Brazil is justifiably proud of the progress it had made in the
implementation of Basel II, due for completion in 2013. However,
a sudden increase in lending is raising a host of data issues and
diverting managements attention away from operational risk.
Brazils regulator and large banks view the introduction
of Basel II as a moment to highlight
the huge advances in the finance sector and
generally welcome its adoption in 2013, just months
after the 2012 deadline. The smaller fry fear losing
further competitive edge and want more time to get
ready. Operational risk management is a particular
bone of contention, as some banks see the guidelines
from Banco Central do Brasil, the Central Bank, as
imprecise, and are dragging their heels ahead of what
they fear might be a slew of further measures implied
by the adoption of Basel III.
The reputation of Brazils Central Bank is riding high.
Tight prudential regulations and high reserve requirements
meant Brazilian banks averted bankruptcy
and the calls for capital seen in the rest of the world.
Today, the Central Bank is frequently consulted for
its views on risk management by other regulators and
is punching at its weight, finally.
That is giving the Central Bank a confident voice
when it comes to implementing Basel II. The Central
Bank put in place a timetable for operational risk as
early as 2004, says Sérgio Odilon dos Anjos, head
of the banks financial system regulation department.
The emphasis has always been on avoiding surprises
for banks by flagging events well ahead of time and
constant consultation, he says.
The Central Bank wins praise from consultants who
agree it has talked extensively with the local market
and come up with a robust and flexible plan. The
Central Bank has granted to banks the discretion to
implement risk management according to their risk
sophistication, says Marcus Manduca, partner at
PricewaterhouseCoopers in São Paulo.
Moreover, implementation has always come only
after detailed consultation with international counterparts,
says dos Anjos. Brazil participates in the
Basel Committee on Banking Supervision, the G-20
and Financial Stability Board as well as talks to local
banks though committees and organizations such as
the well-respected Brazilian Federation of Banking.
We continue to keep all channels of communication
open and to encourage debate, he says.
The timetable for the main provisions is outlined.
At the end of last year, the Central Bank produced
the publication of database attributes for regulatory
capital computation. At the end of 2011, established
criteria for internal models and authorisation process
details will be introduced, with the beginning of the
authorisation process for internal models slated for
June 2013, according to Manduca.
Some consultants believe, however, that the Central
Bank should be providing more specific data. Brazilian
supervisors are dragging their feet in defining a
more precise timeframe for some of the less precise
approaches. They are pushing towards the end of the
timeframe spectrum, says José Molina, a partner at
Ernst & Young in São Paulo.
The Central Bank says it has worked hard to ensure
that the provisions of Basel II are applied fairly
through Brazils relatively complex banking system,
says dos Anjos. The Central Bank regulates 20 types
of institution. Brazil has a significant domestic public
and private sector banking system, with international
banks playing a more minor role than in the rest of
Brazil has adopted a principles-based approach to
operational risk, which is what banks had requested
and no complaints have been heard since, dos Anjos
says. Details of the principles-based approach were
put in place, not only after detailed consultation,
but also following comprehensive assessment of the
impact on all banks, he says. Reserve capital needs
are flexibly interpreted and tailored to the size of the
bank, he adds.
Still, some areas will need to be clarified for the
operational risk elements of Basel II. The definition of
reasonable parameters to set up scenarios for internal
models and stress simulations, the best cost-to-benefit
relation for controls and systems, and an efficient
governance structure that considers operational risk,
internal controls, internal audit and compliance areas
are needed, says Manduca.
The timetable for implementing the wide operational
risk provisions in Basel II might be clear, but
the changing nature of the Brazilian bank business
means senior management are often more focused
on other areas of risk management. Unlike the rest
of the world, Brazilian banks are in frank expansion
mode, particularly in what is today a pariah area in
developed markets: credit. In May, Brazil experienced
credit growth of 19% year-over-year. There is plenty
of scope for more growth, as today credit represents
just over 45% of GDP.
In the wake of the global crisis, Brazilian banks
are, not surprisingly, determined to keep a close eye
on credit. That might be detracting attention from
operational risk. There is a focus today on developing
internal credit risk models, says Manduca. For
credit and market risk, you have much more details
in terms of models, inputs, assumptions and factors
than you do for operational risk. That is unlikely to
change, as more complex financial products, such as
credit and mortgage funds, designed by investment
banks, are rolled out.
