Financial System Stability Assessment

Since the Brazil 2012 FSAP, the financial system has been stable despite the deep recession. The resiliency of the banking system was supported by high profitability, buoyed by large interest margins. While the financial system has grown since the 2012 FSAP, its structure remains largely unchanged. The system is dominated by large, vertically-integrated financial conglomerates and concentrated in liquid short-term instruments. The public sector continues to play a dominant role in the financial sector, and its interconnectedness. Banks are broadly resilient to severe macrofinancial shocks. Current high profits and capital ratios support the resiliency of banks under a severe stress test scenario. Under the stress scenario, small capital shortfalls result; banks would nevertheless experience reduced income, including from market loss on government bonds, and high credit losses on exposures to the corporate sector which, despite recent improvement, is still vulnerable to shocks. This benign outcome deteriorates if their capital is adjusted for deferred tax assets. Moreover, some banks are exposed to concentration risk. Some actions are still needed to address bank-specific risk profiles to boost their resilience. Banks are generally well-positioned to manage short-term and medium-term liquidity pressures and interbank contagion seems limited.


Since the Brazil 2012 FSAP, the financial system has been stable despite the deep recession. The resiliency of the banking system was supported by high profitability, buoyed by large interest margins. While the financial system has grown since the 2012 FSAP, its structure remains largely unchanged. The system is dominated by large, vertically-integrated financial conglomerates and concentrated in liquid short-term instruments. The public sector continues to play a dominant role in the financial sector, and its interconnectedness. Banks are broadly resilient to severe macrofinancial shocks. Current high profits and capital ratios support the resiliency of banks under a severe stress test scenario. Under the stress scenario, small capital shortfalls result; banks would nevertheless experience reduced income, including from market loss on government bonds, and high credit losses on exposures to the corporate sector which, despite recent improvement, is still vulnerable to shocks. This benign outcome deteriorates if their capital is adjusted for deferred tax assets. Moreover, some banks are exposed to concentration risk. Some actions are still needed to address bank-specific risk profiles to boost their resilience. Banks are generally well-positioned to manage short-term and medium-term liquidity pressures and interbank contagion seems limited.

Executive Summary

Since the Brazil 2012 FSAP, the financial system has been stable despite the deep recession. The resiliency of the banking system was supported by high profitability, buoyed by large interest margins. While the financial system has grown since the 2012 FSAP, its structure remains largely unchanged. The system is dominated by large, vertically-integrated financial conglomerates and concentrated in liquid short-term instruments. The public sector continues to play a dominant role in the financial sector, and its interconnectedness.

Banks are broadly resilient to severe macrofinancial shocks. Current high profits and capital ratios support the resiliency of banks under a severe stress test scenario. Under the stress scenario, small capital shortfalls result; banks would nevertheless experience reduced income, including from market loss on government bonds, and high credit losses on exposures to the corporate sector which, despite recent improvement, is still vulnerable to shocks. This benign outcome deteriorates if their capital is adjusted for deferred tax assets. Moreover, some banks are exposed to concentration risk. Some actions are still needed to address bank-specific risk profiles to boost their resilience. Banks are generally well-positioned to manage short-term and medium-term liquidity pressures and interbank contagion seems limited.

Supervision and regulation have strengthened at both micro and systemic levels. This has included risk-based supervision, off-site monitoring, effective use of large data resources, sanctioning powers, and the phasing-in of Basel III requirements. The Banco Central do Brasil (BCB) has put forward guidance for the preparation of Recovery and Resolution Plans by D-SIBs, and has focused on frontier risks related to interdependence, cyberattacks and potential payments system outages. The securities commission’s (CVM) oversight of financial market infrastructures and issuers’ financial disclosure is in line with international standards. Structural reforms have included revisions to the pricing of directed subsidized credit and funding modalities of BNDES, enactment of the corporate governance law for state-owned enterprises, and adoption of a new corporate governance code by CVM.

Nevertheless, strengthening the underpinnings of regulatory agencies is needed. The BCB’s independence and legal protection of staff should be ingrained in law. Likewise, the autonomy of the senior leadership of BCB and SUSEP (insurance regulator) should be protected by clear rules, including fixed terms and conditions of dismissal. Resources should be enhanced to manage challenges from new reforms, particularly at CVM and SUSEP.

The supervisory process is well-structured and thorough but there are areas where further improvements will be needed. The BCB’s and SUSEP’s response times for corrective actions should be shortened. Also, while the BCB’s analytical capacity is impressive, the onus of producing and submitting supervisory indicators should be with the banks. The regulatory and supervisory approach should be upgraded in related party exposures and transactions, large exposures, country and transfer risk and restructured loans. CVM should strengthen oversight practices through industry specialization and more refined risk-criteria. To deter misbehavior, enforcement— administrative and judicial—should strive for prompter results.

Enhancing the macroprudential and crisis management frameworks would help shelter the financial sector against risks in the future. Creating high-level interagency committees with mandates for macroprudential policy and crisis management should be a priority. The existing resolution regime is inadequate and a new framework aligned to best international practice should be introduced promptly. The process for dealing with weak banks and emergency liquidity assistance should be tightened, and the FGC should be strengthened and brought into the public sector, as this would, among other things, help prevent conflicts of interest, retain the mandate for financial stability in the public sector, and improve the exchange of confidential information.

While financial markets—particularly derivatives—are liquid, concentration is high and government securities play a key role in systemic liquidity management. BCB term deposits will be useful as a small-scale fine-tuning sterilization tool, but limited for structural sterilization purposes as most banks use government securities repos to channel funds between related investment funds and the BCB. Adjustments to legislation should be considered to allow the BCB to issue securities for structural sterilization and to broaden investor access to the FX spot market for hedging. The overnight unsecured interbank rate is thinly traded and should be replaced by the SELIC government securities repo rate as a benchmark rate.

Improving the financial intermediation efficiency, reforming the role of public banks and developing the long-term fixed income market are crucial to improve the efficacy of the financial sector and increase productivity growth. In particular:

  • Inefficiencies in financial intermediation. The high margins in the free-credit market are a major economic challenge. These are due to high operating costs and loan loss provisions, bank concentration at the credit-product level, and cross subsidies to the earmarked lending program. SMEs are particularly affected and enhancing SME finance includes reducing information asymmetries, improving legal and institutional frameworks for credit enforcement, and promoting alternative products.

  • Downsize the role of public banks. BNDES needs to adapt its business strategy in light of the TLP reform by selectively assuming risks that mobilize private finance and providing financial services that help develop the financial sector. Caixa requires comprehensive reform, including refocusing on its core mandate, improving governance, risk management and efficiency to boost its capital. A strategic investor could provide stronger corporate governance and know-how.

  • Developing fixed income market. Coordinated actions are required to develop the market including BNDES operating under a project-finance financing model that engages investment partners, and revamping tax incentives that would lengthen the maturity of open pension funds “liabilities” and increase the appetite for and supply of long-term funding.

Table 1.

Brazil: 2018 FSAP Key Recommendations

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Macrofinancial Developments

A. Structure of the Financial System and Role of the Public Sector

1. The financial system is large and dominated by banks and investment funds. While the financial system has grown to nearly 200 percent of GDP its structure has not changed significantly since the last FSAP (Table 2, Figure 1). The banking sector, controlled by three private and three public banks, still accounts for about half of the financial system’s assets. Investment funds make up some 30 percent of total financial sector’s assets. Pension funds and the insurance sector account for 13 and 8 percent of total assets, respectively. Shadow banking, narrowly defined as comprising only the investment funds that perform credit, maturity, and liquidity transformation, is very small. Financial conglomerates—headed by a commercial bank and typically including investment banking, securities brokerage, asset management, and insurance subsidiaries—control around 85 percent of the system’s assets. Since the last FSAP, the presence of the public sector as a share of total assets of financial conglomerates has remained the same (about 40 percent of total banking sector’s assets).

Figure 1.
Figure 1.

Brazil: Financial Sector Developments

Citation: IMF Staff Country Reports 2018, 339; 10.5089/9781484387474.002.A001

Table 2.

Brazil: Financial Sector Structure

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Sources: BCB, SUSEP, PREVIC, SPPS, CVM, ANBIMA, National Treasury, B3 and IMF staff calculations.Note: Depository/non-depository institutions data is aggregated by conglomerates and complemented by individual financial institutions that are not part of conglomerates. Institutions are grouped by financial conglomerates for 2007 and 2012 and by prudential conglomerates for 2017.

Caixa is classified as a multiple bank (not savings bank) as this best describes its activities from an economic perspective.

Exposure to GDP ratio according to CMN Resolution 4553/2017. Exposure is an indicator of balance and off-balance assets, which is defined by Circular 3748/2015.

Funds under the supervision of SPPS (Secretariat of Social Security Policies). Preliminary data indicate that by 2017 there were about 2,000 funds.

