Lending Interest Rates and Bank Spreads potx

Why is the bank spread between consumer and corporate credit operations so different?. How has earmarked credit evolved recently?Earmarked credit can be split into two categories, with d

Frequently Asked Questions

S e r i e s

Lending Interest Rates and Bank Spreads

Updated in March 2008, With data through December 2007

This paper is part of the Banco Central do Brasil’s “Frequently

Asked Questions” series This series, which is produced by the BCB’s

Investor Relations Group (Gerin), provides background information

and analysis on economic data and issues of interest to investors and

the general public

The Banco Central do Brasil is producing this series as part of

its ongoing efforts to enhance the transparency of the Brazilian

economy and economic policy, and to improve its communication with

the private sector

1. What is the total amount of credit in the

Brazilian economy? How it is distributed? 7

2. How has earmarked credit evolved recently? 8

3. How is non-earmarked credit distributed

among borrowers? How has this stock of credit

6. What is the average cost of bank creditin Brazil?

What is the average bank spread? 11

7. How have spreads on non-earmarked fixed

interest rate credits behaved recently? 12

8. What are the components of bank spreads in Brazil? 13

9. How much do reserve requirements contribute

to bank spreads? 14

10 Does the credit contract influence the spread? 15

11 Why is the bank spread between consumer and

corporate credit operations so different? 16

12 What role does collateral play in bank spreads? 16

13 What is the average maturity of bank credit in Brazil? 17

14 What has the BCB been doing to reduce

lending costs and bank spreads? 18

15 What is the effect of legal insecurity or legal

risk on credit and bank spreads? 18

16 What are payroll-deducted loans? How has this

credit instruments evolved recently? 19

17 What is a Bank Credit Bill (CCB)? 20

18 What is chattel mortage? What is its purpose? 20

Law and the changes in the National Tax Code

for the credit market? 21

21 What measures have been adopted to increase

transparency and enhance competition in the

credit market? 22

22 What is Credit Risk Center (SCR)? 23

23 Where can I read more about lending

interest rates and bank spreads? 24

24 Where can I find current data? 26

Lending Interest Rates and Bank Spreads

1 What is the total amount of credit in the Brazilian economy? How it is distributed?

Total credit in Brazil stood at 34.7% of GDP at the end of 2007

At end-December, financing and transfers from the BrazilianDevelopment Bank (BNDES) made up 17.2% of total credit, whileearmarked credit1 to the housing and agricultural sectors represented4.6% and 6.8% of total credit, respectively Lending with non-earmarked funds (i.e funds not subject to directed-lendingrequirements) represented 70.7% of total credit at the end of 2007

Graph 1– Total Credit Distribution (December/2007)

1 Brazil’s directed-lending requirements specify that a fixed percentage of deposit liabilities should be granted to the agriculture and housing sectors at government-set interest rates Source: Banco Central do Brasil

Credit to Corporate 29.3%

Earmarked Credit 70.7%

Non-Externally Funded Credit 7.4%

2 How has earmarked credit evolved recently?

Earmarked credit can be split into two categories, with differentcharacteristics:

- The credit supply to the agricultural sector and the amount ofcredit granted by the BNDES have been strongly growing in recentyears, following the expansion of the farming sector and theinvestment recovery in the period;

- After the strong nominal fall in mid-2001, caused by the recognition

of bad loans, credit to the housing sector has been widening as a result

of the favorable moment of the Brazilian economy, added to fall of interestrates, the personal income increase and the credit supply growth

Graph 3 – Total Earmarked Credit (R$ billion)

Source: Banco Central do Brasil

Jun 02

Dec 02

Jun 03

Dec 03

Jun 04

Dec 04

Jun 05

Dec 05

Jun 06

Dec 06

Jun 07

Dec 07 Housing Agricultural BNDES Others

3 How is non-earmarked credit distributed among borrowers? How has this stock of credit evolved

recently?

Out of the total R$659 billion in non-earmarked credit outstanding

at the end of 2007, R$316.8 billion (48.1%) were individual loans andR$342.2 billion (51.9%) were corporate loans Roughly R$68.6 billion

of corporate credit was denominated in foreign currency

Despite the fact that the credit to GDP ratio in Brazil is quitelow compared to international standards, non-earmarked credit hasincreased substantially over the past years From June 2000 toDecember 2007, the nominal supply of non-earmarked creditincreased to R$659 billion (24.5% of the GDP) from R$169.2 billion(14.3% of the GDP) Over this period, nominal credit to individualswas the most dynamic, increasing fourfold

Graph 3 – Non-Earmarked Credit (R$ billion)

Source: Banco Central do Brasil

Jun 02

Dec 02

Jun 03

Dec 03

Jun 04

Dec 04

Jun 05

Dec 05

Jun 06

Dec 06

Jun 07

Dec 07 Individuals Corporates

4 How has the stock of foreign currency-denominated credit evolved recently?

Aggregate foreign currency-denominated credit, which includesadvances on export contracts (ACC), export notes, import financing,and foreign currency-denominated loans has behaved differently fromthe other types of non-earmarked credit The variation is due notonly to exchange rate movements, but also to volatility in perceivedcountry risk As can be seen in Graph 4, the stock of foreign currency-denominated credit has declined gradually through 2002 as foreignlenders reduced credit lines to Brazilian corporations and banks Since

