Brazil: Failure demonstrates pressure on small banks
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Brazil: Failure demonstrates pressure on small banks

Cruzeiro del Sul’s liquidation damages central bank’s reputation; Scrutiny ‘will unveil irregularities’

The liquidation of Brazilian bank Cruzeiro do Sul has damaged the reputation of the Brazilian central bank (BCB), and heightened funding difficulties for other small and medium-sized banks, according to market participants.

There has been much debate about the role played by the FGC, the privately held credit-guarantee fund, and its attempts to stave off insolvency, but little comment about the supervision by the central bank.

"The central bank and the securities regulator [CVM] haven’t attracted much criticism, but that’s surprising," says one banker. "They had been aware that the bank had some accounting irregularities for some time – at least a couple of years – and I don’t know why it took them so long to act."

The central bank put Cruzeiro do Sul into the hands of the FGC in early June because of a $1.5 billion accounting hole. It is still unclear if fraud is to blame but the suspicion is that the losses are too large to be caused just by sloppy internal accounting procedures.

The delay on the part of the central bank was probably due to its preferred solution of facilitating failing banks’ bailouts by larger participants. The central bank was instrumental in BTG Pactual’s acquisition of PanAmericano after it was found to have been fraudulently double-counting assets into securitization transactions.

Start-up banks also reported that the central bank pressured them to take on failing organizations as a condition of getting banking licences. However, with Cruzeiro do Sul’s losses suspected to be even larger than those stated, a bailout solution was not workable this time, although some see positives from the insolvency.

"Perhaps a benefit from this event to the banking system is that banks will be encouraged to further improve operational procedures and minimize funding gaps, as investors are likely to increase their scrutiny of investment choices knowing that the Brazilian regulators may not bail out investors in the event of future bank failures," says Fitch Ratings. "The combination of these trends should lead to a stronger and perhaps more consolidated banking system."

In the shorter term, the impact will be on less liquidity for the smaller banks in the system that are already struggling with the cost of funding, greater supervision and competition from the larger banks.

Luis Santacreu, analyst at Brazilian ratings agency Austin Ratings
Luis Santacreu, analyst at Brazilian ratings agency Austin Ratings

"It will be very difficult for a mid-tier bank to go to the international bond markets after Cruzeiro do Sul," says Luis Santacreu, analyst at Brazilian ratings agency Austin Ratings. "They will be even more reliant on FGC lines of credit and the possibility of large banks buying their loans." On September 14, the central bank reduced reserve requirements on demand and time deposits. According to Barclays, the measures effectively added R$30 billion ($14.8 billion) additional liquidity into the banking system and, while the central bank denied the decision was linked to the fallout from Cruzeiro do Sul’s bankruptcy, Barclays adds: "This decision was taken to make sure liquidity conditions remain intact for smaller banks, post the announcement of the liquidation of Cruzeiro do Sul.

"The BCB is incentivizing large-cap banks to direct these released resources [up to 50% of time-deposit requirements] to either buy loan portfolios [from smaller banks] or letras financeiras [longer-term funding securities issued by banks]."

Despite this additional liquidity, Santacreu expects other banks to exit the market. "Some banks are closing down in Brazil," he says. "Those that have a niche that isn’t being met by the larger banks will be able to continue by concentrating on their niche, but even these banks won’t be able to grow at the rates they have in the past. It’s going to be difficult – funding has always been an issue for these banks and now it will get even tougher."

Santacreu also thinks increased scrutiny from the central bank might find more banks with accounting irregularities. "[Alexandre] Tombini [the head of the central bank] has made it clear that he will not be tolerant with any creative accountancy practices of the past," he says. "The BCB is also requiring more provisions for their balance sheets. Some of these banks are complaining they can’t operate in this environment but this is going to be the reality for these banks."

Despite the widely acknowledged difficulties to the business case of Brazilian mid-tier banks, their valuations have been improving in recent months. The chart shows that the discount at which small-cap banks trade compared with large-cap banks has tightened since the end of June.

Tightening discount 12 month forward P/E multiples of large- and small-cap Brazilian banks

Goldman Sachs notes: "Some of the risk aversion that was priced into the shares of the banks has declined, resulting in the gap in valuation between large and small banks tightening." However, the fallout from the liquidation of Cruzeiro, as well as growing concerns about asset quality, might lead to this valuation gap widening again.

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