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Fitch on the Lookout After Brazil Intervenes at Bank

On the night of November 12, 2004, the Brazilian Central Bank intervened at Banco Santos S.A. and one of its subsidiaries, Santos Corretora de Valores Mobiliários S.A.

On the night of November 12, 2004, the Brazilian Central Bank intervened at Banco Santos S.A. and one of its subsidiaries, Santos Corretora de Valores Mobiliários S.A.


Fitch Ratings believes that the points that the Brazilian Central Bank mentioned as causing them to intervene in Santos  are unique to that bank, and as a result, Fitch believes that the regulator will continue to monitor and track the financial soundness of the system.


On Nov. 16, the Securities and Exchange Commission (CVM) determined that withdrawals from the funds managed by Santos Asset Management (SAM), a wholly owned asset management subsidiary, would be suspended for up to 30 days to prevent shareholders who continued to have investments in these funds from suffering losses at the hands of those who effected redemptions in days following the bank’s intervention.


Since the intervention in Santos, Fitch has been monitoring the risk of a potential systemic contamination, driven by investor sentiment.


In times of uncertainty, investors tend to reduce their tolerance for risk and may re-allocate deposits, channeling these resources to institutions that are considered to have a stronger credit profile, as well as to banks that benefit from the implicit support from the federal government or from strong shareholders.


This risk is particularly accentuated among small and mid-sized banks, which normally present important liability concentrations, making them more vulnerable to so-called ‘flight to quality.’


Fitch has observed this effect in this segment, but at a level still considered manageable, although quite tight in a few isolated cases.


Part of the deposit movements seen to date stem from investors that, with their liquidity frozen in the intervened bank, effect withdrawals at other institutions to be able to honor their commitments.


Liquidity


A review of the small and mid-sized banks that have ratings assigned by Fitch indicates that a number of them had for some time already been maintaining higher liquidity than usual to be able to face expected or unexpected turbulence.


Fitch’s monitoring of these institutions has demonstrated that they have maintained a liquidity cushion of between 13% and 110% of their equity, or the equivalent of 4% to 70%, respectively, of their time deposits.


In addition, most small and mid-sized banks have been more stringent in approving new loans, which, together with their shorter maturities, has favored their cash positions.


Among the factors that have helped to mitigate the market effects of the Santos intervention, Fitch cites the overall liquidity situation in the Brazilian market and the perception by the regulatory authority of a potential liquidity shortage among small and mid-sized banks.


To forestall this eventuality, the Brazilian Central Bank, on November 19, changed the regulations on reserve requirements against deposits, releasing up to BRL 300 million of the funds each banking institution has on deposit with it.


In Fitch’s opinion, a concern that has not been mentioned nor adequately perceived by the market is the fact that the companies that had credit limits with Santos will have to quickly obtain new lines from other banks.


No Roll-over


Fitch understands that in a bank intervention, the authorities will require that valid contracts be honored, i.e. that lines be paid at maturity, as they will not be able to roll over these lines of credit.


This is, in fact, more delicate, since in Santos’ business niche, it is common for borrowers to also be depositors either in the financial institutions that concede them lines or in their affiliates or to other group companies.


Since Brazilian legislation in the case of intervention of a financial institution does not explicitly provide for the offsetting of a company’s debts against any deposits/assets it holds at the banking institution (netting), these companies not only need to obtain new resources from other banks but they also cannot fall back on their liquidity cushion applications in the bank under intervention.


Fitch is analyzing the potential impact of these factors on all of its public ratings.


With respect to Santos, deposits are covered by a federal guarantee (Credit Guarantee Fund (FGC)) for up to BRL 20,000 per customer. The funds managed by SAM, in the amount of BRL 2.5 billion, based on October 2004 data of the National Association of Investment Banks (Anbid), do not enjoy such a guarantee.


By law, such funds can invest up to 20% of their net assets in the bank’s CD’s, which was probably utilized. Few financial institutions maintained deposits in Santos and/or the investment funds of its asset manager.


Investors in SAM’s mutual funds are said to be mainly pension funds, other institutional investors, and municipalities.