Assets refers to assets under management.

Aggregation may overstate the total size in due to some double-counting.

This aggregation reduces double counting of investment funds with closed and open pensions, insurance companies and depository /non-depositary institutions.

Amount outstanding unless otherwise noted.

2. Financial markets are dominated by short-term assets and derivatives instruments. Shorter-term floating rate or inflation indexed securities are the predominant asset class, in part reflecting Brazil’s history of high inflation. Most instruments are indexed to overnight secured (SELIC) or unsecured (CDI) interest rates. Liquidity is concentrated in the overnight markets making longer-term markets more prone to liquidity fluctuations. FX and fixed income derivatives markets are relatively large and play an important role in shifting risk from risk averse domestic retail investors and pension funds to other domestic institutional and foreign investors and in price discovery.

3. The public sector continues to play a dominant role in the financial sector. Public banks provide 55 percent of bank credit. Earmarked credits are loans with regulated allocation and lower interest rates reflecting embedded subsidies (Annex I) and have led to inefficiencies and the segmentation of credit markets. Government debt securities are the centerpiece of the fixed income market and are the single most important asset class held by investment funds, pension funds and insurance companies. Therefore, the financial sector interconnectedness is reinforced not only through direct exposures but also holdings of the same asset. Moreover, the government guarantees a large share of all banks’ capital due to deferred tax credits (Annex II). Repos of government bonds channel liquidity between end-investors and intermediaries to the BCB, via open market operations (OMOs), that sterilizes Brazil’s structural liquidity surplus (around 17 percent of GDP).

B. Despite the Recession, the Financial System Remained Resilient

4. In two of the past 5 years, Brazil experienced a long and deep recession, but is now on the path of recovery (Figure 2). In 2014, the terms-of-trade deteriorated alongside the fall of commodity prices and in 2015, Brazil lost its investment grade. The recession lasted 11 quarters and reduced output by a cumulative 7.8 percent as unemployment doubled to 14 percent. A high level of international reserves, strong FDI inflows and the flexible exchange rate provided important buffers throughout. Since mid-2016, markets have responded positively to the government’s reform agenda and the economy exited the recession in 2017 Q1. Following a contraction of credit during the recession, there are signs of recovery as financial and credit conditions have eased. Medium-term growth is projected to reach just over 2 percent by 2020 (Table 3), but the forecast assumes that a sufficiently strong set of fiscal measures is put in place to ensure fiscal sustainability.

Figure 2.
Figure 2.

Brazil: Macrofinancial Developments

Citation: IMF Staff Country Reports 2018, 339; 10.5089/9781484387474.002.A001

Sources: CEIC, BCB, Haver.
Table 3.

Brazil: Selected Economic Indicators

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Sources: Central Bank of Brazil; Ministry of Finance; IBGE; IPEA; and Fund staff estimates.

Computed by IBGE using the World Bank threshold for upper-middle income countries of U$5.5/day. This number is not comparable to the estimates provided by IPEA in previous years due to methodological differences.

Includes the federal government, the central bank, and the social security system (INSS). Based on the 2017 draft budget, recent annoucements by the authorities, and staff projections.

Currency issued plus required and free reserves on demand deposits held at the central bank.

Base money plus demand, time and saving deposits.

5. The corporate and household sectors remain vulnerable. Leverage, profitability and liquidity indicators of the corporate sector have all deteriorated on the back of the recession. Despite recent improvements, leverage remains high and profitability and liquidity indicators are below pre-recession levels. The structure of household debt has changed since the last FSAP—the share of mortgage debt has increased to almost 20 percent (up from 12 percent in 2012), and the household debt service-to-income ratio (DSTI) is still one of the highest in the world (22 percent) reflecting high interest rates.

6. Despite the deep recession, the banking sector has remained resilient (Figure 3, Table 4). Since the last FSAP, banks have continued to be well capitalized, profitable, and liquid. Despite record loan losses1, profitability has been supported by prudent lending standards, high interest margins and fees. High profits and deleveraging have ensured that capital ratios have been well above the regulatory minima, but capital ratios of public banks are much lower than those of private banks and continue to be pressured by higher Basel III deductions from capital. External funding exposures are low (at around 10 percent of total funding) and FX risks are largely hedged.

Figure 3.
Figure 3.

Brazil: Banking Sector Developments

Citation: IMF Staff Country Reports 2018, 339; 10.5089/9781484387474.002.A001

Sources: CEIC, BCB, Moody’s.
Table 4.

Brazil: Financial Soundness Indicators

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Sources: Central Bank of Brazil; and Fund staff calculation.

7. The performance of the nonbank financial sector remains solid, but may be challenged by falling interest rates as the authorities’ reform of the long-term interest rate (TLP) advances.2 Assets managed by investment funds have grown steadily since the last FSAP, led by fixed income funds, the dominant investment vehicle in this area. While the growth of insurance premiums has declined since the last FSAP, the sector’s profitability and other key credit metrics have all improved, mainly reflecting higher investment returns driven by higher interest rates. Pension funds have grown steadily as tax incentives support contributions. Still, high unemployment has lowered contributions and poor performance of investment portfolios—driven by losses on equity investments—has weighed on the solvency of defined benefit pension plans, particularly of state owned enterprises. As interest rates approach historical lows, lower returns will weigh on profits on the non-banking sector and a search for yield may increase risk-taking.

C. Developmental Issues

8. Public credit institutions account for about half of total credit (Figure 4). Two federal public commercial banks (Banco do Brasil—BB—and Caixa Economica Federal—Caixa) and a development bank (BNDES) are the three largest public banks in the system by loan portfolios, intermediating most of the earmarked credit, and are the main providers of medium and long-term finance. However, since 2015, their loan portfolios have contracted reflecting weakening demand, tightening of origination standards and lower fiscal resources.

Figure 4.
Figure 4.

Brazil: Public Banks Operations

Citation: IMF Staff Country Reports 2018, 339; 10.5089/9781484387474.002.A001

Sources: BCB, annual reports of banks.

9. Financial intermediation costs as measured by net interest margins (NIM) are particularly high in Brazil. Inefficient capital allocation has been an important drag on productivity growth (Dutz et al, 2018). NIMs in Brazil are similar to those in other Latin American countries but are considerably higher than in other peer economies and its income group. Operating costs are the main factor behind Brazil’s high NIMs, followed by loan loss provisions. Among Brazilian banks, regression analysis shows that higher credit-product concentration, larger banks and share of earmarked credit are strongly correlated with higher interest rate spreads. Structural deficiencies such as poor collateral enforcement, low recovery ratios, and an inefficient judicial system contribute to the high delinquency costs.

10. Small and medium enterprises (SMEs) are key economic agents, but have a large negative productivity differential relative to large firms. Estimates indicate that the productivity of micro, small, and medium firms is 10, 27 and 40 percent, respectively, that of large firms in Brazil (ECLAC, 2013). The relatively low productivity of SMEs is reflected in one of the highest firm creation and destruction rates in the world. Large banks dominate credit markets for SMEs, with lending mostly biased toward short-term financing and the longer-term funding provided via earmarked credit.

11. Brazil’s retail payments foundation is solid and the BCB has significantly strengthened the legal and regulatory framework that governs retail payments, particularly regarding the role of non-banks. The introduction of banking correspondents has been a key factor in enhancing financial inclusion by allowing more services by agents and expanding the list of institutions that may use agents.

12. Brazil’s card market is the second largest in the world, characterized by vertical integration and concentration, from issuing to acquisition and card schemes. In 2010, the BCB opened the market for merchant acquirers, but two firms control 80 percent of the market. Acquirer competition has reduced the cost of card usage, but interchange fees and scheme fees are substantially higher than in comparable markets, anti-competitive practices have been reported, and the low level of interoperability among networks of point-of-sale (POS) terminals and automated teller machines (ATMs) continues to generate inefficiency and unnecessary costs.

Risk Assessment

A. Materialization of Risks Could Result in a Double Dip Recession…

13. Brazil is facing significant downside risks that are driven by both domestic and external factors (Table 4). Political instability and spillovers from the corruption investigations are major sources of risk that could threaten the reform agenda and the recovery. The main policy risk is that the reforms necessary to maintain the constitutional expenditure ceiling are diluted or delayed, prompting adverse market reaction in the near term and necessitating additional fiscal measures. The main external risks are tighter or more volatile global financial conditions associated with the unwinding of the unconventional monetary policy, trade and commodity price shocks arising from U.S. trade policy, and a significant slowdown in China.

14. In an adverse scenario, Brazil could experience a severe recession underpinned by a sudden stop of capital inflows (Figure 5). While domestic factors, namely the loss of confidence, are the main driving forces, the adverse scenario would also take place in a challenging global environment, as described in the RAM, and against the background of weaker private sector balance sheets. The adverse scenario, though featuring financial stress driven by capital outflows, does not consider government default.

