VII. Banking Sector Developments and Issues1
1. This chapter provides an update on developments and issues affecting Brazil’s banking system.2 The sections that follow are the overview (Section B), an update on the system’s structure and performance emphasizing events following the devaluation (Section C); a discussion of issues surrounding the publicly owned banks (Section D); developments in BCB’s supervision and regulation functions (Section E); and, issues in accounting and transparency (Section F).
2. The Brazilian financial system has weathered well the difficult economic environment of the second half of 1998 and the first quarter of 1999. Most banks remain well capitalized, and though showing continued high nonperforming loan ratios, they remain well provisioned. Prior to the devaluation, most banks were positioned to benefit and subsequently elected to use some of their foreign exchange gains to build further provisions for loan and security losses. Two small investment banks were caught unprepared for the devaluation, with large short positions in foreign exchange futures contracts. In the aftermath, one failed outright. A second remained solvent, but is being liquidated under the close supervision of the BCB.
3. The Global Consolidated Inspection (GCI) program, whereby the BCB conducts intensified inspections of financial institutions on a consolidated basis has recently been expanded to include the publicly owned financial institutions. Staffing constraints, however, will have an impact on the effectiveness of this initiative. A large number of supervisory personnel have departed in the wake of recent changes in the social security system, which prompted a spate of early retirements. Moreover, budgetary constraints have delayed the hiring and training of replacements. The pace of GCI inspections has been slowed by staff shortages and priority now needs to be given to institutions that are large and/or have a history of problems.
4. Progress has been made in developing new regulations to control market risk and in the development of a forward-looking loan classification system that emphasizes the borrower’s ability to repay. The new loan classification system is to be integrated with the BCB’s risk bureau (Central de Riesgo), which is used to monitor loan quality. Considerable progress has been made with the risk bureau, which is becoming an effective tool to improve credit portfolio monitoring for both the BCB and the individual banks.
5. The BCB has also made substantial progress toward meeting the Basle Committee’s 25 core principles for effective banking supervision. Moreover, the BCB is working to provide more information to market participants through the distribution of nonconfidential financial statement information from SISBACEN, the BCB’s information system.
C. Structure and Recent Performance of the Banking System
6. With assets of R$720 billion (US$420 billion) and about 200 banks at the end-March 1999, Brazil’s banking system is one of the largest among emerging market countries. The banking system is dominated by large publicly (both federal and state governments) and privately owned banks, and is highly concentrated, with the 50 largest banks holding more than 90 percent of the banking system’s assets. Foreign-owned banks have come to have a sizeable share of the market for both retail and wholesale financial services. At end-March 1999, foreign banks represented 20 percent of banking system assets, which is up from 12 percent at end-June 1997. Table 7.1 provides market share information for assets, loans and deposits of the various institution categories as of end-March 1999.
|Type of Banking Institution (BIs)||Number of BIs||Total Assets||Total Deposits|
|Domestic private banks||102||51||207.9||28.9||75.8||23.0|
|Foreign private banks||60||30||142.2||19.8||38.7||11.7|
|Private banks w/ minority foreign share||18||9||60.8||8.5||20.7||6.3|
|All banking institutions||199||100||719.3||100.0||329.2||100.0|
Effects of the devaluation
7. The January 1999 exchange rate devaluation appears to have been anticipated by most financial institutions. In particular, banks experienced a boost to income from the devaluation, because on balance they held more dollar-denominated assets than dollar-denominated liabilities, and because those involved in derivatives operations were well positioned. Most banks elected to use part of these once-off gains to increase provisions against loan losses, with the result that the ratio of provisions to nonperforming loans increased from 120 percent at end-December to 131 percent at end-March. There were two main reasons for this choice. First, banks expect that some extra provisioning is appropriate given the expected deterioration in the quality of assets over the coming year as the higher interest rates and slower economic growth of late 1998–early 1999 adversely affect borrowers. Second, because of a mandatory dividend payout requirement if net income is reported, banks elected to offset the foreign exchange gain in order to preserve their cash flow. For the latter, if the devaluation resulted in a noncash gain, and if it were to be taken to earnings, (e.g., because banks did not elect to increase their provisioning) the banks would have suffered a net drain in cash resources from the dividend payment.
