The world takes note of Brazil

Brazil’s past battles with hyperinflation have left the legacy of a payment system whose efficiency assists its economy’s stability to such an extent that it has garnered a host of global admirers.

The rude health of the Brazilian banking system in comparison with its developed-world peers, together with praise from august global institutions for Brazil’s robust payments system, are encouraging a new focus on this technologically advanced developing market. Central banks wondering how to tighten up the efficiency of their own payments systems to reduce transaction times, cut transaction risk and boost overall efficiency are looking to Brazil.

The Brazilian payment system is one of the most technologically advanced and rapid in the world. The World Bank has singled the system out, with research papers describing its “efficient, highly automated payment system”. It is all the more impressive when one considers that the country has large remote areas, including the Amazon, a significant number of paper transactions, especially cheques, and has only low interoperability between ATM and point-of-sale networks.

The first drive to improve the efficiency of the payments system stems in large part from Brazil’s traumatic economic history. The country was ravaged by hyperinflation in the 1980s and early 1990s, with a peak at close to 2000% implying daily devaluation of 3%.

That compelled banks to invest heavily in accelerating transaction times. “Speed means a reduction in losses. Investments in IT paid off in weeks in this context of hyperinflation,” says Joaquim Kavakama, director of the Inter-bank Payments Centre (CIP), the Brazilian inter-bank clearing house.

A stabilisation plan in 1994 brought inflation down to single digits overnight, rewriting the rules of business for Brazilian banks, says Plinio Chapchap, partner at asset management company Queluz Gestão de Ativos in São Paulo. Banks had expanded branches to deepen their deposit base. They offered low rates to clients and parked the proceeds in high-yielding government paper.

Many banks faced collapse in the new low inflationary environment and the Brazilian domestic banking system had a foretaste of the recent global crisis. It escaped through a government-organised bank bail-out and a series of mergers, Mr Kavakama says. That programme cost the country some 2.5% of gross domestic product.

Built to last

The infrastructure built during hyperinflation has proven to be of lasting use. The constant push for efficiencies was prescient, creating a system that is efficient and highly appropriate for today’s economy, says Gregory Gobetti, a partner in financial services at Ernst & Young in São Paulo.

The lessons of that technological leap could be applied to other middle-income countries in which many customers do not yet have access to internet banking. Brazil got round this difficulty by focusing technology on ATMs. Cash machines offer a far wider scope of functions than in most developed markets, explains Mr Kavakama. Overall, there are more than 500 types of service, including consultation and payment of bills, movement between funds and even opening of savings funds, he says.

Role of Central Bank

As well as bank investment in IT, Brazil’s central bank and National Monetary Council started concentrating on reducing risk and accelerating payments from 1997. They turned to the Bank for International Settlement (BIS) and Committee on Payments and Settlement Systems (CPSS) for guidance.

Moves to enhance the system accelerated after the millennium bug threat of 2000, at which time the central bank looked at bank systems throughout the world, says Mr Kavakama. In designing a new framework, the central bank decided it was crucial that the risk of failure for systemically important banks should be held by the private, not the public sector.

In 2001, law 10,214 empowered the central bank to decide what constituted a systematically important settlement system and put in place multilateral netting to ensure that insolvency, bankruptcy and liquidity would not be factors in settlement. The central bank created a system of central counterparties to act as guarantors, says Mr Kavakama.

“A bank might have had insufficient liquidity and its failure generated a cascade effect. One actor can affect the whole payment system and leave the financial system facing a very delicate situation. The government wanted to avoid this domino effect,” adds Mr Kavakama.

The reserves transfer system (RTS), which lies at the core of the set-up, means that trades are irrevocably and unconditionally settled in real time and banks keep a reserve balance at the central bank, which provides liquidity. Government securities, cheques, securities traded over São Paulo-based stock exchange the Bovespa, state and municipal bonds and derivatives also settle through the RTS. The net settlement position, which is nationwide and multilateral, reduces the need for each bank to hold reserves.

Speed has remained a central feature of the system and the central bank moved to real-time gross settlement (RTGS) for many transactions. Even cheque clearance, which has remained widespread in Brazil, is rapid. Any cheque with a value more than 300 reais (about $170) clears in one day, while those of a smaller value take two days.

The most recent upgrade to the system has been a move to direct debit accounts (DDA), which was introduced in October, says Mr Gobetti. The system dispenses with the need for physical bills by generating electronic debit notes that can be paid online or at an ATM. There are major efficiency gains and he expects a migration of 50% of transactions to the new system over the next 12 month, he says.

Indeed, a full 99% of banks have thus far registered to use the DDA system, says Mr Kavakama. In addition to the cost and efficiency savings, the new system should reduce fraud, preventing criminals from altering bar codes to redirect payments on physical bills, as well as cutting the time for processing bills from seven days to two. It will also save 37,400 eucalyptus trees - Brazil generates 12 billion bills a year - says Mr Kavakama.

Wide differences between history, culture, economies and banking systems make wholesale adoption of the Brazilian system impractical, cautions Mr Kavakama. That said, elements of the Brazilian system could be used by other countries. “We applied BIS principles and were frontrunners in organising around the idea of central counterparties. This is becoming a tendency in the world,” he says.

The other key advantage of the centralised RTS system is the access to data that it provides to the central bank. A key lesson of the crisis is that the central bank needs to be very present in the day-to-day running of banks and a strong regulator, says Mr Gobetti.

Future Trends

It is difficult to quantify how much the payments system protected Brazil from the full impact of the financial crisis. Low levels of leverage compared with the rest of the world, dependence on the home market thanks to limited international exposure, and high levels of compulsory reserves - plus the beady eye of the central bank - all contributed. Moreover, from now on there will be limited opportunities for banks to improve the payments system and reduce costs as the system is already cutting edge, says Mr Gobetti.

Indeed, Brazilian banks are taking on more risk, with a push to grow overseas and an expansion of their credit.

The largest banks, including Banco do Brasil, Itaú-Unibanco and Bradesco, have been expanding in Latin America and in key financial centres in north America, Europe and Asia. That exposes them to risks where they have limited experience.

A more visible trend has been that of domestic credit growth. Loans to consumers have been expanding at a clip of between 25% and 35% a year in the run-up to the crisis and should surpass 25% again next year, says Mr Gobetti.

Although Brazil has implemented a highly secure payments system, the country has plenty to learn from others about setting up a credit agency. The issue has become embroiled in politics and a proposed bill to enable sharing of data between banks through a central database may not make it through the country’s congress before elections, the first round of which are slated for October this year.

The step up in lending will see leverage and systemic risk increase. During the crisis no large Brazilian bank needed rescuing, although some small banks did run into trouble, including Banco Votorantim, which was bought by the government-owned Banco do Brasil. Fortunately, the central bank had many tools to stimulate the economy and provide liquidity, and it proved very adept in using instruments such as temporary reductions of reserve requirements to stimulate bank participation.

Moreover, the adoption of Basel 2, slated for 2011, should help Brazil control credit risks. The growing exposure to lending will also generate much useful information for banks on future loss expectations, says Mr Gobetti.

The big challenge for Brazil is to devise sensible policies on credit. Low leverage has proven a saving grace during the crisis, especially compared with the excesses in developed markets, but it jeopardises growth in the long run, says Mr Gobetti. Brazil and developed markets need to reach a balance: Brazil has to increase exposure to credit and the developed economies have to lower theirs. A balancing act that is essential but tricky to achieve.

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