Figure 5.
Figure 5.

Brazil: Macrofinancial Scenarios

Citation: IMF Staff Country Reports 2018, 339; 10.5089/9781484387474.002.A001

Sources: Haver Analytics; IMF staff estimates.

B. …Which Could Affect the Financial Sector Amplified by the Nexus with the Sovereign…

15. A recession in the adverse scenario would result in significant financial stress as the nonfinancial sector is weaker, a legacy of the previous recession. Stress would be manifested in all key markets, reflected in a large depreciation, collapsing stock prices, and spiking bond yields. Corporate and household balance sheets would weaken due to rising funding costs and falling income. Banks could face large credit and market losses given borrowers’ impaired repayment capacity and their holdings of government bonds, which are sizeable for some banks. Liquidity risk could also materialize, with banks facing funding outflows and investment funds enduring redemptions in the face of increased market volatility. Financial stress could be amplified by intra-system linkages, while constrained bank lending capacity could further exacerbate the recession. Potential difficulty of the government to recapitalize banks could amplify system-wide stress and affect credit provision, especially of public banks.

16. Based on the solvency stress tests, banks appear to be broadly resilient to severe macrofinancial shocks (Figure 6, Annex VII). In the baseline, the CET1 capital ratio of the 12 largest banks would be on a downward trajectory, reflecting reduced net interest income, persistently large credit losses, and balance sheet growth, with one public D-SIB struggling to meet the capital requirements. In the adverse scenario, the CET1 capital ratio would decline by 4.7 percentage points to 8.5 percent at end-2020. These banks collectively would experience negative net income and incur unrealized losses associated with holding debt securities (mostly government securities) that would bring down the CET1 capital ratio by 0.2 and 1.4 percentage points, respectively. The reduction would also be driven by the increase in risk-weighted assets (1.8 percentage points). Negative profits would mainly result from reduced net interest income due to lower interest margins and substantial credit loss (larger than previous recession due to the weaker nonfinancial sector). Banks would also face significant market loss in 2018, although subsequent market improvements would help reduce the original loss. Four banks would fail to meet the hurdle rates (regulatory minimum and D-SIB surcharge) during the stress testing horizon, with aggregated capital shortfalls amounting to R$46 billion (0.7 percent of GDP), nearly all of which is for two public banks. The BCB stress tests based on the same scenarios showed more favorable results reflecting variations in methodologies, but some banks similarly would need additional capital in both baseline and adverse scenarios.

Figure 6.
Figure 6.

Brazil: Bank Solvency Stress Test Results

Citation: IMF Staff Country Reports 2018, 339; 10.5089/9781484387474.002.A001

Source: IMF staff estimates.

17. However, the benign outcome deteriorates if banks’ capital is adjusted for deferred tax assets (DTAs) and problem loans. The Basel Committee’s Regulatory Consistency Assessment Program (RCAP) has assessed the DTAs within the prudential capital adequacy regulations in Brazil as Basel III compliant (Annex II). However, DTAs may not be an effective loss-absorbing instrument in times of fiscal distress given the public debt sustainability and the lengthy timeframe for the government to release deferred tax credits (DTCs) after banks are out of business.3 Furthermore, restructured and renegotiated loans, which increased during the recession (although reversed somewhat thereafter), might increase future credit risk and loan losses. If all existing DTAs are deducted from CET1 capital (the majority of which are DTCs) and all performing problem loans are downgraded to the “E” credit category, these adjustments would immediately reduce the CET1 capital ratio by 3.3 percentage points, of which about 95 percent is due to DTAs. Under this severe scenario, seven banks would fail to meet the hurdle rates, with aggregated capital shortfalls amounting to R$136 billion (2 percent of GDP). Supervisory actions are needed to address the macrofinancial risks posed by the sovereign-bank nexus, as a result of DTCs, that may materialize in times of severe fiscal distress.

18. Banks are exposed to concentration risk, exchange rate risk, and market risk owing to the holding of government debt and equity securities. The default of the very largest borrowers of individual banks and of the system could have a large negative impact on capital, especially at public banks. State-owned enterprises are among the largest borrowers of public banks and could give rise to contagion due to bank-sovereign linkages. Despite banks’ small net open foreign exchange positions, a sizable impact could arise from depreciation-induced credit losses and increased risk-weighted assets. Furthermore, some banks could face significant losses when equity and government bonds’ prices fall sharply.

19. Banks are generally well-positioned to manage short-term and medium-term liquidity pressures. The regulatory LCR for the 12 largest banks is about 250 percent on average, with all banks comfortably above 100 percent. In the event of severe group-wide deposit outflows and significant stress in the bond market, only one D-SIB would have stressed LCR below 100 percent. However, the NSFR-based tests suggested that six banks would not be able to maintain the required stable funding profile under a stressed scenario within a year. The results of a cash-flow analysis were consistent with the LCR and NSFR analysis. Total liquidity shortfalls and funding gaps that could emerge during the period of stress would be manageable and in the reach of the BCB’s capacity, given substantial required reserves that could be released and provision of emergency liquidity assistance.

20. Investment funds could contribute to short-term price effects in the government bond market in the event of large-scale redemptions. The effects crucially depend on the underlying assumptions for calibration of redemptions. Three calibrations approaches, based on fund-homogeneity, fund-heterogeneity and fund-family, were accordingly used to assess price effects. The three exercises suggest that the funds would use from R$437 to R$77 billion of their reverse repos to meet extreme redemptions, followed by a total sale ranging from R$194 to R$10 billion of government bonds, respectively. This large-scale sale would respectively raise government bond yields from 62 to 8 basis points on average under the 2017 market liquidity conditions. Under more severe market liquidity conditions of September 2015, the average increase in bond yields would range from 99 to 11 basis points.

21. Pillar 2 capital requirements could help mitigate identified risks in the banking sector. Given concentration risk, including large holdings of debt and equity securities, capital add-ons based on individual banks’ risk profiles should be considered. Banks that would experience capital shortfalls in stress tests should be encouraged to build capital buffers, for example by a restriction on dividend distribution.

22. The BCB’s stress testing framework is sound, with significant upgrades since the last FSAP. Under way are the BCB’s initiatives to develop its solvency-liquidity contagion module to better capture potential risk amplification and bottom-up stress testing of banks. Further enhancements to the framework could include the handling of overseas operations; the estimation of credit loss based on default probability and loss given default; and the incorporation of cash-flow analysis. Lastly, given the prominent role of the government in the financial system, the BCB should take an integrated approach to assess the financial-sovereign linkages.

C. …And Vulnerabilities in the Household and Corporate Sectors

23. Notwithstanding the recent strengthening of their balance sheets, households are vulnerable to adverse macrofinancial shocks (Figure 7). Households are exposed to a liquidity squeeze given their large debt servicing obligations. Based on the debt-at-risk analysis conducted by the BCB, the share of financially weak households (i.e., with debt- service-to-income above 40 percent and debt-to-income above 3) and the share of debt belonging to these households (so-called “at risk”) has increased only marginally since 2013. However, shocks, such as falling income and rising interest rates, would bring these figures well above their previous peaks during the last recession, suggesting that more households might become financially distressed. That said, the implication for financial stability could be limited as the share of debt-at-risk not covered by assets would still be relatively small.

Figure 7.
Figure 7.

Brazil: Vulnerabilities in Household Sector

Citation: IMF Staff Country Reports 2018, 339; 10.5089/9781484387474.002.A001

Sources: Banco Central do Brasil; Haver Analytics; and IMF staff calculations.

24. Despite moderate signs of recovery, vulnerabilities linger among financially weak corporates that constitute a large fraction of the sector (Figure 8)4. Low profitability remains a challenge especially for the energy sector, while about two-thirds of firms in the highly-leveraged services sector face difficulty in servicing their debt solely relying on operating income. Macro-financial shock could substantially raise debt-at-risk in the corporate sector. While corporates with international activities utilize a reasonable degree of hedging against their FX exposures, profitability and interest rate shocks could double the amount of debt at risk under the adverse scenario with the manufacturing and energy sectors being most vulnerable (Annex IX).

Figure 8.
Figure 8.

Brazil: Vulnerabilities in Corporate Sector

Citation: IMF Staff Country Reports 2018, 339; 10.5089/9781484387474.002.A001

Source: Capital IQ, BCB and IMF calculations.

D. Interconnectedness Underpinned by the Role of the Government

25. Contagion through interbank cross-exposures seems limited, but could amplify shocks when banks are under significant stress5. Interbank exposures are relatively small—accounting for 5 percent of banks’ total assets—and about 60 percent of interbank exposures are secured. In a standalone exercise a default of one large bank would lead to a default of a medium-sized bank, while contagion would be limited when all other banks default. In an exercise integrated with bank solvency stress tests, the CET1 capital ratio would fall to 7.1 percent, compared with 8.5 percent when credit loss associated with interbank exposures are not considered, in the adverse scenario.

