Financial System Stability Assessment

The paper discusses the stability of Brazil's financial system, which is diversified and shows sustained economic progress. Fiscal and monetary policies have been aimed to improve bank reserves, and foreign exchange intervention has been streamlined to curb volatility in the exchange market. These measures have been effective in achieving the immediate targets, maintaining macroeconomic stability, and ensuring adequate financial sector buffers. However, there are indications of emerging strains in some sectors and asset classes.


The paper discusses the stability of Brazil's financial system, which is diversified and shows sustained economic progress. Fiscal and monetary policies have been aimed to improve bank reserves, and foreign exchange intervention has been streamlined to curb volatility in the exchange market. These measures have been effective in achieving the immediate targets, maintaining macroeconomic stability, and ensuring adequate financial sector buffers. However, there are indications of emerging strains in some sectors and asset classes.

I. Macro-Financial Performance and Structure of the Financial System

1. Brazil has built a strong macroeconomic framework, increasing its policy credibility and resilience to external shocks. Fiscal responsibility legislation, inflation targeting, and a flexible exchange rate have facilitated declining debt-to-GDP ratios and an impressive reduction in inflation during the last decade. Economic growth has been strong, due in part to favorable terms of trade and strong capital inflows, and the economy is now estimated to be the sixth largest in the world (just ahead of the United Kingdom). As a result of its prudent macroeconomic policies, Brazil achieved investment grade in 2008 and had ample policy space to mitigate the impact of the global financial crisis. In 2011, Brazil was upgraded further to BBB by Fitch and S&P and Baa2 by Moody’s.

2. The financial system is characterized by a high degree of conglomeration and public sector presence, but limited foreign bank participation. Total assets in the system are around 180 percent of GDP, more than half of which are held by depository institutions, one-third by investment and pension funds, and about 6 percent by insurance companies (Table 3). Financial conglomerates—headed by a commercial bank and typically including investment banking, securities brokerage, asset management, and insurance subsidiaries—control around 75 percent of the system’s assets. Public sector presence in the financial sector is significant: government-owned banks account for over 40 percent of total banking assets, and directed credit for low-income housing, agriculture, and infrastructure represents around 35 percent of total credit. Foreign bank participation is only about 17 percent of banking assets, lower than in other large Latin American countries.1

Table 3.

Brazil: Financial Sector Structure

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Assets are those under management.

Aggregation overstates total size in absolute terms due to some double-counting.

Amount outstanding unless otherwise noted.

Open positions on BM&FBovespa, notional value.

3. Since the global financial crisis, economic activity has been volatile and policies were adjusted accordingly. In response to the decline in economic activity in 2009, macroeconomic policy was eased, and the Treasury provided the public development bank (BNDES) with funds to expand credit. Altogether the fiscal stimulus, including the quasi-fiscal operations of BNDES, amounted to 3 percent of GDP. Lending by other public banks also played a critical role in compensating for the retrenchment by private lenders. In 2010, economic activity rebounded faster and more strongly than expected, with the economy growing 7½ percent, the fastest pace in more than two decades. The Central Bank of Brazil (BCB) started a tightening cycle in mid-2010. Fiscal policy and Treasury credit to BNDES were also tightened and a range of macroprudential tools were deployed to address financial stability concerns linked to the rapid pace of credit expansion in some sectors. A new monetary easing cycle began in mid-2011, partly in response to the downside risks stemming from advanced economies.

4. Coping with volatile capital inflows remains a chronic challenge in Brazil. Confidence in Brazilian economic prospects and high commodity prices fuelled high levels of FDI inflows over the past decade, even during the recent crisis. Portfolio capital has also been flowing into Brazil, as in other emerging economies with good economic prospects and high interest rates, but has been a lot more volatile. Brazil has utilized several tools to help cope with these inflows, including greater exchange rate flexibility, interventions in the foreign exchange market, and capital flow management measures (Section II). Nonetheless, the policy tensions and dilemmas posed by high and volatile capital inflows will continue to be a challenge in the period ahead.

5. Financial contracts in Brazil are characterized by high interest rates and short durations, complicating monetary policy transmission and creating challenges for financial development. Interest rates are well above those in comparable countries, and most real- denominated debt contracts are indexed to the overnight interest rate (either the unsecured interbank deposit (CDI) or the repo (SELIC) rate). This largely reflects long-standing fundamental factors, including the legacy of past high inflation and volatility, the low level of domestic savings, and high intermediation spreads. Fiscal responsibility legislation, the inflation targeting regime, and a flexible exchange rate have yielded a sizeable reduction in interest rates in recent years. Banking spreads have also declined with improved efficiency (lower administrative costs) and declines in regulatory costs and the net interest margin.2 The concentration in short-duration and highly liquid assets reduces market liquidity risks for investment funds and banks but raises debt service costs for borrowers and discourages intermediation. Directed credit at below market rates (notably for agriculture and housing) helps some borrowers cope with these costs but, at the same time, narrows the monetary transmission channel. Indexation and short durations are deleterious to financial development, as they tilt the balance toward short-term consumer finance at the expense of long-term investment finance.

6. Moving away from the high interest rate-short duration equilibrium will take time and require sustained efforts across a broad policy front. First, it will require perseverance with sound macroeconomic policies to keep inflation expectations anchored. Second, it will require addressing shortcomings in the contractual environment3 and the low rate of national savings and infrastructure investment. Third, reforms in the capital markets, housing finance, and the role of state-owned banks could make an important contribution to the development of longer-term finance (see Section V). Lastly, this process will require watchful monitoring, as the convergence to a lower level of interest rates will intensify the “search for yield” that could lead to a buildup of risk if assets are under-priced and under-provisioned.

II. Financial Sector Risks and Resilience

A. Assessment of Systemic Risk and Monitoring and Mitigation Policies

7. Although systemic risk has declined since the peak of the recent crisis, the financial system is still exposed to risks arising from both global and domestic factors. A Financial Stability Map shows that risk has declined across all dimensions since 2008–09.4 Nevertheless, Brazil is exposed to both external and domestic sources of risk. Staff’s assessment of the likelihood and potential impact of key risks is discussed below and summarized in the Risk Assessment Matrix (Appendix I).


Brazil: Financial Stability Map

Citation: IMF Staff Country Reports 2012, 206; 10.5089/9781475506723.002.A001

1/ Away from center signifies higher risksSource: Staff calculations.

External risk sources

• As a major commodity exporter, Brazil is exposed to fluctuations in commodity prices. The share of commodity exports has increased in the last decade, and the terms of trade and growth are heavily influenced by movements in commodity prices, including oil.5 A protracted global recession, possibly fueled by adverse developments in advanced economies or a hard landing in China (a major market for Brazilian commodity exports), could therefore have a considerable impact.

• As a preferred destination for international investments, Brazil is exposed to capital flow volatility. The equity and derivatives markets are particularly vulnerable to sudden changes in sentiment, since foreign investors account for a significant proportion of trading. On the other hand, banks have limited external liabilities (they are mostly locally funded) and a low net foreign exchange position (around 8 percent of capital); and the impact on the real economy would be largely mitigated by the flexible exchange rate, while Brazil’s large stock of international reserves can be used to mitigate excess volatility.

Domestic risk sources

• Risk from the rapid credit growth of recent years is mitigated by a number of factors. Credit-to-GDP in Brazil doubled in the last decade, with annual increases exceeding 3 percentage points during 2007–09 and 2011. Credit growth at this pace and duration has been associated with an increased probability of banking crisis in many countries.6 In the case of Brazil, however, there are substantial risk mitigants. First, the overall level of credit-to-GDP ratio remains relatively low by international standards, while a significant portion of the recent expansion is due to gains in financial inclusion and the effects of macroeconomic stabilization. Second, the pace of credit expansion—especially to households—has slowed in recent months and, after peaking in 2009, the estimated credit-to-GDP gap7 has declined significantly (Figure 1). Third, banks hold ample capital, have a strong income position, and stress tests suggest they are resilient to a wide range of adverse shocks (Section II.B). And fourth, bank supervision is very strong (Section III). But even though overall bank credit growth does not represent a significant systemic risk right now, it may be contributing to the emergence of vulnerabilities in two specific sectors: financial distress in some segments of the household sector and real estate price pressures.

Figure 1.
Figure 1.

