PROER - Program of Incentives to the Restructuring and Strengthening of the National Financial System

Program encourages bank restructuring

The process of bank mergers is occurring in a number of different countries. These institutions are coping with the imperative of growth in size in order to be able to compete with other corporations operating on the international financial market. While economic globalization in the trade sector has been a gradually ongoing process through the mechanism of economic blocs, the financial sector can already be viewed as a global village. What are the reasons behind these demands? Basically, the causes can be summarized in the process of financial market transformation that has denied the United States of autonomous control over its internal currencies. Today, currency is a global commodity. According to estimates, US$ 11 trillion are unendingly flowing from one corner of the globe to another in search of higher profits, no matter what the language.

Brazil has also been caught up in this eddy. The impact of globalization has reached down deeply into our reality. Brazil has the largest and probably the most complex financial system in Latin America. However, development of the system over the past 30 years has been marked by inflation. The institutional reforms and important legal and normative alterations introduced during this period were largely generated by efforts to combat inflation. The long period of coexistence with inflation produced a situation in which the gains generated by noninterest bearing liabilities, such as demand deposits and resources in transit, compensated for administrative inefficiencies and even for the granting of credits of doubtful return.

In light of the new scenario of price stability achieved by Brazilian society after many failed attempts, it was recognized that spontaneous introduction of the adjustments required for survival in this new economic environment is beyond the capacity of our financial institutions. In a universe of 265 banks, with more than 16 thousand branches and 11 thousand service outlets (without even counting the 1,800 branches of the nation's savings banks - see table below), many institutions have gone under and, consequently, have generated enormous financial and social costs.


INSTITUTIONS IN THE COUNTRY
Types Main
offices
Branches
in country
COMMERCIAL BANKS 35 4,137
MULTIPLE BANKS 208 11,496
DEVELOPMENT BANKS 6 9
INVESTMENT BANKS 16 45
SAVINGS BANKS 2 1,829
COOPERATIVE COMPANIES 926 -
CREDIT, FINANCE AND INVESTMENT COMPANIES 44 105
STOCK AND BOND BROKERAGE COMPANIES 226 360
EXCHANGE BROKERAGE COMPANIES 47 56
SECURITY DISTRIBUTION COMPANIES 348 563
INVESTMENT COMPANIES 4 0
LEASING COMPANIES 77 127
REAL ESTATE CREDIT COMPANIES 19 27
INVESTMENT FUNDS 966 0
SAVINGS AND LOAN ASSOCIATIONS 2 1
GROUP BUYER MANAGEMENT INSTITUTIONS 463 4,742
T O T A L 3,389 23,497

fonte: DECAD/DIVIN
Position on 09.01.95

Intervention or reorganization?

A bank crisis can be compared to a storm that gradually builds in intensity. The most valued asset of the banking industry is its credibility. A run on the banks can result from a loss of credibility at just a few institutions. Such an event would have a domino effect and would generate grave problems for all banks and even for productive sectors of the economy. At the same time, solutions based on such special mechanisms as intervention, liquidation and temporary administration as permitted by legislation have a social cost that is much higher than in the case of measures taken beforehand by the authorities with the aim of transferring control of the institutions to more efficient hands.

The steps included in Provisional Measure no. 1,179 and Resolution no. 2,208, both of which were issued on 11.3.95, introduced the Program of Incentives to the Restructuring and Strengthening of the National Financial System (Proer) designed to mandate bank mergers and incorporations, based on rules set down by the Central Bank. Introduction of this system, which followed closely upon the crisis involving the Banco Econ“mico _ the 22nd bank to be subjected to intervention/liquidation since implementation of the Real Plan on 7.1.94 _ was viewed by the government as a means of resolving problems before they appear and facilitating the process of National Financial System adjustment. With introduction of Proer, society's investments and savings are guarantied. National Monetary Council Resolutions no. 2,197, dated 8.31.95, and 2,211, dated 11.16.95, introduced the system of unconditional adhesion to the depositor protection mechanism, thus avoiding the possibility of localized future problems affecting the entire system and, ultimately, society itself.

Issue of Provisional Measure no. 1,182, on 11.17.95, just two weeks after issue of Provisional Measure no. 1,179, gave the Central Bank the legal instruments that it needed to lead the financial system to a new model. Authority was granted to the Central Bank to maintain within the financial system only healthy institutions with the necessary levels of liquidity and solidity. Consequently, even though the responsibilities of the Central Bank were significantly expanded, the institution was finally given the instruments required to overhaul the entire system.