26. Financial interconnectedness between sectors was assessed from both within Brazil and from cross-border perspectives, identifying the central role of the public sector in the financial system. The role of public banks and state-owned firms, the critical importance of repos collateralized by government securities as the main instrument for conducting monetary policy and carrying out interbank transactions, and the centrality of government securities as the main liquid financial instrument in Brazil are distinguishing features. In addition, banks are the most interconnected sector by the size of exposures and their presence across all financial instruments. The investment fund industry also has strong links with banks, and the insurance and pension fund sectors, by lending to the former and receiving funds from the latter. Institutional investors account for 80 percent of the industry’s assets under management. Meanwhile, the corporate sector seeks 30 percent of their funding from nonresidents.

27. Brazil faces both inward and outward cross-border spillovers in the equity, sovereign credit risk and foreign exchange markets6. For the equity and sovereign credit risk markets, spillovers are both inward and outward within the Latin America region, and Brazil also faces inward spillovers from Europe and the United States. For the foreign exchange market, both inward and outward spillovers are more concentrated among large and financially integrated emerging market economies, with Brazil generating outward spillovers to other smaller Latin American economies.

Risk Oversight: Policies to Mitigate Risks and Enhance Resilience

A. The Architecture of Regulation and Supervision

28. The architecture for supervision and regulation of the financial sector is hierarchical and broadly well-defined (Table 6). Policy boards—committees comprising ministers and heads of agencies—set general prudential principles and guidelines for the financial system, but do not take executive decisions. Regulating entities issue specific regulations and are responsible for enforcement of principles and guidelines. The Committee of Regulation and Supervision of Financial, Securities, Insurance, and Complementary Pension Markets (COREMEC) is a high-level consultative forum that was created for information exchange and the coordination of supervisory policies among the financial regulatory agencies. While reforms have advanced, progress on the 2012 FSAP recommendations has been uneven (Table 6).

Table 5.

Brazil: Risk Assessment Matrix (RAM)

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Note: The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of IMF staff). The relative likelihood is the staff’s subjective assessment of the risks surrounding the baseline (“low” is meant to indicate a probability below 10 percent, “medium” a probability between 10 and 30 percent, and “high” a probability between 30 and 50 percent). The RAM reflects staff views on the source of risks and overall level of concern as of the time of discussions with the authorities. Non-mutually exclusive risks may interact and materialize jointly. “Short term (ST)” and “medium term (MT)” are meant to indicate that the risk could materialize within 1 year and 3 years, respectively.
Table 6.

Brazil: Progress on Implementing the 2012 FSAP Recommendations

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Sources: BCB, and Ministerio da Fazenda.

B. Systemic Risk Monitoring has Improved, but Gaps in the Oversight Framework Remain

29. Progress has been made on the macroprudential toolkit and systemic risk monitoring. Building on an already substantial set of macroprudential instruments, several new tools were introduced in recent years, including: (i) a counter-cyclical capital buffer (CCyB), currently set at zero percent; (ii) DSIB capital surcharges; (iii) a loan-to-value (LTV) cap of 80 percent (90 percent for constant amortization loans) for residential mortgages under the Sistema Financeiro da Habitação (SFH); and (iv) differentiated risk weights for residential housing loans, based on LTV ratios and other loan characteristics. In line with Basel III requirements, a capital conservation buffer (CCB), LCR, and NSFR are also being phased in. As pressures eased during the downturn, LTV limits for car loans were eliminated. Meanwhile, the BCB continues to actively use reserve requirements as a policy tool. Reserve requirements remain at relatively high levels, but the BCB has started to simplify and reduce them, to reduce the cost of credit. Progress was made on house price data and the introduction of a credit bureau, though the availability of “positive” credit information is still pending. Risk analysis has improved with more sophisticated stress testing and interconnectedness analyses. With an eye to potential future risks, the authorities could consider a DTI or DSTI limit to provide an additional instrument to manage risks.

30. But there remains room for improvement of the institutional framework. As in the 2012 FSAP, there is no single agency that has a clear legal mandate and adequate powers for macroprudential policy, though in practice the BCB has taken the lead. While existing informal arrangements seem to have worked in the past, the increasing complexity and interconnectedness of the financial system call for closer coordination among supervisory agencies.

31. Creating a Financial Stability Committee would fill a key gap in the institutional framework. To clarify responsibilities and ensure adequate coordination across agencies, the authorities should establish a high-level committee comprising all relevant agencies (BCB, MoF, CVM, SUSEP, Previc, and FGC once it is transformed into a public agency), with an explicit mandate for macroprudential policy. This committee should have the power to issue macroprudential policy recommendations, with a comply-or-explain requirement. Given its strong expertise in systemic risk assessment, the BCB should have an important role in the committee, and the division of labor with COREMEC should be clearly defined.

C. Prudential Supervision Supported Banking Sector Resilience

32. The framework for banking sector supervision is well-articulated and the BCB has responded thoughtfully to the international regulatory reform agenda. A proportionate approach to implementation of the international standards has been fostered by the BCB’s decision to classify the banking sector into tiers, reflecting their impact in the event of failure and risk profile. Supervisory intensity is adjusted according to this segmentation, but flexibility is also built in to adjust to developing circumstances. The same regulatory and supervisory framework applies to both the private and the publicly owned banks. However, this also means that the two sectors are each subject to the BCB’s unduly deliberate approach to corrective actions. Placing corporate governance assessment at the center of the supervisory process, and integrating conduct supervision into the overall assessment of institution, are recent and significant changes that should yield considerable supervisory insight. The BCB’s use of data is a clear strength (Annex III). However, at a more granular level, the BCB should introduce disclosure requirements for banks to share information on the level of restructured loans (Annex IV) in their portfolios, as this is an important component of credit risk monitoring and management.

33. Since the 2012 FSAP, the BCB dis-applied solo bank requirements. This might give rise to the risk that an individual bank within a prudential conglomerate (i.e., a consolidated financial group that does not include an insurance entity) could suffer due to unforeseen restrictions in access to capital and/or liquidity when needed. Taken together with weaknesses identified in the approach to concentration risk, related party transactions and the country and transfer risk management, a prudential conglomerate could be exposed to risks that are being imperfectly identified or monitored in the regulated entity. While the BCB does not attach major significance to this risk, it should re-instate prudential requirements and monitoring at the individual banking institution level for entities within the prudential conglomerate.

34. Other gaps in the overall approach persist, notably relating to the independence, governance and accountability arrangements to support the supervisor. Deficiencies include the lack of formal independence of the supervisor, the lack of legal protection for staff and the potential for the BCB governor to be dismissed for any reason and without the cause being stated publicly. Failure to remedy these deficiencies weakens the institutional stature of the BCB, notwithstanding the well-recognized commitment, skill and integrity of the staff.

D. However, Inefficiencies Linger Due to Government Interventions

35. Important reforms to downsize public involvement and enhance the corporate governance of financial institutions were adopted in the past two years. The cost of funding of BNDES is being aligned with the cost of sovereign debt (TLP reform), and pre-payment of BNDES liabilities to the government is reducing the funds available for lending operations, with profound consequences for reducing the size and business model of BNDES. Caixa is expected to organically generate resources to meet capital requirements leading to an increased focus on profitability, the efficient allocation of capital, and a concomitant decline in the non-core portfolio. Corporate governance and internal controls are being strengthened, including public disclosure of the appointment and remunerations of management and board members.

36. But wider reforms are needed for a reduced role of public banks. For Caixa, reforms include focusing on core competencies; a solvency strategy that supports reform momentum; and a socially-oriented strategic investor that can improve governance and bring know-how. For BNDES, the TLP reform to its pricing and pre-payment of its borrowing opens the door for a strategic reorientation of the development bank. Instead of providing loans, BNDES’ new strategy should focus on (i) assuming limited risks to catalyze private sector finance (e.g., through guarantee-type products) and (ii) enabling the development of new financial institutions with a view to enhance competition. Strong governance arrangements would be needed to guard against misuse, including an independent monitoring and evaluation function.

E. Further Progress is Needed to Address Governance Risks

37. AML/CFT and anti-corruption policies and measures have evolved and led to a greater effectiveness of the system. Brazil’s AML/CFT system was last assessed in 2010 by the Financial Action Task Force (FATF) and by the Grupo de Acción Financiera de Latinoamérica (GAFILAT) and the report identified important supervisory, customer due diligence and criminal justice gaps, many of which have since been addressed. These technical improvements have supported an increase in the effectiveness of the system, most notably in regard to the number of corruption investigations, prosecutions and convictions. COAF, BCB and CVM issued updated customer due diligence regulations, and increased the number of AML/CFT inspections.

