approximately the same levels in 2003 compared to 2002. Net Interest IncomeThe following table shows the principal components of our net interest income for 2002 and 2003:
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Interest income declined by R$5,690 million, or 37.8%, interest expense declined by R$5,412 million, or 55.5%, and net interest income declined by R$278 million, or 5.2% in 2003 compared to 2002. These changes are principally attributable to a decrease on average interest rates on U.S. dollar-denominated or indexed interest-earning assets and interest-bearing liabilities due to the appreciation of the real. 80 Interest Income Interest income for 2003 decreased R$5,690 million or 37.8%, principally due to a decrease in average interest rates earned on assets denominated in or indexed to foreign currencies as a result of the appreciation of the real. This decrease was offset slightly by the additional interest earned as a result of the increase of 8.8% in our average interest-earning assets. The following table shows the principal components of our average interest-earning assets and the average interest rate earned in 2002 and 2003:
The following table shows how much of the R$5,690 million decrease in our interest income was attributable to changes in the average volume of interest-earning assets and how much was attributable to changes in the average interest earned, including the effects of the appreciation of the real, in each case for 2003 as compared to 2002:
The interest income decrease of R$5,690 million in 2003 was principally a result of:
Interest and Fees on Loans. The interest income from loan operations decreased 27.9% from R$8,514 million in 2002 to R$6,138 million in 2003. This decrease was primarily due to the appreciation of the real. At December 31, 2003, 22.9% of our loan portfolio was denominated in or indexed to foreign currencies, primarily the U.S. dollar, compared with 27.7% at December 31, 2002. The effect of the appreciation of the real was partly offset by the increase in revenues attributable to the period of high interest rates in the first nine months of 2003 and the increase of 3.1% in our loan portfolio as a result of organic growth. The increase of our loan portfolio occurred mainly in the Retail business segment. Interest on Securities. The interest income on securities (including trading, available for sale and held to maturity securities) declined from R$5,519 million in 2002 to R$975 million in 2003. The 82.3% decrease was primarily due to the appreciation of the real. At December 31, 2003, 43.7% of our securities portfolio was denominated in or indexed to foreign currencies, primarily the U.S. dollar, compared to 60.6% at December 31, 2002. 81 Interest on Central Bank Compulsory Deposits. The interest income from our compulsory deposits with the Central Bank, which earn interest increased from R$173 million for the comparable period in 2002 to R$512 million in 2003. This R$339 million increase was mainly due to the increase in the compulsory deposit requirements imposed since the second half of 2002, the increase in the average volume of deposits, as well as the period of higher interest rates in the first nine months of 2003. Interest on Federal Funds Sold and Securities Purchased under Resale Agreements. The interest income from federal funds sold and securities purchased under resale agreements increased from R$652 million in 2002 to R$1,554 million in 2003. This increase was a result of a 110.9% higher average volume of federal funds sold and securities purchased under resale agreements in 2003 compared to 2002. In addition, the average interest rate, as measured by the SELIC base interest rate, was higher in 2003 than in 2002 and the yield in most of these transactions is correlated to the SELIC base interest rate. Interest ExpenseInterest expense for 2003 decreased R$5,412 million or 55.5%, principally due to a decrease in average interest rates paid on liabilities denominated in or indexed to foreign currencies as a result of the appreciation of the real. This decrease was offset slightly by the additional interest paid as a result of the increase of 5.5% in our average interest-bearing liabilities. The following table shows the principal components of our average interest-bearing liabilities and the average interest rate paid on those liabilities in 2002 and 2003:
The following table shows how much of the R$5,412 million decrease in our interest expense in 2003 was attributable to changes in the average volume of interest-bearing liabilities and how much was attributable to changes in average interest paid, including the appreciation of the real, in each case for 2003 as compared to 2002:
82 The interest expense decrease of R$5,412 million in 2003 was principally a result of:
Interest on Long-term Debt. The interest expense from our long-term debt declined from R$3,557 million in 2002 to R$(302) million in 2003, mainly due to the appreciation of the real. As a result of the appreciation of the real, the average interest paid in 2003 on our international long-term debt was a negative 17.9%, compared to a positive 64.2% in 2002. The gains on economic hedges of our investments abroad of R$397 million in 2003 also contributed to the interest expense decline. This effect was partially offset by the increase in average balances of our long-term debt from R$9,551 million in 2002 to R$12,067 million in 2003. Interest on Short-term Borrowings. The interest expense on our short-term borrowings declined from R$2,064 million in 2002 to R$(444) million in 2003, mainly due to the appreciation of the real. As a result of the appreciation of the real, the average interest paid in 2003 on our international short-term borrowings was a negative 10.0% in 2003, compared to positive 33.6% in 2002. The decrease of our average balance of short-term borrowings, from R$6,133 million in 2002 to R$4,553 million in 2003, as well as the gains on economic hedges of our investments abroad of R$101 million in 2003 also contributed to the interest expense decline. Interest on Time and Savings Deposits. The interest expense on time and savings deposits increased R$1,086 million in 2003 due to the increase in