Brazil: Total Credit and Credit-to-GDP Gap

Citation: IMF Staff Country Reports 2012, 206; 10.5089/9781475506723.002.A001

• There are some signs of financial distress in parts of the household sector. Although household debt is in line with that in regional peers, the average household debt service-to-income ratio (DSTI) in Brazil (23 percent) is high, reflecting higher interest rates and shorter maturities (Figure 2). Although this debt service burden appears sustainable now, with relatively high levels of employment and real income growth, it may push certain households into financial distress in a cyclical downturn. Moreover, recent credit and delinquency trends suggest that some segments of the household sector may already be under stress (Box 1).

Figure 2.
Figure 2.

Brazil: Household Debt and Debt Service Ratios

Citation: IMF Staff Country Reports 2012, 206; 10.5089/9781475506723.002.A001

1/ As of 2010 for US.

• There are indications of rapid real estate price appreciation in prime locations. Partial data suggest that prices in Sao Paulo and Rio de Janeiro have been growing by about 30 percent annually in recent years (Figure 3), with the pace moderating somewhat since 2011.8 Although these increases are very large, the stability impact of a decline in prices would be mitigated by the low proportion of housing loans in banks’ loan portfolios (except for Caixa, a public bank focused on housing loans).

Figure 3.
Figure 3.

Brazil: Credit Growth and Housing Prices

Citation: IMF Staff Country Reports 2012, 206; 10.5089/9781475506723.002.A001

Are Brazilian Households Financially Stressed?

The degree of financial stress of Brazilian households in 2008–09 was low compared to advanced countries, but the threshold may be lower for an emerging economy. For the purposes of this analysis, “financial stress” is defined as a debt service-to-disposable income ratio (DSTI) of 40 percent or more, a threshold similar to that used in other studies (a 2006 Federal Reserve report and WP/08/255 on Korean households use a 40 percent threshold; and in a study on Chile, Fuenzalida & Ruiz-Tagle (2010) use 50 percent). Data from the latest (2008-09) Household Budget Survey show that only 5 percent of Brazilian households had DSTI > 40 percent. While comparisons to other emerging markets are limited, this proportion is low compared to advanced economies (15 percent in the US and 17 percent in Spain). However, since household wealth and social safety nets may be more limited in emerging than in advanced economies, the threshold for financial stress may also be lower, especially at lower income levels. Moreover, household borrowing in Brazil includes a higher percentage of unsecured loans than in advanced economies, where a large share of household bank debt is mortgages.

Brazilian Household Debt Service to Disposable Income

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Source: Institute for Geography and Statistics

Household Debt Service to Income in US and Spain

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Source:Federal Reserve Board of Governors, Bank of Spain.

A significant portion of the increase in household debt is due to the success in expanding financial inclusion, which explains why stress levels may still be relatively low. The Household Budget Survey shows that between 2003–2009 the number of households with credit cards and bank loans increased by 7 and 5 percent, respectively, while installment credit increased 18 percent. Separately, the BCB’s credit registry shows that the number of new individuals borrowing at least R$5000 from the banking sector increased by 50 percent between 2009–2011.

Brazilian Household Use of Debt,/1 Change 2003–2009

(Percent of Households)

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Source: Institute for Geography and Statistics and staff calculations.

If payments are outstanding, except for credit cards where possession is counted.

Home owner reporting some housing payments or installments.

For purchase of durables.

However, recent data suggest that the financial stress of at least some households may be increasing. One indirect indication of distress is the increasing use of more expensive lending products—e.g., credit cards and overdraft accounts—in 2011. Delinquency rates have also risen: by early 2012, non-performing non-earmarked consumer loans reached 7.6 percent (up by 2 percentage points since December 2010), with a particularly sharp increase for vehicle loans. Also, the number of bounced checks has picked up.


Brazil: Household Credit Growth

(Year-on-Year Percent Change)

Citation: IMF Staff Country Reports 2012, 206; 10.5089/9781475506723.002.A001

Source: Central Bank of Brazil.

Brazil: Consumer Deliquency Rates

Citation: IMF Staff Country Reports 2012, 206; 10.5089/9781475506723.002.A001

Source: Central Bank of Brazil and Serasa Experian.

8. In contrast, the corporate sector’s resilience to shocks has improved. With equity and earnings rising faster than debt, Brazilian corporates’ leverage has declined and interest coverage and current liquidity ratios have risen in recent years. Their external debt has remained under 25 percent of Brazil’s total external debt, while short-term external debt returned to around 2 percent of their external debt after jumping to 7 percent in 2010. Moreover, the distribution of external liabilities has improved for listed companies (Figure 4). Improvements were also made in monitoring the sector’s exposure to derivatives: since 2010, companies are required to register all derivatives transactions in local custody houses that, in turn, have to report these on a daily basis to the BCB; and a number of steps were taken to strengthen derivatives monitoring in general (Section C).

Figure 4.
Figure 4.

Brazil: Corporate Sector’s External Debt

Citation: IMF Staff Country Reports 2012, 206; 10.5089/9781475506723.002.A001

9. The Brazilian authorities have used a number of macroprudential instruments and capital flow management measures to contain both domestic and external sources of systemic risk, notably a financial transactions tax (IOF), reserve requirements, and differentiated capital requirements. Staff’s analysis suggests that these were generally effective in achieving their objective, although in some cases the impact was temporary.

The IOF was effective in reducing the volume of portfolio inflows and in changing the composition of capital inflows. Moreover, there is no strong evidence that the IOF has had adverse multilateral effects,9 consistent with the finding in a recent Board paper. But the extension of the IOF to different instruments and maturities suggests that there may have been circumvention through other types of inflows after a short period of time.

Increases in reserve requirements (RRs) were temporarily effective in raising interest rate spreads and curtailing credit growth. Based on the team’s analysis, impulse responses to a one percentage point shock in weighted average RRs show a moderate but transitory slowing of credit growth.

Increases in the capital requirements on consumer and vehicle loans and in the minimum payments on credit cards were also successful in changing the composition of consumer and vehicle loans and fostering a more prudent handling of credit card debts by households, and may also be a factor behind the substantial slowdown in overall credit growth to households in recent months.

10. The active countercyclical role of public banks during the global financial crisis was another systemic risk mitigant, helping to contain its impact, but underscored questions about their longer-term impact on the financial system. The three large federal government-owned banks (Banco do Brazil, BNDES, and Caixa) played a critical role compensating for the retrenchment by private lenders during the crisis, as well as in the government’s long-term strategy to expand access to finance and support development. Each bank has a different business model, which includes—especially for Caixa and BNDES—social lending mandates (reflected in relatively low pre-impairment return on assets). Nevertheless, their credit portfolios are less risky than those of private banks, as shown by lower nonperforming loan (NPL) and write-off rates. For Caixa, which focuses on housing loans, this reflects the fact that most of those are granted at prudent loan-to-value and debt-service ratios and amortize rapidly;10 its riskiest housing loans to low-income families are extended with a government guarantee and thus constitute a fiscal contingency. BNDES also has very low default rates, and uses the high returns on its AAA loan portfolio to absorb losses that might result from social lending. Going forward, however, the role of BNDES, in particular, may need to change in order to support the development of long-term private finance (Section V).

11. There may be room for improvement in the systemic risk monitoring and macroprudential tool box. At a minimum, to improve the monitoring of housing prices, comprehensive transactions-based data should be collected. Also, the authorities should issue a regulation on credit bureaus to ensure broad availability of positive information on borrowers. Other targeted macroprudential policy instruments, such as limits on loan-to-value or debt-to-income ratios, have proved effective in other countries to contain housing or consumer credit risks and should be considered. Lastly, the introduction of countercyclical capital buffers planned by the authorities in the context of Basel III would also be useful.

B. Banking Sector Risks and Resilience

12. The Brazilian banking system is very profitable, has a strong capital base, and limited exposure to cross-border funding and foreign exchange risks. Compared to other emerging and advanced countries, the Brazilian banking system has high levels of capitalization, profitability, and liquidity, while NPLs have declined and are in the mid-range (Figure 5). At end-September 2011, the banking system’s capital adequacy ratio (CAR) was 17 percent, with tier 1 capital at 12.8 percent and core tier 1 capital at 12.3 of risk-weighted assets (Table 4).11 Bank profits benefit from high interest rate spreads and high fees and commissions, which more than offset high credit provisioning costs. System-wide liquid assets are very high and exceed short-term liabilities, although the segment of small and medium-size banks relies considerably on wholesale funding (discussed below). Only about 10 percent of banks’ assets and liabilities are denominated in foreign currency, all of which are wholesale, given the ban on foreign currency deposits and loans.

