Brazilian Banking System / Analysis - for Financial Crisis and Reform in EM (Sobol)

8/3/2019 Brazilian Banking System / Analysis - for Financial Crisis and Reform in EM (Sobol)

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Brazils financial system - steady as she goes

Brazil has made significant strides towards creating a modern, stable financial system that

allows capital to reach its most productive societal uses. Regulation is robust and

enforcement is consistent, the Central Bank is almost entirely independent, and market

players have come to see stronger corporate governance as a driver of growth. Still,

serious hurdles remain before the countrys financial system benefits all Brazilians. The

lopsided nature of Brazils wealth distribution is echoed in the financial system, meaning

that the elite play a outsized role and smaller businesses and consumers are excluded

from many parts of the system. Also, the intense participation of the government in long-

term financing via the Banco Nacional de Desenvolvimento Econmico e Social(BNDES)

and the high yields on government securities means that market distortions are rife and

private credit is seriously constrained. This translates into more informal retail and SME

banking, persistent bureaucracy in the formal sector, high financial intermediation costs,

and a systemic financing bias towards large enterprises.

Brazils government and private sector, nonetheless, has actively worked within these

constraints to build a more credible financial sector, including robust and transparent

equity markets like the Bovespa and a banking sector that is constantly covering more

Brazilians. The challenge now is not making radical reforms but rather continuing on the

steady path to greater financial inclusion through deeper private debt markets for long term

corporate financing, broader financial inclusion for consumers and a better-defined role for

government in retail banking and debt capital markets. This essay aims to identify and

discuss the main challenges and opportunities that Brazils financial sector faces as it

moves down a path to greater inclusion and opportunity creation.

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A double-edged sword: the BNDES and its role in distorting the financial sector

Given its near-monopoly in the long-term debt funding market, the BNDES is a crucial

component of Brazils capital markets. By 2010, the bank was lending more than US

$100bn on an annual basis, and was the second-largest development bank in the world

after Chinas. By some accounts, the BNDES has become the largest lender in the

Western Hemisphere, and this fast pace of lending and lending growth is unlikely to abate

as Brazil prepares to be host to the 2014 World Cup and 2016 Olympics. And while the

lending source is a boon for large companies, the distortion effect is undeniable and

accusations persist that the bank actively chooses national champions for its lending

without appropriate due diligence.

Given that BNDES loans must be originated and sanctioned by the bank, access is tightly

controlled and the central government has the final say over its lending activities. And

despite a certain level of independence in determining lending goals, led critics to call

Brazils capital allocation strategy as one geared to creating national champions. Simply

put, in extreme cases the government decides upon which industries it chooses to support,

or which companies within a specific industry, and then approves BNDES lending to that

industry or business at preferential terms.

When there are two separate rate environments, and the BNDES long-term funding rate is

at half that of the market rate, market distortions result on the supply side for debt as well.

When private investors look to invest in Brazilian debt instruments, the premium they will

demand for taking on corporate debt risk is already high given the maturity of the market.

Instead, fixed income investors can lend to the Brazilian government at extremely high

rates--despite the countrys investment-grade rating--and take on much less risk for a high

return. The BNDES only compounds this rate problem by lending at preferential rates,

effectively driving borrowing costs up for truly private sector transactions. For the private

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lending sector to play a constructive role in Brazilian corporate financing, the government

must either change the terms of BNDES loans or gradually lower baseline interest rates.

Both steps require a tough political and economic consensus, and with major infrastructure

projects to finance in the coming years and a development agenda tied to the current

governments political interests, change, if it comes, will come slowly.

Corporate governance in equity markets- paving the way to an international model

Improving corporate governance has been central to the Brazilian financial reform and

maturation process. Nowhere is this more evident than in the Bovespas market

segmentation and revised listing procedures. Through a series of market segmentations,

the Bovespa has captured Brazilian listings that may have otherwise gone abroad. With

four main segments, the Bovespa has moved in to fill some of the gap left by the structural

financing difficulties in the corporate debt market. Nivel 1 and Nivel 2capture more

traditional listings, Novo Mercado that established international standards of best practice

in corporate listings captures those that would have otherwise listed abroad, and Bovespa

Mais that emerged as a financing source for the small and mid-cap market.

The NovoMercado stands out as one of the more innovative tools the exchange has used

to give international investors assurance of strong governance and Brazilian issuers are

reason for not listing abroad. And even where listings have gone abroad, many maintain

dual listings in Brazil and structure their equity in a way that minimizes the serious

repatriation costs and financial transaction taxes imposed by the Brazilian government.

The strategy has been successful--by segmenting listing standards, the Bovespa has been

able to capture wider swathes of the equity market, and spur on domestic listings and

public offerings, even in the context of the international financial crisis.

