Brazil’s government appears to have finally crossed the Rubicon of greater state intervention in the banking sector, with President Lula replacing the head of state-run bank giant Banco do Brasil in early April. The new man for the job, Aldemir Bendine, takes over from Antonio Francisco de Lima Neto, as part of a wider government push to force state banks to lower lending rates on consumer loans. Bendine is probably the perfect man for the job given his previous role as vice president of credit and debit cards, and business development for retail services at Banco do Brasil. With Lula’s henchman at the helm, expect to see some big distortions in the banking sector. This could be an ominous sign of things to come, especially with the economy taking a hit from the global downturn.

Lula’s move comes against the backdrop of already significantly lower average lending rates to individuals charged by Banco do Brasil than most other banks operating in this segment. The big private sector players Itau and Banco Bradesco, for instance, charge an average interest of 76% and almost 80% respectively on lending to individuals, while Banco do Brasil charges 33.9%. Given that Brazil is set to go into recession this year, a push for more aggressive bank lending could undermine overall profitability in the sector for several years to come.

Distorting The Market Place
My main concern here is that direct state intervention in banks’ lending practices threatens to distort the underlying demand and supply dynamics of Brazil’s financial system.
On the supply side:

• Banco do Brasil will be made to assume greater risk on its loan portfolio. Although given the full backing of the state capital adequacy concerns should be averted, the risk of lower profitability could weigh heavily on the bank’s share price. Banco do Brasil’s share price dropped 9% on the day when the leadership change at the bank was announced, indicating that this concern is justified.

• By undercutting most Brazilian banks, state intervention could force private banks to join in on the more aggressive lending practices, in an effort to maintain market share. At best, banks would risk a significant decline in overall profitability, while the worst case scenario could see banks suffer the full consequences of a sharp rise in defaults and deteriorating asset quality. Tapping external financing would become even more difficult than is already the case amid constricted global credit markets.

Consumer Credit Default Rates, % of Total

From the demand perspective:

• Borrowers may become encouraged to take on greater leverage at a time when unemployment and default rates on consumer loans are rising sharply.

• Moreover, artificially low lending rates may result in increased speculative activity and the formation of an asset bubble – in housing for instance – prompting individuals or private entities to take on more debt.

Such distortions could potentially prolong Brazil’s recession this year, or result in a deeper downturn of the economy down the road. Indeed, incentivising consumer lending (and borrowing for that matter) by directly forcing one of Brazil’s largest banks to lower lending rates, may lead to misallocation of resources in the economy and prevent a sustainable recovery. As things currently stand, I believe that Brazil is in a strong fundamental position to bounce back early from the current recession. However, creating artificial incentives to take on more leverage presents serious risks to this view.