38. Nevertheless, further progress is essential. Addressing the remaining shortcomings from the previous assessment would strengthen Brazil’s defenses against terrorist financing and allow Brazil to avoid FATF’s call for countries to apply counter measures that would be harmful to Brazil’s financial sector. To this end, a draft act was prepared. The completion of the national AML/CFT risk assessment, including a targeted assessment of beneficial ownership risks, and follow-up on other pending ENCCLA action items would address remaining gaps in the legal framework. Finally, the introduction of a risk-based approach specific to AML/CFT supervision and sanctioning would strengthen AML/CFT compliance.

F. Oversight of FMIs is Effective

39. Since the last FSAP, the authorities have rightly identified and started focusing on key frontier risks in the four main financial market infrastructures (FMIs)—interdependence in the financial system, cyber-attacks and payment systems outages. Further, FMIs have introduced significant enhancements to risk management frameworks to address liquidity, credit and operational risks. The mission assessed FMI supervision, as well as financial and operational risks in the largest CCP, BM&FBOVESPA Clearinghouse.

40. While FMIs are subject to effective oversight and supervision, improved disclosure is recommended. The supervisory framework by the BCB and CVM broadly complies with the CPSS-IOSCO Principles for Financial Market Infrastructures (PFMI). However, the CVM should disclose its adoption of the PFMI, its specific objectives for FMI supervision, and consider producing a supervisory report disclosing its findings. The BCB and CVM should ensure publication of disclosure frameworks by all systemically important FMIs to improve their overall transparency, their governance, operations, and risk-management framework, and to promote objectivity and comparability of assessments of observance of the PFMI.

41. CCPs should finalize a robust and effective recovery plan consistent with CPMI–IOSCO Guidance. Moreover, the BCB should set an action plan and a schedule with B3, the owner and the operator of CCPs and several other FMIs and the stock exchange, for finalizing such a plan. CCPs are presently subject to the Bankruptcy Code in case of insolvency, which means neither the BCB nor CVM, can intervene on CCPs, even in case of insolvency. Thus, an orderly resolution regime, consistent with international guidance for CCPs, should be introduced.

G. Material Gaps Remain in Insurance Supervision

42. Insurance regulation has been improved since the last FSAP. The Superintendency of Private Insurance (SUSEP) has shifted from a compliance-orientation to a risk-based and outcome-focused approach to supervision. Risk-based capital requirements together with the Liability Adequacy Test (LAT) have improved the soundness of the industry.

43. However, significant gaps remain in important areas, particularly the lack of independence and resources of SUSEP. Superintendents have been dismissed with neither a clear nor public explanation of the reasons. Staff lacks the appropriate legal protection and are not be able to impose sanctions promptly due to legal/procedural limitations. SUSEP’s resources have eroded since the last FSAP, and it does not have the flexibility to hire experts with needed technical knowledge. The shortage of resources prevents proper implementation of new regulations, which hinders the potential growth of the industry.

44. Group supervision should be established with enhanced coordination among supervisors. Large insurance groups belong to financial groups that dominate the market. Despite limited interlinkages between banks and insurers, search-for-yield in a low-risk interest scenario could increase contagion through reputational channels. Oversight by SUSEP and the National Agency for Supplementary Health (ANS) is solely focused at the entity level, without group level oversight. Some of the new regulations, in particular enterprise risk management and governance requirements, should have an increased focus on groups. The implementation of group level supervision would require significant coordination among agencies, especially among SUSEP, ANS, BCB and CVM.

45. Enhancing market conduct supervision is key. The industry is facing high surrender rates in annuity products, suggesting room for improvement in market conduct. Some insurance products are sold as a requirement for loans, typically within the same financial group. In a lower interest rate environment and a search for yield, policyholders would need high-quality advice in order to make informed decisions. Therefore, it would become important to improve the transparency and quality of advice in the sales channel of the insurance products. This highlights the need to clarify the current gap in the oversight responsibility for insurance sales through banking branches.

H. Securities Supervision Faces Resource Challenges to Meet Market Growth

46. Regulation and supervision of investment funds has been strengthened since the 2012 FSAP, in particular through a reform in 2015 of the rules on fiduciary administrators and asset managers. However, the resources of the CVM do not appropriately reflect the number of entities in the investment fund sector that it oversees, the growth of the sector and the important role played by investment funds in financial markets. The last open competition to recruit new staff was held in 2010, making it challenging for the CVM simply to replace employees who retire. Notwithstanding CVM’s risk-based supervisory approach, the lack of resources inevitably means that certain issues are not addressed in a way that CVM itself would consider appropriate.

47. While the regulatory framework for investment funds in Brazil is robust, institutional arrangements should allow CVM proper oversight of ANBIMA’s7 SRO activities with respect to the investment fund sector. The lack of a statutory basis for ANBIMA’s role means CVM is unable to oversee or take due account of what ANBIMA does. The two entities cooperate relatively closely on the development of the regulatory framework but ANBIMA is completely independent for the purposes of its supervisory and enforcement activity. The CVM is not represented in any of ANBIMA’s decision-making bodies, nor does it provide input to the developments of ANBIMA’s supervisory activities.

48. Rules on leverage and liquidity management should be strengthened further. The CVM should introduce a regulatory definition for leverage to allow the authorities to measure and compare leverage across the investment funds sector, and set a cap on leverage for individual funds or groups of funds managed by the same asset manager. With respect to liquidity management, there is a strong and balanced framework to prevent the build-up of liquidity problems. However, fiduciary administrators lack the tools to deal with situations in which illiquidity risk has crystallized and are obliged to move immediately to a suspension of subscriptions and redemptions. Giving fiduciary administrators access to a broader range of liquidity management tools would allow for more flexibility in the management of situations of illiquidity.

49. CVM’s enforcement powers were reinforced in 2017 legislation and it has adapted its supervisory activity to recognize the specific risks of related party transactions and their predominance in what remains a highly concentrated sector. CVM now has the authority to impose larger penalties, and has improved enforcement of good corporate governance (CG), imposing sanctions on grounds of fiduciary duties, related party transactions, and conflict of interest violations, and opined on share valuations in take-overs.

50. The timeliness and quality of information has improved, but there is a need for CVM to have a stronger presence in the market. CVM should deepen its risk analysis, including by industry specialization. It could strengthen its risk-based supervisory methodology by adding other indicators (such as financial indicators and potentially over time also corporate governance). Additionally, the CVM could consider increasing the number of companies reviewed and strengthening the type of review.

51. Effective implementation of CVM’s recently issued CG Code for issuers could face challenges. Reforms have enhanced transparency of ownership structure, non-financial disclosure, material events, and related party transactions. Further, it recommends a range of good practices including on appointment, composition, evaluation, and succession of board members and senior executives, and further defines the role of internal control bodies. However, the quality of reporting has yet to be tested and market participants have raised concerns over compliance costs. CVM should ensure appropriate staffing able to effectively analyze compliance reports and annually report on developments.

52. The 2016 SOE Law (Law 13.303) seeks inter-alia to upgrade CG in SOEs, but it has lacunas and implementation may prove challenging. While the Law upgrades transparency and integrity requirements with the mandatory issuance of the Annual Letter and impact sustainability report, and the adoption of a Code of Conduct, related party transaction and dividend policies, the appointment and evaluation policies of board members and senior executives, and remuneration disclosures may be challenging.

Crisis Management: Enhancing Policy Response

A. Work Should Continue to Strengthen the Resolution Framework

53. Important improvements have been made to the bank resolution, safety net and crisis management framework since the last FSAP. The resolution framework has been strengthened with the creation, within the BCB, of a new Resolution Department, and requirements for recovery and resolution planning have been established.

54. Notwithstanding this progress, the current framework has limitations that are broadly acknowledged by the authorities. Resolution powers are limited and no inter-agency arrangements for crisis management are in place. The BCB has taken the lead in preparing a comprehensive draft law (the “Draft Law”) that seeks to introduce a new resolution regime that is in line with international best practices (Annex V).

55. The proposed resolution reform is a major step toward aligning the safety net with international standards, although room for improvement remains.8 The reform gives options to restore the viability of a failed institution and broadens the toolkit of the authorities for dealing with systemically important institutions (including via bail-in and bridge banks). Importantly, it also strengthens the legal protection regime and removes impediments to temporary public support. However, elements of the law remain unclear, including its application to medium and small-sized banks, elements of bail-in powers, bridge bank transactions and conditions for transfers to asset management companies. The Draft Law will strengthen the recovery and resolution-planning (“RRP”) framework. The BCB is beginning resolution planning and resolvability assessments, and the Draft Law will require D-SIBs to prepare recovery plans. The authorities could benefit from extending RRP requirements (notably for recovery planning) to non-systemic institutions, by implementing such requirements proportionally to the size and complexity of such institutions.