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Another consequence of Brazils growing financial sector maturity is the Brazilian equity

decoupling following the financial crisis in Europe and the United States. Traditionally,

Brazilian corporates looking to list abroad would look to the New York Stock Exchange or

the London Stock Exchange, and indeed some of Brazils biggest names have secondary

listings on the NYSE, including: Vale, Petrobras, Ita, Bradesco, Telefonica do Brasil, and

AmBev. Recently, however, Brazilian equity issuers and the Bovespa have been looking

towards new frontiers for pools of capital and possible secondary-listing/cross-listing

agreements. To that end, the Bovespa in the past year has been in talks with both the

Mexican Stock Exchange and the Shanghai Stock Exchange with a view towards closer

collaboration. Certainly this decoupling is evident across the developing world, butlinkages with American and European capital markets will persist as long as large Brazilian

companies continue to look to their capital markets to raise funds. ADR demand for

Brazilian corporates remains strong, and local markets still are not deep enough for

Brazils world-class corporations, particularly given the state of the domestic bond market.

Bond markets--still dominated by government while private issuance lags

Although the Brazilian corporate bond market is expanding rapidly, the overall market in

Brazil is dominated by government debt. Of the total debt issued that has yet to mature,

government bonds account for 64% of the total market. The rest are by a large margin

financial institutions (35%) and the rest of the corporate market accounts for less than one

percent of the total. The governments predominance in the market is the result of a history

of issuance and peculiarities of the overall market.

The Brazilian government has a long record of issuing sovereign debt, and throughout the

1970s and 1980s was an emerging markets poster child in taking on too much debt to

finance unsustainable spending. After a series of debt crises, several failed debt-

management plans, and the successful Real Plan of 1994, Brazils sovereign debt rating

has been steadily improving--reaching investment-grade (BBB-) in 2008. Net public debt is

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low (37% of GDP) and has been declining steadily throughout the decade. Brazil has also

been successful in issuing liquid, local-currency public debt, with nearly 90% of the public

total denominated in reais. In addition, the average maturity of public debt is nearly six

years, longer than most similarly-rated sovereigns.

Despite Brazils successes in issuing and managing public sector debt, the preponderance

of government debt is a serious hindrance to the development of local corporate debt

capital markets. The steady returns of government debt coupled with the low credit risk

attached to them means that corporate debt has to carry a high risk premium over an

already high base rate in order to attract investors. And with the BNDES and other funding

mechanisms, including well-functioning domestic and international equity participation,

private sector corporate debt is not a viable option for most companies.

Brazils banks - in pole position to solve Brazils financial access challenges

With total banking assets in Brazil clocking in just shy of US $3 trillion at the end of 2010,

more than 100% of that years GDP (adjusted for PPP) and banking deposits near US$1

trillion, Brazils sector is one of the largest in the world. Private Brazilian banks like

Bradesco and Ita have been successful at creating consumer and business banking

products organically, and subsidiaries of international banks like HSBC capture a small but

important part of the overall market. Nonetheless, the state is still a major actor in the

banking sector, with several of the countrys top ten banks majority owned or controlled by

the federal government.

Banks partially or entirely owned by Brazilian federal or state government entities in Brazil

account for nearly 40% of total banking assets, and the largest of these are the Banco do

Brasil, BNDES, Caixa Economica Federal. And while this is not inherently a bad thing, the

lack of accessible consumer and small business credit could be an area of focus for state

banks. Given that these banks operate with similar conditions as privately-held banks and

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work in many of the market sectors as private banks, few actors are better positioned to

advance a dual mandate to deliver returns to shareholders and to the Brazilian

governments development goals.

Finding ways to lower borrowing costs (and consequently returns on foreign lending to

Brazil) would reduce inflow pressures on the Brazilian real and could help abate

appreciation pressure that has driven the currency to unsustainable levels. An overvalued

real has made exports expensive and Brazilian industry uncompetitive, and has made

returns on Brazilian debt not accurately reflect the relatively low risk premium inherent in

the Brazilian market.

Brazils banking sector - a steady pillar in the shifting sands of the financial crisis

Given the already shielded nature of the Brazilian banking sector, the systemic exposure

to the global financial crisis was limited. Banks were not exposed to real estate and

securitization product losses in the same way as their peers in the United States and

Western Europe. One of the key contributing factors was stringent capital adequacy

requirements put into place after the Real Crisis in 1999. These capital requirements are

above and beyond Basel II standards, and the five largest banks in Brazil set aside even

more for reserves by 2008--on average 18.5%. On top of this, the banking system did not

experience problems from overseas-originated asset-backed securities, derivatives or

other exotic financial products due to strict capital control requirements and capital inflow

and outflow restrictions and taxation. It was through this smart application of variable

financial transactions taxes, the country has managed to cool down speculative investment

from abroad while cooling off its hot currency.

