On March 1st, 2013, the Central Bank of Brazil (Banco Central do Brasil – Bacen) released a set of four Resolutions issued by the National Monetary Council (Conselho Monetário Nacional – CMN)1 and announced 15 Circulars to be enacted by the Board of Bacen2 that implement in Brazil the recommendations of the Basel Committee on Banking Supervision regarding capital structure of financial institutions of the Brazilian Financial System (Sistema Financeiro Nacional- SFN). This article outlines the main information disclosed by Bacen about this matter.
The new rules are known as Basel III (BIII) and seek to improve the ability of financial institutions to absorb shocks, strengthening financial stability and the promotion of sustainable economic growth. The increase in the quantity and quality of regulatory capital held by financial institutions is designed to reduce the likelihood and severity of banking crises, and their consequent costs for the real economy.
The first three CMN Resolutions deal with the following matters:
- (CMN Res. No. 4192 about new regulatory capital calculation methodology, named in Brazil "Equity Reference" (Patrimônio de Referência - PR), which will continue to be divided into Tiers I and II;
- CMN Res. No. 4193 about new capital maintenance requirement calculation methodology, adopting minimum requirements of PR, Tier I (Nível I) and Common Equity (Capital Principal), and introduction of Additional Common Equity (Adicional de Capital Principal); and
- CMN Res. No. 4194 about optional new minimum capital requirements calculation methodology for credit unions (cooperativas de crédito) by determining the amount of risk-weighted assets (RWA) in simplified form, known as Simplified Prudential Regime (Regime Prudencial Simplificado - RPS), and introduction of Additional Common Equity specific to these credit unions.3
Additionally, there is CMN Res. No. 4195, which deals with the new way of preparation and remittance of aggregate information through the Analytical Trial Balance Sheet - Prudential Conglomerate (Balancete Patrimonial Analítico – Conglomerado Prudencial). Prudential conglomerate is a new type of consolidated financial statement which will be the basis for calculation of capital requirements and Additional Common Equity of financial groups. It will cover financial institutions and other entities ("related entities") which are not deemed to be financial institutions but must be authorized to operate in Brazil by Bacen, as well as some companies controlled by financial institutions, such as consortium administrators; payment institutions that act as credit card issuer or merchant acquirer; companies that carry out the acquisition of credit operations, including real estate and credit rights, comprising factoring companies, securitization companies and special purpose companies; insurers, reinsurers, capitalization companies and open private pension entities; investment funds in which the entities of the same conglomerate retain substantially risks and benefits, such as exclusive investment funds, credit rights investment funds and other financial investment funds; and legal entities headquartered in Brazil incorporated with the exclusive purpose of holding equity investments in financial institutions, related entities or any other companies already mentioned herein.
The new methodology for calculation of the regulatory capital brings substantial advances in relation to the current methodology. The financial institutions´ capital quality is improved by restriction on the acceptance of financial instruments that do not demonstrate effective capacity to absorb losses and by deducting assets that, in certain situations, may compromise the value of the capital due to its low liquidity, future income dependency to realization or difficulty of measuring its value.4 In the case of Brazil, the most significant deductions relate to deferred tax assets, intangible assets and investments in non-controlled companies that operate in the insurance business.
The calculation of minimum capital requirements is established as a percentage of the amount of RWA. The new rules establish three independent requirements to be followed continuously by the financial institutions:
- 4.5% for the Common Equity, which is composed mainly of shares, units (quotas), reserves and retained earnings;
- 6% for Tier I, which is composed of the Common Equity and other instruments capable of absorbing losses while the institution is operating (going concern); and
- 8% for the total of PR, which is composed by Tier I and other subordinated instruments able to absorb losses when the institution is closed.
The Additional Common Equity is a supplementary capital created to reduce the pro-cyclicality of capital requirement and to establish a gradual range of supervisory actions and corresponds to the conservation (fixed) and counter-cyclical (variable) buffers provided for in BIII. At the end of the transitional period, the Additional Common Equity must correspond to at least 2.5% and up to 5% (maximum) of the amount of RWA, and its exact value will be set forth by Bacen pursuant to the macroeconomic context. Under normal market conditions, it is expected that the financial institutions maintain a surplus of capital in relation to the minimum requirements to the established Additional Common Equity.5
The new capital requirement of BIII significantly increases the percentage of application, mainly from components of PR with greater capacity to absorb losses.
Implantation in Brazil of the new capital structure starts in October 1st, 2013 and follows the agreed international schedule until the completion of the process, in January 1st, 2022. The schedule for phasing-in of the measures aims to provide sufficient time for the adaptation of the national financial systems, allowing each of the institutions, when necessary, to adjust their capital base. Changes related to the calculation of capital for credit risk that not imply additional capital and can be implemented easily already came into effect as of March 1st, 2013.
