Causes and Effects of Changes in the Brazilian Banking System

By Carolina Miccolis-Anwar

ABSTRACT This paper discusses the Brazilian bank experience in the second half of the 20th century. The first part of this paper will describe the origin and development of banks in Brazil, and how the Brazilian economic environment contributed to the explosive growth of these institutions. This paper will then analyze the dependency of public owned banks on the Central bank and the Federal Government, and explain the problems that this dependency caused to both the banks and the government, especially after the implementation of the Real stabilization plan. It will also discuss the programs used to restructure banks, how these programs were implemented, and some of the problems encountered along the way. The final part of this paper will show that although the financial cost of banks restructuring were high, it would had been much more costly to recover from a potential systematic bank crises. 1

TABLE OF CONTENTS: I. II. III. IV. INTRODUCTION HISTORY OF THE BANKING SECTOR DEVELOPMENT IN BRAZIL THE GROWTH OF STATE BANKS AND THE PROBLEMS THAT LED TO PRIVATIZATION RESTRUCTURING AND PRIVATIZATION A. Interventions B. How Banks were Privatized 1. Private Banks 2. Public Banks C. The Federal Banks Situation D. The Costs and Results of Privatization V. VI. CONCLUSION APPENDIX A. Bank Structure B. Tables 1. CMN Structure 2. Transformation of State Banks 3. Value of Issued Bonds for PROES Restructuring per State C. Regulations 1. Legislations 2. Other Government Programs REFERENCES

I.

INTRODUCTION

The banking system of a country is vital to its economy. It is considered the backbone of the economy because it can aid the development of a country as well as leading it into economic crisis if not properly managed. Public banks were established in Brazil during the early 20th century with the purpose of impelling economic growth. A strong banking system was crucial to Brazils development because of the need to finance infra-structure and develop the already existing enterprises. Prior to 1964, there existed only a handful of state banks. Because there was high inflation and currency volatility at the time, private banks were prevented from engaging in long-term capital financing. Since private banks could not take uncertain long-term positions, and there were not enough state banks to handle the countrys demand for long-term financing, the Brazilian government responded by increasing the number of state banks. The governments arbitrary increase in the number of state banks led to significant problems. The lack of proper management and transparencies led to these banks being abused by their respective state governments. This in turn caused two main issues for the federal government to deal with. First, the increasing budget deficit, from the ongoing bail-out of state banks; And secondly, the prevention of adopting proper monetary policy. These problems had to be solved to prevent a potential collapse of the economy. The objective of this paper is to show how the banking systems problems led to escalations in the worsening of the countrys, already harsh, economic situation. Furthermore, to explain the measures implemented to solve these problems and how they affected the country and society as a whole. 3

The method of analysis used in this paper is to evaluate various phases of banking development by pointing out the benefits and difficulties of each phase. Moreover, to evaluate whether the measures implemented were for short-term or long-term goals. To see whether the long-term intent of the policy makers was only short term effective, as well as being detrimental in the long run. The objective of this paper is to explore the governments policies and measures, how they were implemented, how they affected the financial system and the Brazilian society as a whole. This paper is divided in five parts: The first will provide a background of the Brazilian financial system, and show how the government started using state banks to finance the capital needs of the country; The second part of this paper will analyze the reasons leading to the explosive growth of state banks. It will then explain the problems that led to the degeneration of these banks, especially after the implementation of the Real plan, and why it became necessary to restructure state banks; The third section will describe the programs implemented, and the process used in their implementation. It will show in particular how the problems of state banks were addressed; The last section discusses the costs and results of privatization, and how it impacted the Brazilian society as a whole.

II.

THE HISTORY OF BANKING SECTOR DEVELOPMENT IN BRAZIL State banks in Brazil date back from the time at the end of the imperial regime. At

this time, the Brazilian banking system was very weak and poorly distributed through the country. Almost 27 percent of all bank holdings and half of all the deposits were located in Rio de Janeiro (which was the capital of Brazil at the time). The new republics first president, Rui Barbosa, implemented a financial plan in order to address the high demand for credit. This plan consisted of facilitating credit acquisition (borrowing), printing currency and giving more freedom to banks by loosening its legislations. In 1889, the first state bank of Brazil, Credito Real de Minas Gerais, was created along with the financial plan. The government expected to stimulate economic growth. However, the result was a speculative financial market boom that lasted from 1889 to 1892, which led to inflation and currency devaluation. Banks became concerned with potential for bankruptcy, and as a result made loans to non credible enterprises and accepted stocks of questionable value as collateral. The government was forced to make large loans to banks in order to avoid a financial catastrophe. It further demanded that the two largest banks had to merge and become a Treasury Agent later named Banco da Republica1. It was not until after WWI that the bank structure in Brazil developed somewhat. In the 1920s four state banks were created2 in addition to the existing two3. State Banks were created for financing the infrastructure and the development of enterprises in every
1 2

This Bank was later renamed Banco do Brasil. BEP, BANESPA, BANESTADO, and BANRISUL 3 BEMGE and PARAIBAN.

state, thus impelling economic growth. The state banks primary purpose was to aid sectors that were not being properly served by private banks and in some States to substitute for private banks absence. The Agricultural sector, for example, had most of its borrowing done informally and by private institutions. Credit of any kind was rarely available and it was uncommon even for coffee planters to obtain mortgages. Problems arise though, when the inflationary climate rather than the countrys development ended up being the main incentive in the explosive growth in the number of commercial banks that took place during this time period. Inflation allowed banks to earn large sums of revenue based on various types of low cost liabilities (tax receipts, demand deposits, collateral against loans, etc.), on which they paid an insignificant amount of interest for several days. Banks used this low cost resource to invest in short term securities that paid higher interest rates. The return obtained from this transaction was known as the float. The float made the banking business very attractive, thus creating an incentive for people with enough capital to engage in the business to create new banks and for states to develop new banks. These state banks would gradually develop into large commercial banks and establish branches throughout the country. In 1937, there were 200 banks establishments in Brazil with 600 branches. By 1945, these figures had almost tripled to 500 establishments and 1600 branches. Banks owned by the state government multiplied over the course of the 20th century. As the banking system expanded, there was a need to create an entity to exercise monetary control over them. In 1945, the SUMOC (The currency and credit super intendency) was created. Its main responsibilities were to set the reserve requirements 6

ratio for commercial banks, discounted rates, financial assistance for liquidity, and the interest rates on demanded deposits. In addition, it supervised the operation of commercial banks, managed the exchange policy and represented the country at international organizations. The SUMOC was the first step in preparing the basis for the implementation of a Central Bank. The Second World War benefited the development of Brazilian Industry (BNDES, 2002, p. ). The price and demand of raw material and agricultural productsthe main goods Brazil exported-increased significantly. By the end of the war, the country had accumulated a significant amount of foreign reserve and was using it towards developing and modernizing its industrial market and importing consumer goods. The president (Dutra) adopted a liberal credit approach. He made loans through the Bank of Brazil to sectors of the economy considered key to advancement. By the end of Dutras government growth rates were increasing on average 6 percent per year. In 1950, a new president was elected: Getulio Vargas. He emphasized more than ever strategies of economic development, believing that governmental intervention was necessary to guide economic growth. However, it would be ideal to do so with foreign capital. Brazil negotiated the Economic Renovation Fund with the US. The agreement consisted of the US supplying funds to finance projects for industrialization and, in return, Brazil would facilitate the export of raw material to the US at the equivalent dollar amount of the funds invested in Brazil.

In order to properly administer the national and international funds for industrialization, the federal government founded BNDES4 in 1950. The purpose of BNDES was to study and suggest measures to create ways to eliminate obstacles to the flux of investment needed to promote economic development. In addition, it had the responsibility to furnish the resources for projects that demanded long term financing. This was very important because in the 1950s the national financial system only operated with short-term (maximum of 60 days) borrowing. The national bank for economic development arrived as an important policy tool in financing infrastructure and industrial investments necessary for industrialization to take place. In 1956, the government attempted to boost the economy and increase economic growth by using monetary policy resources. It hoped to increase spending and thus increase production to accelerate the growth of the Brazilian economy by supplying money into the market. The results, however, were a significant increase in the inflation rate, which jumped from 17 percent in 1950 to well above 40 percent within a few months of the implementation of the plan. The first years of the 60s were economically harsh. There was a significant amount of debt to be paid off. The Balance of Payments (BOP) was in disequilibrium and the public deficit account had grown significantly. In 1964, the military overthrew the Republic taking over the government. As soon as the military took over, one of the first problems they faced was the bad economic situation of the country budget deficit, high inflation levels and insufficient supply of capital to attend the demand of the Brazilian economy.

When the bank was established it was known as BNDE

Immediately an economic plan was implemented. This plans main objectives were to fight inflation and to industrialize the country. The measures adopted for industrialization were to reduce credit, to control wages and money supply, and to open the economy to foreign capital. Additionally, the decision power for economic strategy planning was centralized in the hands of the executive branch. In addition, institutional reform was proposed. This reform aimed at the specialization of financial institutions5 (similar to the American financial model) and the development of financial instruments to aid the countrys economy. The basis of todays Brazilian Financial System structure was set with this reform6. In order to achieve the reform goal, four legislations were implemented, profoundly changing the financial system. The first one was a law restructuring the banking system. This law created two new institutions: The Central Bank of Brazil and the National Monetary Council (CMN). The purpose of the CMN was to foster the improvement of financial institutions and instruments7. Also a new regulation was established that separated money creation and circulation. These tasks were previously the responsibility of the Bank of Brazil. The second legislation created a housing financial system. A housing bank was founded to finance housing and related infrastructure construction8.

It separated financial institutions in 4 groups: (a) Commercial Banks, which could only engage in short term credit operations; (b) Investment and Development Banks, which were encharged of the long term lending; (c) Financeiras, which are retail banks have the primary purpose of lending to individuals; and (d) Sistema Financeiro de Habitacao, which was encharged of construction and housing. This Financial institutions could operate in the same physical space but they had to have their accounting done separately. 6 Please refer to appendix A for the Structure of the Brazilia nFinancial System. 7 Please refer to table in the end of Appendix A for CMN Structure 8 This bank later merged in to a Federal Savings Bank named Caixa Economica.

A new legislation on Capital Markets attempted to create a special credit program to stimulate credit and inflows to sectors of the economy that were of high priority to policy makers. This special credit program was to be implemented through the development of the domestic market and new financial institutions. The last piece of legislation created indexation. Indexation is an arrangement where periodic adjustments are made to contractual payments based on change in an index of some kind, most often the consumer price index. Indexation allowed for financial assets and liabilities to revaluate parallel to price increase (inflation rate). Indexation became one of the most important financial tools of the financial system, because it allowed for long term financing under a high inflationary scenario. The early reforms of the 1960s helped economic growth, but only in the short run. The instability promoted by inflation was still a problem for long term planning. Inflation aggravated currency volatility. Despite indexation, it became harder for longterm finance capital of the Brazilian private sector. Without long-term finance capital, the potential to develop the country was significantly narrowed. The military first move was to create incentives for private investment in an attempt to fulfill the long-term financial capital needs of the countrys private sector. However, inflation prevented lenders and borrowers to engage in long-term transactions. Borrowers did not want to engage in long term indexed liabilities. On the other hand, lenders refrained from taking uncertain, long-range positions (McQuery, 2000, p.31). Due to the high international liquidity in the 1970s government saw state managed banks as their last resort to finance the countrys growth and development. In exchange for support to achieve national and regional development and establish the 10

country in international markets, the government encouraged the development of public banks. During the 1960s and 1970s both federal and state governments established development and commercial banks. By early 1970s there existed 24 state commercial banks. Almost every state (with the exception of Mato Grosso do Sul and Tocantins had its own state bank. In many cases these banks were created by turning a pre-existent private bank in a public bank. State Banks in Brazil were primarily created with the purpose of aiding the countrys development, and substituting for private banks absence in specific sectors that were not being properly served. In an attempt to boost the economy in 1956, the government used funds from the monetary reserve, which ended up resulting in a drastic increase in inflation. The public deficit accounts grew significantly. The government attempted to boost economic growth with implementation of selected reforms, however inflation was a problem for the long term financing necessary .The harsh economic environment led the government to endorse the creation of banks to fulfill long term financial needs. The high inflation environment was the main incentive behind the explosive growth of banks throughout the 20th century, thus defying the initial objectives of State Banks.

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III.

THE GROWTH OF STATE BANKS AND THE PROBLEMS THAT LED TO PRIVATIZATION

Although state banks came into existence in 1889, it was not until the financial reforms that the state governments role as a banker began. The government used state owned banks to lend funds to the private sector to finance the countrys development needs. Until this point, the government believed that larger (broad) banks and financial groups would allow for more effective competition with foreign banks in negotiating loans in foreign capital markets. These banks became financially strong and began to over take the countrys private banks in lending and deposits. These banks accounted for 55% of deposits and 58% loans to the private sector. During the years of 1969-73, Brazil enjoyed prosperous economic years known as the economic miracle. However, the stability of the military rule and the economy started to see its decline with the first oil shock of 1974. When the price of oil increased from US$ 2.8/barrel to US$ 12/barrel, it placed Brazil, a major importer, in a very sensitive situation. The oil shock led to a recession of the world economy. International interest rates increased significantly, greatly reducing credit, and thus leaving Brazil in a critical situation regarding its foreign debt. The economic focus of the government shifted from growth to stabilization. In addition, financial institutions began to move their assets into 12

more liquid non-monetary instruments and short -term repurchase agreements became predominant in the financial market. Investors profited from these instruments, as it was made possible due to high inflation rates. In the beginning of the transaction investors would arrange for a repurchase value of the investment at maturity that was inferior to the expected inflation rate during the length of the investment. As inflation grew, so did this type of investment that increased from 38 percent of total financial instruments in 1969 to 66 percent in 1977 (McQuery, 2001, p.32). The growth of this type of investment, combined with the large loss of monetary reserves due to the shock, caused liquidity problems in the banking system. When Banco Uniao Comercial, the fifth largest bank of Brazil, showed financial difficulty, the government passed law 1342 authorizing the Central Bank to intervene in failing banks as an attempt to prevent these banks liquidation. However, these interventions were very controversial and generated a lot of criticism because the main source of funds used were treasury resources from the monetary reserve, which had already been largely drained from the oil shock. The second oil shock (1979) and the reduction in international liquidity intensified the economic crisis in Brazil. The government tried to meet its financing needs in the domestic market, but the combination of internal financing jointed with indexation started an inflationary process accompanied by an upward pressure on interest rates (McQuery, 2001, p.32). In the first half of the 1980s, inflation rose on average 8 percent per month. After the second oil shock, foreign banks and agencies that prior to the 1970s had small 13

participation in Brazils financial activities, became important. The share of total assets held by foreign banks grew from 1.7 percent in 1964 to 12.6 percent in 1980. Government and domestic firms (including banks) started to borrow from foreign creditors. The ratio of foreign bank loans to domestic bank loans grew from 13.8 to 40.2 percent between 1970 and 1981 (Abreu and Verner, 1997, p.116). The Mexican default on its loans in 1982 worsened Brazils situation. The credibility on developing countries was undermined, and as a result foreign investments in Brazil were greatly reduced. Every single American bank cut off its credit lines to Brazil. Therefore, the governments public investments programs had to stop, bringing Brazils growth to a stand still. Domestic debt had to be issued in order to pay the interests on external debt. State Banks borrowed heavily so that they could finance the government projects. The public sector banks were responsible for 57% of all loans, and the majority of these loans were directed to the Federal and State governments. The increasing deterioration of the economy weakened the military rule and opened doors for opposition parties to grow stronger. On January 15th, 1985, the Republic was re-established in Brazil. At this time, most government banks were in poor financial health with negative cash flows. The structural characteristics of government owned banks were largely to blame for the bad administrative practices, and represented a threat to the well functioning of these banks. Since these banks were not run by professional managers, but rather a group of party members (appointed by each banks respective government), it became hard to identify the real causes of the losses and to punish anyone for mismanagement. This in turn often resulted in the lack of motivation to allocate the banks financial resources prudently and efficiently. 14

However, the main reason for the banks financial problems was the wasteful and irresponsible government spending, exacerbated by the countrys loose federal structure. As Ness (2000) mentions, public banks struggled with the conflict between their nature as a business and the political and economic goals assigned to them by government policy. Unlike their private counterparts, State banks had multiple objectives, other than profit, which were determined by their respective state government. Problems with public banks included the high volume of government bonds issued by the states with the purpose of helping politicians in financing their campaigns (good examples are Governor Quercia in the 80s and Fleury in early 90s). Another problem with Government Banks was the inadequate manner in which their administrative structure was set up, thus yielding higher fixed costs than income generated could cover. Government bank operational costs were often extraordinarily high due to Patronage (the use of government banks to generate employment). For example, the Bank of the State of Sao Paulos (Banespa) cost per employee reached US$ 26,240, compared with Bradesco or Itaus (private banks) average of US$8,500 (Mackler, 13). While in private banks the ratio between personnel costs and production value in 1995 was 33.8 percent, in public banks this ratio was over 71 percent. (Mendonca de Barros and Almeida Jr.,1997, p.8). State Governments had leaned on their respective banks, transferring the states fiscal imbalance to its bank and thus contributing to its insolvency. Then, when State banks started to show liquidity problems, state governors and town mayors would knock on the Central Banks door to ask for help to rescue their respective banks. This situation

15

aggravated the growing budget deficit, worsening the fiscal situation and making hard to properly conduct an exogenous monetary policy. The democratization process of the 1980s resulted in looser fiscal control on the states. Public banks and financial groups grew significantly. The scale of these banks in term of operations made them powerful institutions allowed by the government in exchange for contributions. By 1988, state banks were responsible for 17 percent of credit operations and 6 percent of liquid assets of the banking system (Salviano, 2004, p.19). However, the larger the bank got, the more fragile it became since there was a lack of proper management. The financial fragility of State Banks started to interfere negatively with the functioning of the national development policy, and created a dilemma for the Central Bank. If the Central Bank intervenes in State Banks and injects liquidity directly or indirectly in the troubled bank to ensure its temporary survival, the Central Bank will be ultimately increasing the states fiscal cost, since a future restructuring or liquidation process of this bank will be inevitable. This situation made it difficult for the Central Bank to have a restrictive monetary policy, since it would be very detrimental to state banks. The reason why the government had to help these banks was that many State Banks were what is called too big to fail. This meant that even if the Federal Government could bypass the State Governments resistance and intervene and liquidate State Banks, it would affect other banks and the confidence of economic agents on

16

national banking institutions, thus causing a potential systematic crisis (Salviano, 2004, p.55). Despite the power these institutions had over the government, they began to deteriorate in the mid 80s. The main issue was that besides overextending themselves in loans and high personnel costs, State Banks could not keep pace with the technological innovations as the private sector could. In addition, the State Government was the owner of most enterprises in Brazil. The money used to sustain these State Owned Enterprises (SOE) functions was financed by the State banks. As the economic conditions of the country deteriorated, so did the health of the SOEs. These enterprises became a burden on the countrys economy because they were draining the government reserves. A large part of fiscal deficit came from the states, and most of the state deficits came from the companies they owned. Public expenditures rose with State Banks as intermediaries. State Banks gradually lost their role as development agencies becoming financial agents for public expenditures. The Federal Government took steps to contain sub national indebtedness principally by freezing loans and assuming the responsibilities for servicing the foreign and domestic house debt9. Extreme Controls were imposed to discipline States. Public accounts were frozen, and States were required to start repaying their loans. However, state governors managed to unblock their respective state accounts by promising to support the approval of an article in the new constitution that was being written that would provide the president with one extra year in office.