56. The effectiveness of the new resolution framework should be improved by providing for the greater operational autonomy of the BCB and putting in place stronger inter-institutional arrangements. As noted above, the BCB enjoys limited autonomy. Coordination between the BCB and other safety net agencies, including the FGC once it is transformed into a public agency, should be strengthened by the establishment of formal, inter-agency crisis management arrangements and tested by regular multi-agency crisis exercises.

57. The process for dealing with weak banks and providing emergency liquidity assistance (“ELA”) should be tightened. While the BCB’s early intervention powers are robust and flexible, a regulation could be put in place identifying progressively tighter measures to address emerging risks in a bank. Further, ELA has not been used in over 20 years, due to, among other things, banks’ concerns about triggering supervisory actions, and relatively easier access to open-bank assistance from the deposit guarantee scheme (FGC). Measures to limit the risk faced by the BCB could be implemented, including a solvency test of the recipient institution and escalating measures such as enhanced supervision—measures that do not reduce flexibility as ELA would remain a discretionary decision of the BCB. Such measures pose a strong bulwark against supervisory forbearance and increasing resolution costs. An indemnity of the MoF could operate in systemic circumstances when solvency is in doubt and there are not sufficient assurances that the facility will be repaid.

58. The FGC should be strengthened including by bringing it into the public sector and ruling out open bank assistance from the deposit insurance fund. The FGC is a non-profit private association composed of financial institutions. Measures to make the FGC more effective include enhancing arrangements for payout, strengthening access to supervisory data subject to adequate confidentiality safeguards, and establishing back-up funding facilities. In addition to depositor protection, the FGC provides open bank assistance to member institutions. Such a role exposes the deposit insurance fund to significant risk and could undermine depositor confidence in the scheme. Shifting the FGC into the public sector could address many of these limitations, as it would help prevent conflicts of interest, improve the exchange of confidential information, allow the FCG to participate in high-level financial stability and crisis management committees, and, importantly, retain the mandate for financial stability in the public sector. In addition, emergency liquidity provision by the FGC should be discontinued once the BCB ELA framework has become fully operational. If solvency support is required in systemic circumstances, it should be provided from the resolution fund and open bank assistance from the deposit insurance fund should be ruled out. In the interim measures should be put in place to minimize the risk of the FGC lending to unviable and insolvent banks.

Systemic Liquidity Management

59. Brazil’s financial markets are generally liquid and sophisticated. Government bonds and overnight government securities repos are the centerpiece of Brazil’s money and fixed income markets. Fixed income and foreign exchange derivatives markets are very well developed and allow investors plenty of scope to manage risks. The infrastructure supporting markets appears sound. The large structural liquidity surplus (around 20 percent of GDP) and Brazil’s substantial FX reserves are key factors bolstering resiliency. Markets are highly interconnected and concentration is high as a handful of related banks and asset managers are involved in channeling funds from end investors through to the BCB via repo transactions.

60. But derivatives are based on underlying instruments that that are much less liquid. Interest rate derivatives use the overnight unsecured interbank CDI rate as their benchmark—a market that is very lightly traded and is not generally perceived to be representative of the true cost of funding for large banks relative to the much more active SELIC repo market. FX derivatives are based on a spot market that is very small and directly inaccessible to most market participants with derivative exposures. The CDI benchmark needs urgent reform, replacing it with SELIC. International efforts to reform interest rate benchmarks provide a good guide on the approach the BCB could take.9

61. The development of the spot FX market lags Brazil’s peers reflecting regulatory impediments. Longstanding FX regulations limit transactions that physically settle in FX to around 180 authorized FX dealers and their customers with a defined underlying reason to trade FX. Hence price discovery occurs in less restricted derivatives markets with spot transactions reflecting the needs of end-users such as importers and exporters. This means that if FX derivatives markets become illiquid or close investors could have limited alternatives to trade and manage risk. Spot markets need to develop to support their larger derivative counterparts. The FX regulatory regime should be updated to reflect the current level of development of Brazil’s markets so more entities can trade in deliverable instruments.

62. The authorities play a key role in backstopping market liquidity. The BCB is a key supplier of high quality liquid assets to banks and asset managers through its large OMO repo operations. The BCB has at times intervened extensively in the FX futures markets to provide FX hedges. The MoF takes an active approach to issuing domestic debt and is responsive to changes in market conditions including using reverse auctions to provide liquidity in the bond market during periods of high volatility. Markets are comforted by the authorities’ intervention roles in the bond and FX markets, the BCB’s significant FX reserves and the high degree of coordination between the MOF and BCB during stress periods. However, reliance on the authorities may at the margin discourage incentives by markets to develop the capacity to manage risks for themselves.

63. Planned changes to the central bank’s operating framework could challenge markets. Legislative changes designed to reduce the variability of transfers between the BCB and MoF, while desirable, may mean the BCB has fewer government bonds to use in OMOs over time. The BCB plans to introduce term deposits as an alternative tool to sterilize liquidity. However, term deposits do not currently fit within asset managers’ investment mandates and may also be costlier for the BCB due to their lower liquidity. Using BCB securities would be better but requires legislative changes that should be pursued if a structural alternative sterilization instrument is needed.

64. The BCB should review its operational framework to accommodate new instruments and better align operations with policy settings. Introducing new instruments such as term deposits demand a revised approach. The BCB should reform its OMO approach to accommodate more conventional fixed volume, variable priced auctions targeted at keeping rates close to the SELIC target rate.

Enhancing Financial Sector Development, Efficiency and Inclusion

A. Financial Intermediation Efficiency

65. Financial intermediation displays high costs that vary substantially by product and bank. Operating costs, loan loss provisioning, and bank concentration at the product level are strongly correlated with higher NIMs in Brazil vis-à-vis peers. Other significant factors are bank size—typically the larger the bank the wider the spreads—and the volume of earmarked-credit provision—among private banks, the higher the share of earmarked credit in their lending portfolio the higher interest rates in free-market loans. Reform directions emerging from the analysis include addressing operational costs, increasing the efficiency of credit enforcement, reducing information asymmetries, and identifying options to strengthen market contestability. A new law on electronic collateral registration may help reduce banks’ costs associated with SME lending. To reduce market power, actions are needed to facilitate client mobility and financial product cost transparency and comparability. The BCB and the competition authority, CADE, recently signed a memorandum of understanding to collaborate on facilitating efficient functioning of the financial market and a legal initiative on competition matters.

Figure 9.
Figure 9.

Brazil: Structure of Key Liquidity Markets

Citation: IMF Staff Country Reports 2018, 339; 10.5089/9781484387474.002.A001

Source: BCB

B. SME Financing

66. Despite their importance to large segments of the population, the share of credit to SMEs as a percentage of total credit is low (approximately 36 percent in late 2017) and volatile (Figure 10). Initiatives to foster SME financing should focus on three broad areas:

Figure 10.
Figure 10.

Brazil: Structure of Credit, by Firm Size and Type of Credit

Citation: IMF Staff Country Reports 2018, 339; 10.5089/9781484387474.002.A001

Source: BCB
  • Information infrastructure to mitigate information asymmetries. The adoption of centralized and digitalized business registries is recommended; while the “Cadastro Positivo” reform, pending approval in Congress, should ease information asymmetries.;

  • Legal and institutional frameworks for secured transactions, creditor rights, and insolvency to address issues of collateral registration and execution. These include the use of movable assets as collateral, and improving the efficacy of the insolvency framework and of judicial enforcements with respect to collateral execution; and

  • Availability of alternative products and sources of financing, including through fintechs.

C. Digital Access to Payment Services and Financial Inclusion

67. Brazil has long been at the forefront of payment systems but needs to adapt to rapid technological changes. The BCB should actively pursue the objectives of interoperability and improved competition in the retail payments market, and promote innovation. There is significant room for improved transparency, price differentiation, unbundling of services and cost reduction.10 The BCB should promote open banking (open application programming interfaces (APIs) allowing authorized third parties to develop services and tools for customers) to facilitate the development of new entrants and new business models, as well as a specific FinTech framework to stimulate innovations.11 E-money is underutilized, and its development would require a structured communication and education campaign.

68. The BCB is encouraged to continue its ongoing efforts to improve the legal framework and the payment system infrastructure. The legal and regulatory framework that governs the National Payments System is complex, and could be consolidated and simplified. In addition, the settlement guarantee mechanism should be extended to deal with the default of a participant, a single platform for bill payment should be established, NB PSP should be represented in the governance of CIP, and a structure to address the security of electronic payments is warranted.