Figure 5.
Figure 5.

Brazil: Key Financial Soundness Indicators—Cross Country Comparisons, 2011

Citation: IMF Staff Country Reports 2012, 206; 10.5089/9781475506723.002.A001

Source: IMF STA FSI database.
Table 4.

Brazil: Banking Sector Financial Soundness Indicators

(in percent)

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Source: Banco Central do Brasil.

13. Staff estimates of economic capital are lower than reported regulatory capital but still reassuring. Staff attempted to estimate banks’ “true” economic capital based on proxies for the parameters used to calculate capital requirements under the internal ratings-based (IRB) approach, notably probability of default (PD) and loss-given-default (LGD).12 Brazilian banks have high write-offs due to low recovery rates—thus high LGD rates—for some types of loans (Figure 6). Given this, the quasi-advanced IRB CAR calculated by staff for the largest banks appears to be 20–30 percent lower than the CAR using the Standardized Approach (Figure 7). Still, most large banks remain above the minimum international standard CAR of 8 percent.

Figure 6.
Figure 6.

Brazil: Default and Loss Given Default

Citation: IMF Staff Country Reports 2012, 206; 10.5089/9781475506723.002.A001

Source: Banco Central do Brasil (left panel); World Bank (right panel)1/ Based on simulation of a default of the same firm (a hotel), without taking into account credit mitigation, e.g. collateral type and level (Djankov, Hart, McLiesh & Shleifer, Journal of Political Economy, 2008).
Figure 7.
Figure 7.

Brazil: Level and Quality of Bank Capitalization

Citation: IMF Staff Country Reports 2012, 206; 10.5089/9781475506723.002.A001

Source: Staff calculations.

14. The planned early implementation of Basel III will provide the BCB with additional tools to boost the resilience of the system. As a G-20 country and member of the Basel Committee on Banking Supervision (BCBS), Brazil is firmly committed to implementing Basel III, including countercyclical capital and surcharges for systemically important banks (SIBs). Indeed the BCB has announced that it will start implementing elements of Basel III capital requirements ahead of schedule: the phase-out of deferred tax assets (DTAs) will start in 2014,13 but banks would be required to meet counter-cyclical capital charges beginning in 2014 (rather than 2016). The BCB has tested the BCBS Global-SIBs assessment framework, and is developing its framework for identifying and measuring the risk posed by domestic SIBs with a view to exploring the scope for surcharges once guidelines are issued by the BCBS.

Stress tests

15. Credit risk stress tests suggest that the vast majority of Brazilian banks could withstand extreme shocks, including a severe global recession. The tests, which were carried out in close cooperation with the BCB (Box 2), included three macroeconomic scenarios: (1) a severe global recession, (2) a reversal of capital flows, and (3) a terms-of-trade shock. Of these, scenario 1—the most severe—was equivalent to a 2.5 standard deviations decline from trend GDP growth in Brazil (a cumulative GDP loss of about 12 percentage points) over a two-year period, with a gradual return to baseline growth thereafter. Under this scenario, the system’s CAR would remain well above the current regulatory minimum of 11 percent, with only a few smaller banks temporarily falling below, resulting in a total capital shortfall of about ¼ percentage point of GDP. Even using economic, rather than statutory capital, quasi-IRB capital adequacy would fall below the 8 percent Basel minimum only temporarily (Figure 8). All scenarios conservatively incorporate a structural reduction in bank income over time toward levels observed in peer countries, without which capital levels would be on average 1-1½ percentage points higher.

Figure 8.
Figure 8.

Brazil: Solvency Stress Test Results

Citation: IMF Staff Country Reports 2012, 206; 10.5089/9781475506723.002.A001

Source: Staff calculations.

16. Single factor tests show that concentration risk in credit portfolios is contained, if uneven, as are market and interest rate risks (Table 5). The failure of one or more of the largest borrowers would mainly affect about 20 smaller banks. Foreign exchange risk is limited, with a ½ percentage point drop in system CAR and no bank failures in the case of a 50 percent depreciation against all major currencies. Interest rate risk is slightly higher but still manageable, with a 600 basis points shock resulting in a 1.9 percentage point drop in system CAR.

Table 5.

Brazil: Single Factor Shock Results

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Impact on all securities in the trading book and available for sale portfolio.

Projected end-2012 under baseline macroeconomic scenario.

Stress Test Scenarios and Methodology

Macroeconomic assumptions. The trajectories of the key macroeconomic variables (GDP, exchange rate, money market rate) were simulated based on historical evidence in VAR or panel models. For Scenario 1 (global recession), the decline in GDP corresponds to 2.5 standard deviations over 2 years; for Scenario 2 (capital flow reversal), the exchange and interest rates shocks are equivalent to twice the changes observed during the global financial crisis; and for Scenario 3, the terms-of-trade shock corresponds to the highest current account deficit observed in the last 20 years.

Bank-specific parameters. The scenarios were translated into financial stress at the bank level using satellite models for credit risk—probability of default (PD) and exposure at default—and pre-impairment profits. Loss-given-default (LGD) was projected conditional on PDs (Schmieder, Puhr, and Hasan (2011). Banks’ behavior was modeled through income and payout ratios varying in line with the severity of scenario, and credit growth reflecting limited deleveraging in the stress scenario. Stress tests also covered public banks.

Solvency tests. A balance sheet approach was used, covering all banks, using end-2011 data, and a five-year period (2012-16) to assess banks’ ability to cope with a protracted macroeconomic shock, as well as with the introduction of Basel III. Concentration and market risks were assessed based on single-factor shocks.

Liquidity tests. The liquidity stress test used historical maximum funding withdrawal rates, taking into account both market-wide funding stress and bank specific vulnerabilities (e.g., concentration and reliance on wholesale funding). This is equivalent to retail deposit outflows of 15 percent, interbank deposit outflows of 20–90 percent (depending on maturity), and cuts in other sources of funding of 70–95 percent over a 21-day period. Liquid assets were also subject to haircuts based on their quality and maturity (20 percent for foreign currency government bonds and assets, 5–20 percent for interbank claims, and 30 percent for investment funds). The test was based on the BCB’s “liquidity ratio” that compares liquidity inflows (unencumbered liquid assets plus scheduled cash inflows, without recourse to required reserve balances) with potential liquidity outflows (funding losses plus scheduled outflows).

Contagion tests. BCB and IMF network models were used to simulate the impact of a default of a bank through bilateral bank exposures with direct and indirect contagion effects. The latter assume that the default of a large bank triggers deposit withdrawals in all banks, reaching (in the most severe scenario) 35 percent.

17. Liquidity stress tests suggest that the system could withstand substantial stress and contagion through bilateral exposures is limited, although some types of banks appear more vulnerable. All large banks pass the liquidity stress test, though some of them only by a narrow margin. However, some small and medium-size banks that rely heavily on wholesale funding are vulnerable to bouts of high risk aversion. In the liquidity stress tests, medium-sized banks had the lowest pass rate, followed by small banks (Figure 9), but all failing banks together account for less than 3 percent of banking system deposits and non-deposit funding. Although there are a few key net liquidity providers, direct contagion risk is limited: the failure of any single bank would trigger a maximum loss of 0.8 percent of the system’s assets. Indirect contagion risk is more severe: if a bank failure were to trigger severe deposit withdrawals in all banks, maximum asset losses would be higher and non-linear (around 8 percent for a 25 percent withdrawal rate and 22 percent for a 35 percent withdrawal rate). The high level of required reserves, however, is a significant buffer against liquidity shocks.

Figure 9.
Figure 9.

Brazil: Liquidity Stress Test Results

Citation: IMF Staff Country Reports 2012, 206; 10.5089/9781475506723.002.A001

Source: IMF staff calculations based on superviosry data.
Figure 10.
Figure 10.

Mutual Funds and their Interconnectedness with Other Sectors

Citation: IMF Staff Country Reports 2012, 206; 10.5089/9781475506723.002.A001

Sources: ANBIMA, BCB.Note: The thickness of each arrow represents the relative size of money flows.