the average balance and average interest paid. The average balances of time and savings deposits increased from R$13,799 million and R$5,284 million in 2002 to R$16,752 million and R$5,735 million, in 2003, respectively. The average interest paid on time deposits increased from 17.5% per annum in 2002 to 20.2% per annum in 2003 and average interest paid on savings deposits increased from 7.6% per annum in 2002 to 9.0% per annum in 2003 due to the increase in the average interest rates, as measured by the SELIC base interest rate, in 2003. Provision for Loan LossesThe provision for loan losses in 2003 decreased from R$1,291 million in 2002 to R$881 million in 2003, posting a 31.8% change on the year-ended comparison. In addition, the provision to average loans ratio improved from 5.2% in 2002 to 3.5% in 2003. These results indicate the credit quality of our loan portfolio. However, these results were also influenced by fluctuations in volumes and in currency exchange rates related to our foreign currency denominated or indexed portfolio. In 2002, the Brazilian economy deteriorated, primarily due to political uncertainty relating to presidential elections. As a consequence, the interest rates increased and the real depreciated, affecting negatively our Retail and Wholesale business segment clients’ risk of default and increasing our balances and provisions denominated or indexed to foreign currencies, principally affecting our Wholesale business segment portfolio. In 2003, the Brazilian economy stabilized, the interest rate decreased and the real appreciated, providing a better environment for credit risk management. The following table shows the changes on our balance of allowance for loan losses on a consolidated basis for 2002 and 2003:
83 The following table shows the changes on our balance of allowance for loan losses broken down by “Unibanco and others” (including Retail and Wholesale business segments), Fininvest and Unicard businesses for 2002:
The following table shows the changes on our balance of allowance for loan losses broken down by “Unibanco and others” (including Retail and Wholesale business segments), Fininvest and Unicard businesses for 2003:
The provision for loan losses decreased from 2002 to 2003 as follows:
The provision to average loans ratio improved from 2002 to 2003 primarily due to a better risk profile as follows:
On a consolidated basis, the loan charge-offs decreased 13.0% in 2003, mainly due to Brazil’s improved economic conditions compared to 2002. 84 Therefore, our allowance for loan losses decreased from R$1,389 million in 2002 to R$1,317 million in 2003, primarily as a result of the improvement in our credit risk profile and the real appreciation. The following table shows our total loans and allowances for loan losses by category in 2002 and 2003:
Our loan portfolio increased 3.1% while our allowance for loan losses decreased 5.2% in 2003 compared to 2002 as follows:
85 The following table shows the current classification of the consolidated loan portfolio by risk category and by business segments for 2002 and 2003:
At December 31, 2002 and 2003, respectively, approximately 62.9% and 72.9% of the loans in our loan portfolio were classified in the categories AA to A, principally due to our Wholesale business segment portfolio. Our Retail business segment portfolio grew 10.3% in 2003 compared to 2002, mainly due to growth in the branch network, and in the auto financing and consumer finance segments. As for the risk profile in 2003, the percentage of loans classified in the categories AA to A of the portfolio remained relatively stable compared to 2002. Our Wholesale business segment portfolio presented a clear improvement on its risk ratings profile, with an increase in the percentage of loans classified in the categories AA to A, from 55.0% in 2002 to 71.3% in 2003 due to the improvements that occurred in the Brazilian economy, including the reduction in SELIC base interest rate, appreciation of the real and better than expected macroeconomic policy by the new government’s administration, which resulted in an improved risk perception by market agents. Non-Interest IncomeThe following table shows the principal components of our non-interest income for 2002 and 2003:
Fee and Commission Income. The fees and commission income increased 16.1% in 2003 compared to 2002. In 2003, 62.6% of this source of income originated from banking tariffs and other fees and commissions, which increased 26.0% in 2003 compared to 2002. The other 37.4% of this source of income, which includes credit card, asset management and collection fees, increased 2.5%, mainly from fees on credit cards. 86 The increase of 26.0% in banking tariffs and other fees and commissions was largely due to the increase in our Retail business segment client base as a result of the "ContAtiva" and "ContAtiva2" organic growth initiatives. The initial goal of the “ContAtiva” program was to add 1.8 million new accounts by the end of 2003. Upon achieving this target in February 2003, well ahead of schedule, we launched a second organic growth program called “ContAtiva2” in March 2003, aimed to attract new accounts through 2008. In addition to this, our Wholesale business segment segment increased their fees from capital markets, investment banking and mergers and acquisitions transactions by approximately 55.7%. Trading Income (Expenses). The trading income (expenses) increased from an expense of R$1,972 million in 2002 to an income of R$689 million in 2003, since in 2003 we were not affected by the unfavorable market conditions that existed in 2002. In 2003, mainly due to the real appreciation, we recognized a gain of R$205 million from realized gains (losses) on securities, R$346 million from realized and unrealized gains (losses) on derivatives and securities which are primarily used to hedge our treasury and commercial portfolios, and R$138 million related to our economic hedges of investments abroad. Conversely, in 2002, mainly due to the depreciation of the real, we experienced a loss of R$108 million from realized gains (losses) on securities, R$166 million from unrealized gains (losses) on securities and derivatives, R$904 million from realized gains (losses) on derivatives and R$794 million related to our economic hedges of investments abroad. Net Gain on Securities. The net gain on securities increased from R$49 million in 2002 to R$193 million in 2003, mainly due to realized results on the sale of securities available for sale. Equity in Results of Unconsolidated Companies. The equity in results of unconsolidated companies increased from R$184 million in 2002 to R$199 million in 2003, mainly due to:
Insurance, Private Retirement Plans and Pension Investment Contracts. In 2003, the insurance premiums, private retirement plan premiums and pension investment contracts increased 13.7% compared to 2002. The insurance premiums increased primarily as a result of our leadership in the corporate segment. This advantage is mainly due to AIG’s insurance and reinsurance expertise in dealing with sophisticated corporate insurance coverage. In addition, market conditions are such that customers have demanded greater protection against credit card theft and fraud, thus further contributing to increase our retained premiums. The private retirement plan premiums increased mainly due to our acquisition of the Brazilian pension business of Cigna Seguradora (a subsidiary of Cigna Corporation) in April 2003, an increase in corporate pension plans and strong sales of our PGBL and VGBL plans. 87 Other Non-interest Income. Other non-interest income decreased from R$1,714 million in 2002 to R$709 million in 2003 because of the positive results in 2002 due to the depreciation of the real on our investments abroad denominated in U.S. dollar. This gain in 2002, of R$1,187 million, was partially offset by a loss on the economic hedges of our investments abroad of R$794 million, and was recorded in our trading income. In 2003 as we faced an appreciation of the real, the impact was recorded in as other non-interest expense. Non-Interest ExpenseThe following table shows the principal components of our non-interest expense for 2002 and 2003:
Salaries and benefits Salaries and benefits increased 24.7% in 2003 compared to 2002 principally due to:
We had 27,625 employees at December 31, 2003 compared to 26,739 employees at December 31, 2002. Other Administrative Expenses Other administrative expenses increased 4.9% in 2003 compared to 2002, primarily due to:
This 4.9% increase in other administrative expenses compares favorably to the 9.3% inflation rate as measured by the IPCA (the Consumer Price Index published by IBGE) in 2003, which we believe demonstrates the efficiency of our cost control program. 88 Insurance, private retirement plan and pension investment contracts. The Insurance, private retirement plan and pension investment contracts expenses increased 27.6% from R$1,306 million in 2002 to R$1,666 million in 2003, primarily due to the growth of the related PGBL and VGBL sales. Other non-interest expense. Our other non-interest expenses are mainly composed of the negative exchange variation on investments abroad, contingent provisions and other taxes related to services, revenues and others. The increase of 64.0% or R$770 million in other non-interest expenses in 2003 compared to 2002 was primarily due to the R$631 million loss on our investments abroad denominated in U.S. dollar as a result of the appreciation of the real. This loss was offset by the economic hedges of our investment abroad that resulted in a gain of R$636 million, R$498 million of which were recorded in the interest expense with the remaining R$138 million recorded in the trading income (expense). Other taxes were impacted not only by the increase of our services and revenues but also by the increase of the COFINS rate from 3% to 4% of gross revenues in the last quarter of 2003. In addition, in 2003 we increased our civil litigation provision. Income TaxIn 2003, a negative result on income tax and social contribution of R$354 million compared to a positive result on income tax and social contributions of R$276 million in 2002, was due mainly to the different tax treatment between our gains (losses) from exchange variations on our investments abroad and on the economic hedges of our investments abroad. The exchange variation gains on investments abroad are not taxable and the exchange variation losses on investments abroad are non tax-deductible for income tax purposes. During 2003, we had foreign exchange losses of R$631 million on our investments abroad and a gain of R$636 million on the respective economic hedges, in each case due to the appreciation of the real. This created a negative tax effect of R$216 million, since under Brazilian tax laws, gains on economic hedges are taxed, whereas foreign exchange losses on our investments abroad are not tax-deductible. By contrast, in 2002, when the real depreciated, we experienced foreign exchange gains of R$1,187 million on our investments abroad and a loss of R$794 million on the respective economic hedges. This had a beneficial effect on income tax and social contribution expenses in 2002, since foreign exchange gains are not taxable whereas losses on economic hedges are tax-deductible. As a result of these differences in 2003 compared to 2002, we had a R$486 million increase in tax expenses related to these economic hedge transactions. This increase was partially offset by a tax deduction of R$158 million in interest paid to stockholders’ equity compared to R$22 million in 2002. The payment of tax-deductible interest on equity was chosen as an option for profit distribution in 2003 instead of dividends as in 2002. 5.B. LIQUIDITY AND CAPITAL RESOURCESOverview Our asset and liability management policy is designed to ensure that our capital position is consistent with our risk profile and applicable regulatory standards and guidelines. In particular, our policy is designed to avoid material mismatches between assets and liabilities, optimize our risk-return ratio and ensure that sufficient liquidity is available to honor withdrawals of deposits, make repayments at maturity of other liabilities, extend loans or other forms of credit to our customers, and meet our own working capital needs. We seek to ensure continuous access to diversified sources of funding at efficient costs, within the framework of our assets and liabilities management policy, which sets limits with respect to risk factors, sensitivity, gaps and concentration in certain instruments, such as government securities. As a general rule, our main funding provider is the financial market either in reais or foreign currencies. For additional information concerning capital and liquidity risk management, see “Item 11. Quantitative and Qualitative Disclosures About Market Risk - Risk Management.” 