2003, however, FX-denominated credits have shown signs of recovery,especially for ACC advances even with the Real appreciation Therecent upward trend is related to demand widening for these financinglines following the expansion of Brazilian external trade

Graph 4 – Foreign Currency-Denominated Credit (US$ billion)

Source: Banco Central do Brasil

Jun 02

Dec 02

Jun 03

Dec 03

Jun 04

Dec 04

Jun 05

Dec 05

Jun 06

Dec 06

Jun 07

Dec 07 ACC FX-Denominated Loans Import Financing and Others

5 What are the major types of non-earmarked credit contracts in Brazil?

Credits in Brazil are contracted with fixed and floating

real-denominated interest rates, and with FX-linked (effectively denominated) interest rates Most credits to individuals, including personalcredit, overdraft credit and credit for the purchase of goods, have fixedinterest rates There are also several types of corporate credits withfixed interest rates, including hot money, working capital, discounts oftrade bills, credit for the purchase of goods, vendor (wholesalerrediscounts of certain types of retail receivables), and guaranteedaccounts (a kind of overdraft account for companies)

dollar-Some types of corporate credits, such as guaranteed account, creditfor the purchase of goods and working capital are also negociated atfloating rates, which are linked to benchmark interest rates such as theSelic overnight rate1 or the One-day Interbank Deposit rate (DI)2.Dollar-denominated loans are also priced at floating interest ratesand involve foreign funds (ACCs, export notes and the so-called

2 The Average One-day Interbank Deposit Rate (DI) represents fund transfer between financial institutions and is calculated by CETIP – Custody and Settlement It is expressed as a percentage rate per annum compounded daily based on a 252-day year.

represents the difference between the lending and funding interestrates, stood at 22.4% p.a Graph 5 illustrates the evolution of theaverage bank spread since January 2001 (including fixed, floatingand FX-linked interest rate operations).

There are significant differences between interest rates andspreads on loans to individuals and loans to companies The averagespread on corporate loans, which stood at 11.9% p.a in December

2007, is roughly 1/3 of the average spread on lending to individuals,which stood at 33.8% in the same month

Graph 5 – Bank Spread – Non-Earmarked Credit (% p.a.)

Source: Banco Central do Brasil

7 How have spreads on non-earmarked fixed interest rate credits behaved recently?

The average spread on non-earmarked fixed rate credits fell to

Jun 02

Dec 02

Jun 03

Dec 03

Jun 04

Dec 04

Jun 05

Dec 05

Jun 06

Dec 06

Jun 07

Dec 07 Total Corporates Individuals

Between late 1999 and mid-2001, the average spread on fixedrate credits fell significantly, particularly for credits to individuals.Since the second half of 2001, restrictive monetary policy and macroeconomic volatility, added to the 2001 and 2002 financial markets turmoil were responsible for an increase in the spreads, reversed in the second quarter of 2003 From then, the spreads recorded a downwardtrend as a result of the favorable environment provided by theconsolidation of macroeconomic stability.

Graph 6 – Bank Spread – Fixed Interest Rate Credits (% p.a.)

Source: Banco Central do Brasil

8 What are the components of bank spreads in Brazil?

With the goal of identifying the factors that contribute to bankspreads, the BCB used sample data from banks balance sheets todecompose the average spread into the following factors:administrative expenses, direct and indirect taxes, costs associatedwith defaults, and banks’ “net margin” According to the most recent

Feb 02

Sep 02

Apr 03

Nov 03

Jun 04

Jan 05

Aug 05

Mar 06

Oct 06

May 07

Dec 07 Total Corporates Individuals

data, released in the “Relatório de Economia Bancária e Crédito 2006” of December 2006(available on http://www.bcb.gov.br/

-?SPREAD) the spread on the fixed interest rate credits could bedecomposed into: administrative expenses (16.9%), taxes (15.9%),reserve requirements (4.7%), costs associated with defaults (43.4%),and a residual (19%) The “residual” represents bank’s net margin.Table 1 shows the spread decomposition for fixed interest rate loans

on an annual basis from 2001 to 2006

Table 1 – Bank Spread Composition (%)

Source: Banco Central do Brasil

9 How much do reserve requirements contribute to bank spreads?

Brazil’s reserve requirements contribute significantly to thecountry’s bank spreads by reducing its ability to increase credit Non-remunerated reserve requirements on demand deposits stood at 45%

in December 2007 The Central Bank also requires an 8%remunerated requirement on demand deposits Reserve requirements

8% and 10% in December 2007 However, as mentioned before,reserve requirements accounted for only 4.7% of banking spread in2006.