For more Restrictions imposed by the Federal Government, refer to Salviano, 2004, p. 33-4.

17

The problem of the increasing deficit was aggravated by the fact that Brazil was also an extremely closed economy -thus its industries were not in a good position to compete on world markets- and that there was a large tax evasion. Despite the large public deficit10 and the criticism of restructuring policies of the financial system (brought w/ law 1342), there was an increase in the utilization of the monetary reserve. This increase can be explained by the restructuring of 5 troubled banks, and by campaign spending for the election of 1986 (which was mainly sponsored by state banks). This resulted in huge increase in state deficits, which were absorbed by the Federal government. The table below shows the value earned from taxes on Financial Operations and the Expenditures from the Monetary Reserve yearly for the period of 1980 to 1988. As of 1985, there was a drastic increase in the use of the Monetary Reserve which as of 1987 was twice as big as the funds collected from taxes from financial operations. AS of 1988 (after the new constitution was passed as it will be discussed) there was a huge retraction in the use of the monetary reserve funds. Table 1 - MONETARY RESERVE Financial Performance Value earned from Expenditures Year taxes on from the Financial Operations* Monetary Reserve* 1980 520.7 4.2 1981 392 3.6 1982 3,068.9 2.7 1983 1,536.6 10.7 1984 1,726.8 1.8 1985 1,488.0 461.2 1986 1,698.9 295.5
10

Public accounts comprehend the Federal Government, including the social security debt, State and municipal government (26 states and the federal district, plus 5500 municipalities) and the state run enterprises controlled by the public sector at the three levels of government.

18

1987 1988

1,718.3 1,024.9

3,417.3 83.9

* Values denominated in Millions of US$ Data Source: Lundberg (1999), pg 4

By the end of the fiscal year, Brazil could not close its accounts and, in 1987, it failed to pay back its loans to foreign lenders. The cost of financing in the country increased as a result of it. A risk premium was imposed on foreign and national interest rates. A new constitution was passed in 198811. The new democratic Constitution (1988) translated into rules that led Brazilian society towards decentralization. The federal system was reshaped in favor of states and municipalities (De Almeida, n.d., n.p.). Fiscal resources were redistributed in detriment of federal government, due to the increase of federal revenues shared with sub national governments. Revenues transferred from states to municipalities also increased. This constitution created a mixed financial system, in which universal banks12 coexist with specialized institutions. The Constitution allowed the creation of multiple banks (they performed at least two of the four functions). A new accounting plan named COSIF was created, allowing the unification of all financial institutions into a single accounting plan. The 1988 Constitution loosened the requirements to open up such institutions, paving the road to a boom in the financial system. The benefits provided by the constitution, combined with the easy means to make profit provided by inflation, made the banking business very appealing. The 1988 constitution exacerbated the structural

11 12

Please Refer to Appendix C1 for more details. Universal banks are credit institutions that engage into different bank activities, such as commercial and retail lending, investment banking, etc.

19

imbalances of the Brazilian fiscal regime. However, this imbalance was camouflaged by the high inflation. Service Revenues were better indexed than expenditures, thus yielding a false fiscal equilibrium. By 1990, almost all State Banks were close to bankruptcy or had gone through government intervention. To aggravate banks situation in the end of 1991, there was a maxi devaluation of the Brazilian currency. The default on foreign loans in 1987, combined with the deterioration of the economic environment in the early 1990s13, placed Brazil in the high-risk investment category. The government was unable to borrow abroad to pay its deficits. To avoid a series of collapses of indebted companies and in an attempt to improve the credibility of the government, the president was motivated to encourage privatization of SOEs and increase fiscal discipline. The government hoped that with the privatization of SOEs, public spending could be reduced and the services of the privatized companies would be improved. The improvement of services was expected to happen because now these enterprises would run like businesses instead of government entities, thus becoming more efficient in order to be able to contain the growth of competitors. The first step in the privatization program was to offer good enough incentives to make firms sell attractive to potential buyers despite the risk of investing in Brazil. Incentives provided included eased payment and financing options.

13

An unsuccessful stablization plan that was implemented in 1990 (Collor I) , contributed extensively for the deterioration of State Banks and the thus the economy. For more information on this plan please refer to Salviano, 2004, p. 60-64.

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The next step was the passing of Resolution 155, setting the legal bases of the National Privatization Program (PND)14. In addition, privatization laws were altered so that foreigners could participate in the privatization process with fewer restrictions15. After a three-month suspension in the privatization process when all the procedures were reviewed, the government resumed the process. More SOEs were privatized between 1990-92 than ever before. Historical experiences of hyperinflation in other economies have led their respective financial systems to collapse. In Brazil, however, this was not the case. Forced to live within such a harsh economic environment, banks developed means of surviving under these conditions. The most surprising aspect is not just that banks managed to survive a traditionally hostile banking environment, but that banks were able to adapt and take advantage of this environment to accumulate capital16. Given this ability to thrive in hyperinflationary conditions, it is not surprising that banks had no interest in the reform of the system and liberalization. Inflation combined with high interest rates paid by government bonds ensured a continuing revenue stream even when lending was not profitable. Banks used short-term deposits imperfectly protected from inflation to purchase securities that yielded much higher rates of interest than were paid to depositors. Banks would delay payment and clearances on accounts earning low or no interest for several days, and invest in high-yield overnight government bonds or any other type of short-term security with high rates of return due to the high inflation. For example,

14 15

Privatization in this case refers to the state owned institutions only. Please refer to appendix C.1. Note that amendment in privatization laws applied to SOEs only. 16 This was possible in Brazil because besides the high inflation rate, interest rates were also high due to the maxi devaluation in 1991.

21

banks would act as government agents collecting water and energy bills from the population but those funds would only be passed to the government three days later. Banks gained from the cash depreciation that occurred between the time a bank received and paid funds-This type of gains were know as the inflationary Float. The float is estimated to have generated profits equal to 1.5 percent of client deposits per day. In the three years between 1990 and 1993, inflationary revenue averaged four percent, twice as much as the fifty years prior to 1990 together (Barros, Roberto, and Almeida Junior, ,p.3). Banks used inflation as a mean to collect easy revenue (the float), and to reduce the real value of its liabilities thus adding solvency and increasing liquidity. Liquidity was promoted by reducing the real value of debts and the increase in money supply injected liquidity into the system, thus making it easier for borrowers to repay their loans. (McQuery, 2001, p.34) The benefits that banks enjoyed from this inflationary climate resulted in a huge growth in the number of Financial Institutions. This growth was also motivated by the hyperinflation years of the 1980s and 1990s. Inflation in the 1980s was over three digits, and in the 1990s it reached well over 1000%. In the first half of the 1990s, inflation revenues accounted for more than one third of bank operating revenue. Among these sources of revenue were: treasury operations (arbitrage on interest rate and currencies), basic banking services (bill and tax rate and currencies) and the float. Because of inflation revenues there was no incentive to accurately invest, minimize costs, improve banking services and develop sound risk assessment techniques. 22

Deficiencies of the banking system were covered up by the large gains from inflation. Little attention was given to develop regular banking services. In 1993, Cardozo, then treasury minister, was responsible for the implementation of the 5th stabilization plan of Brazil, the main objective of which was to control inflation. The strategy of this new plan was to treat the cause of inflation which was the financial administrative disorder of the public sector. Then, a transitional phase between the hyperinflation and the monetary stability would take place until the new currency, the Real, could be implemented17. In the first stage of this plan, the Immediate Action Program (PAI)18 was implemented in June 1994 with the main objective of balancing the governments accounts. The financial disorder winds up making it impossible for public government to exercise its essential functions such as allocating public spending according to the countrys priorities. Scarce financial resources are lost because of waste, inefficiency, corruption, fraud and payment defaults. This in turn affects the other administrative sectors of the economy. If for example, the Government cannot impact a fiscal policy with the future in mind, then the Central Bank will be unable to exercise an active monetary policy. However, the recovery of public finances is not only a matter of the government spending less than it collects. It encompasses reorganizing the public sector and its relationship with the private sector economy. Provisions to reform the public sector were set in place. Among the main objectives of this provision were to control and supervise state banks, to clean up federal
17 18

For an in depth discussion of the Real plan please go to www.fazenda.gov.br Please refer to appendix C.2.

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banks and to put an end to debt default by the state governments ( Ministerio da Fazenda, 1994, p.2). This provision was of great importance because of the history of using state banks as state treasury financing agents19, which was contributing to the increase in the State deficit and draining the federal reserves. (Ministerio da Fazenda, 1994, p.43). The second phase of the Real Plan started with a transitional period leading to economic stability. During this transition period, all monetary values would be converted to a transitory currency called Units of Real Value (URV). The introduction of the URV into economic relations started with the conversion of salaries and welfare benefits, and then was extended to private sector prices and contracts. The URV was pegged to the dollar and it restricted increases in prices for imported and tradeable products. This approach is often compared to the one used in Argentina, however the one used in Brazil was quite different. In Brazil, roughly speaking, everything was translated into dollars, like U.S. subsidiaries in Brazil do with their accounts every year. The Cavallo Plan in Argentina did the opposite. In Argentina they did their purchasing in dollars and their accounting in pesos. For a short while only, the Real Plan invoked keeping accounts in dollars and making payments in Cruzeiros20 (Kanitz, 1995, p.43). Monetary indexation was no longer allowed and the URV standard value would be replaced with the new national currency-The Real. At first, the Real was set on par with the dollar, then a band was set within which the exchange rate was allowed to fluctuate. This crawling peg was introduced because of the concern that a drastic attempt to stabilize the currency would result in an outcome

19

In addition new limits on the minimum amount of capital required to open a bank was established (Puga, 1999, p.417) 20 Cruzeiro was the name of the currency used in Brazil before the Real was implemented.

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similar to the Mexican-style overvaluation21. Brazils reformers left room for some inflation, by pre announcing a series of small devaluations to happen periodically until full stabilization took place. The plan seemed to work. In 1994, inflation was finally controlled, a new currency was born. The problem solved with the Real plan was the elimination of the self-perpetuating effect of indexation, especially because it had already reached 40 percent a month. The Real plan did just that (Kanitz, 1995, p.43). The chart below shows inflations behavior during and after the implementation of each stabilization plan. As it illustrates, the only stabilization plan implemented in Brazil that was able to control inflation for more than six months was the Real Plan (which has completed its 10th anniversary of an inflation free country).

The difference between this plan and prior attempts to stabilize the economy was that the Real plan was the first plan not to create pent-up inflation during the intermediate stage.
21

Refer to Krugman (1999) for an in depth discussion on this topic.

25

In addition, the Real plan was also the first not to distort the price system in Brazil, unlike the Cruzado Plan, for example, that used price freezing. The success of the plan led to election of Cardozo as president of Brazil in 1995. The table below illustrates inflation revenue as a percentage of GDP and as a percentage of banks total revenue from 1990 to 1997. As shown by the table, a large share of banks revenues came from inflation gains. As of July 1994 with the Real implementation, this number was significantly reduced, reaching close to zero within a year and remaining negligible in the following years. Table 2 - Inflation Revenues of Brazilian Banks (% of total revenues) Year Inflation Revenue/ Inflationary Revenues/ GDP Total Revenues 1990 4.0 35.7 1991 3.9 41.3 1992 4.0 41.9 1993 4.2 35.3 1994 2.0 20.4 1995 n.m.* n.m. 1996 n.m. n.m. 1997 n.m. n.m.
*n.m. not meaningful Source: Baer and Nazmi, 2003, p.5

The banking sector was not pleased with the success of the Real Plan. By the early 1990s banks inflationary revenue had grown to approximately 4% of GDP, accounting for almost 40% of the revenue from financial intermediation (ie. The difference between interest receipts and payments) and other services. As shown in the table above, by 1994 banks inflationary revenue dropped to 2% of GDP and in 1995 it was close to zero. The following table shows the output of banks in Brazil as a percentage of GDP by sector for the period of 1990 to 1995. As we can see, after the Real implementation in 26

1994, this number significantly decreased. The drastic reduction in the share of domestic output produced by all financial institutions with the implementation of the Real plan illustrates the impact of inflation control on the banking sector. Table 3 - Brazilian Bank Output As a percentage of GDP Year Private Banks Public Banks 1990 4.6 8.1 1991 4.3 6.2 1992 5.9 6.2 1993 8.5 5.9 1994 6.9 4.6 1995 3.6 3.2
Source: McQuery, 2001, p.36

In 1995 financial institutions averaged a 15.6 percent share of the GDP, after the Real this number dropped to less than 7 percent. In 1994 banks had earned US$ 10.4 billion and within one year, their earnings fell to US$ 500 million (Banco Centrral, 1998, p.16). In an analysis of the 17 largest banks in the country it was reported that in June of 1994 gains from inflation accounted for as much as 58.35 percent of their total gains but dropped within one year to only 2.87 (Alves, 1995, p.4). Financial institutions could no longer maintain profitability (since it was based on general inflation gains). Thus, restructuring of the sector was vital. Financial institutions had to introduce the adjustments necessary for their survival with stabilization. During this process, banks started to close branches, fire employees and increase tariffs on their services22. In the analysis mentioned previously in the 17 largest banks of

22

Resolution 2303/96 allowed financial institutions to charge tariffs on bank services. This resolution in further discussed in appendix C.2, of this paper.

27

Brazil there was a reduction of 19 thousand employees (from 420 to 311 thousand) and an increase in tariffs of R$56 million (from R$141 to 197 million) (Alves,1995, p.4). In the years prior to the Real implementation, inflation significantly increased in the country and banks were able to adapt rather well. Having this in view, the government had hoped that the same adaptation process would take place (at least in private banks) as inflation was extinguished and, that banks would be able to implement the adjustment necessary for their survival. The chart below illustrates Brazils GDP and consumption growth rate for the years 1993 to 1996. We see in this table that with the end of inflation, in 1994, consumption increased greatly after the implementation of the Real plan and then dropped drastically by 1996. GDP and consumption growth rates in Brazil: 1993-1996

Burdened by the economic environment with the end of Inflation and in need of fresh revenue, many banks took advantage of the increase in consumer expenditure and demand for credit to increase lending activities, instead of reorganizing operations to lower costs. 28

Banks extended credit carelessly. The environment of easy inflation gains made it unnecessary for banks to base credit decisions on sound analysis. Now, without inflation, banks had difficulty in operating prudently. Also, with the end of hyperinflation it became more attractive to hold bank deposits. Sight deposits, for example, grew by 165 percent during the first six months after the Real plan (Maia, 2000, p.108). Banks would relent these sight deposits held to compensate for the loss of inflationary revenue. For example, Bradesco increased its lending operations by 62 percent and Banco Boavista by 141 percent. The Central Bank had tried to prevent a rapid expansion in bank credit by raising reserve requirements on sight deposit from 48 to 100 percent and on savings from 10 to 30 percent23. In addition, the federal government kept interest rates at high levels, since it was concerned that this increase in lending operations could trigger inflation. Regardless of Central Bank efforts, financial loans to the private sector grew by almost 60 percent within the Reals first anniversary (Salviano, 2004, p.69). This growth in loans, only delayed the real adjustments that the financial sector needed. The high volume of loans issued more than made up for the loss of float revenues after the implementation of the Real plan. In the case of Bradesco, for example, in the 1994 fiscal year the bank gains from lending were over R$7 billion compared to R$3 billion in the prior year. However, this only helped them in the short run. In the long run this increase in lending was actually detrimental for banks which, without adequate risk analysis and information on borrowers, and without adequate bank

23

In order to prevent a bank boom based on potential Revenues from lending, the Central Bank passed resolution 2399 as mentioned in Appendix C.1.

