Flexible economic institutions

Has Brazil created flexible and creative structures to deal with volatile economic cycles?

Survival of the quickest
Nov 12th 2009
From The Economist print edition

Frequent crises have made for strong banks and nimble financiers

BRAZILIAN businessmen often say that the country’s recent economic past has strengthened companies, and especially banks. The argument goes like this: you need to be good, or at least inventive, to survive and make money when you have no idea whether inflation next year will be 50% or 500%. Bankers and finance directors have had to be particularly nimble. One example is Souza Cruz (a subsidiary of BAT), Brazil’s largest tobacco company, which in the days of high inflation did no better than break even on its cigarette sales. Its profits came from the interest on the cash it held between being paid by retailers and paying tax fortnightly. Companies used to operating in such unusual circumstances flourished when life became more predictable.

There is some truth to this argument, even though it brushes aside the fact that until the 1990s Brazilian companies did not have to worry about foreign competitors. No big companies went bust in the recent financial crisis, despite losses on foreign-exchange derivatives that the Bank for International Settlements estimates at $25 billion. Moreover, no big banks wobbled, let alone had to be rescued, though there were some mergers.

One reason was that a previous round of bank failures, in 1994, had already cleared out the bad ones. Until then banks made their profits by taking deposits from customers, lending the money to the government overnight and pocketing the difference. With inflation at several hundred per cent a year, many banks’ balance-sheets were hard to decipher. When inflation came down, it became clear that a number of them were insolvent. These folded or merged with other banks, leaving only the stronger ones.

Brazil’s financial system got a further boost from reforms carried out when Arminio Fraga was governor of the central bank from 1999 until the start of 2003 (he is now at Gávea Investimentos, an investment firm). The country’s bank-settlement system now operates in real time, so all banks know their cash positions at any given moment and the central bank has an overall picture of what is happening. Before this system was introduced the central bank often ended up honouring the debts of banks that went bust, creating a dangerous incentive to be careless. Both Mr Fraga and his successor as governor, Henrique Meirelles, have made sure that banks report what is going on in any off-balance-sheet vehicles they have funded. This has helped to keep under control the special investment vehicles, conduits and other mysterious creatures that have caused so much damage in other countries.

This transparency extends to financial markets too. All fund managers must disclose the net asset value of their funds to Brazil’s Securities and Exchange Commission (CVM) daily, though with a 48-hour delay. At the end of every month funds must disclose what they were holding 90 days ago. Anyone can go to the CVM’s website and look up these numbers. Fund managers may grumble about too much disclosure, but most are happy with the rules. Maria Helena Santana, who chairs the CVM, explains that they make it harder to pull off a scam of the sort run by Bernard Madoff, whose pyramid scheme was hidden behind a veil of secrecy.

Created equal
Equity investors, for their part, have benefited from new rules for publicly traded companies brought in by the São Paulo stock exchange (Bovespa) in 2002. Big Brazilian companies used to be notorious for abusing shareholders with minority stakes. Under current guidelines, it is illegal to issue shares that pay out different amounts to different holders in the event of a takeover. Any disputes between shareholders are judged by the CVM. With these rules in place, foreigners have been happy to buy shares and Brazilian companies that were unable to borrow in capital markets are now able to finance their expansion.

A boom in initial public offerings (IPOs) followed. At its height, in 2007, 80% of the money for IPOs came from foreign investors. This undoubtedly led to some excesses: at one point there were more listed housebuilders in Brazil than in America. But some of the companies that floated will do well. And the message conveyed by the new rules—that better corporate governance allows people to make money by selling bits of their companies on the stock exchange—has been good for the family businesses that make up the bulk of Brazil’s medium-sized firms.


Plenty to celebrate

Santander Brasil’s recent IPO was a test of whether investors’ appetite for Brazil had returned. It proved to be the world’s largest IPO this year, valuing the bank’s Brazilian subsidiary at more than the whole of Deutsche Bank worldwide. The government is so worried about foreign portfolio investors pushing up the value of the real that it imposed a 2% tax in October to discourage them. IPOs have a wider benefit because companies that want to float all or part of their stock need to get their accounts in order, pay their taxes and make sure their workers are not part of the black economy.

All this has brought sophistication and liquidity to Brazil’s financial markets. São Paulo’s futures and options market is one of the five largest in the world by volume traded. Well-developed markets have been good for consumers too. High interest rates, high inflation and dysfunctional courts once made consumer credit rarer than snow. Thanks in part to a series of reforms carried out in Lula’s first term, credit has grown steadily. Loans for bigger items, such as cars and apartments, have become available for the first time, thanks to a new law under which a lender remains the owner of the asset acquired with the loan until the last repayment is made, whereas previously the money would have had to be chased up through the courts.

