Stop me if you've heard this one before - banks are starting to see increasing loan losses, shrinking spreads and fears of an economic slowdown are leading banks to curtail lending, while government officials would prefer to see more lending to stimulate growth. That's not the United States nor Europe that I'm talking about, but rather Brazil. With economic conditions in Brazil looking less secure, Itau Unibanco (NYSE:ITUB) could be looking at a longer stretch of compressed earnings and returns than optimists want to believe.

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First Quarter Results Point to the Risks
Although Itau's operating revenue rose 13% in the past year, operating margin was up just 4% and net income fell about 3%. Loan growth softened, net interest margin compressed, and provisioning moved higher.

And Now What?
Honestly, there's nothing really that strange about these results. As companies like Caterpillar (NYSE:CAT) and Eaton (NYSE:ETN) have observed, economic activity in Brazil has slowed. The real question is how bad and how long this slowdown gets.

Right now, most analysts are moving their estimates for provisioning in 2012 (that is, reserves taken to cover bad loans) higher by 10 to 20%, a pretty significant move for a single year. At the same time, loan growth assumptions are heading lower, as are assumptions and spread and fee-based income. These revisions aren't pushing Itau even close to a net loss, but it does mean that a bank that formerly reported returns on equity (ROE) well into the 20%'s is more likely to be posting ROE in the high teens for the next year or two.

SEE: Warning Signs Of A Company In Trouble

It's the "or two" part that amplifies the risk right now, and it's not just for Itau Unibanco; Banco Bradesco (NYSE:BBD), Banco Santander Brasil (NYSE:BSBR) and Banco do Brasil (OTC:BDORY) are all going to face more or less the same challenges during this slowdown. Right now the expectation is that economic growth should resume in Brazil late this year or early next year, but if Europe stays soft and China doesn't rebound, it may be hard for this commodity-dependent economy to bounce back.

What's more, Itau's larger investment banking operations and large business loan book could increase volatility.

SEE: Volatility's Impact On Market Returns

Balancing the Risks and Growth Opportunities
One of the risks that the Brazilian banking industry has to face is that of government interference. Government officials have already called on (or called out, depending upon your point of view) bankers to increase lending and help support economic growth. Bankers, though, are well aware of the risks of incautious lending and have come to appreciate the respect and lower costs of capital they have earned from more disciplined lending over the past decade or so.

At the same time, Itau Unibanco has to balance its growth potential with the risk of over-expanding. Itau already operates in Argentina, Chile, Uruguay and Paraguay, and this would appear to be a good time to consider expanding its share. While companies like Banco Santander Chile (NYSE:BSAC) and Bank of Nova Scotia (NYSE:BNS) have held up well, other would-be players like Citigroup (NYSE:C) and HSBC (NYSE:HBC) are tied up elsewhere (and HSBC is looking to sell units in Colombia, Peru, Uruguay and Paraguay).

SEE: The Risks Of Investing In Emerging Markets

The Bottom Line
The biggest risk to Itau shares, apart from the government really ramping up its coercion, is that this pause in Brazilian economic growth turns into a real recession or worse. Investors have reasonable cause to expect solid long-term ROE from Itau Unibanco, but even if the long-run potential remains good, American bank investors have seen just how ugly performance can be in the short term and what that can do to valuations.

Assuming that conditions bottom in 2013 (a more pessimistic outlook than most sell-side analysts have today) and then improve back to the 20% ROE level, these shares are meaningfully undervalued today. Still, at 1.8 times book value, Itau Unibanco is trading well above most American, European and developed Asian banks. While the growth potential and ROE support a higher valuation, investors should realize that even after this pullback, there are risks in this name.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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