D. Long-Term Financing and Institutional Investors

69. Development of the private fixed income market remains a major challenge in Brazil’s capital market agenda. Multiple causes interact to keep this market underdeveloped ranging from institutional and regulatory, to demand and supply factors. In particular: (i) public banks have played a major role in the financing of large companies and infrastructure projects but the bulk of their financing has come at subsidized rates; (ii) BNDES has structured financing for infrastructure under a corporate lending model, a model that is excessively onerous for infrastructure financing projects, which are typically highly leveraged; (iii) vertically integrated, bank-dominated financial conglomerates make competition difficult for the development of strong independent capital market institutions; (v) savings taxation provides weak incentives for long-term savings; and benefiting high-income people in their tax planning; and (vi) pensions funds and fund managers are increasingly focused on showing short-term results.

70. A reform agenda should include (i) a redefinition of BNDES’ role; (ii) new ways to distribute capital market products; (iii) a restructuring of tax incentives; and (iv) a re-thinking of the regulation of pensions. BNDES should move away from a sole-financier business model and corporate guarantees to actively engaging other partners and migrating toward project financing. Competition and supervisory authorities should be vigilant to business practices that reduce market contestability. Tax incentives should reduce deterrents to long-term savings and supervision of pensions funds should consolidate under one agency.

Table 7.

Brazil: Financial Sector Authorities

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Pension funds include open and closed complementary funds.

Sources: BCB, SUSEP, and PREVIC.

Annex I. Directed Credit

1. Credit markets are intervened in a variety of ways from direct credit, often at subsidized rates, to preferred borrowers—these loans are known in Brazil as earmarked. About half of the credit market is earmarked and the large majority of the earmarked credit flows through the public banks. Caixa Econômica Federal dominates the housing market with a more than 70 percent market share, and Banco do Brasil dominates the rural finance market. For households, the earmarked credits are predominantly for housing. For enterprises, they tend to be for investment purposes. Special programs are available to the agricultural sector. The earmarked loans are of much longer maturities than those in the free market.

2. On-budget fiscal subsidies are provided to reduce interest rates for some loans. These are the only costs explicitly recognized. The implicit subsidies provided by the below-market remuneration are not explicitly reported. The interest rates on earmarked loans are with a few exemptions regulated and substantially below market rates and have often been below the monetary policy rate. The exact interest rates depend on a complex set of eligibility criteria.

3. Special funds such as the Workers Guarantee Fund (FAT), the Severance Indemnity Fund (Fundo de Garantia do Tempo e Serviço, FGTS), and Constitutional Funds are used extensively to fund the directed credits. The funds receive a low remuneration allowing the financial intermediaries to lend at low rates. Similarly, the government has been lending directly to BNDES at well below market rates allowing it to on-lend at low rates.

4. Central Bank regulations channel a share of demand, savings, and rural savings deposits to housing, microcredit, and rural credit. In addition to using the special savings deposits with mortgage lending requirements, FGTS provides funding to Caixa Economica Federal to on-lend at below market rates. The central bank has detailed regulations and supervision of the banks to ensure that the credit flows to the intended beneficiaries.

5. The empirical literature suggests that earmarked credits have had modest impact on firm performance. In the aftermath of the global financial crisis, an expansion of earmarked credit provided a countercyclical credit measure. The subsidized lending has reduced interest expenditures for firms, but investment and productivity have not been conclusively supported by these credits. On the other hand, monetary policy has been impeded by the earmarked credit at regulated rates. Analysis has shown that the impact of the monetary policy rate tightening is reduced by one third for firms that receive earmarked credits. Understanding the general equilibrium effects from both the microeconomic and the macroeconomic distortions is complex and remains to be done.

6. A recent reform aims to disconnect subsidies from BNDES lending by linking the interest to the Government’s cost of funds. Previously, BNDES lending as well as borrowing has predominantly been done at the regulated TJLP interest rate. It has been kept below market rates, which has implied a subsidy from those who lend to those who borrow. The reform transitions over a 5-year period and the interest rates on new loans (TLP, starting January 2018) is linked to the sovereign cost of funding using the combination of an inflation indexed 5-year sovereign bond, actual inflation and the old TJLP.

Annex II. Deferred Tax Credits in Brazil

1. In Brazil, banks are required to make provisions for potential losses inherent in credit risk exposures as per BCB prescribed prudential rates. These prudential provisions are required to be established for the credit risk exposures irrespective of whether these are classified as problem assets or not. These provisions are not tax-deductible in the year in which they are established, but are allowed as deductibles only when the bank recognizes a loss and writes-off the exposure, up to the extent of the loss. As a result of the above differences between the timing when a provision is established by the bank and when it is actually allowed as an expenditure for tax purposes, the banks recognize (in compliance with accounting standards) a ‘deferred tax asset’ (DTA). DTAs arise in Brazilian banks primarily because of loan loss provisions (about 55 percent of total DTAs out of aggregate gross DTAs of around R$280 billion).

2. As per Basel III framework, DTAs whose de-recognition relies on future profitability of the bank must be deducted from Common Equity Tier 1 (CET1) capital per the Basel III phase-in arrangements. Instead of a full deduction, DTAs that arise from temporary differences (such as loan loss provisions), may be included in CET1, up to 10 percent of the bank’s common equity.

3. In Brazil, a law (No. 12,838 of July 2013), was introduced to allow banks to convert DTAs arising from loan loss provisions into eligible tax credits (DTCs) when the bank’s taxable income in any year is negative (loss) or when the bank is bankrupt or subject to extra-judicial liquidation. The DTAs arising from other causes are not eligible for such conversion. The law allows banks that have eligible tax credits to claim compensation in the form of cash or securities issued by the central government. It is understood that one bank claimed compensation in lieu of DTCs for about R$36 million. The government has recently approved the payment of the DTCs to it.

4. The Basel Committee’s Regulatory Consistency Assessment Program (RCAP) has assessed the prudential capital adequacy regulations in Brazil as Basel III compliant. As confirmed in the RCAP work on Brazil’s capital framework, the Basel Committee recognizes such DTCs as capital in cases where the law supports this treatment. In practice, only a few Basel Committee members (including also Italy and Spain) have opted for this approach and these jurisdictions were affected significantly by the banking crisis in Europe. In Brazil, the DTCs arising from loan loss provisions amounting to R$146 billion are therefore included in CET1 capital and constitute about 25 percent of CET1 capital.

Annex III. The BCB’s Risk Monitoring System

1. The BCB uses a range of data sources in its supervisory activity and monitoring of risks. In addition to the suite of prudential supervisory reports, it requires management information from supervised entities and also receives data from Trading Repositories (TRs). Reporting to a TR is mandatory in Brazil for most transaction types and for nearly all asset classes. In addition to financial transactions that are traded on and registered in authorized exchanges (CCP) and electronic trading platforms (equity, FX and derivative transactions), OTC derivative, spot foreign exchange, fixed income, and credit operation transactions must be reported. The main TRs operated by the BCB cover FX transactions, (Sisbacen—Sistema Câmbio), a central securities depository for government bonds (Selic), the credit information system (SCR) where all exposures by banks to individual domestic borrowers above R$200 are reported, credit information on domestic residents raising funds outside Brazil (RDE-ROF), and on loans which are originated for on-sale, such as auto loans (CIP-C3). In addition, there is a privately-operated TR (“B3”) covering a range of transactions including private and government bonds, both exchange traded and OTC derivatives (i.e. swaps, futures and options), equities and FX.

2. Monitoring focuses on assessing the economic and financial condition and other risk dimensions, including areas such as balance sheet analysis, regulatory limits and solvency, including risk analysis such as credit, liquidity and market. Peer group analysis identifies outlier behavior. In addition to the supervisory information which is received mostly on a monthly basis from banks, surveillance, and monitoring are mainly supported by an intensive use of granular data received from TRs (liquidity and market risks) and TR-like (SCR). For example, credit risk analysis is supported by the monthly reports of credit transactions from the SCR. Liquidity risk surveillance is supported by daily data from Clearing and Custody entities. The stress tests framework integrates this data sources, which results in many useful outputs for both micro and macro monitoring oversight.

3. Data received populate standard analytical reports and monitoring ratios and indicators as well as being available for interrogation by staff who can create bespoke reports. An early warning system (EWS) generates automatic alerts for variations in various indicators and ratios such as delinquency, provisions, credit migration matrix, the condition of individual debtors, financial soundness indicators, liquidity risk, detection of atypical operations, and prudential limits.

4. One of the main developments in systemic risk analysis since the 2012 FSAP has been contagion analysis based on the development of a real economy network model using Brazilian Payments System data. The BCB analysis, looking at interconnectedness within the financial system and in the non-financial sector, as well impact on unemployment, aims to identify systemic consequences from events such as a bank’s resolution, the bankruptcy of a large economic conglomerate, or reputational/governance issues.