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Since almost all of Brazils financial institutions and transactions fall under the purview of

the Banco Central do Brasil, Brazils financial sector has very little off-balance sheet

activity and a high level of formalization. This formalization has been a boon both in terms

of bestowing credibility in the sector for domestic and international investors alike and in

terms of sheltering capital markets from the destabilizing effects of the global financial

crisis. It also has given the bank the tools to establish strong requirements for capital

markets transactions and corporate governance, and gather the large amounts of

information necessary to regulate even the most complex of transactions. Like many other

major emerging markets, the experience of financial crises in the 1980s and 1990s left

financial systems with strong institutional memories of the instability and systemic damage

left by unfettered capital flows in times of crisis and uncertainty.

Brazil at a banking crossroads

Given its banking sector, Brazil faces important choices that will help or hinder both

financial market and overall economic development. One of the most important choices is

whether the banks can take a more active role in broadening the lending market. As we

have seen, the corporate lending market for long-term borrowing is already heavily skewed

in favor of BNDES-linked loans. But at the consumer market, intermediation rates can be

punishing, reaching into triple digits on an annualized basis.

One step that the government could take to remedy this would be to incentivize the market

participation of major credit scoring agencies for individuals and small businesses. Brazil

currently has three major credit scoring agencies that cover a large part of the financially

active population and actively track credit defaults and payment problems. Serious

problems remain, however, in collecting and reporting positive credit information that could

lower costs to borrowers and aggregate a more accurate macro picture of Brazils

borrowers. Incentivizing or requiring banks and agencies to report and aggregate positive

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lending information could take some burden off the banking sector to develop risk models

for low-return or low-value lending, and also give incentives for further formal sector

market activity. Over time, this could reduce borrowing costs for consumers and

businesses, broadening retail financial formality and creating a virtuous circle of lower

borrowing costs and greater access.

Dont stop thinking about tomorrow

Financial development and reform in Brazil is as much a cultural process as a technical

one. Brazil is an economy that has, in less than 20 years, clawed its way out of decades of

hyperinflation and macroeconomic instability. All at the same time, chronic distrust of the

banking system and capital markets has given way increasing numbers of consumers

banked and brought into retail credit markets, along with a growing number of small

businesses that no longer need to finance their operations through connected lending or

expensive alternative instruments.

From a public that viewed the stock market as what the Economist called a casino for the

elite to a Bovespa chairman realistically trying to attract middle-class investors into the

system, broad cultural changes have taken place. Building upon the strong foundation

Fernando Henrique Cardoso established with his Plano Real, Brazil has demonstrated a

firm commitment to independent banking regulation. This has not come without its

challenges and turning points. Perhaps it is easiest to point to the 1999 crisis, when the

realwas devalued as Brazil was jolted by the emerging markets tremors of the Asian

financial crisis, as the most serious challenge to the Real Plan. A bolder challenge,

however, was the election of Luiz Ignacio (Lula) Da Silva a left-wing union leader and

defender of heterodox economic policy.

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In what has been a surprise to nearly everyone observing Brazil, this potentially fatal blow

to stability proved to be the strongest confirmation of the countrys commitment to reform.

Serious financial reform requires a level of consensus across political boundaries and

sustained commitment to reform in a democratic system means accepting precedent.

Brazil has shown over the course of the two very different administrations that economic

development, financial development, and greater social inclusion can be achieved

democratically and across party lines. President Obama lauded these achievements (while

taking a shot at China) in a speech in Rio de Janeiro in March 2011, observing: the

millions in this country who have climbed from poverty into the middle class, they could not

do so in a closed economy controlled by the state. [Brazilians are] prospering as a free

people with open markets and a government that answers to its citizens.

In a way Brazil, along with many of the countries that we have explored in the course,

have had the perverse good fortune of experience with debt and currency crises. The

troubles that Europe and the U.S. are now living are troubles that countries like Brazil

know very well, and its robust financial system and sustainable government borrowing

profile are testament to the lessons it learned. The crisis both in markets and in

government debt left Brazil as strong as before, unlike in past crises that invoked major

economic crisis. In this sense, the resilience to the global crisis was not so much a result

of sagacity but rather a result of its own fresh wounds from the past two decades. Its

reform process is still a work in progress, but now it is a matter of building on past

successes and staying on a steady course to an inclusive financial system that bolsters

economic growth for all Brazilians.

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Brazilian Banking System / Analysis - for Financial Crisis and Reform in EM (Sobol)

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