29

supervision by the Central Bank ended up increasing their exposure to risk. In addition, the default risk was raised due to the high interest rates. Sure enough, international crises (in Mexico and Russia) created concerns about how badly these events would affect Brazil and Argentina. The over valuated Real currency became the subject of speculative attacks24. Investors lost confidence in emerging markets, which resulted in strong flows of capital out of the region, harming Brazil greatly. Usually adverse external shocks will result in currency depreciation and rise in inflation and thus devaluation of banks liabilities. At this point, however, Brazil still had an almost fixed exchange rate. The fixed exchange rate between Brazils Real and the Dollar had been a centerpiece of the countrys reform program, the program that had brought price stability after generations of high inflation. To give up that fixed rate would be devastating for investors confidence, which Brazil perceived as very important since it wanted to attract foreign investor interest in the national market (Krugman, 1999, p.112). The only tool immediately at hand to defend the Reals exchange rate and keeping it within this band was for the government to drastically increase interest rates (McQuery, 2001, p.6). The already high interest rates had to be raised enough to make it attractive for people to keep money in Brazil despite expectations of the Reals currency devaluation. In addition, strong fiscal adjustment programs to protect the Real value were put in place.

One of the factors considered crucial in this huge reduction of inflation was the appreciation of the Brazilian currency. The Real was initially pegged to the dollar during the transitory period. It then had its value appreciated for 5 consecutive months, until it reached its highest value of R$0.84/US$. In the first 3 months of 1995, GDP grew 10,1% larger than in the first 3 months of 1994.

24

30

This increase in interest rates accelerated the realization of forecasted problems for banks high and careless lending practices. The new economic environment brought forth with the Real had stimulated consumers to buy more than they could afford (using credit cards, taking loans, and other similar credit options). Faced with an increase in demand producers took loans to finance an increase in production. However, consumers were not able to pay the producers that in turn defaulted on their loans to banks (Novo, 1995, n.p.). In addition, individual default on loans reached its highest point ever. Historically, individual default on loans was on average 0.6 to 0.8 percent (including credit card and bank loans). In May of 1995 this default rate reached a historical high of 3 percent. The chart below shows non-performing loans as a percentage of total loans in Brazil from 1994 to 1996. Note that in 1996 the amount of non-performing loans as a percentage of total loans almost doubled. Past Due loans increased from 6% in mid-1994 to 17% in mid-1995 (Cysne and da Costa, 1996, p.).

N on-performing Loans as a P ercentage of Total Loans in B raz il: 1994-1996

16 14 12 10 8 6 4 2 0 1994 1995 ye a r 1996

Percentage of nonperforming loans

non-perform ing loans

source: Baer and Nazmi, 7

31

For the banking industry this increase in non-performing loans was detrimental for profits, which at this point were largely comprised of lending long and funding short. This scenario especially affected the public banks, which for political reasons, never developed the skills of sound banking, credit, and risk management. The traditional role of state banks was to bridge state treasurys credit shortfall, so banks would roll over states non-performing loans and accumulate non-performing assets. State banks would then rely on the Federal government/Central bank to rescue them. These banks were generating large deficits for the federal government, which had to deal with them and with their problems. The countrys chronic state debt issue was the principal struggle between the federal government and its sub-national units. Banespas deficit, for example, was R$57.2 billion in 1995, which represented over 50% of all the states debt. The failing performance of State Banks and the ever-growing drain on the countrys economy was the main reason that privatization became so important. The Federal Government specified that the decentralization process, which had already been started by the BNDES in the SOEs, should be extended to financial institutions, especially state banks. Prior to 1994 the Central rescued state banks in several instances, usually bailing these banks out. This in turn would result in monetary leakages, thus increasing the deficit and moral hazard risk in relationships of both the federal and state government and between the Central Bank as bank supervisor and the banking system. The clean up of Public banks was considered a major step in improving the fiscal performance of the entire public sector. The expected result with privatization was to 32

terminate the role of state bank as a last resort lender to finance state budgets and clean up imprudent fiscal policies, thus reducing the public deficit. Privatizing state banks would eliminate inefficient institutions, minimize the size of the public sector involvement in banking, and promote a healthier environment. In this section, we saw that was not until the military reforms of the 1960s that the role of government as a banker began. The hyperinflationary economic environment combined with political interest, led to the growth in the number and size of public banks. However, the larger these banks got, the more fragile they got, due to the lack of proper management, and the more they interfered with the functioning of the Federal Government and Central Bank. Public banks problems were intensified with the implementation of the Real stabilization program. In need of revenue, banks extended credit carelessly, which in the long run ended up being detrimental to banks, since a large share of this loans were defaulted on. Public banks then turned to the Federal Government for help. The Federal Government decided that the deficits generated by the states had to be drastically reduced, and that one way to move towards the achievement of this goal, was to privatize state banks.

33

IV.

RESTRUCTURING AND PRIVATIZATION A. Intervention: Preparing Banks for Privatization Early bank interventions started due to the liquidity crises of the 1970s. The

government began its intervention and restructuring process with Banco Halles. The regulations on interventions then were not well developed and did not protect depositors. The banks previously contracted liabilities and deposits already existing on the date on which the intervention is decreed were not enforceable. Therefore, whoever had money invested in the bank ended up losing it, since the government did not reimburse anyone for their losses. The first bank intervention (Banco Halles) created a chain reaction, eventually affecting many other institutions. The first attempt by the Federal Government to rescue state banks did not happen until 1983, with the implementation of a program named Programa de Apoio Crediticio (PAC)25. This programs main objectives were to help state banks consolidate their debt to the Central Bank and provide these banks with credit lines. However, the resources directed to PAC were very limited and these credit lines worsened the use of banks for inappropriate project financing. The failure of PAC increased the need of a new program to help state banks. The

25

CMN 233/83

34

Proref26 was implemented as a result. This program had objectives similar to PAC, but, it had provisions for punishing misuse of credit lines and there were limitations on the lending allowed by state banks (Salviano, 2004, p.56). When the fifth largest bank of Brazil (Banco Uniao commercial) showed financial difficulties, the government decided it was time to create a new regulations for the intervention of financial institutions. In 1985, Decree-Law 1342 was put in place to facilitate the Central Banks task of restructuring the financial system. According to this regulation, the Central Bank was allowed to utilize treasury resources from the monetary reserve to intervene in troubled financial institutions. Banco Uniao Comercial was intervened in 1985 and had its accumulated losses paid with funds from the monetary reserve. This bank was the first of a series of troubled financial institutions to be absorbed with funds from the monetary reserve. Then, three other large private banks went through extra judicial liquidation and various state banks were intervened upon in 1987. The first financial institution to be intervened in was Banco Sul Brasileiro. There was a lot of pressure for this bank not to be liquidated. Under these circumstances the new government decided to divide the responsibilities for the solution to this issue with the national congress. The congress determined the creation of Banco Meridional, which would come as a result of the stabilization and merger of the banks Sul Brasileiro and Habitual. The Banco Sul Brasileiro was the only one at that period of time to be taken away from its respective State.

26

CMN 446/83

35

The other two institutions, Comind and Banco Auxiliar, were liquidated in November of 1985. This period of time coincided with the time at which the government established its first economic reform to attack inflation- the Plano Cruzado. This reform kept the interest rates low, thus increasing the value of assets and stocks, which favored the liquidation process. The Plano Cruzado allowed creditors to be reimbursed without losses to the government and stockholders. Another factor that favored the agreements to the end of extrajudicial liquidation of these two banks was the way in which these special regimes were implemented. Immediately after the bank went under intervention (on a Friday afternoon), all the banks branches (with its employees and deposit warrantees by the government) were auctioned to other banks. On Monday, the bank offices reopened under the new administration. However, Law 1342 brought a lot of criticism from the general public and media. The law did not have enough provisions to prevent the drain of the monetary reserve without any assurance of collateral. In addition, under an authoritarian political environment, this law made it easier for privileged select bank owners - based on political interest - to take advantage of funds from the national treasury not holding accountability and lacking transparency. The table below shows the amount of value earned from taxes on Financial Operations and the Expenditures from the Monetary Reserve for the period of 1980 to 1987. As we can see after 1985 expenditures from the monetary reserve increased drastically reaching its highest point in 1987, when it accounted for twice the amount earned from taxes on financial operations. The drastic increase in the use of monetary reserve especially in 1985 and 1987 was one of the main reasons why law 1342 had to be 36

revoked.

Table 4 - MONETARY RESERVE Financial Performance Value earned from Expenditures Year taxes on from the Financial Operations* Monetary Reserve* 1980 520,7 4,2 1981 392 3,6 1982 3.068,9 2,7 1983 1.536,6 10,7 1984 1.726,8 1,8 1985 1.488,0 461,2 1986 1.698,9 295,5 1987 1.718,3 3.417,3 1988 1.024,9 83,9 * Values denominated in Millions of US$ Data Source: Lundberg (1999), pg 4 The worsening situation of State Banks led the government to adopt a more radical measure. In 1987 RAET was created according to decree-law 232127 to intervene in institutions with financial or administrative problems. RAET authorized the Central Bank to take over the administration of problematic financial institutions (Public and Private) and transform, expropriate and/or liquidate institutions under its intervention28. The main difference between RAET and previous interventions is that RAET did not

27 28

Refer to Appendix C.1 Similar to the provisions on law 6024/74

37

affect the normal operations of the bank, which could continue to operate normally29. As soon as RAET was created, the Central Bank placed 23 banks under its administration, such as Banerj, Baneb, Ceara and Credito Real de Minas Gerais30. However, interventions were not achieving the desired results, especially in state banks. Because of the countrys federative structure, the local elite politicking would convince the Central Bank to change the state banks destiny soon after restructuring them. Some institutions would be subjected to RAET, then scheduled to go through extrajudicial liquidation and then ordinary liquidation. In some other cases, however, extrajudicial liquidation would be reverted with the institution going back to its original controller and normal operations (Salviano, 2004, p.59-60). For example, Pedruban (The bank of Alagoas State) was first intervened in 1988 with the intention of liquidation. However, in 1989, the governor of Pedrubans state was the favored candidate to become the countrys next president in the 1990 election. So, Pedruban had its sentence changed to a temporary intervention with the primary purpose of restoring the bank and returning it to its owner (Mackler, 2000, p.22). The bank was returned to the State of Alagoas in 1991, and it fell back into debt shortly after. The main limitation of the RAET was that it was only a temporary special program of administration; therefore the main problem of state banks (its relationship with their respective state governments) was not fixed with the program. So, even if the board of directors administrating the bank during restructuring was completely independent from the government, once RAET was over, the bank would go back to the
29

However, one of the provisions under RAET is that once the bank was being restructured, the executive board members would loose their offices. 30 Please refer to Salviano (2004) on page 58-9 for a list of the banks and dates in which they were put under RAET.

38

hands of the respective state government. It was not hard to forecast that the banking sector would go through some hardships as the Real plan was implemented. After the implementation of the Real plan in 1994, that ended hyperinflation, the easy way that banks made money was eliminated causing state owned banks to suffer. Federal Authorities decided to address the under capitalization and continuing losses of State Banks to avoid future monetary leakages through bailouts. A National Dezestatization Council was created within the PND with the objective of reducing the State participation in selected sectors of the economy31. In addition, at the end of 1994, preventive measure taken by Cardozo was to establish a transitional team, which studied potential state banks for intervention and nominated the Central Bank presidency (Persio Arida). The objective was to perform a broad clean up of the banking sector including identifying potential banks to be privatized. The structure and functioning of the transitional team was described by Freire in the Newspaper, Jornal do Brasil in an article published on September 3rd, 1995; it reads as follows: The Central Bank has ten regional branches all over the country. These branches receive monthly a disk from each of the countrys 3000 financial institutions containing information such as account balances, the twenty largest debtors, creditors, etc. This data is entered into the Central Banks computer system, known as super. This system calculates potential distortions in the accounting information of an

31

Please refer to appendix C.1 for a description of the CND.

39

institution (ex: An increase above the normal average in banks receipts is identified by this system automatically). Every semester, the Central Bank appoints a group of banks of potential risk. These banks must disclose all accounts to the Central Banks inspectors, which will look for evidence to support the computer suspicions. Aside from the computer results, the inspectors run investigations to identify potential risk institutions (based on historical problems and banks relationship with institutions that have or had problems). To avoid external problems, such as political pressure and corruption, the Central Bank sends ten inspectors to the financial institution being analyzed. This makes it difficult for financial institutions to get any kind of privilege or to buy its way out of inspection, since it would have to corrupt ten rather then only one inspector. Another preventive measure adopted by the Central Bank to avoid corruption is the rotation of its inspectors. Inspectors that open a motion against a fraudulent bank are not the same ones that will follow the motion all along. The draw back, though, is that the Central Bank only disposes of 420 inspectors. This number is not enough to keep close track of all financial institutions in the country. It is difficult to detect the existence of the so called dummy accounts, for example. Based on the information collected on the institution, the Central Bank 40

can open an administrative process against the executive board of the institution. In the worse case scenario, a proposal is sent to the directors of the Central Bank for a possible intervention or liquidation of the institution32. On January 1st, as soon as FHC took office, the Central Bank intervened and assumed control of Beron, Benad, Pedruban, BANESPA and BANERJ. These last two banks stood out because of the fact that they had already been intervened multiple times in the past, and due to their history of lending to enterprises that were most likely to default. After the implementation of the Real plan, besides losing inflationary revenues, Beron, Benad, Pedruban, BANESPA and BANERJ had their liquidity monitored and restricted by the Central Bank, and no longer received inter-bank funds from the private banks. This was devastating especially for BANESPA that had 40% of its funds by issuing short-term bonds to this source. BANESPA was reported to have had a balance sheet deficit of US$ 23 billion when the Central Bank first intervened. Within one year of the Reals implementation, the central bank had already taken over 21 banks. Among those banks were Banco Economico, Brazils 8th largest banks and South America 14th largest bank at that time. Banco Economico had over US$ 1 billion in negative assets and US$ 3 billion in Revenue shortfall. As reported in the newspaper Estado de Sao Paulo of the 11 banks analyzed only three were profitable Nossa Caixa, Banese and Besc. Among three federal banks studied, only one (Basa) was

32

Article by Gustavo Freire published on the newspaper Jornal do Brasil, on 09/03/1995. This artcles original is written in Portugues. I have rearranged and eliminate some of the contents of the article and then translated into English prior to inserting it into this paper.

41

found to be profitable. The bank of the Northeast of Brazil (BNB) was reported as not having any remaining assets to refinance. The table below lists the type of interventions implemented, and the number of institutions under each type of intervention between 1994 and 1998. Between the introduction of the Real Plan and the end of 1998, 48 banks had gone under special regimes and sometimes more than once. In practice, the Central Banks intervention has usually translated into the eventual liquidation of the bank under intervention. Between 1994 and 1998, the Central Bank liquidated a total of 31 banks.

Table 5- Number of Institutions per type of Interventions Type of Intervention Number of Institutions Intervention 2 Extrajudicial Liquidation 28 Ordinary Liquidation 3 RAET 5 Bankruptcy 10 Total 48 Source: Central Bank of Brazil The next table shows the Central Banks interventions in the banking system per type of bank. We can note from this table that the majority of the banks intervened were of private ownership, although state banks were in even more trouble than private banks. Table 6-Intervention of Central Bank in the Banking System per Type of Bank (July 1994-December-1997) Type of Bank Number of Institutions Intervened Investment Banks 1 Private Domestic Commercial Bank 4 State Commercial Bank 3 State Development Bank 1 Domestic Multiple Bank w/ Foreign Participation 2 Private Domestic Multiple Bank 28 State Multiple Bank 4 42

Total Source: Baer and Nazmi, 2003, p.8

43

The problems with the ever growing State Government deficits, the difficulties of some banks (considered too big to fall), and the recurring problems with state banks, made it necessary to design a new set of policy instruments such as Parafe33- to prevent the risk of systematic banking crises. This topic will be discussed in more detail I the next section of the paper. In this section we discussed how the government tried to solve banks problems with intervention and restructuring. The process of intervention, however, had to be revised quite often, usually because of its inefficiency, especially in public banks. The reoccurring problems of state banks, especially after the implementation of the Real Stabilization plan, led the Federal government to develop a more aggressive strategy as it will be discussed in the following section. B. How Banks Were Restructured and Privatized 1. Private Banks The continuing deterioration of bank accounts, aggravated with the implementation of the Real plan in the 1995 crises, made it necessary to design a new set of policy instruments to prevent the risk of systematic banking crises. Among the measures of the Brazilian financial reform, it is worth mentioning the program to support the restructuring and fiscal adjustment of the state (PARAFE), the creation of new credit lines to promote exports (PROEX), and to give incentive to the

33

Please refer to Appendix C.1.

