EconSouth (Third Quarter 2001)
Foreign bank entry into Latin America increased substantially during the 1990s, but the pace of this increase and the reasons behind it varied across the region. In Brazil foreign banks were a growing presence, but the legal environment and economic conditions there made the rate of entry slower than in other countries. Today, however, after implementing inflation reduction programs and instituting banking reforms, banks in Brazil are healthier and more diversified. Foreign banks are rapidly integrating into the local environment but have yet to become engines of credit growth.
ne of the notable consequences of banking crises and subsequent reform in Latin America has been a sharp increase in the number of foreign-owned financial institutions with operations in the region. Indeed, a recent report by the Bank for International Settlements — the organization commonly referred to as the central bank for central banks — estimates that the share of assets held by foreign-owned banks in Latin America increased from 10 percent in the mid-1990s to around 40 percent in 2000. Foreign banks also dramatically increased their role in the Brazilian banking system, expanding their presence threefold in the last half of the decade from 8 percent to more than 23 percent of their system assets.
Foreign banks increased their presence in Brazil, however, in a manner that has differed in important ways from the process in many other countries. The key difference is that the legal foundation for foreign bank operations was clouded by a clause in Brazil’s 1988 constitution that temporarily prohibited new foreign banks from entering the Brazilian banking system.
Another notable feature of the Brazilian banking system is that it did not experience the sort of devastating banking crises suffered by many other countries during the 1990s. Serious problems were clearly evident in some of Brazil’s banks by the end of 1994, but the magnitude of these problems did not pose a threat to the banking system as a whole. Further problems were averted by two reform programs enacted by the administration of President Fernando Henrique Cardoso. These programs indirectly resulted in a large increase in the number and importance of foreign banks in Brazil.
The banks and inflation
Ironically, the government’s main stimulus to reform the banking sector grew out of its successful efforts to tame the rampant inflation that had plagued wage earners but benefited banks in Brazil for many years.
During the early 1990s, as basic lending became impossible because of high inflation (see chart 1), banks remained highly profitable by maximizing float in the country’s payments system and using customer deposits as investment capital. Maximizing float — deferring payment or earning interest between the issuance of a payment and settlement — is commonplace in many financial systems. In Brazil, however, these transactions were especially profitable because the customers’ checking accounts paid a rate less than inflation to the account holders, and banks invested these same funds in short-term accounts that paid interest rates that far exceeded inflation. The gains on these transactions, often referred to as inflation transfers or inflation revenue, produced revenue estimated at about 4 percent of gross domestic product (GDP) in each of the years between 1990 and 1993. Float income is estimated to have been nearly 40 percent of banks’ overall revenue during this same period.
Banks often purchased high-yield government bonds indexed either to the inflation rate, the exchange rate or the overnight interest rate at the time of maturity. As inflation worsened, bond yields improved. Despite the high interest paid on these bonds by the government (that is, the taxpayers), Brazilian authorities probably considered themselves fortunate in that they could raise funds domestically where maturities were longer and market access was virtually guaranteed. Brazil’s foreign debt would likely be much larger and more rigidly structured today if this avenue of financing had not been available.
Banks’ profiteering from inflation came to an abrupt end in 1994 when the government implemented the Real Plan and successfully decoupled the nation’s economy from chronic price increases. The Real Plan was effective because it created a new standard of value for monetary transactions and launched a stable, new currency called the real. Inflation in Brazil fell dramatically from 900 percent in 1994 to 22 percent in 1995, the first full year of the plan. The rate of consumer price increases fell even further in subsequent years, rising less than 6 percent in 2000.
Although consumers benefited immediately from lower inflation, the transition for banks was much more difficult. The effects of permanently lowering inflation and ending inflation revenue can be seen in the decline of the financial sector’s contribution to domestic output. During the early 1990s, when banks gained from inflation, the financial sector was responsible for 10 to 15 percent of the country’s GDP. As inflation fell, however, so did the financial sector’s GDP contribution — which reached only about 7 percent in 1995.
As banks’ profits fell, some institutions started to show signs of distress — the least stable banks began to fail, and, ultimately, some larger banks became insolvent. Banco Econômico, Brazil’s eighth-largest institution at that time and the 14th-largest bank in Latin America, was taken over by the country’s central bank in August 1995.
