2. 1 Ilan Goldfajn Katherine Hennings Helio Mori Financial System in Brazil: Resilience to Shocks, No Dollarization, but Struggling to Promote Growth III Annual Latin American CREDPR Conference Stanford University - November, 2002

3. 2 Financial System in Brazil: Main Topics Objective of Paper : Describe Brazilian Financial System and Summarize Several Studies in Brazil Structure :  Stylized facts of the Brazilian Financial System  Restructuring the financial system  The role of the financial system in preserving the real value of private savings  Challenges to promote growth  Recent progress in strengthening the Brazilian Financial System

4. 3 Financial System in Brazil: Frequently Asked Questions  How does financial intermediation survive high real interest rates? Who borrows at those rates?  How does the system deal with high volatility? (high inflation prior to 1994, then interest rates and exchange rates)  Why is the banking system considered to be sound? (restructuring since 1995, important reforms since 1999 )  How is the recent crisis in Brazil affecting the banks?

5. 4 Summary  The Brazilian banking system is well capitalized, profitable, and capable of withstanding market and private credit risks (it is resilient to shocks).  Despite unstable macroeconomic environment in the past, there was no currency substitution  Room for enhancing the financial system’s role in supporting economic growth: banking spreads are still high and the credit to GDP is still low, but trends are changing  Microeconomic measures to improve the efficiency of the system are in place since 1999-2002 reforms

6. 5 Stylized Facts of the Brazilian Financial System Stylized Facts of the Brazilian Financial System

7. 6 A Snapshot of the Brazilian Financial System  Total assets of the Brazilian financial system is around 160% of GDP.  Consolidation of the number of banks (after high inflation).  Smaller presence of public sector (still has two major Federal Banks). Larger share of foreign banks.  Capital adequacy ratios are around 15%, above the required 11% (and Basle’s 8%).  Average Return on Equity has been around 15- 20%.  Banking spreads are still high (30%) and the credit to GDP is still low (30%), but the trend is positive.

8. 7 Banks: Institutions and Branches Source : Central Bank of Brazil, Economic Department Note : Banco do Brasil became a multiple bank in 2001 Itemization 19881994 InstitutionsBranchesInstitutionsBranchesInstitutionsBranches Commercial banks 106 106 13 837 28 28 4 160 24 24 380 380 Universal banks 0 0 173 173 11 305 146 146 14 874 Saving banks 5 2 374 2 1 935 1 1 694 Total1/ 111 11158.2 203 20359.8 171 17172.6 1/ GDP to branches ratio (R$ million/branches) 2002 (June)

9. 8 Number of Banks and Groups, 1994-2001125 150 175 200 225 250 I 1994 III 1995 III 1996 III 1997 III 1998 III 1999 III 2000 II Source: Rocha, 2001 Banks Banking groups

10. 9 Bank Ownership, Total Banking Assets, Dec 1993 and June 2002Institutions 1993 (December) (by ownership) CR$ billion % R$ million % Public banks 46 947 50.94 329 949 33.41 Federal 36 189 39.27 291 137 29.48 State 10 758 11.67 38 812 3.93 Private banks 45 213 49.06 657 674 66.59 Domestic 37 226 40.39 357 925 36.24 Foreign 7 987 8.67 299 749 30.35 Total 92 160 100.00 100.00 987 623 100.00 100.00 2002 (June) Source : Central Bank of Brazil, Economic Department

11. 10 Bank Loans and Spreads30 40 50 60 70 80 50 90 130 170 210 250 Total freely allocated resources Spread p.p. 1998 1999 2000 2001 2002 R$ billion Source : Central Bank of Brazil, Economic Department

12. 11 Credit in Brazil % of GDP 200020012002* Free resources 14.1716.3817.40 Households4.725.906.15 Enterprises6.327.087.13 Forex linked 3.123.404.11 Directed resources 12.869.8710.76 Housing4.621.791.72 Agricultural2.492.212.34 BNDES5.255.536.60 Others0.510.330.11 Leasing1.260.970.82 Public Sector 1.160.830.87 Total29.4528.0529.85 Source : Central Bank of Brazil, Monetary Policy Press Release, October 2002 * September

13. 12 Average Interest Rates and SpreadsDeposits (% p.a.) Loans Spread(p.p.) 2001 Dec 20.349.028.7 2002 Sep 13.543.630.1 Source : Central Bank of Brazil, Monetary Policy Press Release, October 2002