Lula’s first administration also introduced a new bankruptcy law that is credited with making it slightly easier to salvage something from companies that go under. There was room for improvement: a few years ago a World Bank study found that bankruptcy proceedings in Brazil took an average of ten years and left creditors with just two cents in every dollar owed.

Yet for all this progress, two glaring problems with Brazil’s financial system remain. First, credit is very expensive. Second, only the government will lend for long periods, and not to everyone.

Tax and lend
Brazil has a hybrid retail banking system, with state-controlled and private-sector banks competing directly. It is highly concentrated: Itaú Unibanco, the largest private bank, is among the world’s 15 biggest on several measures and yet has almost no presence outside Brazil. Banco do Brasil, the largest state-controlled bank and one of the world’s oldest financial institutions, vies with it for the title of the country’s biggest bank. All told, credit from state-controlled banks makes up 37.6% of the total and has recently been growing.

Despite their different owners, the state-controlled and the private banks seem to be behaving in a remarkably similar way. Aldemir Bendini, the chief executive of Banco do Brasil, talks enthusiastically about international expansion. The bank will soon open five agencies in America to serve Brazilian expatriates. It also wants to help Brazilian multinationals abroad with local-currency financing. Meanwhile it will keep up its role as an instrument of public policy that does the bidding of the federal government, its biggest shareholder, and also look after the 22% of its shareholders who own traded stock. It looks like an incongruous mixture, but it appears to work. Itaú Unibanco too is keen on expansion abroad, but makes so much money at home that it does not seem to be in a rush.

In theory, all this should provide plenty of competition, with the two types of bank keeping each other honest and making sure that Brazilians have access to credit. In practice it does not quite work like that. Even though Itaú alone has 25,000 cash points, more than 500 municipalities in Brazil lack even a single bank branch. The two kinds of bank compete most fiercely in the comparatively wealthy south and south-east of the country. Banco do Brasil recently added to the geographical concentration by buying Nossa Caixa, a São Paulo state savings bank, and a large stake in Banco Votorantim, a private-sector bank.

The government has raised the limit for foreign participation in Banco do Brasil to 20% to attract more capital, but the state-controlled banks are not as well run as the private-sector ones, so the hoped-for competition has not materialised. The clearest sign of this is spreads—the difference between a bank’s cost of borrowing and lending. The Institute for Industrial Development, a lobby group, calculates that average lending rates are 35% higher than deposit rates, against less than 10% in the other BRIC countries. The bankers’ lobby disputes these figures, but nobody thinks that banks’ spreads are thin.

Among the things that make them fatter are a curious tax on bank funding that increases costs, and high reserve requirements which mean that banks must squeeze more revenue from what they are able to lend. Bad-loan provisions are high too, reflecting the fact that consumer credit is concentrated among people who are already stretched. And a lot of credit is subsidised, which pushes up costs for the rest.

Brazil’s banks have many things to recommend them; indeed they seem to exemplify what might happen if regulators elsewhere got their every wish. They are safe and their lending is well-capitalised and profitable. Two-thirds of Brazilian deposits are in local banks, which is unusually high for Latin America and a big change from the past, when anyone who had money kept it out of the country and in dollars. The banks also offer some things that would surprise American or European customers. Many ATMs provide a wide range of financial services, from dispensing cash to providing loans. Even so, for now credit is likely to remain too expensive for the country’s good.

For companies trying to get credit, the problems are much the same. To make up for the absence of a market in long-term debt Brazil created a giant development bank, the BNDES, with a balance-sheet larger than the World Bank’s. This is financed by an impost on labour and lends predominantly to Brazil’s biggest companies—the opposite of what you would expect from a left-leaning country.

Because its large loans to Brazil’s big names carry so little risk, the BNDES is profitable. It also does some more adventurous lending, although trickier credit assessments are farmed out to private banks, which collect a fee for their pains and also assume the risk of loans going bad. The BNDES was useful to Brazil during the recent crisis as a stable source of funding, but its scale as the lender of choice for Brazil’s best credit risks is probably impeding the development of markets in long-term debt, and the way it is funded seems fundamentally unjust.

Still, compared with the bank failures, frauds, market manipulation, volatility, disregard for contracts and near-absence of credit of the past, Brazil’s financial sector has come a long way. Foreign investors have noticed, and have recently started pouring money into the country.


About Janar Wasito

Janar Wasito is the manager of Magis Capital in San Diego, CA. He is a graduate of Harvard and Stanford Law School, and a former Marine Officer.
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2 Responses to Flexible economic institutions

  1. Hildete Vodopives says:

    This article from The Economist, gives us a good historical pespective on Brazil. It helps clarify questions such as: why Brazilian banks didn’t crash but got stronger after the crisis? How are IPOs doing in Brazil?
    It is also interesting to read an article 6 months old..


  2. Pingback: Flexible economic institutions « Brazil Global « Brasil: Economia Global

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