89 Asset and liability management, as well as liquidity and capital resources, are considered at our monthly financial committee meetings. This financial committee discusses and evaluates our liquidity performance in order to determine the minimum liquidity level and, if necessary, holds extraordinary meetings to evaluate our liquidity position in response to unexpected macroeconomic changes. Our financial committee has pre-approved a contingency plan that determines the procedures in the case of a liquidity crisis. As of December 2004, we defined a minimum level of liquidity of R$3.4 billion. Our treasury department is responsible for managing our liquidity and sources of funding, including executing investments, in both reais and foreign currencies. The treasury department maintains what we believe is a proper balance of maturity distributions and diversification of sources of funds. Based upon our levels of resources and the ability to access funding, we believe that our overall liquidity is sufficient to meet current obligations to customers and debt holders, support expectations for future changes in asset and liability levels and support our ordinary working capital needs. Sources of FundingCapital The following table shows our capital at December 31, 2002, 2003 and 2004:
Stockholders’ Equity Stockholders’ equity increased to R$8,572 million on December 31, 2004 from R$6,754 million on December 31, 2003. The increase primarily reflects net income of R$2,063 million, partially offset by the provision of R$527 million of interest on our capital. Subordinated Debt IssuancesOur Tier 2 subordinated debt increased R$430 million in 2004 compared to 2003. In December 2004, we issued US$150 million in subordinated notes with a 5 year-term. Interest on the notes is payable semi-annually at a rate of the 6-month LIBOR plus 2.0% per annum. BNL is the creditor and the issue is part of a credit line negotiated with BNL at the time of the acquisition of BNL’s Brazilian subsidiary. We did not otherwise access the capital markets in 2004 to raise Tier 2 capital. In December 2003, we issued US$200 million in step-up subordinated callable notes due 2013. The interest on the notes is payable semi-annually at a rate of 7.375% per annum for the first five years and 9.375% per annum thereafter. We may redeem the notes beginning in December 2008 or on any interest payment date thereafter. The Central Bank authorized us to record the subordinated debt represented by these notes as part of our Tier 2 regulatory capital in April 2004. 90 Regulatory Capital We are subject to risk-based capital adequacy guidelines and regulations issued by the Central Bank that are similar to the guidelines under the Basel Accord. Under Central Bank rules, we are currently required to have a capital adequacy ratio of 11% of total capital to total risk-adjusted assets as calculated in accordance with Brazilian GAAP. As of December 31, 2004, our capital adequacy ratio was 16.3%. For additional information on capital adequacy requirement see “Item 4.B. Business Overview - Regulation and Supervision”. We measure our capital compliance on a consolidated basis, since we believe this represents the most accurate view of our ability to withstand losses from our direct and indirect operations. The following table shows our capital ratio, as calculated in accordance with BRGAAP, as well as the minimum regulatory capital required under Brazilian laws, as of December 31, 2002, 2003 and 2004. For additional information on our capital ratio, see Note 31 to our consolidated financial statements.
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Our regulatory capital increased from R$8,800 million as of December 31, 2003 to R$9,982 million as of December 31, 2004 on a partially consolidated basis (excluding non-financial subsidiaries). On a fully consolidated basis, our regulatory capital increased from R$9,433 million as of December 31, 2003 to R$10,508 million as of December 31, 2004. The minimum regulatory capital required on a partially consolidated basis increased in 2004 because our foreign currency exposure increased to above 5% of our adjusted capital. According to Central Bank regulations, when foreign currency exposure exceeds 5% of adjusted capital, capital allocation is necessary. This capital allocation contributed to a 2.1% decrease in our Basel capital adequacy ratio. In addition, growth in the volume of risk weighted assets was mainly offset by growth in Tier 1 and Tier 2 capital. The Tier 1 increase primarily reflects net income of R$1,283 million, according to BRGAAP, partially offset by the provision of R$527 million of interest on our capital. The Tier 2 increase is mainly due to our issuance of US$150 million in subordinated debt in December 2004. 91
Basel Capital Adequacy Ratio Impacts Year Ended (Brazilian GAAP)
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The enhancement of our credit portfolio in 2004 reflects an improved outlook for Brazilian economic growth and the gradual recovery of domestic demand. Since our current Basel capital ratio is in excess of the minimum required ratio, we can continue to increase our risk-adjusted assets, especially our loan portfolio. Additionally, the Central Bank limits the amount of investments in consolidated subsidiaries not engaged in banking, leasing or securities activities and in unconsolidated companies, premises and equipment and intangible assets to 50.0% of adjusted capital on a consolidated basis. This limit is known as the fixed asset ratio. At December 31, 2004, our total investment in such assets was 39.5% of adjusted capital on a consolidated basis, lower than the Central Bank’s limit, according to BRGAAP. Third-Party LiabilitiesThe following table shows our third-party liabilities at December 31, 2002, 2003 and 2004:
92 Deposits Deposits are the most important source of funding for our banking operations, representing 49.3% of our total liabilities as of December 31, 2004. Our deposits consist primarily of real-denominated interest-bearing time and savings deposits and real-denominated non-interest-bearing demand deposits. The 31.4% increase in total deposits as of December 31, 2004 compared to December 31, 2003 was due in part to the growth of 45.7% in time deposits, primarily attributable to the increase of funding from Wholesale and the introduction of Superpoupe, for which we had a balance of R$1,625 million as of December 31, 2004. Securities Sold Under Repurchase AgreementsSecurities sold under repurchase agreements decreased 0.9% as of December 31, 2004 compared to December 31, 2003. In 2004, we maintained the same policy as 2003, executing operations in the open market and with institutional investors. Import and Export FinancingsImport and export financings from correspondent banks also represent an important source of funding for us. In general, these trade finance credit lines are denominated in U.S. dollars. We have historically funded our foreign currency trade loans with foreign currency lines from correspondent banks. As of December 31, 2004, approximately R$1,461 million, or 71.3%, of our existing credit lines were considered short-term (up to 360 days), compared to R$2,322 million, or 92.7%, on December 31, 2003. Trade finance credit lines decreased by R$457 million in 2004, primarily due to the appreciation of the real and partially due to our decision to use general purpose funding through other borrowings to fund the import and export segment of our loans portfolio. Other Sources of FundingEuronotes We are an active participant in the capital markets, especially issuing euronotes. As of December 31, 2004, we had R$1,157 million of euronotes denominated in U.S. dollars and other foreign currencies. We use the proceeds of these obligations primarily for general lending purposes, mainly to our Brazilian clients. R$820 million outstanding of these obligations will mature in the next twelve months. The 55.3% decrease in our balance of euronotes outstanding from December 31, 2003, was primarily due to the maturity of US$375 million and to the maturity of €75 million aggregate principal amount of outstanding obligations and the appreciation of the real, partially offset by the issuance of euronotes under our medium-term note, or MTN, program in February 2004 and December 2004. In February 2004, we issued US$100 million of notes which mature on August 10, 2005 and pay interest on a semi-annual basis at a rate of 3% per annum. The issuance was priced at 99.927%, providing a yield of 3.05% per annum for the investors. 93 In December 2004, we offered US$75 million of real-denominated notes through our Cayman subsidiary maturing on June 14, 2006 and paying interest on a semi-annual basis at a rate of 17.9% per annum. Our Medium-term Note, or MTN, program permits the issuance of up to US$2 billion (or its equivalent in other currencies) of securities. Our MTN program is a relatively inexpensive source of funding and permits us to issue securities with a maturity of more than 12 months. As of December 31, 2004, we had the following issuances outstanding under our MTN program:
Notes Issued Under Securitization Arrangements As of December 31, 2004, we had the following notes issued under Securitization Arrangements:
We securitize U.S. dollar payment orders that we receive and process through our correspondent banks. UBB Diversified Payment Rights Finance Company, an exempted special purpose company established under the laws of the Cayman Islands, acquires these payment orders and uses them as an underlying asset for the issuance of notes in the international capital markets, as a financial transaction. Proceeds from the sale of notes are remitted to our subsidiary, Unibanco Cayman, as payment for the sale of the U.S. payment orders. The notes issued under securitization of U.S. dollar payment orders represent an additional source of funding for us. The securitized assets consist of U.S. dollar payment orders, generally referred to as Swift MT-100 payments, received and processed by us through our correspondent banks. On December 31, 2004, we had R$2,668 million outstanding of liabilities representing notes issued under securitization arrangements, an increase of 8.8% compared to R$2,453 million at December 31, 2003. In May 2004, we completed a securitization transaction in the amount of US$200 million. The notes mature on April 15, 2011 and pay interest on a quarterly basis at a rate of 0.50% per annum over the U.S. quarterly LIBOR rate. The principal amount of the notes will be amortized in equal and consecutive payments beginning on July 15, 2007. In September 2004, we completed a securitization transaction in the amount of US$100 million. The notes are due on July 15, 2011 and pay interest on a quarterly basis at a floating rate equal to the LIBOR rate plus 0.45% per annum. 94 Mortgaged-Backed Notes We issue notes collateralized by real estate loans. As of December 31, 2004, we had R$331 million of these mortgage-backed notes outstanding, of which R$328 million will mature within twelve months starting December 31, 2004, compared to R$807 million of outstanding mortgage-backed notes at December 31, 2003. This decrease was primarily due to our use of other sources of funding. Local and Foreign OnlendingsOn December 31, 2004, we had R$5,416 million in local and foreign onlendings outstanding, which consist primarily of real-denominated amounts borrowed from the National Economic Development Bank, BNDES, and the National Industrial Financing Authority, or FINAME, for loans extended to Brazilian clients for investments mainly in fixed assets, such as premises and equipment. Approximately R$1,644 million of these onlendings mature within twelve months from December 31, 2004. The decrease of 8.5% in local and foreign onlendings obligations from R$5,917 million on December 31, 2003 to R$5,416 million on December 31, 2004 was mainly due to the maturity of loans that were not extended or renewed. Uses of FundingThe following table shows our assets at December 31, 2002, 2003 and 2004:
In accordance to our asset and liability management policy and our liquidity management policy, most of our investments are in loans and securities portfolios, as well as cash and cash equivalents. On December 31, 2004, our loan portfolio represented 40.3%, the securities portfolio 19.1% and cash and cash equivalents 20.1% of our total assets, compared to 39.5%, 22.2% and 18.0%, respectively, on December 31, 2003. In addition to cash and cash equivalents, we believe our securities portfolio, which consists principally of Brazilian government securities, is also a contingent source of liquidity because these securities can be readily converted into cash. 95 The Central Bank requires compulsory deposits of 23% on time deposits, 30% on savings deposits and 53% on demand deposits. As of December 31, 2004, we had R$4,808 million of compulsory deposits representing 6.2% of our total assets. See “Item 5. Operating and Financial Review and Prospects - Macroeconomic Factors Affecting our Financial Condition and Results of Operations - Effect of Government Regulation on our Financial Condition and Results of Operations - Compulsory Deposit Requirements” for a detailed discussion of the Central Bank’s regulations regarding compulsory deposits. Federal funds sold and securities purchased under resale agreements increased 31.6% as of December 31, 2004 compared to December 31, 2003. This growth was due to the decision to maintain the same policy as 2003, executing operations in the open market and with institutional investors. The following table shows our capital expenditures in 2002, 2003 and 2004:
In 2004, our capital expenditures were focused on the upgrade and unification of operational and support platforms, expansion of points of sale and the incorporation of acquired companies such as BNL, Hipercard and Phenix. Land and building expenditures increased primarily as a result of the incorporation of BNL and the construction of our new branches, as well as refurbishing of our existing branches to implement the modification of our brand and the renewal of our logo. Data processing expenses increased R$45 million primarily due to the incorporation of Hipercard and BNL and, furthermore, to leasing contracts with IBM to provide the necessary infrastructure, such as hardware, to the new branches. During the period from 2002 to 2004, our capital expenditures consisted primarily of expenditures for data processing to automate our branch network, communication equipment and other technology tools designed to increase the efficiency of our operations, the services offered to our customers and our productivity. We expect that capital expenditures in 2005 will not exceed our historical levels, which consist mainly of investments to improve our communication infrastructure, and customer service and back office administrative systems, as well as investments related to organic growth of our branch network. 96 Changes in Cash Flows The following table shows the principal variations in our cash flows during each of the three years indicated.
In order to improve presentation, prior periods amounts disclosed as investing activities in the Consolidated Statements of Cash Flows relating to (i) dividends received from unconsolidated companies of R$197 million in 2002 and R$158 million in 2003, and (ii) minority interest of consolidated subsidiaries of Unibanco of R$(57) million in 2002 and R$59 million in 2003 were reclassified to operating activities and financing activities, respectively. 2004 Net cash provided by operating activities During 2004, our operating activities provided R$1,383 million net cash, as follows:
Net cash used in investing activities During 2004, net cash used in investing activities was R$1,713 million, consisting of:
Net cash provided by financing activities During 2004, net cash provided by financing activities was R$4,132 million, consisting of:
97 2003 Net cash provided by operating activities During 2003, our operating activities provided R$3,327 million net cash, as follows:
Net cash provided by investing activities During 2003, net cash provided by investing activities was R$1,575 million, consisting of:
Net cash used in financing activities During 2003, net cash used in financing activities was R$9,457 million, consisting of:
2002 Net cash provided by operating activities During 2002, our operating activities provided R$7,397 million net cash, as follows:
98 Net cash used in investing activities During 2002, net cash used in investing activities was R$10,835 million, consisting of:
During 2002, net cash provided by financing activities was R$15,039 million, consisting of:
Managing interest rate sensitivity is a key component of our asset and liability management policy. Interest rate sensitivity is the relationship between market interest rates and net interest revenue due to the maturity or repricing characteristics of interest-earning assets and interest-bearing liabilities. For any given period, the interest rate sensitivity is offset when an equal amount of these assets or liabilities matures or reprices on that date. Any mismatch of interest-earning assets and interest-bearing liabilities is known as a gap position. This relationship is as of one particular date only, and significant swings can occur daily as a result of both market forces and management decisions. Our interest rate sensitivity strategy takes into account:
Our management monitors maturity mismatches in our positions on a daily basis and manages them within established limits, changing positions promptly as market outlooks change. 99 The following table shows the repricing periods of our interest-earning assets and interest-bearing liabilities as of December 31, 2004. The information at that date may not reflect interest rate gap positions at other times and may not represent the future impact on our results. In addition, variations in interest rate sensitivity may exist within the repricing periods presented due to differing repricing dates within the period. Variations may also arise among the different currencies in which interest rate positions are held.