14. 13 Interest Rates and SpreadIndexed 1/ Floatingrate 2/ Fixed rate rate Indexed 1/ Floating 2/ EnterprisesHouseholds 2001 43.8 71.8 25.4 28.4 39.9 4.44.44.44.4 9.39.39.39.3 2002* 42.3 74.7 6.56.56.56.5 25.9 39.4 13.3 8.08.08.08.0 Source: Central Bank of Brazil, Monetary Policy Press Release, October 2002. 1/ Linked to foreign exchange depreciation 2/ Linked to interbank deposit certificates (CDI) * September Spreads (p.p.) Fixed rate Interest rate (% p.a.)

15. 14 Total Deposits in Brazilian Banks, June 1994-June 2002 0 100 200 300 400 500 Jul 94 Jan 95 Jul 95 Jan 96 Jul 96 Jan 97 Jul 97 Jan 98 Jul 98 Jan 99 Jul 99 Jan 00 Jul 00 Jan 01 Jul 01 Jan 02 R$ billion Source : Central Bank of Brazil, Economic Department

16. 15 Restructuring the Financial System

17. 16 Inflation Path, Consumer Price Index, Monthly Variation, 1991-20020 10 20 30 40 50 % p.m. 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Source : Central Bank of Brazil, Economic Department

18. 17 Number of Institutions Liquidated, Intervened in or under RAET, and M & A, 1994-2002Year Institutions liquidated, intervened in intervened in or under RAET Merger and and acquisitions acquisitions 1994 10 10 0 1995 18 18 1 1996 5 8 1997 10 10 6 1998 6 11 11 1999 1 2 2000 2 10 10 2001 4 3 2002* 1 5 Source: Central Bank of Brazil and Rocha, 2001 * Up to October 15, 2002 1/ RAET: Regime de Administração Especial Temporária (under temporary special administration) Total5746

19. 18 Program of Incentives for Restructuring and Strengthening the National Financial System (PROER )  1995 - 1997  New operations using the PROER require a specific authorization (Fiscal Responsibility Law - LRF)  Different mechanism for large banks and for small and medium size institutions  Cost: 0.88% of GDP (June 30, 2002)  Enlargement of the BCB power to deal with problems and prevent crises

20. 19 Program of Incentives for the Reduction of the State Role in the Banking Activity (PROES) Situation of the banks Number of institutions Liquidated10 Privatized15 in process 5 Restructured4 Authorized development agencies 16 Source: Central Bank of Brazil, Gedes  Initially were 35 state financial institutions, 32 used PROES  Cost: 5.7% of GDP

21. 20 Program for the Strengthening of the Federal Financial Institutions (PROEF )  Process started in 1995, although PROEF was created in 2001  Actions: –Transfer of credit risks to the Treasury or a Special Purpose Company –Exchange of assets with low liquidity and low interest rate for those more liquid, paying market interest rate –Capital increase in three of these four banks  Cost: 2.1 % of GDP

22. 21 Costs of Banking Crises CountryPeriod Fiscal and quasi-fiscal costs/GDP High Income Countries (average) 1/12.1 Argentina1980-198255.3 Argentina19951.6 Brazil1994-1996 5 – 10 ( 8.6 ) 5 – 10 ( 8.6 ) Chile1981-198341.2 Colombia1982-19875.0 Indonesia1997- 50 - 55 Malaysia1985-19884.7 Mexico1994-199520.0 Thailand1983-19871.5 Thailand1997-42.3 Uruguay1981-198431.2 Venezuela1994-199520.0 Medium and Low Income Countries (average) 17.6 Source: Hoggarth, Reis and Saporta, 2002 1/ Average costs from: Finland. Japan, Korea, Norway, Spain, Sweden and United States

23. 22 Hirschman-Herfindal Index for Total Loans and Total Deposits, 1994-2001 Source: Rocha, 2001 Source: Rocha, 2001 0.0974 0.0833 0.1023 0.1045 0.00 0.02 0.04 0.06 0.08 0.100.100.100.10 0.12 0.14 0.16 IIIIIIIIIIIIIIIIIIIII 1994199519961997199819992000 Loans - total banking sector Loans - private banking sector Deposits - total banking sector Deposits - private banking sector