18. The direct financial exposure to Europe is limited and the risk of contagion closely monitored. The two large European bank subsidiaries in Brazil (Santander, with a market share of about 8 percent, and HSBC, with some 3 percent), in particular, are mostly locally funded. FSAP stress tests show that foreign banks have high pass rates in the event of a liquidity shock. Given the uncertainties, the BCB is monitoring the situation closely and is confident that it has all the tools at its disposal to ensure adequate liquidity and, if necessary, ring-fence Brazilian operations.

C. Capital Markets, Insurance, and Interconnections

19. Mutual funds and banks are highly interconnected through repo transactions and funds’ investments in bank deposit, CDs, or bonds. As of April 2012, mutual funds’ repo operations with banks accounted for some 20 percent of mutual funds’ total portfolio and their holdings of bank deposits or CDs for another 15 percent. Although this represents a high degree of exposure concentration for mutual funds, repos with banks have low risk because the operations are collateralized by government bonds: banks in effect act as an intermediary, given that mutual funds cannot conduct repos with the BCB. Banks’ reverse repo transactions with the BCB tend to have slightly longer maturities (around 30 days), which earns them a profit of around 3–4 basis points. For the same reason, these transactions do not represent a major source of funding risk for banks. Mutual funds’ holdings of bank CDs, deposits, or bonds, on the other hand, expose them to counterparty risk, but this risk is limited given funds’ conservative asset allocation and liquidity buffers. Nevertheless, as the availability of financial instruments improves over time, the authorities should consider lowering the 20 percent single exposure limit for mutual funds. Moreover, market trends need to be monitored closely, as lower interest rates spur investors to seek higher returns and take more risk.

20. Risks stemming from derivatives transactions are contained, as regulations are strict and risk mitigation mechanisms by the clearing houses work well. Transactions are done through BM&FBOVESPA, a central clearing party, which has strong controls over participant’s positions and monitors their exposures on an intraday basis. Recent initiatives, such as the contract between the Central Custodian and Settlement of Financial Securities (CETIP) and Clearstream to manage collateral and the creation by the Brazilian Banking Association (FEBRABAN) of the Derivatives Exposure Registry to register all the derivative transactions, have further reinforced this framework.

21. The market for the reference rate for interest rate derivatives is shallow. Average traded daily volume of CDIs is low, and usually comprises less than a hundred trades. In addition, the top three market participants account for about 85 percent of the volume. Nonetheless, the CDI is used as the reference rate for a very large derivatives market. Although there has been no evidence of excess volatility or market manipulation, the authorities and market participants are studying alternatives to the CDI.

22. Insurance financial soundness indicators are strong.

  • Profitability levels have been consistently high over the last five years. The combined ratio (incurred losses plus expenses-to-earned premium) of life insurers has been around 75 percent and the return on equity (ROE) above 20 percent. Nonlife insurers, while having a higher combined ratio of around 100 percent, have an ROE between 34 and 47 percent. Investment income of around 25 percent of the premium in both industries has supported profitability.

  • Solvency ratios are strong. The life insurance sector has an average margin of 250 percent above Brazilian regulatory requirements (which are about one-third higher than Solvency I requirements), while the nonlife sector has a 90 percent additional solvency margin.

  • Other financial indicators of the insurance sector also suggest resilience. The risk ratio (capital plus surplus to underwritten premium) is around 1.7 and the capital plus surplus to total assets is 8.3 percent, both within international norms for sound companies. Foreign currency assets are negligible due to the limitation in foreign investments.

III. Financial Sector Oversight

23. Since the initial FSAP assessments in 2002, there has been material progress in key areas of financial sector oversight. This progress is reflected in marked improvements in the compliance ratings with international standards in the three key sectors (banking, insurance, and capital markets).14 Most importantly, the approach to regulation and supervision has shifted from a compliance mode to a risk-based approach, with some agencies already very near full compliance with international standards.

24. The growth of the financial system and the increased complexity of operations, however, will demand a continuous commitment to maintain and improve supervision. Each supervisor would likely require additional financial resources and continued upgrading of its human resources, as well as sufficient operational autonomy and legal protection. And the institutional architecture for systemic risk monitoring and mitigation could also be strengthened.

A. Institutional Architecture for Financial Stability

25. Brazil has a well-developed architecture for supervisory cooperation and information sharing. In 2006, the government created the Committee of Regulation and Supervision of Financial, Securities, Insurance, and Complementary Pension (COREMEC) to promote coordination among the agencies responsible for regulating and supervising financial institutions and sharing information on financial conglomerates. In 2010, a Subcommittee to Monitor the Stability of the National Financial System (SUMEF) was created to expedite information sharing and coordinate supervisory policies. And in May 2011, the BCB established a Financial Stability Committee (COMEF), to better identify and monitor the sources of systemic risk and define strategies to mitigate such risks.

26. Since the legal framework does not assign explicit responsibility for financial stability to any agency, in practice the BCB takes a lead role. The BCB assumes de facto responsibility for macroprudential policy but does not have an explicit legal mandate. There is also no formal framework among the financial safety net players for crisis management, although it is understood that the BCB will play the lead role. The COREMEC has a purely advisory role, and indeed did not play a major role during the recent global financial crisis.

27. Although these arrangements have been sufficient in the past, the authorities should consider establishing a multipartite financial stability committee. Due to the dominance of banks in the Brazilian financial sector, the BCB has so far been successful in monitoring systemic risk and implementing timely measures. But as the financial system becomes more complex risks may arise outside banking, and closer coordination among the various supervisory agencies will become increasingly important. While the BCB should retain a key role, reflecting its expertise in systemic risk analysis, more explicit cooperation arrangements, as well as greater transparency and accountability, might be warranted going forward. The authorities should consider upgrading COREMEC or establishing a new multipartite high-level committee including all financial regulators, as well as the FGC and the Ministry of Finance. This committee should be responsible for systemic risk monitoring, macroprudential policy coordination, and systemic crisis preparedness.

  • Members should conduct regular joint-assessments of systemic risks in the financial sector as a whole and formulate plans and strategies to address them. This committee could consider also publishing periodic financial stability assessments or reports focusing on the entire financial system as a complement to the BCB’s Financial Stability Reports.

  • The committee would ensure that all legal and operational hurdles for information exchange among participants are cleared. Consideration could be given to establishing joint databases to facilitate the sharing of information

  • The committee would establish a road map for crisis management, clarify individual roles and responsibilities for each agency consistent with the mandate legally vested upon each agency, and undertake crisis simulations.

Figure 11.
Figure 11.

A Proposed Institutional Architecture for Financial Stability Policy

Citation: IMF Staff Country Reports 2012, 206; 10.5089/9781475506723.002.A001

1/ The COREMEC or new body would have an explicit financial stability mandate.

B. Banking

28. The BCB’s broad powers and well-developed banking supervision are reflected in very high compliance with the Basel Core Principles. The supervisory process is risk-based, robust, and intrusive. It uses a mix of on-site and off-site supervision and well-structured methodologies to identify and assess the most relevant risks of institutions, as well as the quality of internal controls and risk management systems, in order to allocate supervisory resources. Banks are informed at an early stage of issues and prompt correction is required, followed by close monitoring. The corrective action framework has been strengthened by the adoption of regulations that enhance BCB’s discretion, for example on the adequacy of corporate governance. Since the implementation of Pillar 2, the BCB enforcement has taken on a more preventive approach that may arrest unsafe and unsound practices before they impact the bank’s condition.

29. An extensive quantitative and qualitative review results in a comprehensive understanding of an institution’s risk profile. The BCB identifies outliers in prudential ratios, as well as transactions that do not meet the norm for the institution or the system, and produces a quantitative rating for each institution covering capital, asset quality, liabilities/liquidity and earnings. The supervisor also produces a qualitative rating based on an analysis of business risks and controls on credit, legal, operational, market, liquidity and contagion risks from group entities,15 as well as corporate functions and controls of strategic, reputation, information technology, money laundering and operational risks. The overall rating consolidates the quantitative and qualitative ratings. The supervisory process results in a comprehensive understanding of the operations and risk profiles of the banks. Supervisory plans include meetings with bank management, many jointly with insurance supervisors.

C. Insurance and Pensions

30. Insurance supervision has improved greatly with the implementation of more risk-sensitive solvency requirements and risk-focused inspections. The Superintendency of Private Insurance (SUSEP) has added specific capital risk surcharges, a major improvement on capital rules that until 2010 were based on the type of license and geographic area of activity plus Solvency I requirements. SUSEP also strongly emphasizes inspecting risk management and internal controls.

