Wednesday, June 24, 2009

Lessons from Brazil

. Wednesday, June 24, 2009

Brazil's financial system has made it through the financial crisis relatively unscathed, which is somewhat surprising given their history of financial instability. The broader Brazilian economy has taken a hit as demand for their commodities and manufactured exports has slowed, but the financial system has stayed afloat. How? It seems to be a combination of a poorly-developed financial system (i.e. a system with less systemic importance for the broader economy), draconian reserve requirements, somewhat higher prudential regulations, and a generally cautious approach to financial development:

Mr Tombini points out that Brazil endured several periods of severe volatility in recent decades, although it has become more stable since runaway inflation was conquered in the 1990s. “We are used to dealing with challenging environments, for our institutions and our regulations,” he says. “Everything we have done since the mid- 1990s has tended to take a more cautious approach.”

For example, many countries’ banks are obliged to maintain capital ratios – capital as a percentage of assets – of at least 8 per cent, the minimum recommended by the BIS. Unfortunately, says Ross Levine, an economist at Brown University, “almost all countries have taken the Basel minimums as the norm. They’ve been a lot less cautious than they might have been.”

In Brazil, the minimum required is 11 per cent but many banks keep levels of 16 per cent or more.

Perhaps more question-able are Brazil’s very high reserve requirements – the share of their deposits that banks must park at the central bank. Many countries have phased these out but in Brazil they are about 30 per cent of all deposits.

Francisco Vazquez, a specialist in banking regulation at the International Monetary Fund, says Brazil’s reserve requirements should be replaced with more modern instruments, such as deposit guarantee funds. “The system is so complex that it’s hard to get a good idea of what the cost to banks really is,” he says. It is also one reason why borrowing costs are so high in Brazil.

Brazil has suffered through some nasty financial crashes in the last few decades. Because of that, they've erected an institutional structure that prizes stability and low inflation over growth in the financial sector. Some of these regulations -- like the extremely high reserve requirements and bans on short selling -- have probably done little more than make financial transactions more costly and inefficient.

Another aspect is the composition of assets held by banks. This World Bank study [pdf] shows that in 2007, 43% of all bank assets was sovereign debt, while credit was 34%. The above study also shows very high interest spreads between corporate and retail loans. In other words, access to credit for common borrowers is limited, and comes at a high cost. This should mean that credit is rationed primarily to borrowers of a very low credit risk, but that does not appear to be the case: Brazil's non-performing loan rate is fairly high even by Latin American standards.

One thing does stand out. In 2007, Brazil's banking system held assets equal to roughly 75% of GDP (see above study). This number is relatively high for Latin American countries, but low relative to many other countries. In Spain, for example, banking assets totaled over 200% of GDP, and Spain's financial system has been decimated by the financial crisis. Before its implosion, Iceland's banking sector was so large relative to its economy that "it made no sense to calculate the percentage". It's possible, in other words, that Brazil (and much of the rest of Latin America) has had fewer adverse effects from the financial crisis not because of tighter regulations, but simply because its financial sector was smaller than in OECD countries.

If any readers know of any studies that look at this question, please post them in the comments.


Lessons from Brazil




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