Brazil's economy is weak but the banks are strong. That is the popular belief among investors. The banks are well-capitalized and liquid, with high profits. Brazil's banking sector has been restructured and balance sheets cleaned up. While investors fret over the government's failure to sort out public finances they can rest assured that the financial system is solid. Right?
Well, not exactly. The reason Brazilian banks are seen as strong is that their credit exposure is low and their dollar liabilities are matched. But the banks hold 25% of their dollar assets in dollar-indexed government securities and around half of total assets are in government paper. The argument about the strength of Brazil's banks only holds good as long as you believe that the government will not default on or restructure its domestic debt.
Following the real's devaluation the government's fiscal predicament has worsened. The government's debt is predominantly short-term domestic debt of which 60% is indexed to the overnight rate and over 30% is dollar indexed. So the effect of high interest rates and a devaluation is to escalate debt servicing costs.
As long as the government can keep its head above water the banks will enjoy high and increasing profits. But without doubt Brazilian bank risk has increased in step with the increased risk of a government default following the devaluation. It's the latest example of how the real contagion in the world economy is not so much between countries but between the public and private sectors.
"I wouldn't say the banking system in Brazil is bad but I would advise caution because the basis of its strength is capital and profits," says Liliana Rojas-Suarez, managing director and chief economist, Latin America. "Brazilian banks look profitable because they are holding short-term government paper but if there were to be a debt restructuring into long-term maturities asset prices could come down. That would seriously hurt Brazilian banks. In addition, the deepening of the recession will also affect the performance of loans. This could, in turn, adversely affect the quality of bank capital."
The other important issue is the banks' dollar liabilities. Several Brazilian banks have been active in the international capital markets in the past few years. In a research report on Brazilian banks, Deutsche Bank Securities points out that 12.5% of the system's consolidated assets and liabilities are in hard currency. The asset side is made up up 25% of dollar-indexed government securities, 48% dollar loans to domestic producers and 27% on other dollar assets. The report points out that corporate Brazil is under pressure due to the oncoming recession while "Brazilian government securities, normally considered a safe guarantee, are no longer completely sound, as doubts about the government's ability to service its debt exist".
The report cites two mitigating factors. First, that official banks, in particular Banco do Brasil, are net providers of dollar hedges. This reduces the vulnerability of the private banks. Second, the chances of contagion spreading through the interbank market are reduced because small banks do not use it much in uncertain times. "Nevertheless, it will take only one big bank [failure] to contaminate the interbank mechanism," says the report.
But the Brazilian banking system still has its supporters. "They [the critics] have a point if they are working with a scenario where the government will default on its internal debt but we are not working with this scenario," says Bruno Pereira, banking analyst with Brazilian investment bank Banco Icatú.
Pereira says that the top three Brazilian private banks - Bradesco, Itaú and Unibanco - all have low dollar liabilities relative to the size of their equity and that their dollar assets are larger than their liabilities. Itaú's total dollar liabilities at the end of December 1998 were $5.7 billion compared to equity of $3.8 billion, Bradesco's $5.3 billion which is less than its $5.5 billion equity and Unibanco's $6.3 billion with equity of $2.4 billion. "Unibanco is the most leveraged among the top three and depends more [than the others] on foreign borrowing to keep its leverage," says Pereira.
The capital-adequacy ratios of the banks are Itaú 21%, Bradesco 18% and Unibanco 15% and the top five banks, including the two large official banks, account for around two-thirds of the system. So if these banks are good the system as whole should be strong, argues Pereira.
Interestingly, this hasn't stopped the central bank looking at new measures to increase minimum capitalization levels which the Brazilian newspaper Gazeta Mercantil reports will be enforced by the end of the year.
At present the minimum capital is 11% of total risk-weighted assets but only credit risk is considered. The new rules will take account of market risk. Gazeta Mercantil reports that "the improvement of the preventive norms became an urgent priority when the IMF included the issue in the latest version of the $41.5 billion aid agreement for Brazil".
As the Brazilian government contemplates how it should sort out its fiscal difficulties, without any fallout in the banking sector, it may wish to ruminate on one further idea from Deutsche Bank. In these days when achieving inflation targets ranks higher than most other considerations and monetization of debt is a totally unacceptable practice - even, it seems, for Russia - Deutsche Bank surprises by proposing an inflationary solution.
"Lacking the necessary conditions to undertake successful voluntary debt refinancing, the only way to avoid a forced restructuring would be to allow 'stabilizing' inflation to emerge. Although this last alternative is quite costly in itself, it may prove the most palatable long-run option," says a report on dealing with Brazil's short-term debt problem written by Rojas-Suarez and Gustavo Canonero.
The Deutsche report on Brazilian banks says that Brazil's problems lie not in policymakers' lack of credibility but in the lack of credible policies.
Will the idea of stabilizing inflation fill the gap? Brian Caplen