December 02, 2013

Lending carnival

Public banks in Brazil

Increasing fiscal deficits and a higher chance of downgrading of its sovereign ratings are main factors behind the recent pledges of austerity on lending plans by public banks in Brazil. Finance Minister Mantega announced a 20% reduction on lending by BNDES next year, shortly after the IMF warned Brazil on the rapid expansion by its three major state owned banks.

BNDES (long term financing of development projects), Caixa (housing loans) and Banco do Brasil (rural credit) boosted their lending 25% per annum on average in 2011 and 2012, compared to 10% of private banks (domestic and foreign). They enlarged their books further this year, overtaking private lenders participation, reaching 50.7% share of the USD 1.09tr market.

As reported by the IMF´s mission last October: 
 “The substantial credit expansion in recent years by public banks has been financed significantly with transfers from the Treasury. Since the global financial crisis, the Treasury has provided subsidized direct lending to public banks, mostly to BNDES"
“The fiscal cost of government lending has also increased as the long term interest rate the rate public banks pay on obligations to the Treasury was reduced by 100 bps to 5 percent during 2012, with the lower rate applying to all outstanding loans”.
For those so called Sustainable investment loans, nominal rates are still as low as 3.5% while 12 month inflation is a higher 5.8%.

Government and IMF concerns added to earlier action by Moody´s when it lowered BNDES and Caxias’s ratings by two notches, to Baa2 last March. The deterioration of core capital indicators was a key factor in the downgrading decisions; however public banks were still in compliance with minimum regulatory Tier 1 requirement of 5.5% of capital adequacy, reflecting the usually healthy performance of a fairly young portfolio in its rapid growth phase. 

Brazil´s case illustrates very well the typical tension the development banks are subjected to: even if loans were not subsidized and fiscal costs were negligible- (often not the case, indeed) - the pressure to use lending as a development policy tool conflicts with banking supervision standards and prudential rules. This is especially so when government-promoted loans would perpetuate beyond what either counter-cyclical or market-failure motives would justify.

For the sake of financial soundness, Brazil is rightly signaling the need to curb public lending expansion. However, still needs to address implicit subsidies in government funded loans at negative real interest rates. The latter harms the efficiency of investments- (e.g. projects developed on the grounds of artificially cheap funding). 

As stated in the recent OECD recent country report when suggesting a desirable phasing out of BNDES lending to large corporations:   

“The development of private credit markets has much potential to relieve credit constraints and improve the allocation of credit”

As important as allocation efficiency, below market interest rates in public lending are also unfair - (e.g. the more you manage to borrow, the more you gain). Interestingly enough, 69 % of BNDES loan portfolio is concentrated in the 60 nation´s biggest corporations.

As much as financial crisis may burn tax payers’ money when rescue formulas are implemented to bail out private financial entities, public banks represent a potential fiscal destabilizer as well. Several developing countries have suffered from the fiscal burden of bad lending with honorable purposes, most notably by public but poorly regulated development banks and agencies. 

A case in point we learned first-hand in Chile: when the Chilean CORFO shut down its direct lending operations in the nineties, the best bid received in the auction of its old portfolio was a meager 12.8% of the face value

Since suffering from such an adverse policies, many development banks have moved from direct to on-lending. Chile pioneered on-lending schemes : long term funding was auctioned to, and then channeled through, private commercial banks, the latter absorbing the credit risks while the public bank or agency might provide some partial collateral to certain small commercial borrowers. As reported for Latin America, these reforms, together with the public provision of advisory and other services to small-medium scale borrowers have resulted in better performance of commercial loans in recent years. That is why, credit boosting through public direct lending as reported in the Brazilian case, represents not only a fiscal threat but a step back in improving development banks´ good practices.

As an analyst phrased when commenting the OECD report: “Brazil's wasteful state bank can learn from Chile”.