With these new instruments, the Central Bank can now act preventively and with much greater efficiency. What the Bank was only able to suggest in the past, it is now able to mandate. As a matter of fact, every time he has spoken on the subject, Central Bank President Gustavo Loyola has emphasized the preventive character of Proer. "We are not benefitting banker A or banker B", Loyola stated during a speech before the Brazilian Association of Leasing Companies (Abel), on 11.17.95, "our concern is not one of favoring the banks, but rather of preserving the system and the economy as a whole". Minister of Finance, Pedro Malan, defined Provisional Measure 1,182, which expanded the array of powers available to the Central Bank, as an effort to strengthen the financial system and protect depositors. According to the Minister, the country will go through a process of restructuring of the stock control of the financial segment of the economy (accompanying what has occurred in other countries). Though it is impossible to predict the dynamics of this process, he guarantied that "it will not be traumatic".

In this regard, the newspapers that circulated on 11.19 published a statement by the Vice President of the Federal Reserve Board of the United States, Marvin Goodfriend: "it is of the utmost importance to structure a system of preventing crises before they happen". His statement is supported by a simple fact: taxpayers in the United States have already spent US$ 25 billion in aid to the country's savings and loan system. And the government now predicts that the problem will only be resolved with the injection of an additional US$ 100 billion.

The preventive nature of Proer was also defended by former ministers M rio Henrique Simonsen and Ernane Galvˆas. In Simonsen's opinion, the Central Bank must have the instruments required "to force banks to correct their ways". He recalled that the Federal Reserve has a rating system for each institution that ranges from one (institution in a situation of normalcy) to five (high risk institution). Banks given a five rating are obligated to present a restructuring plan immediately. Galvˆas stated that countries like Venezuela, Argentina and Mexico have already had to cope with grave problems resulting from bank failures: "there are precedents and the Central Bank wants to avoid the possibility of this occurring in Brazil".

The powers of Provisional Measure 1,182

In ten articles, Provisional Measure 1,182 creates the concept of the individual responsibility of controllers that is also applicable to financial institutions submitted to intervention or extrajudicial liquidation. This concept already existed in the case of the Temporary System of Special Administration. Parallel to this, it extended the concept of the inalienability of property to controlling stockholders and facilitated federal government expropriation of the stocks of institutions in difficult situations for purposes of future privatization. Those properties that are considered by law as inalienable or not subject to lien are excluded from the concept of inalienability. Among these, one should mention stocks held by state governments, labor debts and balances in the Employment Guaranty Fund, among others.

Should a situation of equity or financial insufficiency be found to exist, the Central Bank can require capitalization of the financial institution in an amount deemed necessary for its recovery; transfer of stock control, merger, incorporation or split-up. Should the Central Bank's demands not be complied with in the predetermined time period, the monetary authority will be able to decree the special system judged to be suitable to the specific situation at hand (Temporary System of Special Administration, intervention or extrajudicial liquidation).

In cases of intervention, extrajudicial liquidation or the temporary system of special administration, the Provisional Measure grants the Central Bank autonomy to authorize the intervening party, liquidator or board of directors (in the case of the temporary system of special administration) to transfer or assign properties and rights to third parties, as well as to transfer rights and obligations to another company and even to proceed to the stock reorganization of the institution in question.

When it initiates administrative proceedings against a financial institution, the Central Bank can _ for precautionary purposes _ remove anyone under indictment until the investigation of responsibilities is concluded. It can also impede indicted administrators from assuming positions of authority or management in financial companies in general. Moreover, the Central Bank can also impose restrictions on the activities of these institutions. For example, if it uncovers irregularities in exchange operations, it can forbid the bank from operating in exchange. Should the administrative proceedings not be concluded within 120 days, any precautionary measures that may have been taken lose their validity.

The federal government may expropriate the shares of banks subjected to the Temporary System of Special Administration. In each case, the expropriation decree will specify the time period for the transfer of stock control. The shares will be placed in public offer, with the explicit condition that the institution will remain within the private sector, thus eliminating any possibility of federalization of the bank in question. Even when the process of intervention has come to an end, the Central Bank will still have authority to verify the existence of any irregularities that may have been committed by the controllers of the institution. There is also the possibility of choosing another bank (or other legal entity) to carry out this task.