43

merger of financial institutions (PROER), and also and the FGC34. In addition the Federal Government passed measures to increase the power of the Central Bank in such a way to allow for the control of financial institutions with the objective of protecting the health of the financial system. The PROER was officially implemented through resolution 2208, on November 4th of 1995. The PROER worked as a credit line program that provided a special central bank credit line to banks in need of liquidity and or funds for restructuring. The purpose of the program was to stimulate the restructuring and strengthening of the Financial System through merger and acquisition. To encourage Mergers and Acquisitions, tax dispensation subsidies were given to buyers35. This incentive was expected to increase potential buyers interest in banking privatization, which had been severely diminished because of corruption that affected the banking sectors credibility as a whole. The basic principles of PROER can be summarized as safeguarding the payment systems, and penalizing bad banking policies. In order to promote stability and increase the credibility of the National Financial System, a formal deposit guarantee system to protect depositors needed to be created. The difference of this restructuring plan from previous Special Regimes (intervention, RAET and extra judicial liquidation) was that measures now carried a preventive character in which the Central Bank could apply remedies, such as transfer of

34 35

For additional measure and further explanation of the above mentioned measures, refer to appendix C The regulations of the FGC were amended in 2002 under the resolution 3024. Please refer to provisional measure1179 on appendix C1, for more information on this resolution.

44

stock holder control, mergers or acquisitions if banks showed no improvement36 (Banco Central, 2001b, p. ). The restructuring of the Brazilian Financial System started in the private sector with the sale of Banco Nacional in 1995. At that time, Banco Nacional was the 4th largest private bank in the country. Soon afterwards, Banco Economico, an old private Brazilian bank, was put under the Central Bank intervention after a $3.5 billion shortfall. The Government wanted to prevent it from being liquidated due to the lack of qualified national buyers, so the Cardozo Administration divided Econmico into two: the profitable side of it was sold to the Excell Bank and the other was under the government intervention for eventual liquidation. However, there was still a problem: bank Excell would be required to inject $309 million to increase the capital of the new bank after the purchase. Considering the size of Excell Bank and the economic environment due to the financial crises, this would not be a feasible task. Having this in view, in order to accelerate Economicos sale and increase confidence in the Brazilian banking system, the Federal Government authorized Switzerlands Union de Bancaire Prive to be a co-owner with Banco Excel. This sale marked the opening to foreign ownership of strategic industries. This two banks privatization marked the first step towards the end of restoring the problematic banks and returning them to original controllers. With the closing of Economico and Nacional The countrys top domestic banksit seemed that no bank, regardless of its size and status, would be spared from

36

Please refer to provisional measure1182 on appendix C1

45

transformation if it was necessary. However, party ties and political connections still influenced the sequencing and sale of banks. In August of 1995, the National Monetary Council (CMN) passed Resolution 2197, which authorized the setting of a private non-profit organization to control the protection of credit holders against financial institutions in case of intervention, extra judicial liquidation or bankruptcy37. In November of the same year, the Regulations of the new organizations were approved (according to resolution 2211), establishing the deposit guarantee system in Brazil known as the Guarantee Credit Fund(FGC)35. The purpose of the FGC was to: protect small account holders, ensure the stability of the financial system, and prevent a systematic banking crisis. This fund insured deposits and investments up to R$20,000 in the event that the bank goes bankrupt, claims insolvency, is intervened and liquidated extra judicially. All Brazilian financial institutions with the exception of credit unions, were compulsory members of the FGC. Members contribute with 0.025% of their deposits account balances monthly to the FGC, which provides an adequate level of resources to fund the needs of the SFN under normal circumstances. According to an article published in O Globo, Brazilian bankers did not contest the fee that they had to pay. They supported the measure because they were concerned that if another large bank failed, a run to the banks would occur, which could have a tragic repercussion similar to Venezuela, not too long before.

37

Please refer to Appendix C.1.

46

The success of the Real plan impelling economic stabilization, and the commitment of the government to privatization programs, brought new credibility to investments in Brazil. Foreigners started to show more interest in the Brazilian financial market. As of 1995, Brazil was under a lot of international pressure, especially from the United States, regarding restrictions on the entrance of foreign financial institutions ( in accordance to act 52 of the Brazilian constitution of 1988). The administration proposed amendments to Brazils constitution that would allow the entrance of foreigners in the financial market through the purchase of State Banks38 in the privatization program (Berlink, 1995). This measure would not only take care of foreign countries complaints, but would also act as a step towards reducing the federal deficit and further establish credibility. In addition, the government wanted to increase competition in both the bank selling process and bank operations. National banks took advantage of small competition in the privatization process to demand more incentives. The candidates acted like they were doing the government a favor in acquiring a bank being auctioned. For a while, their strategy worked; they obtained more subsides and in most cases the government assumed the debts and problems of the auctioned banks. Moreover, the entrance of foreign financial institutions in the market could stimulate bank efficiency, since it would force institutions already established in the country to adjust to a more competitive environment.

38

State Banks represented 55% of the Banks in Brazil.

47

The national banking system that has been incapable of implementing the necessary technological advancements for the development of the sector would have to respond to foreign banks more advanced technology by introducing similar technologies. This increase in competitiveness in the financial system could reduce the spread and banking fees. The other advantage is that Foreign Banks would receive services from their respective home country regulators, thus reducing Brazilian domestic liabilities while simultaneously improving system soundness. In addition, Brazil is a country highly dependent on FDI for international development purposes, thus financial liberalization would free capital inflows and outflows, which tends to facilitate renewed access to international financial markets. Although the administration needed foreign investments to alleviate the State Bank deficit and fortify the banking system through the injection of fresh capital, opening the banking sector that had been almost completely nationally owned to foreign investors was an ideological challenge. Most National Banks started to express their concern regarding the financial liberalization issue. National banks feared that foreign banks would cause a significant revenue loss to the national banks that for the most part were not as advanced technologically. In addition, the private national banks were not happy with the increase in competition on the banks auctioning/ privatizations. Despite it all, in August of 1995 an executive decree called Exposicao de Motivos 311was issued allowing Foreign Financial institutions participation in the Brazilian financial system through PROER lines of credit, on the basis of National interest. The first banks to be restructured after the revisions regarding foreign banks 48

entrance in Brazil and the creation of the FGC were Banco Banorte and Banco Bamerindus. In May of 1996, Banco Bandeirantes bought the healthy part of Banco Banorte, and it was immediately incorporated. In this case, the deal was financed with resources from the FGC, which was responsible for the money amount correspondent to the protection of small depositors. The total amount that customers had deposited at Banorte totaled R$ 256 million. Although the FGC had initiated its operations only a few months prior to the Banorte privatization and did not have enough funds in its current accounts, FGC managed to pay off Banorte creditors and close its first fiscal year with R$ 74 million in funds. The authorization of foreign banks to purchase any Brazilian bank was a change that advanced bank privatization, which had started in the early 90s. A notable portion of these inflows was for the purchase of federal or state-owned institutions. At year-end 2000, privatization receipts resulting from the sale of financial institutions totaled close to US$ 4 billion, representing 14 percent of total federal privatization receipts excluding transfer debts (BNDES, 2001, p. ). The privatization of six banks owned and sold directly by the states brought in approximately US$1.5 billion (IMF, 2001, p.172). In March of 1997, as Bamerindus showed the first signs of collapse, the administration quickly arranged for the privatization by HSBC, a foreign buyer, to accelerate Bamerindus privatization. This was the first complete acquisition by a large foreign buyer. According to legal regulations, the FGC reimbursement obligations with Bamerindus depositors was initially estimated in R$ 3 billion. However, at that time, 49

FGC funds were slightly more than 300 million. The FGC had not yet accumulated enough funds to cover all the depositors of such a large bank. The reimbursement of Bamerindus depositors was done with PROER financing from the Central Bank. This was agreed upon, provided that these funds would be repaid to the Central Bank by the FGC according to the circular 2.748 edited in 03/26/97. This circular allowed for PROER to finance up to 80 percent of the total debt of the bank. In November of 1998, negotiations for the liquidation of FGCs debt were concluded. The initial value of the debt was R$2.8 billion (this value was adjusted to inflation rate). A share of the debt was paid on the spot after negotiations, and the remaining balance was divided in 48 monthly payments to be started 24 months later. Although this debt takes long to be paid off, the FGC has not defaulted on its payments. The advantage of this process is that the Central Bank did not take money from the citizens or the national treasury to privatize Bamerindus. Instead, a private institution that collected funds from the banks themselves was repaying the money. In 1988, there were 26 banks with foreign controlling share in the National Financial System (SFN), by 1998 this number increased to 60 (Banco Central 1998, 10). As reported in the Central Banks annual report in 1998, the majority of foreign capital entered the country through the authorizations for transference of institution controlling share from national groups to foreign ones (19 banks and some other institutions not linked to bank groups). By December of 2000, out of the 191 banks, 104 were of private ownership, 16 public and 71 had foreign control. The assets controlled by foreigners had an increase of 33 percent between 1988 and 2000. Of the ten largest banks in December of 1998, six 50

were still among the top ten in December of 2000 - although half of them had their controlling share transferred to foreign ownership. We started this section with the discussion on how the continuous deterioration of banks, that was aggravated with the end of hyperinflation after the implementation of the Real plan, led the Government to adopt measures to reduce the potential of a banking crises. One of the most important measures taken by the Government was the creation of the PROER credit lines for bank restructuring and the FGC. The first bank to take advantage of PROER was Banco Nacional in 1995. Shortly afterwards, another important bank was intervened and sold to Excell and Union de Bancaire Prive, thus marking the open of the financial industry to foreign owners. The opening of the market to foreigners, as it will be discussed in the following section, was a very important step in the privatization process. 2. Public Banks The public banks problems were worse than the private banks ones. The loss of revenues after the Real stabilization plan was put in place was the common problem shared by private and public banks; however, private banks did not have to deal with one of the biggest problems of state banks: The state government itself. State banks were created through state law and were granted protection by the government. As a result, state banks were willing to engage in riskier operations than their private counterparts, since they were aware that if the bank developed liquidity problems, the respective sate government would make use of its political power to obtain resources from the Federal Government to prevent the bank from falling.

51

Since State Governments new that they could always resort to the Federal Government for help, State authorities abusively used their respective banks resources. Although there were legal limits on the financing volume that the state governments could obtain from their respective banks, these laws were not followed. States would borrow from their respective banks with no limits and become highly indebted. The state banks on the other hand would end up having liquidity problems after the government abusive borrowing. The state governors would them put pressure on the Central Bank and/or Federal Government to help the bank. Between the years of 1983-96, many different programs with the objective to restructure the states were implemented39. According to the Central Bank, over R$30 billion were spent on these programs. Despite all the Federal Government efforts, banks would fall back in debt shortly after being restructured. Having this in view, it seemed like privatization was the only solution for the ever-growing problem of State Banks. The two banks that caused the most concern for the federal government were Banespa and Banerj, due to their size. However, before they could be privatized, they needed to be restructured. So, in December of 1994, when governors terms were close to finish and thus state governors did not have political capacity to react to Federal government actions, the Central Bank put both Banerj and Banespa under RAET40. At this time, however, the purpose of RAET was to clean up the banks with the intention of privatization.

39

See Puga,1999, p. 423 for programs and a brief explanation of them. Also see Apendix C.1 for decree 2258/97 for Program of reorganization of decentralized government units. 40 These banks were put under RAET on 30/12/94, which was the last day in office of the current governors. The new governors in office, would be exempt from any responsibility regarding the deterioration of the banks intervened, which would become known as RAET cleaned up the banksaccounts.

52

The first bank to be privatized was Banerj41. Three months after the Bamerindus sale, the state bank of RJ (BANERJ) went under PROER intervention. A private bank (Bozano Simonsen) selected from a pool of applicants prepared Banerjs privatization. Bozano Simonsens responsibilities were to restructure, downsize and suggest a minimum selling price for Banerjs auction. The CMN approved specific rules for the pre-qualification of Banerj buyers, such as the buyer had to prove financial capacity of at least 220 percent of the minimum capital required for the bank itself. This rule was kept throughout the remaining state interventions under PROES (Salviano, 2004, p.93). The majority of these rules were put in place as a mean to assure that whoever bought the bank would be able to maintain its functioning. It was also specified in the rules of the bank offering that the bank ownership could not be broken into shares it had to be transferred to a single buyer. The reasons for this were: First, to try to maximize the bidding price on the bank and, second, to attribute legal responsibility to the purchaser. Initially, the only potential buyers were the large national private banks that had enough capital to purchase banks and that wanted to expand its operations to position itself strategically better in the market. However, the rules for prequalification to purchase state banks narrowed down significantly the already small number of potential buyers. In addition, some of the large banks that were capable of making such sizeable purchases did not feel in a favorable position to expand their operations, since they were still trying to adapt to the loss of inflationary gains. This was one of the reasons that made the opening to foreign banks to participate in the privatization process so important. In

41

Detail on Banerjs privatization can be found at www.bcb.org.br/

53

addition, if the auctions had not been open to foreign participation when the Asian crises broke out devaluating the Real in the first semester of 1999, it would have impacted the privatization process significantly and likely delaying it. To encourage bidding for Banerj, the State of Rio de Janeiro stipulated that it would allow up to 70% of the total price of the bank to be paid with non standard financial assets such as its previously issued privatization certificates cotas, and moedas podres, which were a variety of discounted government securities. Additionally, the government tried to easy financing projects, by either providing finance directly to borrowers, or through BNDES. Also, the government isolated the credits of difficult recovery (bad bank/good bank policy)42. This was criticized for supposedly represent a socialization of the losses and a privatization of the profits/gains. However, the reason for separating the bad bank and good bank was not because the bad bank had a negative value, but because the value was unknown. Therefore the bad/good bank model was important not only as an incentive to reduce uncertainty of the buyer regarding the bank purchased, but it also to allow for a significant increase in the price of the bank auctioned. This became a stamp of Public banks privatization (Salviano, 2004, p.91-2). On November 30th, 1996, seven institutions were pre-qualified to Banerjs auction. These were: Bank Itau, Bradesco, Bank of Boston, CCF Brasil, BBA Creditanstalt and another two companies (Cia. de Investimentos Latino Americana, and General Eletric Capital Co.).

42

Refer to Maia ( 2000), for an in depth discussion of this model.

54

In Feb. 1997, (1 year after intervention) the Federal government assumed Banerjs deficit and the State of Rio de Janeiros entire debt (RS$11.6 billion) to accelerated Banerjs privatization. In March, the government authorized PROER financing. The difference between PROER financing on private bank and state bank, is that, the latter can recover funds from the federal government that they lost when they accepted less valuable privatization and government securities for their banks. A month later Caixa Economica Federal (the federal government savings bank) provided Banerj with a bridge loan of 3 billion Reais to cover any employees and pension claims outstanding. On June 26th of 1997, two and a half years after intervention, Banerj was finally sold to Banco Itau, the only participant in the auction to make a bid. Itau bought Banerj for R$311 million, only 0.3 percent above the minimum price established (Salviano, 2004, p.94). Despite the low bids, the sale of -BANERJ was encouraging to the governments bank privatization effort. The process that BANERJ went through was shaped by private banks transformations and accomplished through loans, settlements and the PROER program43. This privatization marked the turning point on State Bank ownership (Mackler, 19). After Banerjs privatization, the government realized the need to implement special measures and develop restructuring programs directed to state banks issues. This need was reinforced with the hardships in negotiating with many governments regarding their respective banks, especially the state of Sao Paulo (Banespa).

43

Due to the large number of state banks to be privatized and the limited number of potential buyers, many of the incentives used for BANERJs privatization, were also used in future state banks privatizations.

55

A new program specially designed to take care of State Banks restructuring, PROES, was put in place according to Provisional measure 151444 and resolution 2365/9745. The PROES differed from previous programs, such as RAET and PROER, mainly because it was a broader program directed to address government debts and fiscal adjustments. An important characteristic of PROES was that it was up to each state to decide whether they wanted to join the program or not. The main incentive of PROES, as it will be discussed in more detail, rests on the provisions of the program, which allowed for up to 100 percent refinance of state debts. The main objective of PROES was to reduce the presence of the public sector in banking activities. Along with PROES, law 9447 (former Provisional Measure 1182), increased the power of the Central Bank by allowing the monetary authority to demand that financial institutions with liquidity problems must transfer major shareholders control, or reorganize its executive board by mergers and/ or acquisitions. In the event that the problematic institution refuses to follow the Central Banks advice, the Central Bank is allowed to sell major shareholders stocks in an IPO. With the implementation of the new measures, the States administrators knew that they could no longer resort to the Central Bank to take care of their financial difficulties. Banks needed to reduce their debt to the Federal Government to avoid liquidity problems and continue functioning. Banks had three options to eliminate their debt. The first option was recapitalization, which would have to be done by the state government without any help from the federal government. The second option was to liquidate the bank in which case
44

This is the first of the 70 editions of this provisional measure. The last revision was in 2001 and it was numbered as MP 2192 45 Please Refer to appendix C.1 for more details on the legality of PROES.

56

the state as the major shareholder would have to pay for the gap between the liquidation value of bank assets and the banks liabilities. The third alternative was to enter PROES by first assuming a long term debt with the federal government at below market interest rate46 to be repaid in monthly installments47 for 15 to 30 years varying on a case by case basis. State Governments knew they would not be able to obtain such long term and low interest rates in the market to finance their debt. Therefore out of these options, the least costly path for most banks was to assume a long-term debt with the federal government. The total debt assumed under these agreements was R$ 94.2 billion of which 91.2% was refinanced. Under PROES arrangements the Federal government finances the restructuring of State Banks. The federal government assumes state bank claims on impaired assets and this debt is also consolidated with other state debts under restructuring. The catch for such aid is that the State bank has to agree with one of the four choices allowed by PROES concerning the future of their banks48. These banks choices were to be privatized (either by the State itself or by the Federal Government), liquidated (extinct), transformed into a non-banking financial institution or restructured and returned to the state (Maia, 2000, p.116-7). However, if banks opted just to be restructured and remain under state control, the federal aid would be limited to only 50% of the total necessary resources for

46

The interest rate to be paid is equal to an inflation index (IGP-DI) plus 6 to 7.5% yearly depending on the State. This is a very low rate in contrast with the current Federal Government market borrowing rate of 30%. 47 Monthly installments could not exceed 13% of banks revenue. 48 For a detailed description of each option refer to Salviano, 2004, p.84-88.

