At What Height Does A Seawall Protect From A Tsunami?

Brazilian bank analysts are trying to convince you that their country is not experiencing a consumer credit bubble. They see the possibility of a full-blown crisis as remote.  However, the very statistics they cite -high bank reserves- make us worry.  Banks may be beefing up their reserves because they fear high levels of non-performing loans (NPLs) from consumer debt.  We are particularly concerned about the vulnerability of non-bank financial institutions.

Please note, I did not say that Brazil is going to have a credit crisis.  However, Brazil is experiencing a serious consumer credit bubble.  Outstanding balances for consumer credit in Brazil have grown at very high rates over the past year.   Analysts estimate that the average Brazilian is now paying 25% of income to service his debt compared to 16% in the United States (Financial Times).  The percentage of consumer NPLs relative to the entire portfolio continues to grow nearly vertically.

Brazilian analysts stress the protective power of reserves.  They point out that the Central Bank of Brazil demands that Brazilian Banks hold a minimum of 11% in reserves versus 8% for the rest of the world.  On the other hand, foreign newspapers such the Financial Times have been calling attention to the growing imbalances in the Brazilian economy and raising the possibility of an economic crisis.  The growth of consumer credit in Brazil is one of the indicators that they cite frequently.

The biggest banks are maintaining Basil Indices well above the Central Bank of Brazil target.  On Wednesday, August 17th, the Brazilian Federation of Banks (Febraban) reported that the large banks have significantly increased their reserves beyond the Central Bank target. Santander maintains the highest Basil Index at 21.4%.  Itaú Unibanc’s index is 16.1%, Bradesco 14.7%, and Caixa Econômica Federal 14.6%, and Banco do Brasil 14.4%.

Febraban also reported that banks currently provision on average 170% of problem credits on their books – more than in 2008.  The Brazilian newspapers focused on the extreme level of provisions by the largest banks: Banco Santander is provisioning 143%, Bradesco 189%, Banco do Brasil 226% and Caixa Econômica Federal 310%.

High reserves and over-provisioning may be bad omens. Building bank reserves is like building walls to protect from tsunamis.  Building the wall is costly and it generally has to be built higher than need be to hold tsunamis that come every 100 years. High reserves are especially expensive when the risk-free interest rate is 12.5%.  Provisioning 200% and 300% of non-performing loans is also admirable, but people build higher walls when they expect bigger waves.   In other words, the banks incur these costs because they want to protect themselves.

The current statistics cited in the press for NPLs are low because they are averages.  However, some of the individual NPL series for bank-held consumer debt -such as Credit Cards and Debt for Acquisition of Goods- are near their highs for past ten years (Central Bank of Brazil Data).

Non-bank financial companies seem especially vulnerable. Serasa/Experian, the Brazilian credit bureau, just released numbers that show that the index of NPLs at non-bank finance companies continues to worsen and is 43% higher than the previous peak in 2006.  The Serasa/Experian index for NPLs at banks is not too pretty either; it is 27% above the highs seen in 2008/2009.

If the wall holds, the land stays dry with maybe some minor damage.  However, if the tsunami breaches the wall, everything gets destroyed.  Likewise, if the public has confidence in the banking system then high levels of reserves will protect the banking system from a “normal” credit crisis.  However, if the crisis becomes so bad that the public loses confidence then there is no level realistic reserve level that will protect a factional banking system and the economy comes apart at the seams.

As we have written before in the other blogs and papers, the key is confidence.  Can a small segment of the finance sector experience high levels of default so high that it erodes confidence in the entire banking system?   The 2008 credit crisis in the United States provides grounds for responding with a resounding YES to this question.  We hope this does not happen.

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