Between the beginning of the Real Plan and November 1995 when the first of two restructuring programs was enacted, the central bank took control of 21 banks. PROER, or the Program to Support the Restructuring and Strengthening of the National Financial System, was the first of these programs and targeted private-owned banks. PROER aimed to preserve the solvency of the financial system by removing distressed banks and bolstering those that remained.
Another program — PROES, or the Program of Incentives for the Reduction of States’ Participation in Banking Activities — targeted distressed banks owned by state governments. The country’s developmentalist policies over previous decades had spawned a network of state-owned banks to help finance the varied economic needs of a geographically dispersed and socioeconomically diverse population. Most states also owned their own development bank to fund large-scale projects. When PROES began in the second half of 1996, several state-owned banks, including banks in São Paulo and Rio de Janeiro, had already been placed under central bank control.
These programs directly and indirectly reduced the number of financial institutions. Central bank records show that they intervened in or closed a total of 135 financial institutions of all types between November 1995 and year-end 2000. Almost one-fourth of these institutions were banks, and more than one-third of them were eventually closed. The overall number of banks in operation fell from 233 at the end of 1995 to 191 at the end of last year. The presence of banks owned by state governments was reduced from 18 percent of system assets and liabilities to around 5 percent at the end of 1999.
New wine in old bottles
Although increasing the number or importance of foreign banks operating in Brazil was not an explicit objective of either PROER or PROES, leading international banks have entered the market there as a result. The London-based bank HSBC purchased one of the banks that was supported with funds from PROER, and the Netherland’s ABN Amro and Spain’s Santander bought banks that had been privatized using PROES funds. These purchases reflect how Brazil’s accomplishments in taming inflation made it attractive to foreign capital.
While a handful of Brazil’s domestic banks were world-class financial institutions and industry leaders in the adoption of new technologies, the majority of the country’s banking institutions needed new capital to enact competitive improvements. As in other emerging market economies, in Brazil foreign capital offered a much larger potential supply of investment funds than domestic sources. While the larger domestic banks did acquire several smaller banks as well as purchase some privatized banks, domestic banks were generally unable to continuously provide the large sums of money necessary to clean up antiquated or troubled financial institutions. Furthermore, academic research suggests that greater foreign bank presence tends to stimulate even the best domestic banks into better performance and operating efficiency.
In addition to generating competition, foreign banks are thought to reduce systemic risk because the domestic central bank (Brazil’s, in this case) does not have to act as their lender of last resort. Foreign banks receive this service from their home country’s central bank, simultaneously reducing potential domestic liabilities while improving system soundness.
Despite the pragmatic necessity of introducing greater foreign capital into the Brazilian financial system, the country’s policy toward foreign banking capital initially led to some confusion because it seemed to be simultaneously for and against greater foreign participation.
Foreign banks have been operating in Brazil for several decades, and the size of their presence has varied along with the economy and legal factors. In 1930, foreign banks held around 25 percent of total system assets in Brazil; this share dropped to less than 3 percent by 1960. Foreign banks’ indirect influence has also varied over time. During the 1970s, the government borrowed heavily abroad to fund development, and domestic firms and banks also borrowed directly from foreign creditors. This influence virtually disappeared in the 1980s as the economy stagnated and the country lost access to foreign credit.
In 1988, Brazil’s new civilian leaders revised the constitution. Included in these changes was a temporary prohibition on “the installation, in the country, of new branches of financial institutions domiciled abroad” until a new comprehensive law governing the financial sector could be developed. This same section, however, seemed to contradict that ban by allowing foreign banks to enter the system through “authorizations resulting from international agreements, from reciprocity or from interest of the Brazilian Government.”
In the mid-1990s, the Cardoso administration provided some clarity when it affirmed that allowing greater foreign bank participation was in the nation’s best interests because it would allow for the use of foreign savings, the introduction of new technologies and increased efficiency. The president invoked this clause several times over the next few years to allow new and expanded participation by foreign financial institutions.
Although the constitutional prohibition on foreign capital is a hallmark indicator that Brazil’s banking system is not fully liberalized, the clause has also proved to be a powerful tool in influencing the direction of the financial system. The prohibition has allowed the government and the central bank to have something of a guiding hand and to encourage foreign banks to purchase public bank assets instead of pursuing other avenues of entry such as chartering a new bank or acquiring a private bank.