57

restructuring. The remaining share would then be responsibility o f the respective state government that had to prove financial capability to do so before selecting this option. The choice of State Governments regarding which option to choose under PROES depended on how much control it was willing to give up over the bank itself and the process under which the bank was resolved and restructured. It was basically a trade off between the benefits of having the State Banks as a patronage tool and the cost of continuous losses that could no longer be externalized to the Federal Government. Although restructuring was the preferred option, the cost of recapitalizing State Banks was for the most part larger than the losses absorbed by loosing it. States with higher poverty rates and fiscal deficits that owned banks with lower efficiency and worse performance were more likely to accept the liquidation and privatization option. In November of 1996 the first agreement with the State of Sao Paulo regarding Banespa was reached. The State Government of Sao Paulo accepted to transfer 51 percent of Banespas voting capital to the Federal Government, so that this share could be sold in exchange for funds to pay a debt that the State had with a housing and mortgage institution. However, this was only the first step towards Banespas privatization. The first state to reach an agreement with the Federal Government regarding its banks was Minas Gerais (MG). While most states procrastinated on a decision hoping that at some point they would be able to keep their banks, MG signed a protocol agreeing to privatize both of its commercial state owned banks (Credireal and BEMGE), to transform their development bank (BDMG) in a non-financial institution, and to finalize Minas

58

Caixa extrajudicial liquidation which had been going on since 1991- by making the bank extinct49 (Salviano, 2004, p.95). The first bank to use PROES credit lines to be privatized was Credireal. This bank was auctioned and sold in August of 1997 to Banco Privado Nacional (BCN) for R$127.3 million-five percent above the minimum established price. However, PROES financing was not liberalized for another 10 months. Then, in May of 1997, Minas Caixa had its extrajudicial liquidation transformed into an ordinary liquidation. And finally in September of 1998 BEMGE was auctioned. Some of the main Overall Refinancing Guidelines of BEMGE were: a. The states' debts should be comprehensively analyzed, and "ad hoc"

solutions should not be proposed; b. c. Only exclusively financial debts are eligible; Already renegotiated debts, even when included in the analysis mentioned

in item "a", would not be eligible for renegotiation. Some other Refinancing Characteristics were: a. Consolidation of the security debt and other debts which are not

renegotiated under a single contract; b. Immediate payment of at least 20% of the debt by utilizing assets accepted

by BNDES and immediately transferred to the Federal Government, also with immediate inclusion in the PND (National Privatization Program). The purpose of
49

For more details on the agreement between the State of MG and the Federal government and terms of these banksprivatization, refer to Salviano (2004) and to the Federal Government website, at www.fazenda.gov.br/ingles/ajuste/iajusrs.html

59

this immediate payment is to encourage the privatization process at state level and to cut the Federal Government's allowance; c. Refinancing conditions: 30-year term, interest of 6% a year, monthly

correction by the IGP-DI (general price index - domestic supply), with monthly payments; d. Presentation of effective guarantees represented by the State's own

revenues and FPE (States' Shares Fund) quotas50. BEMGE privatization process51 started with two consulting studies to establish the minimum price that should be accepted, the necessary restructuring before the bank is for sale and the structure of the privatization operation. Then the government published an announcement (without the minimum price) to inform interested buyers that the prepurchase qualification process to buy the bank was open. The Government and the Central Bank analyzed the potential buyers that entered the qualification process to determine which ones have the minimum conditions to operate the bank properly. BEMGE had 11 pre-qualified buyers52. Once a candidate is pre-qualified, he has access to info appropriate for valuation of the bank being sold. The auction of the State banks is usually done in a sealed envelope process. Each potential buyer selects a single broker to represent the buyer in the bidding process. If there are sealed bids 10-15% of the highest bid the auction continues on a live bid basis, otherwise, the highest sealed bid wins. In the case of BEMGE the auction went the live

50

The overall refinancing guidelines and refinancing characteristics were taken from www.fazenda.gov.br/ingles/ajuste/iajusrs.html 51 Most banks went through the same process for privatization 52 BEMGE was the state bank with the largest number of pre-qualified buyers.

60

bid basis stage. The final price paid for the bank ended up being almost twice the minimum price fixed by the consulting firms. The State of Pernanbuco initially wanted to have its bank restructured and kept it. However, Pernanbuco could not raise enough money to pay for the remaining share of the restructure. Therefore, on June 12th, 1998, the state agreed to privatize Bandepe. Two months after Bemges privatization Bandepe was sold53. BANDEPEs case was quick. There was only one bidder, ABN-Amro, which bought the bank for the minimum price of R$183 million. During this time period, the state of Parana negotiated its contract with the privatization of its bank. The State of Parana intended to restructure its bank and then convert it in a retirement plan institution owned by the state. This decision created conflicts between the State and Federal Governments. The State Government believed that the transformation of the bank in a non-banking institution, should entitle the State to obtain 100 percent refinancing for the restructuring of the bank. On the other hand, the Federal Government claimed that the type of transformation suggested by the State should only get half of the capital necessary for the restructuring of the bank, because after the restructuring it would still be a financial institution and owned by the State government, thus in the case of an eventual insolvency, the institution could come to the Federal Government/ Central Bank for help. Since the State of Parana did not have enough funds to pay for half of the banks restructuring, it finally agreed to privatize its bank. The estimated amount necessary to refinance this bank was R$3.85 billion, which was higher than the amount used on the restructuring of Banerj or on all the banks in the

53

BANDEPs privatization process was similar to BEMGE, however it did not go to live bid.

61

state of Minas Gerais together. Still the process was delayed by the States political resistance (Salviano, 2004, p.98). Banestados auction did not happen until October of 2000. Out of the five pre qualified purchasers to acquire the bank (Itau, Bradesco, Unibanco, Satander and ABN Amro Real), Itau was the one to place the highest bid of R$1,625 billion, about 300 percent above the minimum purchase price established. The lack of buyers interest was a common problem in state banks of smaller scale and /or located in states with lower living standards. . Having this in view, the majority of the smaller state banks (especially the ones in the North and Northeast of Brazil) were likely to become non-financial institutions rather than being privatized. However, even among these banks there were differentiated situations. The State Banks of Rondonia and Mato Grosso for example, were reluctant on selecting the transformation option and wanted to restructure and privatize their respective banks. These banks had been under RAET intervention since 1995 and their intervention kept on being extended year after year based on the hope of privatization. However, in 1997, the Central Bank decided that the privatization of these banks were not a viable option mainly due to the lack of potential buyers. So, in January of 1998, Bemat had its extrajudicial liquidatial converted into ordinary liquidation and in June of 1999 it was extinct. Beron went from RAET to ordinary liquidation in August of 1998 when it became extinct. Other three states (Espirito Santo, Sergipe and Para) opted to restructure and kept their respective state banks54.

54

Refer to appendix A table 2 for a list of State Banks and their current status.

62

The continuation of the privatization program was delayed due to the Real devaluation in the first quarter of 1999 as a result of the Asia Crises. During this time period some of the remaining State banks that had chose no to enter PROES were going through financial difficulties. To help these banks the Central Bank reopened PROES credit lines in December o f 1998. These banks deadline to show interest in entering PROES was on the 15th of January. By them every single state with the exception of Amapa State entered PROES. The process restarted with the sale of the State Bank of Bahia (Baneb) in the second half of 1999. The bank was sold in June of 1999 by the only bidder, Bradesco, for R$260 million. Finally, on November of 2000, after three years of delays, high political resistance and three extensions on the PROES deadline for the banks privatization55. The State Bank of Maranho (BEM), auction took place on July 12th of 2000, however, none of the pre-qualified buyers bided on the bank. In this case, the control of the bank is transferred to the Federal Government (the bank is federalized) and all the steps before the auction can take place (estimate value of the bank, select pre-qualified buyers, etc) have to be re-done56. The State Bank of Sao Paulo, Banespa, was notorious for its mismanagements and abuse for political purposes, however, its huge size (comprised of 573 branches and about US$15 billions in assets base) attracted a lot of attention to its privatization by bank analysts and the media due to the potential of a foreigner to become the owner of one of the largest banks of Brazil. The privatization of Banespa was a challenge to the Federal government not only for its size and importance, but also due to the Federal Government
55

The third deadline had a provision that if privatization did not take place up to t11/30/2000, the bank control must be transferred to the Federal Government. 56 There was a total of six federalized banks: BEM, BEC, BEG, Besc, BEP and BEA.

63

lack of experience in conducting the privatization process. Previous privatizations were conducted by the banks respective states, which hired outside consultants to do the job. The importance of Banespas privatization contributed to the delay of the privatization of the remaining federalized banks, since Banespa privatization process can be compared to a soap opera of endless episodes. In addition, the limited number of employees directed to take care of federalized banks (at some point there were only three people in charged of it) who had no experience on how to perform specific tasks , since prior privatizations were conducted by the banks respective states, who in turn hired outside consultants. In January 2000, the Central Bank finally published the prospectus of Banespas privatization process, in which it was established that the banks auction would take place on May 16th, 2000. In April a list of the nine pre qualified purchasers was released. Among these purchasers there were 5 foreign groups that demonstrated interest in the purchase of Banespa (Banco Bilbao Vizcaya Argentaria S.A., Banco Santander Central Hispano S.A., Citibank Overseas Investment Corporation, Fleet National Bank and HSBC Holdings B.V.), and 4 national banks (Banco Bradesco S.A., Banco Itau S.A., Banco Safra S.A. and Unibanco). The dataroom was supposed to had been opened to the pre-qualified banks shortly after, however, legal disputes delayed this process. The dataroom was finally opened on May 22nd. Meanwhile, the Banks Union was trying to do everything possible to prevent Banespa from being privatized57. The Union passed around the countrys citizens a petition requesting that the State Legislative Assembly put together a plebiscite open to
57

The Union negative propaganda regarding state bank privatization was largely to blame on the revolt of Brazilian citizens.

64

the population regarding the privatization of Banespa. This petition comprised 290 thousand signatures and it was handed in on May to the president of the Assembly. In July more legal issues were brought up, paralyzing Banespas privatization process (including pre-qualified buyers access to the dataroom) for another two months. The long amount of time spent preparing Banespa for privatization and the delays resulting from judicial disputes involving the privatization of the bank ended up making the price estimates of the bank obsolete. The new estimates58 were released in middle of 2000. And in October, a new prospectus (with all the details and rules of Banespas privatization) was published establishing the auction date as November, 20th, 200059. Around that same time period estimates from Dieese60 and Unicamp (A University in Sao Paulo) were released contesting the estimates of the consultants hired by the Central Bank. These two institutions sent their estimates and requested the suspension of the auction so that a new set of pricing estimates could be done. The Federal Government started to get concerned that any more delays in the Banespa process would be detrimental to the Banks privatization. The majority of the pre-qualified buyers started to show signs of insecurity due to the length of the process and its excessive interruptions. Out of the nine pre-qualified banks only five responded to the Compania Brasileira de Liquidacao e Custodia (CBLC), which is the entity responsible for collecting all the required material from the institutions that intende to participate in the auction. Three of the banks that decided to no longer participate in
58 59

These estimates were given by two consulting agencies: Booz-Allen and Banco Fator. The edital can be found in the Central Bank of Brazil web site at www.bcb.gov.br/?BANESPAPND. 60 Departamento Intersindical de Estatistica e Estudos do Departamento Socio Economicos (dieese) is responsible for the statistics on Socio-Economics departments.

65

Banespas auction were foreign banks (Banco Bilbao Vizcaya Argentaria S.A., Citibank, and HSBC) and only one national (Banco Safra). Another fact that concerned the Federal Government and the Central Bank is that the recent privatization of the State Bank of Parana (Banestado), which was bought by Itau, would diminish the interest of Itau in Banespa. The main issue was that with the reduction in the number of competitors, and since Itau had just spent a significant amount of money on Banestes, it would not be willing to place a bid as high on Banespa as it would had otherwise. This in turn could reduce Banespas price low enough that the minimum price is not reached (Salviano, 2004, p.115). Despite all the problems on 11/20/2000 Banespa was privatized. Almost six years after it was intervened, after many delays and reschedules due to political and judicial disputes, Banespa - the largest of the state owned banks - was finally privatized with PROES credit lines. The controlling share of the bank was sold to the Spanish bank Satander for R$7.05 billion (US$ 3.59 billion), 281 percent above the minimum price. Following state banks privatizations followed the model used by Banespa (minus the delays). Between 2001 and 2002 another 3 state banks were privatized and the four federalized banks had their pre-qualification stage to select potential buyers done. The State Bank of Goias State (BEG) was privatized within 6 months of its opening for interested purchasers to apply for the pre-qualifying round for a price 121 percent above the minimum price established. The State Bank of Amazonas (BEA) was bought by Bradesco (The only bank to show up to the auction) on January 24th,2002, for its minimum price of R$183 million. The State Bank of Paraiba was privatized on

66

November 8th, 2001 by its own State. This last privatization, however, did not use PROES credit lines. As we described in this section, public banks had more problems than their private counterparts. Public banks had to deal with the abusive borrowing of their respective States. The States knew that if their banks became insolvent, they could always resort to the Federal Government for help. This, in turn, triggered another problem: Public banks did not develop proper management practices. The lack of proper management increased these banks fragility, which became evident with the implementation of the Real plan. After many attempts to restructure and clean up these banks as mentioned earlier sections of this paper, it became clear that the only way to solve the drain that state banks caused on Federal Government budget was to privatize these banks. The first bank to be privatized was Banerj. The privatization of this bank led the government to develop a restructuring program directed to take care of state banks problems called PROES. This programs main objective was to reduce the presence of the public sector in banking activities, by providing financing to restructure state banks in exchange for state government to privatize, liquidate or transform their banks. If states wanted to keep their banks, however, they had a fourth option, but this would only allow for half of the refinance funds necessary. These measures greatly helped the reorganization of state bank; the Federal Banks situation though, was not improved as will be discussed in the following section. C. The Federal Banks Situation There are at present 5 Federal banks in Brazil: The Bank of Brazil, the BNDES,

67

the Federal Savings bank, the Northeast Bank and the Bank of Amazon61. Each of these banks has a specific purpose. The Bank of Brazil is a general purpose bank in charge of different activities (refer to appendix A). The BNDES is a development bank and one of its main activities at present is the privatization of SOEs. The Federal Savings bank specializes in housing, construction and infrastructure financing. The last two banks on the list -the Northeast Bank and the Bank of Amazon- are regional banks with purpose of servicing the less developed areas of the country. Some of the problems experienced by State Banks are common to Federal Banks. Just like State Banks, Federal Banks are highly influenced by politics. First of all, the requirements for opening a branch are political, thus resulting in self-defeating competition and operation is deficiency. In addition, there is political pressure for loans and financing operations. In turn, Federal Banks impose pressure on the ministry of finance, the CMN and Bank of Brazil to concede privileged treatment that goes beyond the financial system legislation. The Bank of Brazil for example required a R$ 9 billion capital subscription in 1996 to recapitalize its previous years losses. This money was almost entirely withdrawal from national treasury funds. In addition the Bank of Brazil had the same Patronage problem as State Banks. In 1998, administrative expenses of the Bank of Brazil were US$ 7 billion (Puga, 1999, p.448). Lack of transparency in activities and mismanagement is also a common feature of these banks. The Federal Savings Bank for example, has been unable to obtain a clean auditors report, due to the lack of records and information. Despite all of these problems

61

In addition to the three State Banks Federalized BEC, BEP and BESC- that are waiting to be privatized