Putting oprisk in place
If operational risk has been playing second fiddle to
credit risk, banks have at least been defining procedures
and getting staff in place. Moreover, devising
the structure for the operational risk department and
figuring out reporting lines, as well as keeping the
model validation separate from model design is leading
to some innovative solutions in Brazil.
Larger banks are putting in place a separate department
to validate internal models, says Manduca. The
problem for such banks lies in devising a structure
that avoids conflicts of interest and ensures segregation.
Some have chosen to have the risk area report to
the internal audit committee or directly to the board
and at others a chief risk officer has been designated,
in which case departments develop their own models,
Some banks, especially smaller ones, are setting
up a validation department and inserting it into the
internal audit area, where accountants and administrators
and sometimes economists are readily available.
To bolster these teams for operational risk needs,
banks are then looking to hire staff with solid quant
backgrounds, including engineers, says Manduca.
Even when the structure has been decided, the
issue of staffing is becoming an expensive headache
as banks upgrade and scout for experienced statisticians.
Many banks are having to change
the professional profiles as existing
staff dont have the necessary
quantitative and statistical
background to manage data, says Manduca.
Alexei Koslovsky, superintendent of compliance
and risk at São Paulo-based Banco Banif, says that
recently one of his operational staff resigned when
they were offered a 100% raise by a competitor. Its
a very close-knit industry and post-crisis everyone is
looking to put in place good staff, he says.
Quant staff are particularly needed as data issues
are prominent in Brazil. Its a real issue because of
fragmentation and a lack of models; banks need to
understand the depth and volume of data they need.
They need to define a model and not all institutions
have done this, Manduca says.
Brazil will also need to move to a 90-day definition
of delinquency against the current 30 days in local
law. That changes the whole frame of reference and
will require banks to treat data differently. The banks
will need to look afresh at all delinquent borrowing
and update the data in accordance with the longer
timeframe for delinquency allowed under Basel. That
will require them to also change the models for calculating
Problems related to data stem from fundamental
changes in Brazils banking system over the past 10
years and one reason Brazil proved its mettle during
the crisis is a lack of sophistication in financial
markets. That might have saved the day in 2008 but
is causing problems in managing and understanding
Credit is the hot button issue in Brazil. Ten years
ago, credit was a negligible part of the countrys
banking industry so the history of data collection is
short. The historical lack of a credit market means
national credit data is weak and most loans had only
short durations and were given to the highest quality
borrowers. Mortgage products are brand new and
represent a tiny fraction of overall loans. Lastly, strict
banking privacy laws have stymied the creation of a
loss data consortium.
Large banks are discussing the creation of a loss data
consortium and companies such as Serasa Experian and
Equifax would certainly like to develop this business
in Brazil, says Manduca. But mistrust is widespread.
Banks fear that if they share loss databases, they might
share their strategy and profile with competitors, and
are very concerned by this, he says.
Indeed, Brazil has still to finalise a national positive
credit and loan database. Although the project does
not have any serious opponents, a tradition of privacy
has slowed the moves. The bill to create the database is
in Congress and is unlikely to be passed until next year,
thanks to presidential elections slated for this October.
Only after this database is up and running are moves
to set up a loss data consortium likely.
Another data issue arises from the development
of products and changes in legislation, which occur
much more rapidly in Brazil. This is a market thats
aggressive in terms of changes, new products and new
opportunities, says Manduca. Many banks do not
have dynamic system interfaces that can keep pace
with taxation changes and new product launches,
he believes. This is one of the biggest challenges in
Brazil, agrees Molina.
In particular, smaller banks and international banks
with headquarters overseas that need approval from
the centre to change models are finding it hard to
keep pace, says Molina. Increasingly, external service
providers such as Oracle are stepping into the breach
with products tailored for the Brazilian market.
Banks say they are improving in collecting internal
error data. At the start of 2007, only 23% of error
forms were filled in at Banco Banif. We worked on
this over that year and 100% were being filled in
by the end of the year, Koslovsky says with pride.