31. However, insurance and pension supervision also has some gaps.

  • Supervision and disclosure requirements for brokers should be enhanced with the issuance by SUSEP of rules for a self-regulatory entity, with mandatory affiliation for all brokers, strong governance, and supervision by SUSEP.

  • The regulatory framework for group supervision is weak, and enterprise risk management (ERM) requirements need to be introduced. There is no definition of a financial group or conglomerate for the purposes of insurance supervision. A regulation for consolidated supervision, including the introduction of ERM and capital requirements at group level, is urgently needed. Also, open pension funds assets are not segregated from those of insurance companies’ and there are no explicit corporate governance requirements applicable to insurers other than those set out in the Companies’ Act. To meet the new international standards, surveillance and cross-border crisis prevention frameworks need to be strengthened. For cross-border cooperation, in particular, MOUs with foreign jurisdictions are strongly recommended.

  • The operational autonomy of SUSEP’s and PREVIC’s should be strengthened. The supervisor of closed pension funds, PREVIC, was established in 2010 and needs to start supervising a larger number of funds and complete its transition to risk-based supervision. Operational independence for both PREVIC and SUSEP should be strengthened by introducing a transparent appointment procedure for senior officers, requiring their technical input on related regulation, and ensuring budgetary autonomy.

D. Capital Markets

32. The Securities and Exchange Commission (CVM) has made substantial progress since the 2002 FSAP. CVM has developed a risk-based supervision program that includes on-site inspections of collective investment schemes (CIS), market intermediaries, listed companies, auditors and other regulated entities, as well as becoming a more assertive enforcer. There have been several notable improvements in capital market regulation, including new instructions on CIS in 2004; on internal controls and investor protection requirements for market intermediaries in 2011; and on the regulation of credit rating agencies in April 2012. In 2009, the CVM created a new company-based electronic disclosure report for listed companies.

33. However, the highly concentrated financial sector poses regulatory challenges, including ensuring adequate resources. The CVM should consider whether a single stock exchange operating in the secondary market as a for-profit company warrants regulatory action to promote competition and reduce transaction fees that seem high by international standards. Similarly, the high level of concentration in the CIS sector may partially explain high mutual fund fees, while the preponderance of CIS owned by banks requires continued effective monitoring of related party transactions and the risks associated with high degrees of concentration in portfolios. Also, to meet the challenges posed by an increasingly complex and growing industry, the CVM requires additional resources, an operating budget commensurate with the fees paid by the capital markets, and greater freedom to hire staff with critical skill sets.

IV. Financial Sector Safety Nets

34. The Brazilian authorities’ response to spillovers from the global financial crisis was swift, flexible, and effective. At the onset of global financial crisis, the central bank moved adroitly to boost systemic liquidity, intervening in the foreign exchange futures market to accommodate hedging, cutting reserve requirements, expanding eligible assets for the rediscount window, and opening a foreign exchange window to help offset the loss of external credit lines. The deposit insurer (FGC) also provided support by extending guarantees on deposits and providing liquidity to small banks, which relied heavily on wholesale funding. In addition, the FGC also extended its deposit insurance coverage and provided solvency support by lending to firms which invested in undercapitalized banks, while the prohibition on the state-owned banks buying banks and loan portfolios was temporarily lifted. These steps were effective in preserving financial stability and, together with the significant capital and liquidity buffers, helping the Brazilian financial system cope with the impact of the crisis.

35. However, there is scope to improve the existing financial safety nets to ensure they can cope with future shocks and limit moral hazard in a system that is growing in size and sophistication. While the system had performed well, the financial sector is evolving and future crises are likely to pose different challenges and could entail more severe shocks. The FSAP thus focused on options to make financial safety nets in Brazil more effective, many of which were already under consideration by the authorities. The FSAP recommendations in the areas of emergency liquidity assistance, bank resolution, and deposit insurance were guided by international best practice and the emerging standards in these areas.

36. The BCB’s Emergency Liquidity Assistance (ELA) facilities, while well-designed, could be made more effective in practice. ELA facilities were not used in the recent crisis, as other sources of liquidity were deployed to support small and medium-size banks under pressure, such as incentives for large banks to buy loan small bank portfolios, asset purchases by state-owned banks, and funding from the FGC. While successful, these methods may prove insufficient in the face of a more severe shock that affects systemically important banks. Therefore, the BCB should ensure that it is in a position to disburse promptly temporary liquidity to solvent but illiquid banks through its existing facilities by (i) developing clear internal procedures to approve ELA that clarify roles and accountability of different departments and minimize the risk of legal challenges to staff, e.g., by using the legal protection afforded to the Governor (see below); (ii) introducing systems to enable quick acceptance of collateral other than government securities, including valuing and determining haircuts; (iii) pre-determining haircuts for asset classes, reviewing these periodically, and disseminating this information regularly to reduce uncertainty; and (iv) ensuring that sufficient expertise is readily available and undertaking simulation exercises and test transactions.

37. The authorities are considering a new framework for bank resolution, based on two separate resolution regimes for systemic and non-systemic cases. For the former, the resolution toolkit is to be expanded to include bail-in powers and allow for related solvency support. For the latter the authorities will maintain the current intervention regime but plan to convert administrative extrajudicial liquidation to a court-based bankruptcy proceeding under the Bankruptcy Law to accelerate the currently lengthy bank bankruptcy process. Staff broadly endorsed these plans but noted that if the latter approach is pursued, the BCB should retain residual powers of direction, as it may not be possible for the intervenor to ensure that all necessary actions are taken to facilitate the resolution within the statutory 120 day-period (including the transfer of crucial services such as IT); as well as the power to petition the court to replace the liquidator in the event that the liquidator does not comply with its directions.

38. Without reforms, the broader role played by the FGC in the recent crisis creates potential conflict of interest. The FGC has evolved from a paybox to an institution with a wider role in providing liquidity and guarantees to preserve financial stability. While appropriate, this evolution means that stronger safeguards are needed to protect the funds of the FGC. A key staff recommendation in this regard was implemented shortly after the FSAP mission with the reform of the FGC’s governance that removed active bankers from its Board. Its wider role underscores the importance of applying the least cost principle when deciding resolution options in order to mitigate moral hazard and safeguard the soundness and credibility of the fund. The FGC’s authority to provide funding beyond least cost assistance in a purchase and assumption (P&A) or bridge-bank transaction (such as open bank assistance in the form of loans to purchasers or capital injections) should be restricted only to cases where there is a systemic threat, with the determination made at a high level in the government and the BCB to limit moral hazard and the risks to the FGC. Furthermore, open bank assistance, if provided by the FGC, should be capped at 50 percent of its cash or cash-equivalent resources.16 The FGC should also have access to a backstop unsecured credit line from the either the BCB or the government at market rates in case of a systemic crisis.

39. The recourse to public resources to support banks in a systemic crisis needs to be carefully considered. The Fiscal Responsibility Law of 2000 bans the use of public funds for solvency support, unless Congress passes a specific law to allow this. Given this constraint, the authorities are considering empowering the BCB in the new resolution regime to provide funds for bank recapitalization after shareholders have been written off using the proposed bail-in powers. This may not be a first-best approach, but the authorities explained that existing mechanisms ensured that the BCB would be indemnified for any losses incurred as a result of such operations.

40. In addition, staff suggested strengthening further the resolution regime by removing certain impediments, clarifying the legal provisions for purchase and assumption and bridge banks, and strengthening legal protection. The legal framework currently provides a broad range of powers for bank intervention and resolution. These were not used during the crisis, due in part to provisions in labor and tax legislation that require the mandatory transfer of tax liabilities and employment contracts to the purchaser or bridge-bank. Moreover, although legal protection for the BCB Governor has been strengthened since the last FSAP, the BCB as an institution does not enjoy such protection and has faced court actions in relation to past exercise of its regulatory powers and provision of financial assistance. To ensure that the full range of effective resolution powers are available in practice, consistent with the FSB’s Key Attributes of Effective Resolution Regimes, the authorities should:

  • remove these impediments in labor and tax legislation and strengthen the purchase and assumption and bridge bank statutes;

  • clarify that FGC’s resources can be used to assist in a resolution transaction (P&A or bridge-bank) to facilitate the transfer of insured deposits, with its contribution capped (except in systemic cases) at the amount of insured deposits that would have to otherwise be paid in a liquidation;

  • introduce depositor preference, placing depositors above unsecured creditors in the hierarchy of claims in bankruptcy, with the FGC subrogated to the preferred claim if its resources are deployed;17

  • expand the resolution toolkit to include the ability to override the rights of shareholders to carry out a recapitalization or a transfer of shareholding interests;

  • limit the scope of judicial action to suspend resolution proceedings on appeal, since any delay in the resolution of a bank may jeopardize the effectiveness of the resolution action; and

  • enhance legal protection by elevating the threshold for civil liability for employees, intervenors, liquidators, and directors during temporary administration to gross negligence, as opposed to mere negligence; and extend a similar level of protection to the BCB.