While the level of assets controlled by foreign banks in Brazil grew substantially during the second half of the 1990s (see chart 2), the level remains low compared to other developing countries, according to an International Monetary Fund study. This study compared the level of foreign-controlled assets in several emerging market economies in 1994 and 1999. Although the share of foreign-controlled banks in Brazil doubled in the five-year period from 8 percent to about 17 percent, the higher level was less than half the participation in Argentina (49 percent), Chile (54 percent) and Venezuela (42 percent) during the same time. Emerging market economies in Europe (the Czech Republic, Poland and Hungary) had around 50 percent of their banking system assets under the control of foreign banks, but emerging market economies in Asia (Korea, Malaysia and Thailand) had much lower levels than in Brazil.
The overwhelming majority of foreign banks in Brazil — 71 percent — originates in Europe. U.S. banks hold another 25 percent. However, Brazil represents less than 1 percent of these banks’ global holdings, reflecting the comparatively low level of foreign bank presence there.
Forces of change?
The profound changes under way in the Brazilian banking system — including the consolidation of an expanding foreign bank presence — have yet to fundamentally shift the banking system back to its traditional function as a credit provider. In fact, there is little evidence that foreign banks operate substantially differently than domestic banks. Both foreign and domestic banks still lend relatively little and rely primarily on yields from government bonds for income.
A recent study by Brazil’s National Association of Open Market Institutions found that foreign banks lent an average of 25 percent of their assets compared to an average of 27 percent for domestic private banks. State-owned banks lent approximately 29 percent of their assets last year. Foreign banks made 49 percent of their revenue from government bonds compared to 17 percent from lending operations. Private domestic banks took in 29 percent of their revenue from public bonds and approximately 27 percent from credit lending. Public-owned banks got a similar share of their revenue from credit operations (30 percent) but were less invested in government bonds (24 percent) than the private banks were.
Several factors shape these trends for the economy as a whole — not just the banking sector. The primary factor is Brazil’s continued economic volatility, making longer-term credit operations infeasible for domestic and foreign banks. Consequently, bank credit has fallen in recent years and remains low by developed-country standards. For example, bank credit to the private sector fell from approximately 53 percent to 31 percent of GDP in 1997. During that same year, bank credit to the private sector in the Unites States and Japan was 119 and 200 percent of GDP, respectively. Another factor behind the slower lending by foreign banks is a lack of local market knowledge — or knowing the ins and outs of a particular market — which puts foreign banks at a disadvantage at this early stage in their consolidation.
An estimated 80 percent of Brazilians do not have bank accounts. This statistic alone indicates that there is ample room for growth by domestic and foreign banking institutions. Furthermore, the provision of credit in Brazil must grow if the economy is to expand and prosper on a sustained basis. These trends suggest that foreign banks will continue to seek new opportunities in the country. Another attractive feature of the Brazilian market is that it is a universal banking system allowing banks to engage in a broad range of financial activities such as selling securities, insurance and similar products.
Overall, foreign bank interest in further expansion in Latin America appears to remain strong. Spain’s Santander purchased a controlling share in Banespa, the largest of Brazil’s privatized banks, in 2000 for U.S.$3.7 billion, almost four times the minimum asking price. Interestingly, until this purchase, Spanish banks had been less aggressive in entering the Brazilian market than they had been elsewhere in Latin America.
In Mexico, Citigroup recently purchased Grupo Financiero Banamex. The merged company is the country’s largest financial services group. The purchase is also interesting because of Citigroup’s stated goal of using Banamex and its subsidiary, California Commerce Bank in Los Angeles, as a way to reach the growing market of Mexicans and Hispanics living in the United States. If successful, Citibank’s acquisition may encourage similar acquisitions by other U.S. banks.
Still, foreign banks in Brazil are not likely to continue the large-scale gains they have experienced over the past few years. The central bank has temporarily halted foreign banks from entering the retail banking market except through the purchase of former state-owned banks undergoing privatization. So the opportunities for entry are few until this process is completed.
Plans are being developed to reform and recapitalize Brazil’s federal-owned banks, including stock sales and product line innovations in some of the banks. Regardless, public banks, which currently control around 37 percent of system assets, are likely to maintain a strong presence over the coming years. Public-sector banks can play an important role in banking systems like Brazil’s where private banks have not yet assumed the level of credit intermediation necessary to meet the economy’s financing needs. The question of how much longer the dominance of public-sector banks continues will partly be answered by the performance of foreign banks in the coming years.
This article was written by Elizabeth McQuerry, research coordinator of the Atlanta Fed’s Latin America Research Group.