Banif could then see and analyse the errors, see their
frequency and learn how to mitigate this risk. It now
has a database of nearly four years of data, he says.
Basel at the big banks
Data collection, analysis and mitigation is a challenge
for all banks, but the large banks have the resources
and will to meet this and other challenges related to
Basel II. Some banks are ahead of the curve. They
want to catch up with the rest of the world and internationalisation
is part of their plans, says Molina.
These banks see their peers as other large, international
banks and as they start to expand overseas they
want to be sure their Brazilian home domicile is no
impediment to global operations. This is particularly
the case for Banco Itaú-Unibanco, which is the bank
with the most foreign operations and the most aggressive
approach to expansion overseas, so is particularly
interested in international regulations.
These banks are mulling whether to implement
the advanced measurement approach (AMA) for op
risk. No Brazilian bank has yet stated it will pursue
the AMA when it becomes available, however. One
reason is the lack of a loss data consortium, believes
Manduca. This is a big gap that we need to fill before
banks can submit robust AMA plans, he notes.
If large banks are gung-ho on Basel II, smaller banks
were more affected by the recession and are reluctant
to pony up. Many found themselves unable to
borrow in the capital markets and sold credit portfolios
to larger banks to stay afloat. Now, they feel they
are being hit by additional expenses and complications.
These second-tier institutions are waiting for a
more defined framework, believes Molina.
Koslovsky at Banco Banif believes the Central Bank
has not given enough specific guidelines and clarity to
smaller banks in its op risk provisions. I participate in
committees and this is an issue that is widely discussed
among smaller banks. We have sent representatives
to the Central Bank to ask for clarity, he says. He believes the most complex part of the equation is internal
controls and approaches for risk calculation.
Moreover, the sheer volume of new and updated
regulations complicates life for smaller banks. We
need to keep up with new regulations and norms
daily. I personally collate them and distribute them
to the right areas, says Koslovsky.
Foreign and investment banks
The international crisis shone the spotlight on foreign
banks operating in Brazil and the Central Bank has
tightened up on risk management at these organisations.
President [Inácio Lula da] Silva approved
the bank licence for Lehman Brothers in Brazil just
before its collapse in the US. That has made the
Central Bank more wary of foreign institutions in
Brazil, says Manduca.
The Central Bank is now calling for international
banks to submit a more complete business plan covering
three to five years, and detailed explanations of
their risk management, corporate governance and
credit models as well as their liquidity management
tools. In addition to Santander, investment banks such
as JP Morgan, Morgan Stanley, Standard Bank and
Barclays Capital have expanded operations in Brazil to
take advantage of growing capital markets activity.
Investment banks face the further complication that
the stock market regulator, the Rio de Janeiro-based
CVM, which is seen as tough, oversees their brokerage
and asset management business lines. The Central
Bank and CVM have different standards and that can
cause confusion, says Koslovsky.
When the bank was
audited by the Central Bank and CVM, the two teams
drew different conclusions on documents needed for
anti-money-laundering measures. Theres a lack of
standard procedures, he complains.
With some banks still grappling with provisions in
Basel II, further measures being considered for Basel
III are not yet on the radar screen at most Brazilian
banks. Dos Anjos says the Central Banks timetable
will not be derailed by additional measures envisaged
in Basel III.
The Central Bank is contributing to the
international process while keeping the timetable for
Basel II on track at home, he notes. There continues
to be discussion on the timetable for Basel III and the
provisions of implementation are not yet known.
Manduca predicts the Central Bank will need to
reinforce governance controls to make sure the risk
committees, and asset and liabilities committee really
oversee and understand all the risks of the business.
Also, the new provisions might alter modelling and
risk mapping in the validation function, a complex
and intensive requirement involving qualitative
compliance within a framework of stable and updated
quantitative database, factors and models, he notes.
Overall, Brazil is making good progress in adapting
itself to Basel II and the largest, best-run banks are
preparing for implementation. But the phenomenal
growth in lending, almost from scratch, poses a dual
problem: it diverts management attention and means
data is patchy and of short duration. Meanwhile, at
smaller banks, much remains to be done to prepare
for Basel II as they finish licking their wounds from
Brazils short-lived recession.