8. Nonperforming loans have been increasing as a proportion of total loans in recent years as a consequence of high interest rates and low growth. The ratio of nonperforming to total loans increased from 6.0 percent at end-1997 to 9.5 percent at end-1998 before declining to 9.2 percent at end-March 1999 (Table 7.2).
9. Given the high rate of return on government securities and the presumption of lower risk, most banks have shown a strong preference for the holding of liquid government securities, as well as short-term interbank placements. Typically, the sum of these two categories of earning assets has been comparable to loans. For the banking system, securities and interbank placements make up a high 37 percent of total assets. This relatively high share proved important in the second half of 1998 and the first quarter of 1999, as many foreign banks withdrew credit lines to Brazilian financial institutions. By virtue of the large holdings of liquid, dollar-indexed government securities, most banks were able to meet the withdrawal without suffering severe liquidity problems, and without having to call on the BCB to provide emergency liquidity. Liquidity conditions were generally eased in the third quarter of 1998 and again in the first quarter of 1999, as the central bank sterilized a large part of the outflow of international reserves. The central bank absorbed the liquidity it created by borrowing in the overnight market.
|Number of institutions||223||210||210||199||199|
|Balance sheet indicators||(Percent)|
|Total loans to total deposits ratio||101.1||88.3||90.0||90.3||86.8|
|Securities to total assets||15.8||23.2||19.9||24.2||21.5|
|Interbank placements to total assets||21.5||18.8||16.9||15.3||15.5|
|Total loans to total assets||45.7||40.4||40.4||42.9||39.7|
|Total equity to total assets||8.2||7.7||7.7||9.8||9.1|
|Asset quality indicators||(Percent)|
|Nonperforming loans to total loans||6.0||7.0||7.9||9.5||9.2|
|Provisions for loan losses to total loans||7.8||10.0||10.9||11.4||12.1|
|Provisions to nonperforming loans||130.3||143.0||136.5||120.4||131.4|
|Balance sheet items||(In billions of reais)|
10. The external financing constraint has also eased. The large domestic banks have recently returned to international debt markets. Banks Bradesco, Itaú, and Safra placed a combined US$600 million in Eurobonds in April and May.
Results of a stress test
11. A stress test was performed to assess the vulnerability of the banking system to deterioration in asset quality based on financial information of the 50 largest banks as of March 31, 1999. The test simulates that nonperforming loans will increase by an amount equal to 8 percent of normal loans and that profits in 1999 will be same as those in 1998. As a result, aggregate nonperforming loans would increase from about 10 percent to about 18 percent of total loans. Under the test, regulatory capital is reduced by the additional provisions that would be needed to sustain full coverage of nonperforming loans.
12. The result of the stress test is that 18 banks would become under-capitalized and would need R$8.8 billion of new capital to meet the regulatory minimum (Table 7.3). The capital shortfall would represent 1 percent of 1998 GDP. The outcome of the simulation is skewed substantially by the effects of the five publicly-owned banks, which together represent 38 percent of the assets of the 50 largest banks and would need R$7.0 billion in new capital. Ten foreign-owned banks make up the next largest segment that would need new capital as a result of the simulation. These ten represent about 9 percent of the assets of the group of 50 largest banks and would need about R$1.5 billion to restore capital adequacy.
|I. Number of Institutions that Would Become Undercapitalized|
|Capital range||Publicly-owned banks||Domestic banks||Domestic with foreign bank participation||Foreign-owned banks||Total|
|Less than 0 percent||1||0||0||1||2|
|0 to 3 percent||1||0||0||2||3|
|3 to 6 percent||0||0||0||2||2|
|6 to 9 percent||3||2||1||2||8|
|9 to 11 percent||0||0||0||3||3|
|II. Assets in Institutions that Would Become Undercapitalized (In millions of reais)|
|Domestic banks||Domestic with|
|Less than 0 percent||7,072||0||0||2,632||9,704|
|0 to 3 percent||117,322||0||0||4,740||122,062|
|3 to 6 percent||0||0||0||21,977||21,977|
|6 to 9 percent||153,236||20,916||3,096||16,850||194,098|
|9 to 11 percent||0||0||0||22,178||22,178|
|III. Capital Needed to Reach 11 Percent Risk-Based Capital (In millions of reais)|
|Domestic banks||Domestic with|
|Less than 0 percent||898||0||0||189||1,088|
|0 to 3 percent||3,905||0||0||268||4,174|
|3 to 6 percent||0||0||0||685||685|
|6 to 9 percent||2,185||271||42||280||2,777|
|9 to 11 percent||0||0||0||118||118|
13. Overall, the private banks (including those with partial foreign ownership) demonstrate considerable resilience to deterioration from the simulation exercise. Only three relatively small banks, with assets representing 3 percent of the total, would become undercapitalized.