10 Does the credit contract influence the spread?

Bank spreads differ significantly according to the type of loancontract In the case of loans to individuals, in December 2007 the averagespread on auto financing stood at 16.4% p.a., while the spread onoverdraft loans was 127.7% p.a in the same month In the case of loans

to companies, spreads varied from 5.0% p.a on vendor loans to 48.5%p.a on guaranteed accounts

Table 2 shows the spreads for the main fixed rate credit operations,from December 2000 to December 2007

Table 2 – Spreads on Fixed-Rate Credit Operations (% p.a.)

Source: Banco Central do Brasil

Dec 00 Dec 01 Dec 02 Dec 03 Dec 04 Dec 05 Dec 06 Dec 07

Corporate 21.6 24.4 25.0 26.4 23.2 24.1 24.3 21.0

Discount of Trade Bills 29.4 31.6 31.4 27.8 22.8 21.7 23.5 21.2 Working Capital 15.8 17.7 14.5 20.1 18.7 17.7 18.4 16.3 Guaranteed Account 39.1 45.2 55.7 54.0 50.3 52.1 52.6 48.5 Purchase of Goods 13.5 13.3 13.5 13.6 11.2 11.6 11.6 4.8 Hot money 24.2 27.6 30.3 37.9 34.9 29.2 41.6 32.7

Consumers 49.7 51.0 54.5 50.9 42.9 42.6 39.6 31.9

Overdraft 137.5 141.6 142.3 128.9 127.8 129.2 129.8 127.7 Personal Credit 50.9 64.1 63.5 64.6 50.4 50.7 44.7 33.7 Purchase of Motor Vehicles 17.5 16.0 23.5 20.9 18.2 18.5 19.8 16.4 Purchase of Other Goods 49.8 49.4 53.0 55.8 48.9 48.2 48.3 45.1

General Total 36.1 40.0 42.5 41.5 35.6 36.4 34.8 28.4

11 Why is the bank spread between consumer and

corporate credit operations so different?

Among other factors, credit quality, as expressed by delinquencyrates, explains a major share of the difference in spreads between thetwo types of borrowers

Graph 7 shows that in December 2007, for credits 90 days or morepast due, delinquency rates for individuals (7.0%) were more than threetimes that of corporate (2.0%)

Graph 7 – Delinquency Rates by Type of Borrower (% in arrears over

90 days)

Source: Banco Central do Brasil

12 What role does collateral play in bank spreads?

The existence and quality of collateral (i.e whether it can beeasily recovered) have a major impact on spreads For example,spreads on auto loans are much lower than spreads for personal credit,although the borrowers are similar and have similar credit risk Auto

transferred from the debtor to the creditor as a guarantee on theloan, while the debtor remains as a depositary of the good or asset.

In the case of delinquency, the loan can be recovered or renegotiatedeasily Other types of credit contracts, like overdraft accounts andcredit card loans, offer little or no collateral, and typically require thecreditor to undertake long and expensive legal procedures in order toseize collateral

13 What is the average maturity of bank credit in Brazil?

The average tenor of non-earmarked bank credit felt from June

2001 to the end-2003 as a result of high macroeconomic volatility, driven

by the 2001/2002 financial market turmoils Since the beginning of 2004,there was a strong recovery of the average tenor, standing at 351 days(roughly twelve months) in December 2007 (Graph 8) Credit to thecorporate sector has, on average, shorter maturities (276 days) thancredit to individuals (average of 440 days)

Graph 8 – Average Length of Non-Earmarked Credit (Days)

Source: Banco Central do Brasil

Jun 02

Dec 02

Jun 03

Dec 03

Jun 04

Dec 04

Jun 05

Dec 05

Jun 06

Dec 06

Jun 07

Dec 07 Total Corporates Individuals

14 What has the BCB been doing to reduce lending costs and bank spreads?

In 1999 the BCB launched a major ongoing initiative aimed atreducing bank spreads Under this program, the BCB has identifiedand focused its efforts on three key areas:

– Promoting increased competition in the credit market throughgreater transparency and provision of creditor and debtorinformation On the creditor side, access to accurate information

on borrower risk is essential to enable financial intermediaries

to select clients and effectively evaluate their credit risk Fromthe borrowers’ point of view, accurate and complete informationabout borrowing costs and contractual conditions enhancescompetition among lenders and works to reduce lending rates;– Increasing the effectiveness of contracts enforcement, enablingbanks to reduce losses associated with defaults The inefficientlegal enforcement of contracts inhibits the supply of credit byinducing banks to be more restrictive in the selection of clientsand increasing the risk premium demanded from all theborrowers;

15 What is the effect of legal insecurity or legal risk

on credit and bank spreads?

Legal insecurity (i.e excessively long judicial processes in theevent of default) limits the credit supply and increases the spread.This occurs through two channels: an increase in financial institutions’administrative costs (mainly the legal and credit risk areas) and adecrease in the certainty of payment, even with collateral The latterchannel pressures the risk premium - the additional fee included inthe spread to cover nonpayment

In recent years, several measures have been approved by thegovernment and the legislative, aimed at reducing the default risk