Exchange Rate Sensitivity Most of our operations are denominated in reais. However, we traditionally have outstanding, at any given time, assets, liabilities and derivatives denominated in foreign currencies, principally the U.S. dollar. We enter into derivatives contracts, including swaps, futures and options, to manage our overall exposure, as well as to assist customers in managing their exposures. Central Bank regulations limit our maximum foreign currency exposure to 30% of our regulatory capital. As of December 31, 2004, our net foreign currency exposure was 15.4% of our regulatory capital, according to Central Bank regulation. For additional information see “Item 5. Operating and Financial Review and Prospects - Macroeconomic Factors Affecting Our Financial Condition and Results of Operations - Effects of Government Regulation on Our Financial Conditions and Results of Operations - Capital Adequacy”. 100 As of December 31, 2004, the composition of our assets, liabilities, stockholders’ equity and derivative financial instruments by currency and term was as shown below. The information below may not reflect the net exposure at that date under the Central Bank’s guidelines, mainly because operations with final maturity in the following business day are not subject to changes in foreign currency as they are settled with an exchange rate of the previous day. In addition, the information at that date may not reflect the net exposure at other times and may not represent the future impact on our results.
5.C. RESEARCH AND DEVELOPMENT, PATENTS AND LICENCES ETC. Not applicable.5.D. TREND INFORMATION Looking at 2005, we believe that Brazil will experience moderate economic growth, primarily as a result of a more stable economic and political environment. Although spreads are expected to fall, we believe the attractive economic environment will lead to higher confidence levels, and consequently a higher demand for loans, offsetting the margin compression, and leading to higher fees and commission revenues through the increase of cross selling. Our Retail segment, particularly our consumer finance and SME businesses, are well positioned to benefit from the opportunities of higher demands for loans. Furthermore, with our improvements in credit risk analysis, we believe that we can expand our businesses without compromising credit quality. In addition, we will continue to focus on organic growth, strategic acquisitions and cross selling to increase profitability and retention rates. These initiatives should lead us towards economies of scale and lower transaction costs. We expect to realize growth in our Wholesale segment by identifying and targeting our corporate clients’ financial needs. We believe that our restructuring and the integration of our domestic network will help us achieve that goal by leading us to a higher level of customization and new product offerings, such as derivative products. We also expect to continue our growth in our Insurance and Pension Plans segment, mainly in commercial lines and in property risks, such as D&O, aviation, and petrochemical insurance, among others. Additionally, we believe our market share leadership for extended warranty products should enable us to sustain and improve our results for the segment. 101 In our Wealth Management segment, we believe our market position and our unique business model should allow us to maintain our growth and competitiveness. We believe our profitability will be enhanced in the long-term mainly as a consequence of recent developments to our businesses and new organizational structures. Additionally, we will continue search for improvements in expense controls, such as:
We seek to improve quality in processes that directly impact the quality of our financial services. For this purpose, we have recently created a consolidated quality department to manage all customer related issues regarding financial products and services. In addition, we created an exclusive ranking with customer complaints, which should lead us to resolve critical demands and offer solutions more promptly. 102 5.E OFF-BALANCE SHEET ARRANGEMENTS We and our subsidiaries have entered into several types of off-balance sheet arrangements, including lines and letters of credit, financial guarantees, and certain derivative and hedging transactions. We have no off-balance sheet entities or off-balance sheet arrangements that we believe are reasonably likely to have a material adverse effect on liquidity or the availability of or the requirements for capital resources. Notional Amounts of our DerivativesWe use derivative financial instruments to manage our overall exposures, and to assist our clients in managing their exposure, with respect to market risks and currency exchange rate and interest rate fluctuations. We also enter into derivative contracts for trading purposes to take advantage of market opportunities. The following table presents the notional amount and the fair value at December 31, 2004 of derivative positions held for trading and hedging purposes. For information related to 2003, see Note 28 to our consolidated financial statements.
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Non-Hedging Transactions Interest rate and currency swaps are contracts in which a series of interest rate cash flows of a single currency or interest or principal payments in two different currencies are exchanged for a contractual period. The notional amount represents the basis on which the cash flows are determined. The original maturity on these contracts at December 31, 2004 ranges from three days to nine years. The risks associated with swaps relate to the potential inability or unwillingness of the counterparties to perform according to the contractual terms and the risk associated with changes in market conditions, due to movements in interest rates and the exchange rate of currencies. Interest rate and currency futures and forwards contracts are contracts for the delayed delivery of an instrument at a specified price or yield. The notional amounts represent the face value of the underlying instrument for which daily cash settlements of the price movements are made for the future contracts. Maturities of these contracts at December 31, 2004 range from one day to nine years. The credit risk associated with future and forwards contracts is minimized due to daily or monthly cash settlements and by entering into transactions with a select number of high-quality institutions. Options are contracts which (i) transfer, modify, or reduce interest rate risk, or (ii) allow us to purchase or sell a currency in exchange for the payment of a premium at inception of the contract. As a purchaser of options, we pay a premium and as the writer of options, receive a premium in exchange for bearing the risk of unfavorable movements in future interest rates and market prices for the underlying currency. 103 Hedging Transactions Cash flow hedges: At December 31, 2004 we had future contracts with a notional fair value of R$8,446 million, as hedges of the variability in expected future cash flows associated with the interbank interest rate (CDI) relating to certain time deposits. The carrying value, represented by fair value, of all derivatives described above are included in trading account assets and in other liability – derivative liability as summarized in Notes 6 and 17 to our consolidated financial statements. Financial GuaranteesAs part of our lending operations, we enter into various off-balance sheet credit instruments with our customers, which are summarized below:
Co-obligation for credit assignment are assignments of credit in which we continue to have a co-payment obligation in the event of default by borrower. Guarantees and standby letters of credit are our conditional commitments to guarantee the performance of a customer to a third party in borrowing arrangements. Other letters of credit are issued to support transactions on behalf of customers. At December 31, 2004, the carrying value of financial guarantees is recorded in “Other liabilities” in the amount of R$42 million, including the provision for probable losses in the amount of R$25 million. Additionally, at December 31, 2003 and 2004 we have contractual amounts of R$11,955 and R$16,711, respectively, of unfunded commitments to extend credit for a specified time period to lend to customers who have complied with predetermined contractual conditions. These contracts have maturities of less than one year and can be renewed. For a detailed discussion of the impact of off-balance sheet arrangements see Note 28 and 29 to our consolidated financial statements. 104 5.F. TABULAR DISCLOSURE OF CONTRACTUAL OBLIGATIONS Contractual Obligations Our contractual obligations as of December 31, 2004 are summarized as follows:
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For additional information related to contractual obligation see Note 16 to our consolidated financial statements. Other CommitmentsWe lease many properties under standard real estate leases that can be canceled at our option and include renewal options and escalation clauses for adjusting rentals to reflect changes in price indices. During 2002 and 2004, we sold many properties used as branches and subsequently we rented them for the purpose of continuing our operations. Fines on rescission of real estate leases were R$48 million and expenses of real estate leases were R$189 million in 2004. The following table set forth the real estate leases commitments:
Our monthly amount of rental payments with no stated maturity in renew process and under litigation is R$1million. 105 SELECTED STATISTICAL INFORMATION The following information is included for analytical purposes and should be read in connection with our U.S. GAAP Financial Statements. Average Consolidated Balance Sheet and Interest Rate Data The table below presents the average consolidated balances for our interest-earning assets and interest-bearing liabilities, the related interest income and expense amounts and the average yields and rates for each period. The average balances were calculated from the month-end principal balances together with the related accrued interest balances (see Note 2(b) to our consolidated financial statements). We have broken down certain liabilities into domestic and international currencies. The domestic balances represent liabilities denominated in reais while the international balances represent liabilities denominated in currencies other than reais, primarily the U.S. dollar. Asset balances were not broken down into domestic and international currencies, as substantially all of our assets are denominated in reais. All nonperforming loans are also nonaccrual loans and they have been excluded from “Loans” in the average balance and included as non-interest-earning assets. The accrual of interest on typical Brazilian financial assets and liabilities includes nominal interest rates and a monetary correction component. Such monetary correction may be related to an inflation index, changes in foreign exchange rates (usually U.S. Dollar) or other floating interest rate. The interest rate and monetary correction are applied at the end of each month to the principal balance of each operation. The updated value becomes the new basis for the accrual of the next month’s interest and monetary correction, and so forth, until settled. As a result, it is not practical (and it would not reflect the actual return on our investments) to segregate only the interest rate component for purposes of showing our average consolidated balance sheet and interest rate data. On the other hand, for prospective financial information we only considered the interest rate component, as we cannot predict the effects of monetary correction up to the maturity date. Brazilian tax law does not currently provide income tax exemptions for interest earned on any investment securities. Therefore, interest income has not been presented on a tax-equivalent basis. Additionally, fees received for loans are included in interest income on loans. We do not consider these amounts to be significant. 106
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(1) The average balance for securities classified as available for sale do not include the effect of changes in fair value.
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Changes in Interest Income and Expenses - Volume and Rate Analysis The following table shows the allocation of the changes in our interest income and expense between average volume and changes in the average yields/rates for 2003 compared to 2002 and to 2004. Volume and rate variances have been calculated based on movements of average balances over the period and changes in average interest yield/rates on interest-earning assets and interest-bearing liabilities. The net change attributable to changes in both volume and rate has been allocated to the change due to volume and the change due to rate on a proportional basis.
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The following table shows our average interest-earning assets, average interest-bearing liabilities, net interest income and the comparative net interest margin and net interest spread for 2002, 2003 and 2004.
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Returns on Equity and Assets The following table shows certain of our financial data for the periods indicated:
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(1) Defined as dividends declared per share divided by net income per share
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General The following table shows our portfolio of trading assets, securities available for sale and securities held to maturity as of December 31, 2002, 2003 and 2004. The amounts exclude our investments in unconsolidated companies (see Note 11 to our consolidated financial statements). Trading assets and securities available for sale are stated at fair value and securities held to maturity are stated at amortized cost (see Notes 2(d), 2(e), 2(f), 6, 7, 8 and 28 to our consolidated financial statements).
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At December 31, 2002, 2003 and 2004 we held no securities of a single issuer or related group of companies whose the aggregate book value and market value exceeded 10% of our stockholders’ equity, except for the R$11,293 million, R$10,515 million and R$11,090 million of investment on Federal government securities and Brazilian sovereign bonds representing 180.8%, 155.7% and 129.4% of our stockholders’ equity, respectively. Maturity Distribution The following table shows the maturity distribution and average yields as of December 31, 2004 for our trading assets, securities available for sale and securities held to maturity. Brazilian tax law does not currently provide income tax exemptions for interest earned on any investment securities. Therefore interest income has not been presented on a tax-equivalent – basis. 110
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