D. Developments Involving the State-Owned Banks
14. The restructuring of the state-owned banking system was implemented through the federal government’s PROES program (Provisory Measure 1514). Under PROES, the federal government committed itself to financing 100 percent of the costs of restructuring provided that the state-owned banks were either privatized, converted into developmental agencies, or liquidated. In the event that none of these three alternatives was chosen, the federal government would provide only 50 percent of the restructuring costs, with the remainder to come from the states. Under the terms and conditions of the program, the federal government provided a low-cost 30 year loan, payable monthly at an interest rate equivalent to the variation in the general price index (IGP-DI) plus 6 percent per year.
15. At the time of the establishment of PROES in August 1996 there were a total of 35 state-owned banks, of which 23 were either commercial banks or multiple banks. The latest privatization was the State Bank of Bahia (Baneb) which was privatized in late June 1999. Table 7.4 summarizes the progress of the restructurings through June 1999.3
|Option Adopted||Number of Banks||State (Name of Bank)|
|Not participating in PROES||3||Paraíba (Paraíban), Espírito Santo (Bandes), and Federal District (BRB).|
|Restructuring by the State||6||Pará (Banpará), Sergipe (Banese), Espírito Santo (Banestes), Santa Catarina (Besc), Rio Grande do Sul (Banrisul), and São Paulo (Nossa Caixa-Nosso Banco).|
|Privatization4||8||Bahia (Baneb), Maranhão (Bern), Minas Gerais (Credireal and Bemge), Paraná (Banestado), Pernambuco (Bandepe), Rio de Janeiro (Banerj), and São Paulo (Banespa).|
|Federalized||4||Amazonas (Bea), Ceará (Bee), Goiás (Beg), and Piauí (Bep).|
|Transformed into Developmental Agencies||14||Acre, Alagoas, Amapá, Amazonas, Bahia (Desenbanco), Mato Grosso, Minas Gerais (BMDG), Paraná, Pernambuco, Rio Grande do Norte, Rio Grande do Sul (Sulcaixa), Rondônia, Roraima, and Santa Catarina (Badesc).|
|Liquidation||10||Acre (Banacre), Alagoas (Produban), Amapá (Banap), Mato Grosso (Bemat), Minas Gerais (Minas Caixa), Goiás (Caixego), Rio Grande do Norte (Bandern and BDRN), Rondônia (Beron), and Roraima (Baner).|
16. The PROES program was amended in July 1998 (Provisory Measure 1702–26). In light of the continued financial difficulties of individual states, the revised program mandated that further federal financing would only be available for restructuring of state-owned banks that transfer control of the institution to the federal government. In turn, the federal government would either privatize the institution or liquidate it. States were requested to indicate interest to participate in the program by January 15, 1999 (Provisory Measure 1773–32).
17. Except for the states of Mato Grosso do Sul and Tocantins, which did not have official financial institutions, only the Federal District (BRB), and the state of Paraíba (Paraiban) did not participate in the program. In addition, the state of Espírito Santo chose not to participate for one of its banks (Bandes).
18. The federal government expects to privatize the State Bank of São Paulo (Banespa) in 1999, possibly as early as October. Previously, Banespa was the system’s largest state-owned bank, and with assets of R$24 billion is the seventh largest commercial bank overall Banespa represented about half of the state-owned banking system. There is substantial interest among the larger domestic banks in acquiring Banespa, as it will be important to building market share in a period of expected consolidation within the banking system. The acquisition of Banespa is likely to put pressures on other banks (particularly, the medium and small banks) to consider merging.
E. Supervision and Regulatory Developments
19. Beginning in the second half of 1997, the BCB put in place its Global Consolidated Inspection (GCI) program, whereby the BCB conducts intensified inspections of financial institution on a consolidated basis. The GCI program includes specialized inspection teams that review information systems and treasury and market risk. Historically, the BCB has directed its supervisory resources to the private banks, but of late has turned greater attention to the federal and state-owned institutions. BCB is now conducting GCI inspections of these two types of publicly owned institutions.