Foreign trade lines may receive different treatment. Provided the export financing line (ACC/ACE) has been recorded in the exchange contract, as provided for in Law 9450, any amount received by the bank under intervention in payment of this exchange contract, whether from an underlying foreign collection or from a judicial or amicable collection received from the exporter, the proceeds will be obligatorily destined to pay the bank that financed the operation.


Risks


Fitch points out that institutions providing such financing could, then, face two risks: a multiplicity of financing in the event the assets and liabilities relative to export financing operations were not perfectly matched at the institution under intervention and the fact that the market in general has made little use of this facility.


Nevertheless, should one of these situations occur, the Brazilian authorities, as on previous occasions, could effect the payments, perhaps with some delay, to maintain confidence in trade financing.


Import financing lines can be paid with greater agility, since the Brazilian Central Bank considers that the financial institution merely acts as an intermediary transferring the resources in such financing.


This being the case, provided the Brazilian importer effects payment, the interventor will arrange payment to the financing bank overseas.


External securities issuances (bonds) will be included in general obligations of the bankrupt estate, as will demand, savings, and time deposits.


Not only is the bankruptcy process generally drawn out, but it is also difficult to assess the degree of expected recovery, given the little data available currently.


However, information provided by the Brazilian Central Bank that the bank allegedly had a negative net worth of BRL 100 million, initially indicates that the percentage of losses to be divided among the creditors would be low should all Santos’ assets be honored by its debtors.


Nevertheless, Fitch believes that with intervention, the potential for additional loan losses will be substantially larger and, as a result, the negative net worth will increase, since, as mentioned before, creditors are likely to present problems.


Another concern relates to the very high amount of lines made available to Santos by BNDES, the Brazilian national development bank, (approximately BRL 1 billion) that represent Banco Santos risk.


BNDES


Nevertheless, in its financing, BNDES enjoys a subrogation of rights, i.e. in the event of the bankruptcy of the BNDES on-lending agent, the flows resulting from the financing using such funding do not enter the bankrupt estate but are repaid to BNDES in accordance with Law 9365, which clearly leaves BNDES in the role of a senior creditor.


On November 18, 2004, BNDES informed the market that all payments relative to past due installments as of November 12, 2004 related to BNDES on-lending or Finame lines made available by Santos to its clients must be paid directly to BNDES through an account opened at Banco do Brasil.


In a similar case that occurred in the second half of 2003 (Banco Royal, BRL 300 million in BNDES lines), BNDES has informed us that it has experienced no problems receiving repayments, which have been made in accordance with the contracts.


However, in this case as well, Fitch believes that Santos’ debtors can be expected to experience varying degrees of difficulty in making the payments owed, which could occasion losses for BNDES. Fitch will continue to monitor the performance of BNDES’ lines and the potential impact on its credit profile.


Following contact with the market after the intervention, Fitch believes that the recent event should not set off a chain of more perverse systemic effects.


The financial system currently has liquidity and some small and mid-sized banks, which are more likely to be suspect in the eyes of institutional investors, anticipated the action of Central Bank, strengthening their liquidity reserves.


Fitch is also comfortable that the regulator will continue to be vigilant and willing to provide liquidity to the market if necessary. Fitch believes there are undoubtedly isolated cases of liquidity pressure, and Fitch will continue to be on guard, adjusting ratings whenever necessary.


In Fitch’s view, the points that the Brazilian Central Bank mentioned as causing them to intervene in Santos are unique to that bank, and Fitch believes that the regulator will continue to monitor and track the financial soundness of the system.


In other institutions analyzed by Fitch, risk factors and rating limitations – reflected in the ratings assigned – do exist, but they have not all been observed at the same time in the same entity at any of the banks analyzed.


In Fitch’s opinion, the easing of regulation on compulsory deposits on November 19 was a crucial measure and has relieved liquidity pressures for the small and medium-sized financial institutions.


Nevertheless, given the tension, volatility and stress experienced by the Brazilian financial market in the past week, market sentiment and investor behavior could overcome credit fundamentals.


Business Wire

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