RELATION BETWEEN POPULATION AND BANK BRANCHES
Period Population (1)
(in thous. of inhab.)
No. of branches (2) Pop/Branches (3)
(3)=(1)/(2)
1980 118,561 13,088 9,059
1981 121,213 14,379 8,430
1982 123,885 16,404 7,552
1983 126,573 16,701 7,579
1984 129,273 17,016 7,597
1985 131,978 17,757 7,432
1986 134,653 17,098 7,875
1987 137,268 16,525 8,307
1988 139,819 19,645 7,117
1989 142,307 18,357 7,752
1990 144,724 19,996 7,238
1991 147,074 17,942 8,197
1992 149,358 17,825 8,379
1993 151,572 17,442 8,690
1994 153,724 18,223 8,436
1995 154,835 18,151 8,530

Source: IBGE and Central Bank
Position in June/95
Population estimate based on growth rate of last two years

The challenge to the Real

Today, the specter of a bank crisis in Brazil is the major concern of economic authorities and a challenge to government authorities. The efforts made to strengthen the national financial system are of such importance that _ one can clearly state _ their success is the key to guarantying the success of the Real Plan. After all, the banks are elements of fundamental importance to the process of sustained economic growth which is the Real Plan's overriding goal. In the November 17 interview already cited above, President Gustavo Loyola was emphatic: "I challenge the critics of the merger incentive program to come forward with just one example of a country that has grown with stability and in a sustained manner, without a strong financial system". Loyola also argued that the country's entire economy operated around the structure of the banks. In other countries that have gone through inflationary crises, savings fled into real assets. This did not occur in Brazil.

Speaking on the subject of the health of the financial system in any country, Professor M rio Henrique Simonsen recalled a very bitter moment in American history: "one cannot fail to recall the 1930 recession in the United States, which was transformed into an economic depression precisely because the American Central Bank was unable to avoid a bank crisis". Simonsen adds that, in the wake of the Central Bank's August intervention in Banco Econ“mico, there was nothing else to do but create mechanisms capable of generating market solutions for institutions in difficult situations. In his opinion, "the incentives being offered by the government are few, since significant amounts of public monies are not involved. The banks are simply being given the possibility of recognizing as losses what are effectively losses and deducting these from their balance sheets over a period of five years".

Though the United States faced dramatic banking problems in the 1930s, Minister of Finance, Pedro Malan, affirms that, in the case of Brazil, there is no possibility of a systemic crisis in the financial system. Speaking before the Federation of Trade Associations of Rio Grande do Sul on November 20, the Minister stated, however, that the process of restructuring the sector will consume several years. In Malan's opinion, the banks will have to adapt to a new reality that already exists in the United States and Europe and which is related to the concept of economies of scale, developments in the area of information sciences, efficiency and enhanced competitiveness (See "International Experience")

Central Bank measures adopted
Period: 3.13.74 to 12.4.95
7 subjected to intervention
13 Temporary System of Special Administration
108 extrajudicial liquidation
Subtotal .. 128 institutions currently subject to a special system
6 terminated by judicial decision
296 special systems lifted
72 ordinary liquidations
84 bankruptcies
3 systems suspended by judicial decision
Subtotal .. 461 special systems terminated
Overall Total .. 589 institutions submitted to special systems up to Dec. 04, 1995

With Proer, inspection will be expanded

At a congressional hearing held on November 28, President Gustavo Loyola informed Congress that the Central Bank is in the process of reformulating its inspection sector, in order to enhance its efficiency in accompanying the equity situation of the nation's banks. Aside from this, changes will be introduced into current legislation in order to hold independent auditing companies accountable for their statements of position with respect to balance sheets analyzed. In Loyola's opinion, these are two measures needed to complete Proer. Gustavo Loyola added that, today, the major part of the Central Bank's inspection structure is absorbed by ensuring compliance with National Financial System norms. The intention is to achieve a consistent process of strengthening the system of prudential inspection of banks through verification of the liquidity and quality of their assets. Criticized for the lateness of Central Bank measures to reorganize the financial system and, consequently, for allowing such large institutions as Econômico and Nacional to fail before taking steps to encourage mergers and incorporations, Loyola did not accept the role of the Central Bank as keeper of a financial institution graveyard. He requested that society give greater attention to the many occasions in which the Central Bank was right on the mark. "It would be the same thing as judging a doctor by the number of death certificates he has signed", stated the Central Bank President. "We also have to check on the ill patients that he has cured", he concluded. The tasks entrusted to the Central Bank _ including such responsibilities as overseeing group buyer associations and Proagro _ have absorbed a major share of the Central Bank's activities. And this has had detrimental effects on the institution's work within the National Financial System. The Bank's Department of Inspection has 548 technicians charged with analyzing the operations carried out at 3,389 entities, including everything from financial institutions to group buyer associations. "Today, we have just one inspector for every six institutions. There is a need for redefining the role of the Central Bank so that it will truly be able to inspect banks effectively", added Loyola. The President of the Central Bank went on to affirm that, from this point forward, it is his hope that the Bank will be able to adopt a significantly more agile system of operation, enabling it to take preventive measures based on mechanisms capable of ensuring greater bank liquidity. The Provisional Measure on the financial system has given powers to the Central Bank to act in a preventive fashion, once any liquidity problems are identified (See table "Central Bank measures adopted").