V. Developmental Issues, Consumer Protection, Corporate Governance, and Insolvency and Creditor Rights

41. The government’s Capital Market Reform Package offers some promising initiatives to increase long-term private finance. The government’s proposal includes a series of incentives to issue and invest in long duration bonds. Its most promising measure includes a tax incentive to non-residents investing in long duration investments and infrastructure bonds. The National Association of Financial Market Institutions (ANBIMA)’s New Fixed Income Market proposal also recommends tax incentives to invest in longer duration instruments, and consideration should be given to extending these incentives to infrastructure funds (Fundos de Investimento em Direitos Creditório—receivables-backed investment funds).

42. Stricter market-making rules could also be considered to improve secondary market liquidity. The New Fixed Income Market proposal includes a set of measures aimed at supporting secondary market liquidity (standardization of issues, market making arrangements, and the set up of a liquidity fund). These initiatives could benefit from measures aimed at further increasing the liquidity of the public bond market, e.g., a narrower set of benchmark issues for all primary dealers; requiring trading through the same electronic platform; and providing a securities lending facility.

43. BNDES should shift towards supporting market-based financing and capital market development. BNDES is a pillar of the Brazilian financial system and its mandate has evolved with developmental needs over the years. As the Brazilian economy grows, however, financing constraints will increasingly limit its capacity to remain the single financier of long-term investments. BNDES should now focus on supporting market-based financing by crowding in private sector intermediation, for instance by co-financing projects and securitize the proceeds, placing the securities with institutional investors. Also, BNDES should move away from direct financing of large corporations with market access (such as Petrobas and Vale) towards helping to develop the long-term corporate debt market through standardization, market making, and signaling (through minority investments). Pricing should be actuarially fair (covering expected losses as well as administrative and funding costs), but this will require strengthening governance and transparency, as well enhanced supervisory oversight.

44. The housing finance system needs to move to longer-term funding, linked to market interest rates. The system is based on two non-market based funding pillars: the earmarked allocation from savings accounts Sistema Brasileiro de Poupança e Empréstimo (SBPE); and earmarked funds from the workers’ severance fund Fundo de Garantia por Tempo de Serviço (FGTS). While the latter is relatively stable, the interest rate floor and short duration of the former has contributed to lenders limiting mortgage duration. In April 2012, the government eliminated the minimum returns on savings deposits (which previously had a floor of 6 percent), clearing the way for these mortgage rates to fall without undue compression of the interest rate spread. In addition to this first step, the authorities should now introduce a regulatory framework for covered bonds, as well as standardization and use of cédulas de crédito imobiliário (CCI) to stimulate broader private capital participation in the housing finance system.

45. Financial consumer protection could be improved, including by creating a dedicated, adequately staffed unit. In banking, consumer protection is currently the responsibility of the Ministry of Justice. However, the relevant department is seriously understaffed, and needs to be strengthened and establish ties to the BCB and other members of COREMEC. Also, as a large number of first-time insurance buyers come into the market, further improvements of consumer education and protection will be needed, alongside the strengthening of broker oversight mentioned above.

46. In preparation for the FSAP, assessments of compliance with standards on Insolvency and Creditor Rights, Auditing and Accounting, and Corporate Governance were undertaken by the World Bank. While work on some these assessments is continuing, key findings include:

  • The legal framework for creditor-debtor relationships has improved, but shortcomings remain that deter debt restructuring or liquidation in some cases. The Law on Business Reorganization and Bankruptcy (2005) improved the insolvency system. However, the system could be more effective by (i) making the tax treatment of debt write-offs neutral; and (ii) reducing legal uncertainty by clarifying that a fraud is required to adjudge the creditor personally liable. Furthermore, rules could be reviewed to encompass sectors that lack access to an effective mechanism of restructuring or insolvency liquidation (e.g., cooperatives, mixed-capital companies, and health care plan companies).

  • Judicial enforcement and resources need to be improved. Lenders strongly prefer taking movable collateral or real estate under “fiduciary sales” or financial leasing because they can use either out-of-court settlement or abbreviated judicial enforcement procedures. Judicial enforcement of other security interests (such as classic mortgages) and unsecured claims is still complex and slow, increasing the cost of financing, especially for small and medium enterprises (SMEs). While the specialized courts in Rio de Janeiro and Sao Paulo are generally satisfactory, the backlog of cases is significant, indicating that more resources are necessary.

  • The registration system for both immovable assets and charges over movables could be significantly upgraded and centralized at the federal level. Currently, registries are administered at the municipal level and most are not electronic, with significant variation in the reliability of information cross municipalities.

  • Corporate governance has improved, but there is room for improvement of minority rights and requirements for Boards of Directors. CVM has introduced new requirements on disclosure (e.g., Instruction 480/2009) that meet international standards and has stepped up enforcement efforts. Disclosure and transparency were improved by the adoption of IFRS accounting standards in 2007 (that came into effect in 2010). However, the ability of minority shareholders to influence Board elections is generally difficult; Board committees are often not well-developed (except for banks, where BCB regulation mandates Board audit committees at institutions of a certain size) and lack independent members; and the rights of shareholder groups during takeovers and corporate restructurings remain a challenging issue.

Appendix I. Brazil: Risk Assessment Matrix

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Appendix II. Brazil: Stress Testing Matrices

Stress Test Matrix for Solvency

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Source: IMF staff.

Stress Test Matrix for Liquidity

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Source: IMF staff.

Stress Test Matrix for Other Systemic Risks

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Source: IMF staff.

Annex I. Basel Core Principles—Summary Assessment

Introduction and Methodology

47. This assessment of the Basel Core Principles for Effective Supervision (BCP) was conducted as part of the 2012 FSAP update. The supervisory framework was assessed against the BCP methodology issued by the Basel Committee on Banking Supervision (BCBS) in October 2006, using both essential and additional criteria. The BCB is the sole supervisor of the banking system and as such, the assessment covers only the BCB. The assessment was performed by Laura Ard (World Bank) and José Tuya (IMF consultant) from February 27 through March 20, 2012.

Institutional, Macroprudential Setting and Market Structure

48. The Brazilian banking system is large, concentrated, and highly interconnected domestically, but with relatively limited foreign participation. There are 1,475 deposit-taking financial institutions with assets exceeding 100 percent of GDP, including 137 banks, 4 development banks, and one savings bank as of November 2011. The five largest banks account for two-thirds of total assets and are typically part of larger financial conglomerates, which often include insurance, securities brokerage, and asset management operations. Foreign banks (mainly from Europe) control slightly less than 20 percent of total banking assets (down from close to 30 percent in 2002 and significantly less than in some other Latin American countries).

Banks by Ownership

(In percent, unless otherwise noted)

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As of September 2011.

Public Includes BNDES and the Federal Savings Bank (Caixa).

49. The banking system reports high levels of capitalization, liquidity and profitability. In September 2011, Brazilian banks, in general, were capitalized above regulatory minimum levels. The average Basel capital adequacy ratio was 17.2 percent, well above the 11 percent required in Brazil, and above the 8 percent required by the Basel I and Basel II standards. The leverage ratio (around 10 percent) and liquidity ratio based on a liquidity buffer/stressed cash flow (around 1.1) were also prudentially adequate. The Return on Equity (ROE) of the banking system was 22.8 percent.

50. The Brazilian legal framework provides adequate support for banking supervision. The BCB de facto operates independently and has the authority to impose sanctions and preventive or corrective action, and to resolve weak banks.

51. The debt collection process has improved and supported the increase in credit to individuals. The reform of the Bankruptcy and Judicial Recovery Law (Law 11101) in 2005 was an important step in the evolution of the Brazilian credit market, since it establishes the priority of bank liabilities over the tax liability. The result is a more efficient debt collection process, especially for home loans and vehicle financing. Along with the introduction in payroll deduction loans in 2004, this is considered the most relevant factor for the increase of credit to individuals over the last few years.