68

there has been no indication of any intention to privatize these banks. Some measures were implemented with Immediate Action Plan (PAI) such as the White Collar Law (Refer to appendix C.2) used to keep administrators of Federal Banks in line. In addition other programs, such as Refis and PROEF were put in place with the objective of fostering the normalization of federal government credits and restructuring federal banks. The only Federal Bank privatized to date though was Banco Meridional. This bank had continuous problems and had already been saved from bankruptcy in the 1980s. Meridional was sold to Bozzano Simosen in December of 1997 for R$ 265 million. The Federal Government had indicated that it would privatize the Bank of Brazil securities distributor and the Brazilian Reinsurance Institute. These privatizations however, were put on hold due to unfavorable conditions caused by the Asias crises and still nothing has happened to date. A total of six state banks were federalized and three of these remain in the hands of the Federal Government waiting for privatization (BEC, BEP and Besc). Potential auction dates were set for all the federalized banks; however none of them were realized. BEG and BEA were privatized in 2001 and 2002 respectively as mentioned earlier. The most recent privatization to date in Brazil was of the State Bank of Maranho (BEM). As mentioned previously BEM was first auctioned in 2000, but t was federalized due to the lack of buyers. BEM was then auctioned for the second time in February of 2004, when it was bough by Bradesco. As we described in this section, federalized banks display similar problems to those of the state banks. Both state and federal banks were highly influenced by politics, 69

suffered from high loan issuance and patronage for political purposes. Some measures, such as the white collar law, have been implemented to keep the administrators of Federal banks in line. Although the problem of federal banks has been recognized, there has not been any indication that these banks would privatized in the near future. D. The Costs and Results of Privatization The public opinion regarding the privatization of state banks was much divided. Many people questioned the privatization of public banks as a process leading to the concentration of the banking industry in Brazil and the long term consequences of it. In addition, some people felt that by privatizing State Banks, the government would be selling an important tool of regional development. However the main criticism to the privatization of States banks can be attributed to the potential of a foreigner buying Brazils largest banks, such as Banerj and Banespa. What most people against privatization failed to realize though is the fact that the relationship between public banks, the government and bank administrators had to be changed. Although State Banks contributed to the development of the Brazilian economy, when the banking system in Brazil was poorly structured, this was no longer the case. Since the 1980s State Banks were just a burden on the States and Federal government fiscal accounts. In addition, the constant aid that the Central Bank had to give to the forever indebted State Banks made it difficult to carry on proper monetary and fiscal policies. This in turn was a threat to the Real Stabilization plan, which depended highly on the proper management of these policies for its success. To defend the Real plan and the health of the Brazilian economy, the Federal Government attempted different measures. PROES was the most successful program in 70

aiding state banks. This program contributed significantly to the decrease of government ownership in the Brazilian banking system. By the end of 1999 the share of government ownership had already been reduced to 43% of Total Assets. This reduction was largely due to Banespas privatization. Especially the volume of State Bank Loans, which fell from US$44 billion in June of 1997 to US$12 billion in December of the same year (Puga, 1999, p. 438). Another positive aspect is that now public banks have to follow the same regulations and are subject to the same supervisory procedures as private banks. This has shown significant improvement of internal controls in the remaining banks. As shown in the appendix B table 1, by the end of 2003, out of the 35 State Banks that existed in 199662 only 10 still remain. Out of these remaining ten, four are in the process of being privatized, 4 have been restructured and 2 opted out of PROES. Although PROES did not include loans and cash outlays and did not incur any fiscal liabilities like PROER, the cost ended up being considerably higher. The cost of PROES was on the interest paid on the bonds to the state that were swapped by Federal Government bonds63. As of August 2000 the face value of the bonds already issued considering interest income was R$ 92 billion, whereas the cost of PROER as reported by the Central Bank in 1999, was R$15.7 billion (US$7.8). The Central Bank showed that 53% of bonds SWAPS with PROES were issued to BANESPA (IMF 2001, 167-9). Although this was a very costly process for the Brazilian Government, it would had been far more expensive if the government had not intervened. If the financial sector had not been restructured there would had been a high potential for a systematic bank

62

The total number of financial institutions owned by the States government in 1996 including banks were 64. This number was reduced to 23 by the end of 2002 (Salviano, 2004, p.125). 63 Refer to appendix B table 3 to a list of the value of issued bonds for PROES restructuring per state from the beginning of PROES to 2002.

71

crises had brake out. If that had happened, not only depositors, investors and bankers would suffer, but the whole countrys economy would go down the drain as we have seen in other countries that were faced with similar problems(e.g. The Argentinean Crisis in 2001-2002)64. In a study done by Salviano (2004), the advantages and disadvantages of PROES are compared to the other potential choices that the government had at the time. This comparison leads to the conclusion that PROES was the best available option regarding the advantages and disadvantages of the different options it is compared to. The most negatively affected groups by the privatization were the privatized banks employees and large investors. The employees that did not loose their jobs had their incomes greatly reduced, since private banks paychecks were far less generous than the public banks ones. The large investors for the most part had political connections, which they used to obtain large loans at below the market interest rates. In addition, payments on these loans now had to be performed in a timely manner. The group to enjoy the most benefits from the privatization of the State Banks was the remainder of the society as a whole. Although most people did not realize it, the privatization of State Banks eliminated the largest drain on the Federal Government accounts and reduced its deficit, thus allowing the government to channel this money to improve the countrys infrastructure, health, education, etc. Unfortunately, the positive results from public banking sector restructuring do not solve the public finance problems and government deficits in Brazil permanently. The problems of public financing can be compared to a cold: You may treat it and get better;
64

For more information on how a banking crises can have a dramatic adverse impact on the economy in the absence of intervention, please refer to Friedman and Schawartz (1963).

72

however, if you do not take the necessary preventive measures, you just may catch it again.

V.

Conclusion

Was it necessary to differentiate between the problems between state banks and private banks? This paper analyzed the development and problems of both. It showed that private banks main problems were related to external shocks and after the Real Implementation, to the loss of inflationary revenues. On the other hand, although state banks suffered from the same problems as private banks, their biggest enemy was their respective state government; Thus the need to adopt different ways to solve these banks

73

problems. Private banks needed to be re-organized, whereas state banks needed to change their controllers. Although, the development of banks in Brazil was viewed as a beneficial process to the development and growth of the countrys financial system and the economy as a whole, it was not the case. As we discussed in this paper, corruption (especially at a political level) and the instability promoted by the hyperinflationary environment, are the main causes that led to banking problems. Initially, the instability problems created by inflation led the government to develop state banks to finance the countrys development. The use of state banks as financing tools based on political interest led to these banks deterioration. State governments abusively borrowed from their banks because they knew that if these banks became insolvent, they could always rely on the Central Bank to bail them out. On the other hand, since state banks knew that if they had financial difficulties their respective states would use their political power to rescue them, and thus they tended to engage in riskier activities than their private counterparts. Since state banks could resort to the government to take care of their financial problems, there was no incentive to properly manage them, thus they incurred high costs and were used as patronage tools. These problems were magnified with the implementation of the Real Stabilization plan. The many decades of poor management made it very hard for banks to implement the changes necessary for their survival in a low inflation environment, especially because the majority of these banks gains had come from inflation revenues.

74

The inefficiency of state banks and the drain they represented on the Federal Government made the drastic restructuring of the banking system, a necessity. The Federal Government developed measures and programs to take care of these banks problems. The most successful of these programs was PROES, which reduced significantly the role of government in banking. Although PROES was a financially costly process, the benefits enjoyed with the reduction of state bank participation in the financial system and the prevention of a systematic banking crises, far outweighed PROES financial costs. Having in view the fragility of banks in Brazil, if a banking crises had broken out, it would most likely affect the vast majority of the banks, especially the public ones. This would have been devastating for the economy, and the magnitude of the damage that this could had done could be compared to the recent banking crises of Argentina. In addition, despite the fact that many people were not in favor of government banks privatization, it was the vast majority of the population that gained the most with this process. These people will gain in the sense that now they will have banks operating like businesses, more effectively and efficiently. This will trigger competition, which in turn will lead to the advancement of the sector. In addition, people will benefit from having their government working on functions that are of the governments responsibility, such as education, health and infrastructure, rather than performing private sector duties, such as banking. Most of all, taxpayers money collected by the federal government can now be used toward services to improve the populations living conditions, rather than on bailing out banks.

75

Although the full restructuring of the banking sector is not complete, it has already produced important changes in the banking system. The restructuring of state banks followed by liquidation, transformation or privatization, and the entry of foreign competitors into the banking sector, has shown significant improvements in the efficiency of how they operate. These improvements have been extended to include the operation of the countrys private banks. Could the privatization process have been fairer for the Brazilian people? For the most part the process did not affect the majority of the population directly. However, the privatization could had possibly had been fairer in at least two different ways. First, the Federal Government could have taken action sooner. The problems with state banks were eminent for a while, however because of political pressure there was a delay in carrying on proper measures to address state banks situations. Secondly, the utilization of the countrys monetary reserves to rescue public banks should have been avoided. The monetary reserve fund should not had been used to bail out indebted banks. The Federal Government should have searched for alternatives to save these banks rather than draining the countries resources. Although, the process that shaped privatizations in Brazil may not have been the fairest to its citizens, it taught its regulators many lessons. Perhaps, without the lessons learned ,the system would not be where it is today, and quite possibly be in a much worse situation, had the initial privatization process been done otherwise. Thus the lessons learned from the hardships encountered may lead a path where banks are better equipped to handle the problems that they may encounter in the future.

76

Another issue of concern refers to how the entry of foreign banks in Brazil will affect the domestic market. Policy makers expect that foreign entrance in the banking sector will bring positive results to the domestic banking sector. The expected result is that the increase in competitiveness and the more advance technology of foreign banks will push domestic banks to be more efficient. However, there is a concern in part of the population that the drastic difference between domestic and foreign banks could make this competition unfair and that the national banks would be harmed for not being able to cope with such strong competitors. Studies have been conducted to assess the impact of foreign entry on the domestic market65. Although findings on the increase of domestic bank efficiency with foreign competition varied, there seems to exist a consensus among most authors is the fact that the entry of foreigners have not increased concentration in the banking sector or harmed domestic banks. Foreign entry in the Brazilian domestic market is a relatively recent phenomenon and thus the availability of data is limited. Having this in view, the impact of foreign banks in the domestic market is one question that we carry on without a satisfactory answer for the time being. The competitive dynamics of the substantial increase in foreign competition in the banking system will be more fully revealed with the passage of time.) Brazil has come a long way, and it has shown the willingness to commit to the privatization of its state banks; however, the restructuring of the banking sector cannot be complete until the federal banks issues are addressed. The future challenges to Brazil rest on using the experiences acquired with the financial systems privatization and use them to solve the Federal Banks situation.
65

Refer to articles on the Latin America Business Review, volume 3, no 4, which can be assessed at http://egade.sistema.itesm.mx/labr/index.html.

77

78

APPENDIX A
Bank Structure

Bank Structure The Brazilian financial system is constituted today of the Bank of Brazil, BNDES, National monetary Council (CMN), and Subdivisions of the CMN [Central Bank, CVM, SUSEP, SPC and financial institutions (public and private)]. 1.Bank of Brazil The first institution created was the Bank of Brazil, formerly known as Banco da Republica. The bank was created to carry out treasury agent duties. In the beginning of the 20th century, the bank was nationalized becoming a federal government bank. It had its name changed to Banco do Brazil as it is still known today. Bank of Brazil is the financial agent of the national treasury. Among its responsibilities are tax collection, government accounts depositor, policy lending for agriculture and external trade, etc. 2.BNDES 79

In 1950 the then called BNDE was created to administer national and international funds for industrialization. Its main function was to provide long term financing. Today the BNDES is the government agency encharged of privatization issues. 3.CMN In Brazil, the financial system is regulated by two federal agencies, the Brazilian Central Bank (BCB) and the Brazilian Securities Commission (CVM), both subordinate to the National Monetary Council (CMN). The CMN was created by the institutional reform according to law 4595 in 1964. The National Monetary Council (Conselho Monetrio Nacional) is responsible for the macro-stability of the financial system, through the monitoring of the set of policies that affect the system with respect to monetary, credit, exchange rate and public debt issues. It is integrated by the Ministers of State for Finance and for Planning, Budget and Management, as well as by the Governor of the Central Bank. The National Monetary Council is the entity of the financial system that has gone through the most structural changes since its creation in 1965. Today the decisions made by the CMN are done by the minister of finance (President), the minister of budget and planning and the president of the Central bank (Secretary). The objectives of CMN are to set monetary foreign exchange and credit policy. In addition the CMN is the primary regulator of all financial institutions services and activities. It is encharged of overseeing financial institutions liquidity and solvency, and help in their improvement. The CMN consists of its main office and four supervisory authorities-The Central Bank, CVM, SUSEP and SPC-, which help the CMN in regulating financial institutions: a. Central Bank Prior to the creation of the Central Bank, the entities charged with monetary regulation were the superintendence (SUMOC), the Bank of Brazil, and the National Treasury. Although improvements in the monetary control entities had been reached, some more changes were needed. The Central Bank was now the currency-issuing bank and carried out the functions of the government bank, however Bank of Brazil still had a strong voice on Central Banks actions. Besides, financial institutions deposits, were allowed to be held not only by the Central Bank but by the Bank of Brazil as well. In addition, the function of national treasury cashier still belonged to Bank of Brazil. In 1985 a financial reorganization that lasted three years started separating the activities and functions of the Central Bank, Bank of Brazil and National Treasury. After the implementation of 1988s constitution, the functions of monetary authority were transferred from Bank of Brazil to Central Bank, and activities such as economic incentives and administration of Federal Public debt were transferred to the National Treasury. In addition, a complimentary law dealing with the structure and activities of the Central Bank was issued. Today the Central Bank deals with the regulation and supervision of most financial activities. Its main responsibilities include currency issuance, the execution of monetary Policy, change in reserve requirements, supervision of financial institutions in the intermediation and clearing systems, and control of foreign capital flow and credit risk of the financial system. 80

The Director of Supervision and the Director of Regulations carry out the supervisory duties of the Central Bank. The Central Bank has to make sure that the current legislation and rules issued by the CMN are being followed. The Central Bank can apply penalties, authorize entry and exit of the financial market and establish prudential rules in general. Additionally, the Central Bank is authorized to intervene, take temporary control or liquidates a financial institution in order to protect the solvency of the national financial system. b.CVM (Securities and Exchange Commission) While it is the Central Banks responsibility to supervise institutions with funds containing assets that yield fixed returns (such as commercial and savings bank, mortgage companies, etc), the CVM is responsible for institutions whose funds contain assets that yield variable returns (for example: the stock market.). It also regulates, jointly with the Central Bank, commodities and futures exchanges, investment banks and funds, foreign investment portfolios, securities dealers and brokers. The Securities and Exchange Commission of Brazil (CVM) was created in 1976 under the law 6385. The main purpose of this institution is to supervise activities of all market participants in the Brazilian security and stock market. In order to help prevent insider trading and ensure that investors have adequate information on the market. It also implements regulation consistent with policy direction and decision of the CMN c.SUSEP and SPC SUSEP and SPC are mainly in charge of insurance companies and private pension funds.

81

APPENDIX B
Tables

82

Table 2 - Transformation and Status of State Banks STATE

Acre Alagoas Amapa Amazonas Bahia Ceara Distrito Federal Espirito Santo

INSTITUTION
BANACRE PRODUBAN BANAP BEA BANEB* DESEMBANCO BEC BRB BANESTES**

STATUS
Liquidated Liquidated Liquidated Federalized and Privatized Privatized Converted to a Development agency in 2001 Federalized, scheduled to be privatized Opted out of PROES Restructured, Intended for privatization

BUYER
n.a. n.a. n.a. BRADESCO BRADESCO n.a. n.a. n.a. n.a.

DATE
n.a. n.a. 1997 01/24/2002 06/22/1999 n.a. n.a. n.a. n.a.

PRICE+
n.a. n.a. n.a. 76,8 147 n.a. n.a. n.a. n.a.

83

Goias Maranhao Mato Grosso Mato Grosso do Sul Minas Gerais

BANDES BEG BEM*** BEMAT CREDIREAL BDMG BEMGE MINASCAIXA BANPARA PARAIBAN BANESTADO BANDEPE* BEP BANERJ BANDERN BDRN BANRISUL CEE-RS BERON RONDONPOUP BANER BESC BADESC BANESPA
NOSSA CAIXA/ NOSSO BANCO BANESE -

Opted out of PROES Federalized and Privatized Federalized and Privatized Liquidated Privatized Restructured, Kept by State Privatized Liquidated Restructured, Kept by State Opted out of PROES, Auctioned by State Government Privatized Privatized Federalized, intended for privatization Privatized Liquidated Liquidated Restructured, Kept by State Liquidated Liquidated Liquidated Liquidated Federalized; scheduled for privatization in2005 Converted to development agency Privatized

n.a. Itau BRADESCO BRADESCO and BCN n.a. Itau n.a. n.a. ABN/ Amro Itau ABN/ Amro n.a. Itau n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. Santander

n.a. 12/04/2001 02/10/2004 08/07/1997 n.a. 09/14/1998 n.a. n.a. 11/08/2001 10/17/2000 11/17/1998 n.a. 06/26/1997 n.a. n.a. n.a. n.a. n.a. n.a. 1999 n.a. n.a. 11/20/2000

n.a. 269,4 78.00 112 n.a. 494 n.a. n.a. 29 869 153 n.a. 289 n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. 3.604,3

Para Paraiba Parana Pernambuco Piaui Rio de Janeiro Rio Grande do Norte Rio Grande do Sul Rondonia Roraima Santa Catarina
Sao Paulo

Restructured, Kept by State

n.a.

n.a.

n.a. n.a. -

Restructured, Kept by State n.a. n.a. Sources: Folha de Sao Paulo, Jornal do Comercio, Correio Brasiliense, Oglobo, Jornal do Brasil and Banco Central
*

Sergipe Tocantins

The minimum auction price- almost twice the value of the banks liquid assets- established difficulted the privatization of these banks ** The government is trying to privatize BANESTES, but the bank is stalled in scandal *** This was the first privatization of a federal entity since Lula became president + Prices are denominated in US$ million. The data of the prices are from ppr 18 with the exception of BEM which was published on OGlobo newspaper.