Dimensions of the new National Financial System

The professionals and executives who now operate on the financial market are already involving themselves in a bit of futurology. In the opinion of some, the new financial system will be subdivided into three distinct markets: retail (with few and very large institutions), investment (with few and highly agile institutions) and specialized (in vehicle sales, for instance). Current opinion is that the number of institutions will diminish, while the size of the system will increase since it will have to accompany the process of economic growth and, therefore, will have to provide banking services to an increasingly larger array of people and businesses. Also by way of prediction, it is possible that the entire financial system will have been restructured by the next decade. Aside from the process of mergers and incorporations and reductions in the number of banks, there will be a totally new reality in the area of services: cheaper credit for the population.

In order to delve into the Central Bank President's view of the future of the financial system and the role to be performed by the Monetary Authority, we queried him as follows:

Question: The measures implemented in the Proer framework will reduce the number of banking institutions operating in the country. In your opinion, what will be the extent of this reduction and what are the transformations through which the Central Bank will have to go in order to adapt itself to the new financial system structure?

Gustavo Loyola: "It is very premature to speak of the number of banks that will come out of this process. We have all read and heard about varying predictions, but that is pure speculation. Nobody can foresee the results of a process that, by its very nature, is highly dynamic. What is being done is the creation of a program in which, by means of credit lines, the Central Bank will seek to encourage mergers, incorporations and transfers of stock control as a means of preventing problems before they occur in the Brazilian banking system. In this context, the Central Bank has been given new instruments to be used in preventing situations of risk. These measures include punishing and removing administrators and controllers of financial institutions. Extension of the concept of accountability stated in Law 6,024 to controllers was a highly important measure. The idea behind Proer is to generate the least possible cost for the Treasury and for society, while preserving the interests of depositors. The program also involves a deposit insurance system up to a level of R$ 20 thousand, thus covering 95% of the universe of depositors, who are precisely those who have less access to information on financial institutions. In this way, these people will be protected in cases of intervention or liquidation.

The measures taken to this point still demand two other complementary steps. A system would have to be adopted _ and already exists in many parts of the world _ by which auditors would be accountable for the statements of position that they issue with respect to the balance sheets of both financial institutions and companies in general. At the same time, it is necessary that we alter the Central Bank's inspection philosophy. Today, this activity concentrates more on verifying formal compliance with specific norms set down in regulations than it does on analyzing the equity situation of these institutions. This situation is now being altered through exchanges with regulatory agencies of other countries and internal and external courses that will make it possible to introduce a short-term change in philosophy. There are still other complementary tasks that must be carried out in order to preserve the liquidity and solvency of financial institutions. There is nothing that would stand in the way of all this generating a healthy public debate on the Central Bank's performance in the past and the instruments that it intends to utilize in the future, with the condition that the discussion not be allowed to degenerate into useless speculation on the subject of the financial system".

International experience

In many countries, globalization of the international financial market has made the process of bank and financial institution mergers and acquisitions inevitable. For the same reasons, this phenomenon is also present in the other sectors of the economy.

United States - In the last ten years, the number of banks in the United States has declined from approximately 14,500 to a current level of 10,000 and the process of mergers is accelerating. The most recent example occurred at the end of August when Chase Manhattan was acquired by Chemical Bank, an operation that resulted in the largest bank on that market. Another case that deserves mention is the operation involving the Bank of America and Continental Bank.

Nordic Countries (Norway, Sweden and Finland) - In these countries, governmental concern with the possibility of a bank crisis resulted in various alternative solutions. Liquidation is a rarely used instrument applied only to small institutions.

One alternative has been sale through a "Purchase and Assumption Agreement". These agreements can take the form of a "bank as is" agreement or a "reorganized bank" agreement. In the first case, all the assets (including low quality assets) and all the liabilities are transferred to the buying institution. Control remains within the private sector, thus strengthening the incentive to reorganize. With the aim of recovering the value of net worth, the government provides a line of assistance and can receive guaranties convertible into stock. The result is potential participation in the future profits of the institution. Should it be difficult to define the value of bad assets, this will make it more difficult to specify the value of the needed assistance. In this case, the authorities may provide "coverage for capital losses" or, in other words, they can issue guaranties for the low quality assets that remained on the institution's balance sheets or they can offer "permanent payments" for bad investments.