24. 23 Increasing the Presence of Foreign Banks  Legal framework: Article 192 of the Constitution and Article 52 of the Transitory Provisions  Importance of privatizations  Effects –increase competition –new technologies –access to foreign markets

25. 24 The Role of the Financial System in Preserving the Real Value of Private Savings

26. 25 Brazilian Banking System  Brazil's economic history has shaped its financial system structure and characteristics, helping it to be resilient to shocks  The country had experienced several episodes of high inflation, but did not give rise to significant process of currency substitution

27. 26 Low Level of Dollarization Dollarization in emerging markets at the end of 1996 Country Dollarization ratio Bolivia97.9 Hungary36.9 Mexico32.1 Peru80.5 Poland24.1 Chile14.2 Brazil11.6 Israel18.2 Ize, Alain and Eduardo Levy-Yeyati, Dollarization of Financial Intermediation: Causes and Policy Implications, IMF, WP/98/28, 1998 Source: Actual dollarization ratio is obtained as an average of total dollar deposits over total domestic and cross-border deposits for the period Note:

28. 27 Composition of the Domestic Public Sector Debt (Marketable) % of total DPSD Fixed rate Selic Price index linked Forex linked Others 199116.0667.175.3011.470.01 199254.809.0423.563.009.60 199326.413.7842.0817.2610.47 199440.2016.0312.518.2922.96 199542.7037.775.265.288.98 199661.0018.611.759.389.26 199740.9134.780.3415.368.61 19981.6870.980.3720.916.07 19999.1961.092.3724.233.11 200015.3452.365.8721.704.74 20017.2153.767.0828.113.84 2002*10.9552.228.7226.351.76 * September Source : Central Bank of Brazil, Economic Department

29. 28 Total Deposits in Brazilian Banks, June 1994-June 2002 0 40 80 120 160 Foreign banks Private domestic banks Public banks Jul 94 Nov Mar Jul 95 Nov Mar Jul 96 Nov Mar Jul 97 Nov Mar Jul 98 Nov Mar Jul 99 Nov Mar Jul 00 Nov Mar Jul 01 Nov Mar R$ billion Source : Central Bank of Brazil, Economic Department

30. 29 Financial Investments, 1995-2002 % GDP 1995199619971998199920002001 2002 July Mutual Funds 11.6 11.6 16.3 16.3 16.2 16.2 17.1 17.1 24.2 24.2 28.2 28.2 30.2 30.2 27.6 27.6 Saving Accounts 9.8 9.8 9.2 9.2 11.1 11.1 11.8 11.8 11.5 11.5 10.3 10.3 10.0 10.0 10.6 10.6 Time Deposits 12.6 12.6 10.3 10.3 10.0 10.0 9.7 9.7 9.8 9.8 8.3 8.3 9.1 9.1 10.2 10.2 Total 34.0 34.0 35.8 35.8 37.3 37.3 38.5 38.5 45.6 45.6 46.8 46.8 49.3 49.3 48.4 48.4 Source : Central Bank of Brazil, Economic Department

31. 30 Financial Investments Proportional Share0 20 40 60 80 100 Jan/95 Jul/95 Jan/96 Jul/96 Jan/97 Jul/97 Jan/98 Jul/98 Jan/99 Jul/99 Jan/00 Jul/00 Jan/01 Jul/01 Jan/02 Jul/02 % Mutual Funds Saving Accounts Time Deposits Source : Central Bank of Brazil, Economic Department

32. 31 Challenges to Promote Growth

33. 32 Challenges to Promote Growth  Levine –Survey of literature –Financial development  economic growth –Less evidence on the opposite  Financial System –Information –Transaction costs  Liquidity –Assets  purchasing power –Transform maturity

34. 33 Challenges to Promote Growth  Function –Facilitating trading; hedging; diversifying; pooling of risk –Allocating resources –Monitoring managers and exerting corporate control –Mobilizing savings –Easing the trading of goods, services and financial contracts

35. 34 Challenges to Promote Growth  Brazil –Macroeconomic instability  high inflation, volatile nominal variables  management of liquidity and idiosyncratic risks  Economic Growth (Carneiro de Matos) –Credit to the Private Sector –Residents maintain assets in the domestic financial system

36. 35 Economic Growth Test  Carneiro de Matos (2002) tested the causality between financial development (D) and economic growth (Y) by adopting the following specification: ttjt m j jjt k j jt ttjtmj jjtkj jt VDYD udUDcYbaY             1 11 1 11.... where U and V are error-correcting terms; k and m, lags of Y and D respectively.