52. The Brazilian system of payments and settlements exhibits high compliance with international standards and includes mandatory central counterparty (CCP) settlement and reporting of over-the-counter (OTC) derivatives transactions. The six main components of the system covering payments, foreign exchange, securities, and derivatives settlement that are considered systemically important are the BCB’s large-value real time gross settlement system (RTGS); the OTC clearing house for corporate bonds, securities issued by state-owned companies, derivatives and State and Municipal bonds (CETIP); the central depository and clearing and settlement institution for government securities (SELIC); the equities clearing house and CCP (BM&FBovespa Agoes); the derivatives clearing house and CCP (BM&FBovespa Derivativos); and the foreign exchange clearing house and CCP (BM&FBovespa Câmbio).

53. The accounting council has adopted international auditing norms and is adopting international accounting norms. The Federal Accounting Council (CFC) was created to advise, regulate and supervise the accounting profession and issues technical and professional norms. There is also the Institute for Independent Auditors of Brazil, which is an independent, nongovernmental entity that convenes auditing and accounting professionals, and issues guidelines of a practical nature, which are commonly referred to by the CFC. The CFC already adopted the auditing norms issued by the International Federation of Accountants (IFAC) and is in the process of adopting the accounting norms issued by the International Accounting Standards Board (IASB).

54. The BCB is responsible for issuing accounting norms for the banking sector, and listed banks must also comply with CVM regulations. The BCB’s responsibility for accounting norms is established in Law 4595/64 and Article 61 of Law 11941/2009. The accounting regime for banks is in the process of convergence with the International Financial Reporting Standards (IFRS) issued by the IASB. CVM’s regulations, which do not conflict with those issued by BCB, are also applicable to financial institutions that are listed, as established by Article 22, §2 of Law 6385/1976. Since December 31, 2010, listed banks must publish accounting statements in accordance with international standards.

55. Auditors that provide services to institutions supervised by the BCB are subject to stringent independence and professional criteria. These include a certification exam that covers specific knowledge of the financial system, as well the international norms set out by IFAC.

56. Banks are required to disclose accounting, prudential and other types of information. In addition to disclosing to the general public, financial institutions are required to send periodically individual and consolidated accounting statements to the BCB, in compliance with both the Banking Law and the Corporate Law.

57. Deposit insurance is provided by the Credit Guarantee Fund (FGC). The FGC is a private entity established by Resolution 2197 to manage a protection mechanism for financial institution creditors in case of a default. Investors and depositors of multiple banks, commercial banks, investment banks, development banks, the Federal Savings Bank, credit, financing and investment companies, mortgage companies, and savings and loan associations are entitled to protection by the FGC. The maximum value guaranteed by the FGC is R$70,000. Funds for the guarantees provided by the FGC come from associated institutions’ ordinary contribution, fees from the default of checks, credit rights subrogated by the FGC from associated institutions, as well as from the results of the services rendered by the FGC and the interest from investing its resources.

Main Findings

58. The main recommendations of the 2002 FSAP with respect to banking supervision were largely addressed. The licensing process was tightened, the memorandum of understanding (MOU) between BCB and CVM has been fully implemented, and the improvement of capital quality by excluding goodwill and tax credits was (is) being addressed by the implementation of Basel II (and Basel III). However, the recommendation concerning the need to amend legislation to formally ensure the autonomy of the BCB remains unaddressed.

59. Since 2002, the banking supervision planning process has been upgraded significantly. The BCB has established the Annual Program of Supervision that encompasses the planning of supervisory activities. The supervisory program is based significantly on the outputs from the Risk and Control Assessment System (SRC), which is a well-structured methodology for identifying and assessing the most relevant risks of institutions, as well as the quality of internal controls and risk management systems. The SRC provides a comprehensive understanding of the operations and risk profiles of the banks and aids in allocating resources in accordance to risk.

60. Corrective actions and enforcement have also improved, although actions against weak banks could be hindered by the minimum dividend payout rule for preferred stock shareholders. The timeliness of corrective action has been improved by the adoption of regulations (resolutions) that enable the BCB to impose corrective action based on judgmental factors, such as the adequacy of corporate governance. Furthermore, with the implementation of Pillar 2 BCB enforcement now takes on a more preventive approach that may correct unsafe and unsound practices before they impact the bank condition. However, banks are subject to corporate law in the area of dividend pay-out, which in most cases requires that at least 25 percent of profits must be paid to preferred stock shareholders. Although the BCB could mitigate the requirement by asking for additional provisioning and capital to offset the dividend, the requirement hinders the ability of the BCB to preserve capital in a weak bank situation.

61. Although the BCB operates with de facto independence, amendments to the Banking Law (Law 4595/1964) could protect operational independence. The BCB has a tradition of operating independently. However, as also recommended in the previous FSAP, the independence should be codified by granting the BCB authority to directly issue resolutions without having to go through the National Monetary Council (CMN), establishing in law the a fixed-term and reasons for removal of the BCB Governor.

Objectives, independence, powers, transparency, and cooperation (CP 1)

62. Formal aspects of independence and hiring remain an issue, although operationally the BCB functions efficiently and without evidence of interference. There is a long-standing tradition of independent operation and since the last FSAP the legal protection of the BCB governor and the BCB’s enforcement powers have been strengthened. However, one of the main recommendations of the 2002 FSAP concerning the need for a fixed term for the Board has not been addressed. Furthermore, the law should require specific reasons (“due cause”) to justify removal of the governor and allow the BCB authority to issue prudential regulations directly (without going through the CMN). Hiring is based on civil service entry examinations for entry level positions, and the BCB has the flexibility to tailor the examination to the expertise needed. However, to protect the integrity of the civil service, the BCB is not permitted to hire specialized staff at other than entry level positions. While the supervisory staff is well trained and talented and some experienced staff has been hired at the entry level, it is recommended that the employment framework be reviewed to determine whether technical position staffing depth is adequate.

Licensing and structure (CPs 2—5)

63. The licensing process has been enhanced and recommendations of the 2002 BCP assessment implemented. The licensing process involves a thorough analysis of strategic plans, capital projections, and fit-and-proper tests. Additionally, for the first three years of operation the new bank is closely monitored to determine its ability to achieve projections.

64. Although the Banking Law requires banks to obtain the prior approval of the BCB to invest in any company, this was not implemented until recently. Article 30 of the Banking Law states that: “private credit institutions, with the exception of investment institutions, may participate in the capital of any company only with prior authorization from the Central Bank of Brazil.” However, Resolution 2723 failed to include this requirement. As a result, investments, other than where control of a financial institution is involved, were not subject to BCB approval, but required ex-post notification. After the mission concluded, Resolution 4062 was issued requiring prior BCB approval for acquisition of an interest in nonfinancial institutions.

Prudential regulation and requirements (CPs 6—18)

65. The quality and risk-sensitivity of capital has been improved. The quality of capital was improved by excluding goodwill (which was a recommendation of the 2002 FSAP). Basel II implementation started in 2007; all regulations for credit and market risk approaches are currently in place and the regulation for the advanced approach for operational risk was issued for public comment in March 2012. The prudential framework governing loan securitization was strengthened in 2008 by requiring banks to report securitized loans on their balance sheets, unless a final and irrevocable transfer of risk is in place. The forthcoming implementation of Basel III will further improve the quality of capital; in particular, Brazil will begin the phase-out of deferred tax assets in 2012 (ahead of the international timetable).

66. Since June 2010 banks have been allowed to apply for the use of internal models for market risk, and from December 2012 will be allowed to apply for the Internal Ratings Based (IRB) approach for credit risk. Applications for market risk approaches started being filed in 2011. After a lengthy consultation period, the regulation for IRB approval was issued. Starting in December 2012 banks can apply for approval to implement the IRB approach. Approvals to implement IRB are expected in 2013 after the validation process. Banks will file the first internal capital adequacy assessment process (ICAAP) report in July 2013.

67. Consultations are now underway for the gradual phase-in of Basel III. A challenge for some banks will be deductions for deferred tax assets, which now account for about 20–25 percent of Tier 1 capital but which are not allowed under Basel III. Banks are expected to meet the new standard primarily through a mix of retained earnings and some stock issuances.