The option of the "reorganized bank" in the purchase and assumption agreement makes it possible for the acquiring party to assume all of the liabilities and none of the assets (or, at least, none of the bad assets). These are transferred to another bank, designated the "bad bank". The hypothesis here is that a single institution specialized in bad assets will be more efficient in the task of recovering maximum possible value. From the point of view of the acquiring party, separation of the assets increases the incentive for concluding the transaction since risk is reduced, at the same time in which, once the operations has been worked out, the healthy institution will be capable of obtaining improved levels of performance without constant government interventions.

Mexico - In Mexico the mechanism of incentives to bank mergers began in the mid-80s and consists of issues of debentures convertible into the stock of the participating bank. The major characteristics are as follows: -management through the Savings Protection Banking Fund (Fobaproa), with resources supplied by the Bank of Mexico; -duration: five years, subject to reduction should the administrator decide that favorable market conditions exist for capitalization of the institution; -obligation for the participating institution to maintain a capital coefficient of at least 9%; -during the period of the program, the institution is not permitted to issue shares or debentures convertible into stock, except in the case of prior redemption of debentures issued in the framework of the program.

Argentina - At the end of 1994, the Mexican crisis generated impacts on the Argentine financial system in the form of massive withdrawals from deposit accounts. Aside from other measures, such as institution of a deposit insurance mechanism, steps were taken in April to encourage mergers and absorptions, as the monetary authority concentrated on minimizing bank closings. The Argentine government established a fund for purposes of capitalizing banks. Initially, the fund will be financed through issue of US$ 2 billion in three year government securities, available only to those institutions that are deemed to have the capacity to recover. Besides this, with no restrictions as to nationality, the government has encouraged healthy institutions to acquire insolvent or closed banks. As a result, the 168 banks that existed at the end of December 1994 declined to 133 at the end of October of the current year. Through this process, the government hopes to recover public trust in the financial system.

Chile - As a consequence of the 1982 and 1983 financial crisis, a process of capitalization and reprivatization of banks previously subjected to intervention was initiated in 1984. In order to resolve the question of capital deficiencies as rapidly as possible, acceptance of guaranties was tied to presentation of a plan for increasing the stock capital of problem institutions.

Among the instruments utilized for purposes of sale and capital injection with the aim of normalizing the banking system, the following deserve mention: capitalization through issue and sale of new stocks with significant credit and fiscal advantages, direct sale to investors, mergers and changes in the legal objectives of these institutions. Normalization was, therefore, pursued through highly stringent state regulation.

Japan - At the end of the 1980s, the Japanese economy went through a period of economic boom which sharply increased the value of both financial assets and stocks in financial institutions and other corporations. At that moment, an expansionary monetary policy provided abundant liquidity which, together with the supply of international capital, further stimulated increases in the market price of the papers traded. In this context, the financial banking institutions _ and particularly the nonbanking institutions _ sharply increased their credits and often granted loans to undertakings of doubtful profitability. In many cases, these operations were contracted at rates of return that would have been unacceptable in the rest of the world. With reversal of this cycle and implementation of a restrictive monetary policy at the end of the 1980s and early 1990s, the shortage of financial resources generated a drop in the value of assets. The result was a high level of default and abnormal deterioration of the assets of financial institutions. Normally, the difficulties faced by financial entities are resolved through incorporation/merger with large and healthy institutions. In this framework, in 1992 the Japanese government proposed that permission be granted for stock participation and mergers of commercial banks with long-term credit banks and banks specialized in exchange operations. Aside from this, other measures were adopted such as authorization for putting off accounting of problem credits and delaying the providing of information on poor quality assets, so that instead of seeking immediate financial gain, investors will be encouraged to capitalize the institutions involved. At the same time, it was announced that funds would be made available to aid banks in liquidating their bad credits.

Simultaneously to the measures taken by the local government, the current situation of Japanese banks has provoked varying reactions, such as the debate in the United States on the possibility of financial aid to be supplied by the Federal Reserve, in view of the negative impact that an interest rate rise caused by possible massive sales of the bonds held by these institutions would generate on the American economy as a whole.

Recent information has dealt with the possible merger of the Daiwa and Sumitomo banks, which would create one of the world's largest institutions. According to the Japanese Minister of Finance, this merger would be necessary to avoid financial market problems in the wake of the decision taken by United States regulators at the end of October, ordering Daiwa to cease its operations in that country.