37. 36 Challenges  Inefficiencies –Long Term Credit  Government –High Bank Spread –Self Financing  Low Credit to GDP  High Bank Spread –Nakane  Macroeconomic Factors –Afanasieff, Lhacer and Nakane  Microeconomic Factors –E. Cardoso  Seignorage  Development with Economic Stabilization –Expansion of Credit –Reduction of Spread

38. 37 Accounting Decomposition of Banking Spreads Direct taxes 21% Indirect taxes 8% Administrative costs 19% Bank net margins 36% Default expenses 16% Source: Central Bank of Brazil, 2001

39. 38 Econometric Decomposition of Long Term Spread Estimated equation: tttttt impriskadmselicTendspreadln723.0ln219.0ln554.1ln503.0003.0ln(2.94)(2.86)(4.37) (3.55)(2.12) were Spread: loans interest rate to deposit certificate interest ratio Selic: current interest rate adm: administrative expenses to total loans ratio Risk: spread between C- bond and Treasury bonds with same maturity imp: indirect tax rate

40. 39 Econometric Decomposition of Long Term Spread Selic rate 16% Administrative costs 20% Risk perception 45% Indirect taxes 19% Source: Nakane and Koyama, 2001

41. 40 Recent Progress  Central bank is working towards a reduction of banking spreads: –Policy of gradual reduction of reserve requirements –Cuts in the financial market tax rate –Other measures  Effects: banking spreads shows a downward trend, with more credit being offered until mid 2001.

42. 41 Spread Composition – Cyclical and Persistent Factors2.0% 2.4% 2.8% 3.2% 3.6% 4.0% Jan/99 May/99 Sep/99 Jan/00 May/00 Sep/00 Jan/01 May/01 Sep/01 Spread and Persistent -0.4% -0.2% 0.0% 0.2% 0.4% Cyclical Spread Persistent Cyclical Source: Afanasieff, Lhacer and Nakane, 2001

43. 42 Challenges to Promote Growth  Factors that affected negatively confidence in the system –Changes in inflation indexes –Plano Collor –Bank failures  Risk Aversion –Demand for Risky Financial Assets –Dollarization  demand for risk-free asset (U.S. dollar)

44. 43 Challenges to Promote Growth  Developing a bank intermediation based on adequate risk assessment  Institutional reforms to reinforce public's confidence on the financial system

45. 44 Recent Progress in Strengthening the Brazilian Financial System There has been a wholesale improvements in the observance of internationally accepted financial sector standards, codes and good practices. Recent Progress in Strengthening the Brazilian Financial System There has been a wholesale improvements in the observance of internationally accepted financial sector standards, codes and good practices.

46. 45 Scenario to Be Changed  Enhance the role of Financial System –Macroeconomic: fiscal consolidation  address “crowding out” -Microeconomic: - Supervision and Regulation -Information and Transparency

47. 46 Supervision and Regulation  Adaptation of several regulations and supervisory practices to the Basle Core Principles  Global Consolidated Inspection  New regulation on a forward looking loan classification and provisioning system  New prudential regulation for foreign exchange and market risk

48. 47 Information and Transparency  Disclosure of basic information on interest rate charged by financial institutions  Revision of the Accounting Statement of Financial Institutions (Cosif)  Credit Risk Data Center  Transparency of Monetary Policy: minutes and reports.  Investor Relations Group - Gerin

49. 48 Recent Structural Reforms  New Payment System – Launched in April 2002  New Bankruptcy Law – Proposal in Congress  Private Deposit Insurance Scheme – FGC  New Corporate Governance Law – Novo Mercado  Other Measures to enhance liquidity in financial and capital markets (increase savings and a more efficient intermediation)

50. 49 ConclusionsConclusions

51. 50 Conclusions  The Brazilian Financial System is resilient to shocks  Despite unstable macroeconomic environment, there was no currency substitution  Room for enhancing the financial system’s role to support economic growth  The banking spread is still high and the credit to GDP is still low, but trends are changing  Microeconomic measures to improve the efficiency of the system are in place

52. 51 Ilan Goldfajn Katherine Hennings Helio Mori Financial System in Brazil: Resilience to Shocks, No Dollarization, but Struggling to Promote Growth III Annual Latin American CREDPR Conference Stanford University - November, 2002