SAO PAULO - mounting loan-loss provisions restrain further lending. Assets at the country's 40 biggest banks - accounting for 80% of the banking system - grew 12% to $340 billion in the first half. But loan-loss provisions in the same period nearly doubled to $4.3 billion -and one consultant says they may well double yet again by yearend. Despite the overall downturn, Brazil's big private banks have largely come through the economic turmoil in fairly decent shape, with the top 40, excluding government-owned Banco do Brasil, managing to post first-half net profits of $1.6 billion, just slightly below year-earlier results. But state-owned banks are mired in a deep crisis from which they may not be able to emerge without giving up the ghost to private ownership. Indeed, a reshuffling is already said to be under way. Big state-owned banks - like Banco do Estado do Sao Paolo and Banco do Estado do Rio de Janeiro - as well as such smaller government-owned banks as Credireal in Minas Gerais have all become candidates for privatization. To facilitate the process, the Brazilian government last month authorized a constitutional change that would allow foreign banks for the first time since 1988 to acquire Brazilian banks. Still, amid the banking industry's shifting terrain, no one disputes that Brazil's economic potential remains enormous and that its financial markets will benefit from rates of growth unparalleled in more-developed markets. "Brazil has a tremendous future," says Randolph L. Freiberg, managing director at Bankers Trust in Sao Paulo. "You only have to look at all the American investment banks rushing in to understand that Brazil is growing." But "if the economy remains stable, there won't be any state banks left within 10 years," predicts Gilberto M. Meiches, chief executive at Banco Cidade SA. "Society is convinced these banks are problematic and there is no reason for them to remain government-owned." Carlos Daniel Coradi, president of the Sao Paulo-based consulting firm Engenheiros Financeiros & Consultores, sums up Brazil's overall banking situation this way: The banking system is suffering the consequences of a sharp drop in inflation and it is in a process of restructuring that will take a few years. "Some have adjusted very quickly," he says, "but this is not true for the entire system - especially the large state banks and some private banks." Enrique de Campos Meirelles, country head for Bank of Boston in Brazil, commented: "It wasn't exactly what you might call a soft landing." Among the worst hit in the financial quake was Banco Economico, the country's oldest bank, which collapsed in August after experiencing severe liquidity problems. Banco do Brasil, the country's biggest bank with $93 billion in assets at yearend, has also run into problems. In August, the 187-year-old government bank posted a first-half loss of $2.63 billion. Analysts speculate that the loss may be just as high in the second half. Bankers said the red ink at Banco do Brasil in part reflects a decision to clean up losses that previously had been swept under the rug and not disclosed. But they add that like other big government banks, Banco do Brasil's principal problem is that too many of its loans are politically dictated for handing over to government-owned enterprises. On top of this draconian policy, analysts say cuts need to be made in the bank's swollen staff of more than 100,000 and in its enormous branch network. Without these changes, they say, significant improvement is unlikely. Other troubled government-owned banks, such as Banco do Estado do Sao Paulo, face similar problems. The bank, which has been under central-bank management since December, has some $13.7 billon in loans to government- owned enterprises on its books. Bankers estimate that at least half of these must be repaid before the government can even think about privatizing the bank. The roller-coaster Brazil's banks have been riding is the result of a sharp reduction in inflation stemming from a hard-currency program introduced in July 1994, which triggered a surge in economic growth and an accompanying demand for credit. "Consumption increased enormously because inflation came down, people could suddenly afford to buy things again, and everyone decided to start spending," Mr. Coradi says. Concerned about the surge in borrowing and spending, the Brazilian government ordered the banks to set aside up to 40% of their deposits in reserves. This drastically reduced funding available for credit, and as revenues from lending started to fall, banks hiked interest rates to new levels. But bankers in this sprawling, dynamic city are fatalistic about the latest changes. "We've been adjusting since the first economic plan was launched in 1986," says Antonio Bornia, executive vice president and managing director at Banco Bradesco, the country's second-largest bank, with more than $22 billion in assets. "And we've still continued to grow." Brazil's bankers say working in their favor are some of the world's most sophisticated electronic clearing systems designed to cope with hyperinflation and enormous, far-flung branch networks. "We cannot say 'thanks to inflation,' but the fact is that high levels of risk created high levels of technology to deal with interbank activities and transfers of funds," says Manoel Francisco Pires da Costa, director of Banco Patente and board chairman of Bolsa de Mercadorias & Futuros, Brazil's futures exchange. The experience of Brazil's banks with hyperinflation, he adds, "has been unique and it has prepared them for any challenge." Bankers also say improvements in productivity and efficiency will help them cope with changes in the future. Bradesco, for example, employed more than 150,000 people as recently as 1986, but has since reduced its headcount to 53,000. The bank is now investing some $200 million to add automated teller machines, telecommunications, and other technology. Bankers say once current restrictions are removed and economic growth returns to a more manageable pace, banks will probably begin expanding again, though at a slower pace. But analysts caution that Brazil's banks will be unable to set specific strategies until some of the country's economic and political uncertainties are resolved. "The longer the central government takes to define the economic realities by adopting the promised constitutional and labor reforms, the greater the danger of banks not being able to sustain a consistent strategy to properly redeploy assets for longer-term economic stability," Moody's Investors Service Inc. said in a late-September report. Just how banks hope to move forward varies from institution to institution. Bradesco, for example, remains firmly rooted in its tradition as a major retail and commercial bank. "We still have a lot to do in this country," says Mr. Bornia. Others, however, are turning their attention to capital markets and investment banking-related operations like mergers and acquisitions, or retail fund management. "We're expecting a pickup in areas like underwriting as a result of stabilization," says Mr. Meiches, adding: "Stabilization will encourage new products like asset securitization, hedging instruments, and mutual funds." Still others, like Banco Itau, Brazil's second-biggest privately owned bank after Bradesco, with $17 billion in assets, are expanding into neighboring countries, hoping to build business in the expanding Mercosur free-trade zone. Itau recently announced plans to open 35 branches in Argentina and a subsidiary in Lisbon, and to set up a joint investment-banking company with Bankers Trust New York Corp. "Our focus is corporate finance and capital markets," says Mr. Freiberg.

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