68. Collection of country risk data has been expanded and cross-border exposures are not significant. Banks cannot place abroad funds raised in Brazil and only funds raised directly by the facilities located abroad can be invested in foreign securities and corporates. The vast majority of transactions conducted by Brazilian banks’ foreign branches are related to Brazilian bonds issued abroad or financing local clients or Brazilian companies. The total securities of the six largest Brazilian banks in December 2011 were R$630 billion and foreign securities represented only 1.4 percent.

69. A comprehensive legal framework and supervisory process is in place for Anti-Money Laundering/Combating the Financing of Terrorism (AML/CFT). The BCB closely monitors compliance through a mix of offsite and onsite activities, including horizontal reviews by its specialized AML/CFT staff. The field work is supported by detailed inspection procedures and is included in the SRC.

70. Requirements for risk management oversight and structures are comprehensive, include conservative assumptions, and are linked to capital adequacy determination. For purposes of supervisory oversight, risk is divided into eleven risk categories: credit, market, liquidity, corporate (level) operational, business area operational, contagion, legal, reputational, strategic, information technology (IT) and money laundering. Risk monitoring is a key activity and substantive analysis of each risk group and the respective management process is conducted. Controls are expected to exist and be commensurate with the size and complexity of the operations of each institution. Risks are evaluated at the institution level as well as at the consolidated level. Supervision examines the risk metrics used by banks to measure their risk, including the assumptions used in the stress tests. Supervision also runs stress tests on banks’ positions. Capital calculations for each risk are prescribed and are consistent with or more conservative than those of Basel II. Risk ratings are assigned not only for banking and banking related activity but also for insurance and asset management in the relevant cases. Contagion risk is also rated in the context of the impact the given institution would have on the system if it experienced significant financial distress. The risk rating process is quite granular and is built upon layers of various risk considerations including assessments of corporate governance, management (and AML specifically), as well as of the direction and trend of the risk.

71. Banks are required to implement adequate internal controls for their activities and must be in compliance with the relevant legal norms and regulations. The Supervisor can direct additional controls if risk management deficiencies are found, and it can impose more restrictive operational limits when such deficiencies are not corrected on a timely basis. Recent regulation has provided the Supervisor with the basis to address risk management and control concerns on a proactive basis rather than waiting for identified concerns to have an impact on the financial condition and performance of the institution.

Supervisory Process and Accounting and Disclosure (CPs 19—21)

72. The BCB carries out rigorous, intrusive risk based supervision. Processes are well developed based on extensive information and intensive analysis. Supervision is tailored to each institution based on its risk profile and the size and complexity of its activities. Accordingly, each institution is on a 12 or 24-month supervisory cycle, which is planned and guided by the plan set out by the SRC. The supervisory plan consists of a combination of continuous monitoring and onsite activities. Systemic banks are considered as high priority due to their impact. Turnover is low at the BCB and the number of existing staff (over 700 supervisors and examiners) supports the number of activities planned in the annual supervisory plan.

73. An overall risk rating is assigned to each institution based on quantitative and qualitative measures. The quantitative rating is based on indicators of asset quality, capital adequacy, liquidity, and profitability. The qualitative rating is based on an analysis of: (1) business risks and controls: credit, legal, operational, market, liquidity and contagion risks. (2) corporate functions and controls: strategic, reputation, information technology, money laundering and operational risk. The contagion risk analysis includes the risks posed to the banking group from nonbanking affiliates and subsidiaries. The bank is assigned a qualitative, quantitative and an overall numerical rating ranging from 1–4 and the frequency and scope of the activities will reflect the risk of the institution. Frequent discussions with banks take place to discuss performance and the level of the discussions reflect the risk profile of the bank.

74. State-banks are systemically significant and are subject to the same supervisory process as private institutions. A review of annual supervisory plans, reports of inspection, and enforcement actions for the state-owned banks did not reveal any difference when compared with private banks. The inspection reports are detailed and highlight deficiencies concerning corporate governance, information systems, and capital. A case reviewed highlighted internal control deficiencies and the follow-up action by the BCB was prompt, requiring correction plans, and discussions with the bank’s board.

75. Continuous monitoring leverages information from several sources including banks’ regulatory reporting and data links with clearing houses and registrars. Virtually every financial instrument is registered in Brazil, and the supervisor is able to access transactional information for each and every bank with a one day lag. Subsequently, supervisory systems can monitor transactions as well as reconstruct various bank positions such as liquidity positions, funds provider information, and market risk exposures. The BCB, based on its information flows, is able to stress test certain positions and monitor extraordinary trends. Activity identified outside of normal parameters is flagged and further follow-up conducted.

76. The onsite department is configured into teams responsible for designated institutions or groups of institutions as well as specific risks. Teams monitor information generated by continuous monitoring system, as well as conduct their own monitoring and oversight according to the supervisory plan and cycle established for each institution. The onsite department houses teams specialized in specific risks, including: (i) credit, liquidity, market, and operational risks; (ii) legal and fiscal issues; (iii) validation (internal models); (iv) Basel II and III implementation; (v) corporate governance and internal controls; and (vi) AML. Supervisory cycles begin and end with a full review of the given institution, evaluation of supervisory activities and results, and development of a subsequent supervisory plan.

Accounting and Disclosure (CP 22)

77. Banks are required to comply with BCB established regulatory accounting standards and to appoint a director specifically responsible for compliance with the required standards, basic accounting principles, and professional ethics and banking secrecy rules. All banks are required to publish semiannually audited statements according to the accounting plan of national financial system institutions. Conglomerates that include a publicly listed financial institution or financial institutions required to appoint an audit committee must also produce annual statements according to IFRS. Furthermore, financial conglomerates are required to publish consolidated statements according to IFRS. All financial institutions must receive an external audit according to international audit standards. Since 2008, the BCB has been conducting an Accounting Convergence Project for the purpose of evaluating the differences between the local and international standard, with the aim of convergence of domestic rules applied to general purpose financial statements of banks to IFRS where feasible. In general, national standards for financial institutions result in more conservative figures, particularly regarding provisioning.

Corrective and remedial powers of supervisors (CP 23)

78. Enforcement powers are broad and have been significantly enhanced with the issuance of Resolution 4019. The resolution improved the ability of the BCB to require early correction of issues identified through its supervisory process by making it possible to require correction based on judgmental views on the adequacy of internal controls or corporate governance, thus not having to wait until the bank condition demonstrated quantitative indications of deterioration.

79. A number of examples of enforcement cases were reviewed and the proactive nature of the BCB was evident. The BCB has taken enforcement action due to inadequate corporate governance and internal controls and has taken enforcement action for capital and asset quality issues. The actions are initiated by a letter of issues sent to the bank asking for resolution of the issues within a timeframe. The enforcement action escalates quickly after the timeframe expires without adequate bank response. The actions are closely tracked in the ongoing supervision process and, if needed, intervention of the bank takes place to protect the erosion of bank capital. The BCB meets with the Board and management and stresses the significance of its recommendations.

80. Brazilian corporate law requires companies to pay a minimum of 25 percent of profits as dividends for preferred shares. While the BCB could offset this requirement for banks in a weak situation by requiring increased provisioning or additional capital, a permanent solution would exempt banks from the requirement.

Consolidated and cross-border banking supervision (CPs 24—25)

81. The BCB has broad authority to conduct consolidated supervision. The BCB is empowered to supervise banks on a solo and consolidated basis, including all the offices or entities within the group, irrespective of their location or legal structure.

82. Consolidated supervision is primarily based on the information compiled at the parent bank level in order to manage the risks and controls across the group. Parent banks are subject to mandatory detailed regular reporting to the BCB, which also covers internal global risk management and information on internal controls. Additionally, the BCB coordinates and exchanges information with domestic and foreign supervisors to attain a full view of risk.

83. Through supervisory colleges and on a bilateral basis, the BCB collaborates with home-host supervisors. As home supervisor, the BCB conducts supervisory colleges for Banco do Brasil and Itau-Unibanco and participates as host in a number of others. Additionally, the BCB has signed MOUs with a number of countries.

Table 6.

Summary Compliance with the Basel Core Principles—ROSCs

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Table 7.

Recommended Action Plan to Improve Compliance with the Basel Core Principles

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Table 8.

Brazil—Summary of Observance of the Insurance Core Principles

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Table 9.

Brazil—Recommendations to Improve Observance of ICPs

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