84

Table 3: Value of Issued Bonds for PROES Restructuring per State (R$ millions)
State Acre Alagoas Amap Amazonas Bahia Date Value of Bond Total per state Value in US$ R$ US$ 29.03.99 131,07 74,27 74,27 457,00 45,00 24,85 4,00 312,55 51,10 53,27 164,53 1.433,06 117,98 11,62 20,58 2,00 172,61 26,47 29,27 108,82 1.240,42 129,60 22,58

16.10.02 16.10.02 29.12.98 24.02.99 02.08.99 25.08.99 06.09.00 01.06.98 25.06.98

228,36

85

Cear Esprito Santo Gois Maranho Mato Grosso

Minas Gerais

Par Paran

Pernambuco Piau Rio Grande do Norte Rio Grande do Sul Rondnia Roraima

Santa Catarina

So Paulo (1) Sergipe Total

03.10.01 27.05.99 25.11.98 27.05.99 20.06.00 04.10.00 15.12.98 13.01.99 22.01.99 15.06.98 16.06.98 24.06.98 02.07.98 06.08.98 19.08.98 04.05.00 22.01.99 05.03.99 16.06.99 01.12.99 15.12.99 15.08.98 27.08.98 24.02.00 06.09.00 18.03.99 22.12.99 10.12.98 05.07.00 20.05.98 18.02.99 29.03.99 05.05.99 07.08.00 30.08.00 01.03.02 26.03.02 06.09.02 26.09.02 26.09.02 09.10.02 10.10.02 23.12.97 24.12.97 18.01.99

113,41 984,72 260,36 476,21 60,00 65,14 29,82 302,14 193,11 336,38 616,12 2.280,38 329,45 172,06 902,84 59,96 127,41 2.687,36 136,75 735,01 1.638,51 328,66 915,74 69,08 76,80 100,94 4,00 2.379,88 176,27 549,20 39,98 197,76 68,48 779,97 0,02 89,62 28,20 62,80 20,49 349,99 357,82 41,59 33.578,50 2.548,00 40,98 57.998,34

41,57 574,88 217,44 278,01 33,36 35,17 24,76 229,15 113,32 291,41 533,85 1.974,18 284,89 147,40 769,42 33,06 74,77 1.348,67 77,40 382,56 886,02 284,78 779,68 38,87 42,20 54,30 2,20 1.978,95 97,72 478,36 21,02 112,06 40,67 434,45 0,01 37,99 12,00 19,64 5,46 93,31 92,91 10,60 30.136,87 2.286,84 26,65 47.242,92

1.390,81 574,88 217,44

346,55 253,91 113,32

4.034,23 74,77

2.694,65 1.064,46 81,07 56,50 2.076,66 478,36 21,02

859,12 32.423,71 26,65 47.242,91

86

1 values financed out of PROES.

Rio de Janeiro (2) 15.07.98 2 There was no bond issuance.

3.879,68

3.493,00

3.493,00

87

APPENDIX C
Regulations66

1. Regulations Law 6024 (March 1974) The purpose of this law is to discipline interventions and the extra-judicial liquidation of financial institutions, and to take other measures. For more information on the Intervention and its process under this law please refer to the following website: http://www.bcb.gov.br/ingles/6024Eng.shtm Decree-law 2321 RAET (February, 1987)

On February of 1987 the decree-law 2321 was edited creating a Special Temporary
66

All of the regulations on this appendix were obtained at the Brazilian government homepage at www.fazenda.gov.br.

88

Administration Regime (RAET). This law was edited to allow for more flexibility in the intervention of official state banks and to correct the problems with law 1342. Under this legal provision, private and non-federal public financial institutions could be made subject to certain procedures known as special regimes (RAET). The Banco Central do Brasil may decree a temporary special administration regime, if financial institutions: (a) Repeatedly practice business contrary to the economic or financial policy guidelines established by federal law; (b) Show existence of uncovered liabilities; or (c) Do not comply with the rules on Bank Reserve accounts or display negligent or fraudulent management by its officers. The Banco Central do Brasil maycould use any of the three following options to intervene in the financial institution: (a) authorize the transformation, merger, consolidation, spin-off or the transfer of the shareholding control of the institution in view of the guarantee conditions presented by the interested parties; (b) propose the expropriation, by necessity or in the public or social interest, of the shares of the institution's capital stock; (c) decree the extrajudicial liquidation of the institution. The duration of special administration is established in the act that decrees it. However, in practice RAET has been applied for a period of 6 months. RAET may be extended if absolutely necessary for a period which shall be no longer than the first. If within one year from the time bank was first intervened, it has not returned to its normal activities, it goes into extra-judicial liquidation. Once the extrajudicial liquidation of the institution has ocurred, for all intents and purposes, including for determination of the liability of the ex-officers, the date when the temporary special administration regime was decreed shall be used as the base date. The decreeing of temporary special administration shall not affect the ordinary course of business of the entity nor its normal operations, and it shall immediately produce loss of office of the managers and the members of the Audit Committee of the institution. Once the temporary special administration regime has been decreed, the persons or legal entities having a control relationship with the institution shall assume joint liability with its ex-managers for the obligations assumed by the institution, whether or not fraud or negligence has been established. Temporary special administration shall be carried out by a Directors Council appointed by the Banco Central do Brasil, with full management powers, to be composed of as many members as shall be deemed necessary to conduct the business of the institution. The Directors Council shall render account to the Banco Central do Brasil, regardless of any requirements, immediately when the special regime ceases, or at any time, upon request. The Banco Central do Brasil may designate legal entities specialized in the area to carry out the temporary special administration hereunder. Once the regime hereunder has been decreed, the Banco Central do Brasil is hereby authorized to use Monetary Reserve funds to remedy the economic financial condition of the institution. The amounts drawn from the Monetary Reserve account shall be used to pay obligations of the institutions which are subject to the regime hereunder, by assignment and transfer of the corresponding credits, rights and shares, to be made by the respective 89

holders to the Banco Central do Brasil, and shall be guaranteed in accordance with the agreement to be executed with the beneficiary institution. RAET is terminated in case that: (a) the Federative Republic of Brasil assumes the shareholding control of the institution; (b) the institution goes through transformation, merger, consolidation, spin-off or transfer of the shareholding control; (c) the institution's situation has been normalized (subject to the discretion of the Banco Central do Brasil); or (d) the institution is extrajudicially liquidated. Although the RAET system was created to help both public and private banks, it was used more frequently to help State banks. The reason is that the application of RAET is costly for the Central Bank, which has to assume troubled banks liabilities. 1988 Constitution

In 1988 the National Congress wrote a new constitution. The 1988 Constitution, transferred the functions of monetary authority from the Bank of Brazil to the Central Bank and the functions related to economic incentives and the administration of the federal public debt were transferred from the Central Bank to the National Treasury. The 1988 Constitution prohibited to direct or indirect granting of loans to the National Treasury. It was on article 192 of this constitution that Acts relevant to the National Financial System were enacted. This article authorized financial institutions to access all the instruments of the banking financial market. A fund or insurance was created, for the purpose of protecting the public economy, guaranteeing credits, investments, and deposits up to a pre-established value. To make it clear that public resources should not be used to restructure financial institutions a clause prohibiting the use of federal funds was included. Although on article 52 of this very same constitution it is stated that new foreign banks are not allowed to come to the country, this article was contradicted on article 192 which reads the following on the same issue: the participation of foreign capital in financial institutions are conditional to national interests, and/or international agreements. Extreme controls were imposed to discipline the states. To reduce spending, the assets in both private and public accounts were frozen, and states were required to repay a portion of their loans and accumulated interest annually. Real interest rates, including commission and any other consideration directly or indirectly related to the extension of credit, shall not exceed twelve percent per annum; interest charged above this limit shall be considered as a usury crime and shall be punished in all of its forms as the law shall determine. Resolution 155 (March, 1990)

In March of 1990 resolution 155 was passed. It had the legal bases of PND. With the creation of PND, privatization became part of the economic reforms initiated by the government. The magnitude of privatization was significantly increased. In 1995 the PND was expanded with the creation of the National Dezestatization Council (CND). The CND is the highest decision making organization of the PND and it is directly controlled by the President. 90

Today the PND is constituted of the CND and the BNDES (which is the manager of the National Privatization Fund (FND).) The FND is the institution in which the shares of the company to be privatized are deposited. The Responsibility of the BNDES as the administrator of the FND are to manage, monitor and carry out the sale of companies included in the PND. In 1995, the CND substituted the privatization commission with similar functions. This speeded up privatization, because it was carried out directly through its relevant ministries. - MEASURES IMPLEMENTED AFTER THE REAL PLAN: Provisional Measure 1179

This provisional measure created fiscal incentives for merger of financial institutions allowing for the purchaser to account as losses the credits of difficult retrieval. Provisional Measure 1182/ Law 9447

The Provisional Measure 1182 allowed the monetary authority to demand the institutions with liquidity problems to have its shareholding control transferred or to have its executive board reorganized through a merger or acquisition. Later in March of 1997 this Provisional Measure was established as law 9447, which gave the CB the right to expropriate the shares of the controlling shareholders and sell then in an IPO if the Central Banks directions were not followed by the troubled banks executive board. Resolution 2208/ Law 9710 (March, 1995) Program of Incentives to the Restructuring and Strengthening of the National Financial System (Proer) The program is designed to ensure National Financial System liquidity and solvency while safeguarding the interests of depositors and investors by stimulating administrative, operational and stockholding reorganizations previously authorized by Banco Central and that result in transfers of stock control or alterations of the corporate objectives of the institution in question. The Program also encompasses the financing of operations involving federal government liabilities, losses generated by reorganization processes, including those consequent upon demobilization of assets belonging to the participating financial institutions. It also permits release of funding from obligatory reserves on demand deposits for purposes of acquisition of CDB from institutions participating in the program, a more flexible approach to compliance with the operational limits applicable to financial institutions and deferral of outlays consequent upon ongoing processes of restructuring and reorganization. Law 9,447, dated 3.14.1997, determines that the controllers of institutions subjected to the administrative systems specified in Law 6,024, dated 3.13.1974, and Decree Law 2,321, dated 2.25.1987, bear individual and joint liability previously restricted only to those currently charged with administration 91

of the institution and, within 12 months, to the institutions former administrators. The aforementioned law also deals with the inalienability of their properties; the liability of accounting companies and of independent auditors; privatization of institutions following expropriation of their stock, according to the terms of Decree Law 2,321/1987, and takes other measures. It was expected that the program would increase potential buyers interest in banking privatization, which had been severely diminished because of corruption that affected the banking sectors credibility as a whole. The PROER worked as a credit line program that provided a special Central Bank credit line to banks in need of liquidity and or funds for restructuring. It provided tax dispensation subsidies to encourage mergers and acquisitions to reduce the number of institutions. Institutions interested in acquiring troubled banks had to seek Central Banks approval. In addition, they had to be able to retire all merger costs in 5 years and assume all liabilities of the troubled bank. Successful purchasers would then receive preferential credit lines at below market interest rates to acquire the new bank. A condition for the loan was that the bank pledged collateral, such as real state, valued at 120% of the loan. The Acquiring Bank was able to write off the non-performing loans of their acquisition at 30% of their face value. In addition the buyer was allowed to absorb the financial losses of the acquired bank on its balance sheet through tax write offs. Also, merged banks were allowed to maintain only 8 % of total capital in reserve (significantly inferior to the original 32%) (McQuery, 37). Access to PROER credit lines was given upon the authorization of the Central Bank, which demanded change of bank ownership as a minimum pre requisite. Also, authorization by Central Bank, to access PROER was granted only to selected types of Financial Institutions. PROER was implemented through administrative, operational and corporate reorganization resulting in the transfer of shareholding control of private financial institutions. The sanction applied was that shareholding control of the troubled bank was transferred to new reputable owners, thus reducing the risk of a moral hazard from bailout operations. For new financial institutions, the government increased minimum capital requirements as a way to encourage merges and acquisitions that were expected to strengthen existing institutions. Other Central Bank regulations were enacted to insure that shareholders of institutions that were sold or transferred were still liable for previous wrong-doings thus assuring accountability, and preventing any potential bailouts. Among these regulations was the capability of the Central Bank to restructure problematic financial institutions. The PROER comprises two general models. The first model is for medium size banks, in which case, the problematic bank is taken over by another bank. A line of credit is made available to the buyer with the maturity of up to five years. This line of credit is usually used by the buyer as a cushion for potential withdrawals and to replace banks impaired assets. In the case of a larger bank there are a few extra measures before the bank is taken over. First the troubled bank is divided in two parts: troubled bank good assets and deposits are put on one side (which we shall call it part one for the sake of this 92

discussion) and on the other side the remaining troubled bank assets and liabilities (which we shall call it part two). The PROER operation in this case is used to close the troubled banks asset gap (deposits minus selected assets) to redress the balance sheet of part one of the troubled bank. The Central Bank then selects a liquidator who will dispose all the troubled banks impaired assets and liquidate part two of the troubled bank. The managers and majority shareholders of the troubled bank are dispossessed, may be prosecuted and are prevented from selling any property they hold, pending final resolution. The Central Banks issuing claim on part two of the troubled bank is collateralized by federal debt instruments whose face value must exceed 20 percent the amount of PROER finance. Financial charges correspond to a spread of two percent over the remuneration of collateral provided (Maia,113-4). Resolutions 2,217/1995 and 2,218/1995 Program of Support to the Restructuring and Fiscal Adjustment of the States (Parafe) This Program makes it possible to implement measures that will aid the states in achieving sustainable budget equilibrium. The federal governments strategy is to impose conditioning factors in the form of fiscal equilibrium targets, in exchange for financial assistance to the states provided through the opening of credit lines. The aforementioned conditioning factors encompass: a) control of reductions in personnel expenditures; b) adherence to programs involving privatizations, concessions of public services, asset reform and control over state enterprises, through agreements formalized with the National Bank of Economic and Social Development (BNDES) and the ministries responsible for the services to be assigned to other entities; c) increased revenues, modernization and improvement of collection systems, spending controls and generation of fiscal information; d) utilizing primary equilibrium as the reference base, commitment to a minimum fiscal result; e) reduction and control of state government indebtedness, making use of the instrument of internally generated assistance which grants the National Treasury power to retain part of the transfers due to the states to cover financial commitments assumed at the time of the renegotiation of their financial liabilities and to impose restrictions on new operations based on Anticipated Budget Revenues (ARO). Resolutions 2,214, dated 11.29.1995 Export Financing Program (Proex) Proex succeeded Export Financing Fund (Finex) and has the objective of operating in the financing of exports of goods and services, as well as providing financial assistance through interest rate equalization operations with the purpose of facilitating placement of Brazilian products on the foreign market, principally involving capital goods. Proex financial assistance consists of: a) discounting of securities, in cases involving exports of goods; 93

b) discounting of securities, in cases involving exports of services to foreign public sector entities; c) financing, in cases involving exports of services to foreign public sector entities. Resolution 2197 (August 31, 1995) The National Monetary Council's Resolution 2197of August 31, 1995 authorized the "setting of a private non-profit organization to control the protection of credit holders against financial institutions". The financial institutions which receive demand, time and savings deposits, and the savings and loans associations must be associates of the institution and participate as contributors. However, Credit cooperatives and credit departments of cooperatives are not subject to the disposition in the previous paragraph. For more information on this resolution refer to the following website: http://www.fgc.org.br/novo/ingles/legislacao/resolucoes/resolucao_2197.htm Resolution 2211 (November 16, 1995) In November 1995, the Statutes and Regulations of the new organization were approved and Resolution 2211 of November 16, 1995 establishes Fundo Garantidor de Crditos - FGC, introducing the deposit guarantee system in Brazil. Fundo Garantidor de Crditos - FGC is a nonprofit civil association, established as a private legal entity, regulated by the legal and regulamentory dispositions applicable. The purpose of FGC is to guarantee credits held against participating institutions in cases of: adjudication of the institution's intervention, extrajudicial winding-up or bankruptcy; recognition by the Central Bank of Brazil (BACEN) of the state of insolvency of the institution, which in conformity with effective legislation is not subject to the regimes referred in item I. FGC will have its head office in the city of So Paulo (SP) and is under the jurisdiction of the So Paulo courts. The duration of FGC is indeterminate. The credits guaranteed by FGC are: a. b. c. d. e. f. demand deposits or deposits which can be drawn on prior notice; savings deposits; time deposits with or without the issue of a certificate; bills of exchange; real estate bills; mortgage bills.

The total credits owned by each party against the same institution or against all the institutions of the same financial conglomerate shall be guaranteed up to the amount of twenty thousand reais (R$ 20,000.00).

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The costs of the guarantee to be provided by FGC shall be funded with resources arising from: a. b. members' ordinary contributions; service fees arising from the issue of bounced checks;

c. recovery of credit rights purchased in which the FGC is subrogated in view of the payment of indemnities to creditors covered by the guarantee; d. recovery of credit rights purchased in which the FGC is subrogated in view of the payment of indemnities to creditors covered by the guarantee; e. net results of services provided by the FGC and profits from the investment of its resources. Members' responsibility is limited to the contributions for which they are liable to support the costs of guarantee. If the FGC equity is insufficient at any time to cover the maximum guarantee prescribed by article 4.o of the respective Regulations, resources from the following sources will be used in the following order: a. b. extraordinary contributions of associates, as prescribed by article 17, item I; advances by associates of up to twelve (12) ordinary monthly contributions;

c. advances of net resources in cash from the Monetary Reserve as addressed in Law 5143, of 8.20.1974, through previous authorization of the National Monetary Council ; d. other sources, through previous understanding between the Central Bank of Brazil and the FGC administrators. The associates of FGC are the financial institutions and the savings and loans associations currently operating in the country, which: receive, demand, time and savings deposits; accept bills of exchange; and finance funding by issuing mortgage bills and mortgage bonds. FGC will be administrated by the Board of Directors, consisting of 3 (three) to 9 (nine) effective members and an equal number of alternate members, all Brazilian residents, appointed by the National Confederation of Financial Institutions - CNF, including for the position of Chairman of the Board. The term of office of Board members shall be of three (3) years reappointment being admitted. The Board of Directors has the obligation to fix the conditions of extraordinary contributions that associates must make to fund the guarantee to be provided by FGC.