20. The BCB has experienced substantial turnover of personnel in the wake of recent changes in the social security system and budgetary constraints have slowed the hiring and training of replacements. The staffing constraints have affected effectiveness of the GCI program. Presently, the BCB’s pace for GCI inspections is less than 30 per year. Priority selecting banks for inspection is given to larger institutions or those with a history or evidence of problems. Given the pace of inspections, the period between inspections can in some cases exceed 24 months. Strengthening the staff in an environment of greater budgetary constraints, will be an important challenge for the supervisory function.
21. The BCB is making progress with the implementation of the risk bureau credit information system, which functions to provide information on the quality of loans to individuals and economic groups. The system receives monthly information on all borrowers with exposures to banks in excess of R$50,000 (about US$28,000). Information provided by the system includes debts forgiven, collateral protection and internal loan grading information. The BCB has devoted considerable effort to ensuring that banks are accurately filing borrower information in the risk bureau system. Banks have been able to incorporate information from the risk bureau into credit scoring models for use in evaluating prospective borrowers. The high utility of the system stems from the fact that most borrowers have loans with more than one bank.
22. Progress has been made in the development of new prudential regulations for foreign exchange and market risk, as well as the development of a forward-looking loan classification system that emphasizes the borrower’s ability to repay. The new loan classification system is to be integrated with the BCB’s risk bureau.
Foreign exchange regulation
23. As part of the efforts to upgrade capital regulation to take adequate account of market risk, the BCB issued a regulation dealing with foreign exchange risk. The regulation was issued in May and became effective on July 1, 1999. It mandates a progressively higher capital charge, as banks elect to take on larger foreign exchange positions. The foreign exchange position is defined to be the sum of the net on-balance sheet asset-liability exposure, the notional value of derivatives and the delta for options contracts. The regulations subject the position to two quantitative limits:
The foreign exchange position is subject to a maximum limit of 60 percent of tier 1 plus tier 2 capital
For positions that exceed 20 percent, the institution needs to have additional capital equal to 50 percent of that excess position. The additional capital would be on top of that needed to meet the 11 percent risk-based capital requirement for credit risk.
24. The result of the regulation is that banks with moderate foreign exchange exposure below 20 percent do not have to hold additional capital beyond that needed for credit risk, but to the extent that a bank wants to take on additional position risk, there is a progressively increasing capital charge. Because of the regulation, certain banks Will need to constrain their foreign exchange activities or increase their capital base.
Market risk regulation
25. The BCB is making progress towards putting in place an interest-rate regulation for the trading book that mandates an add-on capital charge based on a standardized interest-rate model.5 In many respects, the standardized model is similar to the approach used under the Market Risk Amendment to the Basle Capital Accord.6 Still under development are additional components to the market risk framework that consider equity and commodities risk in the trading book.
Forward-looking loan classification system
26. The BCB is developing a new regulation for loan classification and provisioning that will replace Resolution 1748, which was introduced in 1990. The new approach will classify loans according to a borrower’s ability to repay and places special emphasis on the payment status, the borrower’s financial factors (e.g., cash flow, guarantees, collateral) and the evaluation of the borrower by other banks in the central bank’s credit risk bureau. To be included with the new regulation will be controls on the rescheduling of loans, which has been a weakness of the current system.
F. Accounting Issues and Transparency
27. Brazil’s National Monetary Council delegates to the BCB the authority to set accounting principles for financial institutions. Accordingly, the BCB has imposed extensive reporting and publishing requirements on these institutions. By internationally accepted accounting standards, these requirements are fairly conservative. Two areas where accounting practices allowed in Brazil may lead to distortions that impede the ability of market participants to interpret the performance of individual banks are the reporting of tax credits and rules for the consolidation of certain types of subsidiaries. These two areas are discussed below.
28. Common to many Brazilian financial institutions are large tax credits (créditos tributários). The accounting basis for the origin of tax credits is not unique to Brazil and their treatment resembles reporting practices used in many other countries. Where Brazil’s accounting practice differs is in the amount that is allowed as an asset. In the context of standards in common practice internationally7 the amount of a tax credit that is eligible needs to be based on what is realizable in the foreseeable future. For some Brazilian financial institutions tax credits are very significant, and given the size of the credits and the income potential for the institution, there is doubt as to whether the tax credit will ever be realized. If there is substantial doubt, the value of the tax credit should be written down or a valuation allowance should be established.