5. The BCB applied contagion analysis most notably in the wake of the “Lava Jato” corruption investigation. A range of companies were reputationally tainted by the investigation of Petrobras, and the BCB sought to assess the financial system’s resilience to possible defaults. By analyzing payment system transactions, the BCB mapped a network of the real economy and estimated the degree of dependency between the companies involved. Conservative assumptions, were applied to trigger default of the core companies to analyze subsequent chain of defaults and contagion effects in the financial system stemming from the defaults and job losses in the real sector. The BCB was thus able to publicize the resilience of the system based on findings of moderate impact on bank capital. Similar exercises have been run to examine financial risk contagion effects from both real and hypothetical shocks.

Annex IV. Renegotiated and Restructured Loans in Brazil

1. Renegotiated household loans, as reported by banks, increased from 8 percent of total to 12 percent during 2014–16, while for companies the increase was from 4.1 to 9.7 percent of total loans over the same period. The increase in restructured loans was from 1.7 to 3 percent for households, and 0.8 to 1.9 percent for firms.

2. While renegotiation reflects any change of terms of contract, there can be two perspectives to restructuring (“forbearance”). On the one hand, “forbearance” may enable borrowers to overcome temporary financial difficulties, and may enable banks to maximize the recovery value through repayments or by disposal of the borrower’s assets. Forbearance can thus be a tool for sound risk management of problematic loans, applied by banks to mitigate or even eliminate credit losses. Moreover, forbearance may limit negative macro effects by keeping fragile but viable businesses in operation. On the other hand, “forbearance” can place institutions in an even worse position if it is extended without careful consideration to the borrower’s individual circumstances. This can be a cause for concern, since in the absence of a clear and prudent regulatory framework, banks may have the wrong incentives to resort to restructuring to overstate the quality of their credit portfolio and eventually their profitability and capital adequacy. In other words, without meaningful credit assessment and a sound business case, restructuring can be seen as a technique to disguise the deterioration of a loan portfolio. The mission’s stress testing exercise made assumptions related to loan quality and adequacy of provisioning in the sensitivity analysis.

3. In Brazil, until recently, the regulatory framework for restructured exposures was unclear. This was addressed when the regulations for prudential classification of credit risk exposures were revised for the largest institutions from end August 2017. These revisions will become effective for other institutions from end February 2018. The new regulation provides a clear definition of restructuring (including classification as a problem asset), an articulation of prudential treatment of restructured exposures and a clear guidance for reclassification (upgrading) of a problem asset.

4. Previously, ‘restructuring’ was not defined, but ‘renegotiation’ was defined as any procedure or arrangement that modifies the contractual terms of a loan. The volume of renegotiated loans is informed by the Credit Information System (SCR). However, renegotiations in the past were understood in different ways by different financial institutions. Because of this, the BCB does not use renegotiations as an indicator of credit risk but the volume of restructured loans which are a subset of renegotiation. Restructured loans are estimated by an algorithm, which identifies nonperforming loans converted back to the performing status without past due debt being fully paid.

5. The regulations for restructured exposures in Brazil can be further improved to be consistent with the Basel Committee’s Guidelines on the prudential treatment of problem assets. This would promote a better prudential discipline and comparability of the asset quality positions across institutions and across time. This could be done by establishing clear criteria for identifying forborne exposures and exit conditions from the forborne exposures category and clarifying the prudential treatment of repeatedly restructured exposures.

Annex V. Resolution Reform

1. The BCB has taken the lead in preparing a comprehensive draft law (the “Draft Law”) that seeks to align Brazil’s resolution regime with the international standards. The Draft Law— which has not yet been submitted to Congress—would overhaul the existing regime in certain key areas.

  • Resolution mandate and proceedings. The Draft Law designates the BCB as the resolution authority for financial institutions licensed by it and for financial market infrastructures, while the CVM and SUSEP would be empowered, respectively, to resolve securities and insurance companies.

  • Resolution and insolvency proceedings. The Draft Law contains two new proceedings— stabilization and compulsory liquidation. With the exception of the court-based bankruptcy procedure that will remain in place, these new proceedings will replace the existing regimes (i.e., temporary special administration, extra-judicial liquidation, and intervention) in their entirety. While stabilization is aimed at preserving the continuity of the firm under resolution, the triggers for stabilization and compulsory liquidation are the same, and the resolution authority has wide discretion to opt for either option.

  • Resolution and recovery plans. While recovery plans are currently required under BCB regulation, the Draft Law seeks to provide for comprehensive recovery and resolution planning requirements, adapted to the (wider) tools which would be available under the new framework.

  • Resolution powers. In the context of a stabilization proceeding, the BCB—as the resolution authority for banks—may order an administrator, appointed and overseen by it, to take certain measures, such as (i) a transfer of certain assets and obligations of the failed firm to a third-party acquirer, including a “transitional institution” (i.e. a bridge bank); (ii) establish subsidiaries or arrange for a spin-off of the failed firm; and (iii) convert certain categories of debt into equity.

  • Temporary public support. Currently, the fiscal responsibility law restricts the injection of public money into troubled financial institutions. The Draft Law removes this prohibition, subject to safeguards aimed at preserving the public interest.

2. Overall, while the above design features provided in the Draft Law represent a major improvement, the clarity of several provisions should be enhanced in order to operationalize the new regime (see paragraphs 47–49). Moreover, many gaps of the existing regime—such as the lack of autonomy of the BCB, the shortcomings in the mandate and operations of the FGD, and the absence of inter-agency arrangements for contingency planning—are not addressed in the Draft Law.

Annex VI. Financial Inclusion

1. Brazil has made significant strides toward financial inclusion (Figure 1). Over the past five years, the share of population with an active relationship with financial institutions increased by 21 percent reaching 138 million people, or 87 percent of the population aged 15 and above (BCB 2017). All 5,570 Brazilian municipalities have at least one point of access to financial services. More than half of all financial transactions are being made through digital devices using the internet. As a result, Brazil has one of the highest levels of bank account penetration among emerging economies—68 percent of adults in Brazil have an account. Factors contributing to this success include the expansion of a national correspondent banking network, consolidation of the credit union sector, and growth in microfinance and cooperatives and policies to increase incomes at the bottom of the pyramid.

Figure 1.
Figure 1.

Brazil: Financial Inclusion Indicators

Citation: IMF Staff Country Reports 2018, 339; 10.5089/9781484387474.002.A001

Sources: World Bank Findex database.

2. Nevertheless, gaps remain in achieving the national financial inclusion objectives. Despite the recent growth in access to financial institutions, 6.4 percent of Brazilian municipalities in 2014 remain without any physical access to banking services, relying solely on correspondents and electronic service outposts. Moreover, access to finance varies significantly across Brazil’s regions. In terms of usage of financial services, average savings rates among the Brazilian adult population (12.3 percent) is four times smaller than the OECD average, with Brazil’s poor saving slightly less than half of the national average. Furthermore, small and medium enterprises (SMEs) are credit constrained, as are microenterprises. From the 8.7 million microenterprises registered in the Special Secretariat for Micro and Small Enterprises (SEMPE), only 19 percent have accounts in financial institutions and 8 percent have credit operations as of December 2016 (BCB 2017).

3. Banco Central do Brasil (BCB), has played a dominant role in promoting financial inclusion advancements in Brazil, defining financial inclusion as its strategic objective since 2004. As a principle regulator of the national payment system and its infrastructures, BCB allows non-discriminatory access to payment services and market infrastructures, and promotes competition, financial inclusion, innovation, and interoperability. To encourage greater coordination and cooperation mechanism in development of national financial inclusion policies, BCB has partnered with a variety of government, business, and social sector stakeholders, including the Ministry of Finance and Ministry of Justice (improving the regulatory framework for microfinance and financial services delivery channels); Ministry of Communication (defining legal and regulatory framework for mobile payments); pension and private insurance regulators (encouraging diversification of financial services); and various research institutions such as IBGE and SEBRAE (analysis of financial services access and use).

4. To catalyze efforts aimed at promoting financial inclusion in Brazil, BCB launched the National Partnership for Financial Inclusion (PNIF)1. In 2015, PNIF launched the Plan for Strengthening Financial Citizenship, aimed at strengthening financial education, financial consumer protection and financial inclusion. The program also leverages on the existing financial inclusion initiatives, such as the PNIF and the National Plan for Consumption and Citizenship (Plandec)2. The financial citizenship program is one of the central bank’s top priorities and its importance was further reinforced in its “Agenda BC+.3

Annex VII. Bank Solvency and Liquidity Stress Test Results

Table 1.

Brazil: Bank Solvency Stress Test Results—Scenario Analysis

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Source: IMF staff estimates.
Table 2.

Brazil: Bank Solvency Stress Test Results—Scenario Analysis

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Source: IMF staff estimates.
Table 3.

Brazil: Bank Liquidity Stress Test Results

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Sources: BCB and IMF staff estimates.Note: *Numbers are in % of foreign reserves.