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FGC is forbidden FGC to invest resources to purchase real estate, except when received in settlement of credits in the name of the institution, after which they must be dispose of. FGC can be liquidated either in cases where legislation enforce is applicable or by determination of the National Monetary Council, after the General Meeting has deliberated and being the Board of Directors responsible for the appointment of the liquidator after having consulted with the Central Bank of Brazil. http://www.fgc.org.br/novo/ingles/legislacao/estatuto_social/estatuto_pg3.htm Resolution 3024 (October 2002) In October 2002, Resolution 3024 amends the Regulations and Statutes of the FGC. Article 1 - To amend and consolidate, in the wording of Attachments I and II to this Resolution, the rules of the Statutes and Regulations of the Fundo Garantidor de Crditos - FGC. Article 2 - To fix the monthly contribution of FGC participants at 0.025% of the balances of the accounts corresponding to the obligations which are guaranteed. Paragraph 1 - The monthly average of the daily balance of the accounts covered should be used to calculate the amount of the contribution established by this article. Paragraph 2 - The value of the contribution should be calculated and passed on to the associated institutions by the 25th day of each month. Paragraph 3 - The value of the fee should be paid to the FGC on the first working day of the month following the one mentioned in the previous paragraph. Paragraph 4 - A penalty of 2 % (two percent) over the value of the fee, plus monetary indexation at published Selic rates, will be charged in case of delay in the payment of the aforementioned fee. Article 3 - Amends chapter IV of the Regulations attached to Resolution 1631, of 8.24.1989 with the wording given in Resolution 2211, of 11.16.1995, now effective with the following wording: http://www.fgc.org.br/novo/ingles/legislacao/resolucoes/resolucao_3024.htm Exposicao de motivos 311 (August, 1995) The Legislative intent of Exposicao de motives 311 of 23/8/95, allowed the President to authorise on a case-by-case basis the entrance of 96

foreign banks into Brazil. On that occasion, the Brazilian government announced that foreign banks would not be allowed to open new branches or acquire smaller banks unless they purchased one of the troubled banks. The norm establishes that the entrance of foreign banks interests the country, and emphasises the following favourable aspects: (i) improvement in operational efficiency of the banking sector with positive effects on bank intermediation; (ii) increase in banking competition would cause a reduction in the spreads and banking fees, with positive impacts on the loans rate of interest; (iii) diversification and improvement of the supply of financial services with lowest costs; (iv) introduction of new management technologies and innovations in products and services. Provisional Measure 1334 (March 1996)

This provisional measure made audit companies and independent accounting auditors responsible for any irregularity in the financial institution. The Provisional Measure forced external auditors to inform the Central Bank of any difficulties of the institution.

Resolution 2303 (July1996) This Resolution allowed financial institutions to charge tariffs for banks services.

Provisional Measures 1,514 and Resolution 2,365 2.28.1997 Program of Incentives to the Reduction of the State Public Sector in Banking Activities (Proes) Creates conditions for reducing the presence of the state government public sector in bank-related financial activities by transforming and/or privatizing government banks; issues regulations covering mechanisms that make it possible to enhance banking supervision, principally by making accounting auditors and independent auditors jointly liable; stimulates reorganization measures aimed at reducing overbanking situations (excess number of banks) as well as overbranched banks (excess number of bank branches) and cutting personnel outlays, at the same time in which it deals with the extrajudicial liquidation of institutions found to be in situations of grave irregularities. Resolution 2390 (May, 1997)

In May of 1997, the CNM created a credit risk central system through Resolution 2390. The measure provisions are that financial institutions have to inform the Central Bank about the clients that have the value of their debt over R$50,000. The list with the 97

information of these clients is made available to other banks (note that this is authorized by the client that signs a waiver). Resolution 2399 (June, 1997)

This Resolution was implemented in order to change the value of the minimum capital requirements that institutions are required to have in the bank Decree 2,258 (June, 1997) Program of Reorganization of Decentralized Federal Government Units Foster improvement in services rendered, strengthening of end activities and optimization of the resources allocated to civilian units of the direct federal public administration. The Program will be implemented through specific projects developed on the basis of the local characteristics of each state. These activities should comply with the following guidelines: a) restructuring of organizational units targeted at executing administrative support activities, giving priority to the sharing of human, material and equity resources; b) reevaluation of structures responsible for end activities that are not the sole responsibility of the federal government; c) gradualism in the implementation of any measures that could impact the continuity of services; d) incentives to the constant participation of users in the evaluation of the administrative support services rendered in a decentralized manner; e) professionalization of the management of the units rendering administrative support services; f) utilization of mechanisms designed to redistribute personnel and reallocate material and equity resources among different entities, with the aim of providing for shortcomings and ensuring enhanced efficiency in the distribution of resources; g) gradual absorption and unification of the management of administrative support services by the Ministry of Federal Administration and State Reform. Law 9,491 (September,1997) and Decree 2,594 (May, 1998). National Privatization Program (PND) Restructure the strategic position of the State in the economy by transferring activities unduly operated by the public sector to private initiative; contribute to the economic restructuring of the public sector, particularly through improvements in its profile and reductions in the net public debt; make it possible to recover the flow of investments into companies and activities that may come to be transferred to private initiative; contribute to the economic restructuring of the private sector, particularly to the modernization of the nations infrastructure and industrial base, enhancing its competitiveness and strengthening business capacity in diverse sectors of the economy, 98

including the granting of credit to such sectors; make it possible for the public administration to concentrate its attention on activities in which the presence of the state is of fundamental importance to achieving national priorities; contribute to the strengthening of the capital market by increasing the supply of monetary instruments and democratizing proprietorship of the capital of the companies encompassed by the Program. The following may be included in the privatization process: a) companies, including financial institutions that are directly or indirectly controlled by the federal government and have been instituted by law or by an act of the executive branch; b) companies created by the private sector and that, for any reason whatsoever, have been transferred to the direct or indirect control of the government; c) public services included in concessions, permissions or authorizations; d) state public financial institutions when the shares of the institutions capital stock have been expropriated; e) direct and indirect minority government participation in the capital stock of any other corporate entities; f) stockholdings of the government in excess of the minimum amount required to maintain control of Petrleo Brasileiro S.A. (Petrobras). The following are excluded from the National Privatization Program: a) public companies or joint capital corporations that perform activities that are the exclusive responsibility of the federal government, as specified in indents XI and XXIII of article 21, line c of indent I of art. 159 and art. 177 of the Constitution; b) Banco do Brasil and the CEF. (converted into Law 10,219, dated 4.11.2001). Provisional Measure 1,923 (June, 1999) and Decree 3,431 (April, 2000) Fiscal Recovery Program (Refis) The purpose underlying Refis is to foster normalization of federal government credits generated by corporate debts involving taxes and contributions administered by the Secretariat of Federal Revenue and the INSS, when such debts were generated prior to October 31, 1999, independently of whether they have or have not been registered under debts subject to judicial execution, have or have not already been judged by the courts or are scheduled to be judged, have or have not been suspended or are a result of a failure to deposit specific amounts withheld. Refis does not encompass debts: a) of directly administered public sector entities, including foundations instituted and maintained by the public sector and their respective semi-autonomous entities; b) involving the Rural Land Tax (ITR); c) involving legal entities that have been split since October 1, 1999. The corporate entity in question must opt to be admitted to Refis and will be entitled to a special system of consolidation of the aforementioned fiscal debts and will be permitted to effect payment on an installment basis. The option should be formalized 99

by the final business day of the second month subsequent to the issue of Program regulations. The debts existent in the name of the party opting for the Program will be consolidated on the date on which the request for admission to Refis is duly formalized. The consolidation will encompass all debt existent in the name of the corporate entity, both as taxpayer and as party responsible for payment, independently of whether such debts have or have not been duly constituted and will include such additional amounts as fines, arrears and other levies, interest or arrears and other charges specified according to the terms of current legislation at the time in which the facts generating such debts occurred. The consolidated debt: a) will, as of the date of consolidation, be subject to interest corresponding to the monthly change in the value of the Long- Term Interest Rate (TJLP) and no other additional levies will be permitted; b) will be paid in monthly and consecutive installments to mature on the final business day of each month and the value of each installment will be defined on the basis of a percentage of gross revenues in the immediately previous month, calculated according to the terms of Law 8,981, dated 1.20.1995. The option for Refis subjects the corporate entity to: a) irrevocable confession of the debts referred to above; b) authorization of unrestricted access on the part of the Secretariat of Federal Revenue to information concerning the entitys financial operations as of the date of option for Refis; c) specific fiscal monitoring, with the periodic supply of data by magnetic means, including revenue-related information; d) full and irrevocable acceptance of all of the established conditions; e) regular compliance with the liabilities generated by the FGTS and ITR; f) regular payment of the installments of the consolidated debt, as well as of taxes and contributions consequent upon generating facts that occurred subsequent to 10.31.1999. Provisional Measure 2,155 (June, 2001). Program for Strengthening Financial Institutions (Proef) Proef has the objective of fostering a wide-ranging restructuring of federal banks Banco do Brasil S.A. (BB), Banco do Nordeste S.A. (BNB), Banco da Amaznia S.A. (Basa) and Caixa Econmica Federal (CEF) with the aim of enhancing the transparency of these institutions accounts. With this, many of the operations carried out by these banks will now be explicitly stated in the Federal Government Budget. The principal measures adopted by MP-2,155/2001 were as follows: a) in operations originating in rural credits in which maturities have been lengthened or renegotiated by BB, Basa and BNB according to the terms of Law 9,138, dated 11.29.1995, authorizes the federal government: a.1) to dispense with the guaranties granted by the aforementioned financial institutions in operations assigned to the federal government; a.2) to acquire credits consequent upon operations formalized with Worker Support Fund (FAT) resources or other resources managed by the BNDES System in operations with companies that are part of that System; 100

a.3) to receive credits against borrowers corresponding to the operations referred to in item a.2 in the form of payment in kind; a.4) to acquire credits corresponding to the operations formalized with resources from the financial institutions cited; a.5) to receive the credits corresponding to operations formalized with National Treasury resources in the form of payment in kind.

OTHER PLANS AND PROGRAMS: Immediate Action Program (PAI) (June 1994) Principal measures: a) revision of 1993 budget law with spending cuts of US$6 billion; b) increase in public sector revenues, not only through adoption of such transitory solutions as creation of the Provisional Tax on Financial Transactions (IPMF), but also through improvements in the instruments used in tax inspection activities and combating tax evasion; c) normalization of the payments made by state and municipal treasuries on their debts with the federal government in an overall amount equivalent to approximately US$40 billion; d) strengthening of the instruments of control and inspection of state banks with the objective of not allowing them to operate as financing agents of their respective treasuries; e) extension of the provisions of the so-called white collar law to the government financial system, subjecting managers of financial institutions who grant loans to their own controlling stock holders or to companies controlled by them to imprisonment for periods from two to six years; f) reorganization of federal banks by redefining their roles, with the purpose of eliminated duplicate activities and predatory reciprocal competition, streamlining their structures, while also granting Banco Central greater autonomy to control and inspect the activities of these institutions; g) accelerate and expand the scope of the National Privatization Program (PND), in order to give continuity to the process of redefining the role of the State and resolving the question of public sector financial imbalances. Macroeconomic Stability Program 1999/2001

Principal measures: Announced in October 1998, the Macroeconomic Stability Program was based on three fundamental pillars: deepening of the fiscal consolidation program Fiscal Stability Program, adoption of a monetary policy based on inflation targets and additional achievements in the structural transformation of the economy. In terms of structural policy, the Programs objective was to intensify progress in the following areas: approval of the Fiscal Responsibility Act (LRF), expansion of the privatization 101

program, consolidation of legislation related to implementation of the social security reform, as well as to private pension funds, and approval of the tax reform aimed at streamlining the inefficient system of indirect taxation. The Macroeconomic Stability Program was created with the aim of reversing the trajectory of public accounts. In its first version, the target was to obtain primary surpluses (consolidation of the three levels of government) corresponding to 2.6% of Gross Domestic Product (GDP) in 1999, 2.8% in 2000 and 3% in 2001. Achievement of these targets would require the government to make a significant fiscal efforts, combined with cutbacks in spending and growth in revenues, in such a way as to generate additional resources totaling R$28 billion in 1999, R$33 billion in 2000 and R$39.4 billion in 2001. To a more in depth discussion of the activities performed with the aim of implementing this fiscal effort refer to the following website: www.bcb.gov.br/ingles/FinPub/cap1i.pdf Program of Improvement in Banco Central do Brasil National Financial System Intervention Instruments (Proat) This Program is a component of the State modernization effort undertaken by the Brazilian government. Implementation is based on funding provided by Banco Central through a technical cooperation agreement with the World Bank. The fundamental objective is to improve the instruments utilized by Banco Central do Brasil to supervise the National Financial System (SFN). The Program was conceived on the basis of the evident need to accelerate modernization of bank supervisory procedures, update technological and information resources and permanently train Banco Central personnel. The components of the Program are as follows: a) improvements in banking supervision; b) training of all Banco Central personnel; c) studies aimed at developing a strategic vision of the future of the SFN; d) study of alternative solutions to the question of the assets of financial institutions being liquidated by Banco Central. e) Annual Plan of Action. To a more in depth discussion of this topic refer to the following website: www.bcb.gov.br/ingles/FinPub/cap1i.pdf REFERENCES Abreu, Marcelo, and Dorte Verner (1997) Long Term Brazilian Economic Growth: 1930-1994 Development of the Organization for Economic Cooperation and Development: Paris.

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Arraes, Maria Celina B.(2000). In Reform of Latin American Banking Systems The Structure of Banking System: case studies. edited by Ernesto Aguirre and Joseph Norton. London: Kluwer Law International ltda. 29-44 Baer, Werner and Wader Nazmi. (2003) Privatization and Restructuring of Banks in Brazil. Quarterly Review of Economics and Finance: 40 (Spring): 3-24. Banco Central do Brasil (BCB). Empresas Sob Regime Especial Apos o Plano Real: Regimes Especiais Apos o Plano Real (01.07.94) Por Tipo de Empresa. <http://www.bcb.gov.br/htms/deres/preal/prealtpe.htm> ____________________(BCB). Evolucao do Sistema Financeiro Nacional Relatorio Especial, Brasilia, BR. December 1998- December 2000. < http://www.bcb.gov.br/htms/Deorf/e88-2000/texto.asp?idpai=relsfn19882000> ____________________(BCB). Evolution of National Financial System Semestral Report of December/1998.<http://www4bcb.gov.br/deorfi/r199812/Anex35.htm> ____________________(BCB). Evolution of National Financial System Semestral Report of June - 1999 <http://www4bcb.gov.br/deorfi/r199912/Anex23.htm> ____________________(BCB). Evolution of National Financial System Semestral Report, December 1999 . ____________________(BCB). Evolution of National Financial System Semestral Report, December 2000 . ____________________(BCB). Evolution of National Financial System Semestral Report, December 2001 . ____________________(BCB). Annual Report 1999: Monitoring the National Financial System. Brasilia, BR. ____________________(BCB). PROER Program of Incentives to the Restructuring and Strengthening of the National Financial System. <http://www.bcb.gov.br/ingles/himf1602.shtm> ____________________(BCB). Bank Supervision in Brazil. Brasilia, BR, undated. ____________________(BCB). Consolidating Stablity and Structural Reforms. ____________________(BCB). Focus. October 9, 2000. Brasilia, BR. 103

____________________(BCB). Focus. November 21, 2000. Brasilia, BR. ____________________(BCB). Programa de Reducao da Participacao do Setor Publico Estadual na Atividade Bancaria Os Bancos Estaduais e o PROER. Brasilia, BR. Mimeo, January 1999. ____________________(BCB). PROER Program of Incentives to the Restructuring and Strehgthening of the National Financial System. Brasilia, BR. http://www.bcb.gov.br/ingles/himf1602.shtm ____________________(BCB). Recent Developments in the Brazilian Supervisory Framework Consolidated Supervision in Brazil. By Carlos Eduardo de Freitas, Deputy Governor. Brasilia, BR. Banco Nacional de Desenvolvimento Economico e Social (BNDES). 2001. Resultados do PND. www.bndes.gov.br/pndnew/period.htm (Feb 14) _______________ (BNDES). PND: Historico do programa www.bndes.gov.br/privatizacao/resultados/historico/history.asp _______________ (BNDES). Privatizacoes Estaduais <www.bndes.gov.br/privatizacao/resultados/estaduais /estadual.asp> _______________ (BNDES). Privatizacoes Federais <www.bndes.gov.br/privatizacao/resultados/federais /federal.asp> _______________ (BNDES). Resultados por Empresa www.bndes.gov.br/privatizacao/resultados/federais/pnd/compriv.asp _______________ (BNDES). Resultados por Gerais <www.bndes.gov.br/privatizacao/resultados/already.asp> ______________ _ (BNDES).ResultadosSetoriais www.bndes.gov.br/privatizacao/resultados/federais/pnd/sector.asp Barbosa, Fabio O. (1999) Capital Markets and Deficit Financiang in Brazil Fiscal Conference presented by the Latin American Research Group. Beck, Thorsten ; Juan Miguel Crivalli and William Summerhill (2003) State Bank Transformation in Brazil Choices and Conseqences. The World Bank Publication.

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