29. The tax credits arise from two sources (i) temporary differences between when an expense can be deducted for accounting purposes and when it can be recognized for tax purposes, and (ii) the carry-forward of tax losses. Temporary differences result from the recognition of certain expenses that are not deductible for income tax purposes in the current year and need to be deferred to a future year. The latter is generated when revenues are less than tax-deductible expenses.
30. Temporary differences result primarily from the provision expenses for loan losses that are not deductible for tax purposes until later years.8 The difference between the actual expense and that allowable for tax purposes results in a deferred tax asset with an offsetting amount that is included as current period revenue. The amount included in the deferred tax asset and recorded as a revenue is equal to the provision expense multiplied by the tax rate. In future years, the deferred tax asset is reduced through a current period expense as the provision can be realized for the purpose of offsetting taxable revenue.
31. Tax losses are created when taxable revenues are less than tax deductible expenses. The tax losses can be carried forward indefinitely and be used to offset taxes in future periods; however, the amount of tax expense that can be offset by the tax loss is limited to 30 percent of the current period taxable income. For example, in the current year, if taxes owed are R$100, and the value of the tax loss carry-forwards is R$100, only R$30 of the carry-forward amount can be used to offset taxes leaving R$70 available for future years. Effectively, the tax loss carry-forward represents a contingent asset, as it only has value if the institution is sufficiently profitable. In many countries, tax loss carry-forwards expire.
32. The BCB’s rules allow certain types of wholly owned subsidiaries to be carried as investments without line-by-line consolidation. Instead, there is the requirement that financial institutions discuss and provide details about investments in unconsolidated subsidiaries through notes to their financial statements, which are issued twice a year. This special treatment affects primarily those institutions not regulated by the BCB, which includes bank-owned insurance and credit card companies. Both of these types of financial companies are becoming more important in terms of their contribution to the consolidated earnings of banks.
33. To the extent that a subsidiary is not consolidated, income flows to the parent organization through either dividends or as a result of the revaluation of the investment. For many Brazilian financial institutions, income from unconsolidated subsidiaries makes up a substantial portion of net income. Although these investments are discussed in the notes to the financial statements, the information is not sufficient to explain the true nature of the source of the earnings.
34. An example of the distortion that could occur because reporting rules do not require line-by-line consolidation would be the exclusion from the bank’s consolidated accounts of nonperforming loans of a credit-card subsidiary as well as the adequacy of provisions for loan losses that have been made by the subsidiary. As a result, the user of financial statements may be left unaware of potential loss contingencies, since they are not reported in the consolidated results. The BCB reviews the credit quality of subsidiaries in the course of the GCI inspections, but given the extended periods of time that can pass between inspections, there can be substantial deterioration in the credit portfolios.
Prepared by Michael Moore.
For background and more details, see the discussion of Brazil’s financial system in Chapter V of the IMF staff country report No. 98/24, April 1998.
The total number in Table 7.4 exceeds 35 as several of the banks have been divided into separate parts for privatization, conversion into a developmental agency, and liquidation.
BEMGE, CREDIREAL, BANDEPE, BANERJ and BANEB are already privatized. The federal government has taken over BANESPA and expects to privatize it in the last quarter of 1999. Paraná is to be privatized during the first half of 2000.
Currently, many banks use internal models to consider their capital requirements. In time, the BCB will consider allowing the use of internal models as an alternative to the standardized model
Basle Committee on Banking Supervision, 1996, Amendment to the Basle Capital Accord to Incorporate Market Risks (Basle: Bank of International Settlements).
Standards accepted internationally are U.S. Generally Accepted Accounting Principles (U.S. GAAP) as promulgated by the U.S. Financial Accounting Standards Board and International Accounting Standards (IAS) as promulgated by the International Accounting Standards Committee.
Law 9430 of 1996 determines the tax deductibility of provision expenses. Provisions are deductible depending upon the loan balance, whether secured or unsecured, and the number of days overdue as follows: loans up to R$5,000 after 180 days, unsecured credits over R$5,000 after one year and secured credits in any amount after two years. For loans over R$30,000, the financial institution needs to have begun judicial proceedings against the borrower for provisions to be deductible. Furthermore, provisions for loans to borrowers that are temporarily protected from creditors are deductible only when the courts declare the borrower bankrupt.