As from 2014 the financial institutions will have to use the Analytical Trial Balance -Prudential Conglomerate to calculate the PR and the new minimum capital requirements to be required of the regulated institutions. Its creation has ensured that the accounting document could adequately reflect the economic, financial and equity positions of the financial groups and the risks arising out of the operations consolidated there, in order to facilitate the monitoring and analysis of this information by Bacen.
The approved Circulars complement the rules laid down in the Resolutions, establishing the procedures to determine the amount of RWA and also introduce several operational adjustments and naming changes which are necessary for the new capital structure, bringing significant advances in risk measurement and methodology in the calculation of the amount of RWA for market and operational credit risks.
According to BIII, exposure to clearing and settlement clearing houses, which were outside the regulatory scope, will now receive a 2% weight, compatible with the offered security mechanisms. Over-the-counter (OTC) derivative transactions will also need new capital requirement to tackle the risks of market value adjustments due to changes in credit quality of the counterparty.
The Circulars also enhance treatment for exposure to investment funds, titles of securitization and credit derivatives, among others. Adjustments are made in certain risk weighting factors (fator de ponderação de risco - FPR) seeking to adapt the current methodology to the new structure of BIII, mainly in relation to exposure related to certain real estate loans, consigned credits (payroll loans) and loans to large companies. In line with the existing approaches to credit and market risk, the Circulars allow financial institutions applying to use internal models for the calculation of regulatory capital for operational risk.
The main changes affecting real estate loans are the following: (i) loans guaranteed by fiduciary alienation, if the financed amount represents less than 80% of the value of the asset – the FPR is 35%; (ii) loans guaranteed by mortgage, if the financed amount represents less than 80% of the value of the asset – the FPR is 50%; and (iii) loans guaranteed by fiduciary alienation in the case of residential real estate (home equity) – the FPR is 50%.
The FPR of the consigned credits with term exceeding 60 months, which is considered low risk, is now reduced to 150%. The FPR of all the other modalities of credits granted to individuals, that represent higher risk, continues to be 300%.
In the case of the exposure of large companies whose aggregate amount of loans (active portfolio) in the SFN exceeds R$ 100 million, if the value of the active portfolio of such company in a certain institution is less than 10% of the PR of the institution, the FPR has been reduced from 100% to 75%. According to Bacen, the level of default of the large companies is substantially lower than the exposure represented by the small and medium size companies.
Regarding the exposure to exchanges, in the case of exposures arising from own operations to be settled in clearing and settlement systems by clearing houses or providers of clearing and settlement services, the FPR is 2%, when the clearing house or service provider acts as a central counterparty. This measure aims to encourage these operations with consequent reduction of the systemic risk. Credit operations maturing in up to three months carried out directly with such entities has a FPR of 20% and if the maturity term exceeds three months, the FPR is 50% - this treatment equalizes the clearing houses and service providers to financial institutions and related entities. For exposures held by financial institutions in default funds (funds for liquidation of transactions in the exchange environment), the FPR is 1,250%.
The large stock of deferred tax assets of the Brazilian banks, estimated at approximately R$ 60 billion, will continue to be regarded as capital reserve. As determined by BIII, tax credits that depend on the generation of future taxable income or profits to be realized will be deducted from the Common Equity. The President of the Republic enacted Provisionary Measure (Medida Provisória) No. 608, of February 28, 2013 (MP 608/2013), which deals with assumed credit calculated on the basis of credits arising from temporary differences from bad debt reserve (provisões para créditos de liquidação duvidosa - PCLD) in accordance with the conditions established therein and regulates credit securities and instruments issued by financial institutions and other entities authorized to operate by Bacen for formation of PR.
According to MP 608/2013, the PCLD arising in Brazil began to be liquid and certain since their exploitation can occur regardless of the existence of future profitability. Thus, these specific tax credits will not be deducted from the Common Equity. As the deferred tax assets credits arising from tax losses and negative social contribution basis and tax credits arising from temporary differences that are not originated from the PCLD, like those resulting from passive reserves, will compose the basis for deductions.
In the SFN the most significant deductions are those relating to tax credits that depend on future income or profits to be realized and deferred tax assets arising from tax losses. In some institutions the deductions for intangible assets, actuarial assets related to defined benefit pension funds and minimum capital required for insurance companies are also important.
Some of the deductions will not be made in its entirety. Direct or indirect shareholdings exceeding 10% of the share capital of other non-consolidated related entities and tax credits arising from temporary differences that depend on generation of future taxable income or profits to be realized can form the financial institution´s capital (PR) in a limited way. Only values greater than two pre-set limits can be deducted, the individual and the aggregate, both calculated based on the value determined for the Common Equity before these deductions. The individual limit is 10% and it is applied both for shareholdings and for the tax credits. The aggregate limit is 15% and it is applied to the sum of shareholdings and tax credits after the individual deductions.
The Basel Agreement and CMN's proposal establishes a ceiling for the participation in the capital of subordinated debt instruments that do not meet the requirements of BIII. The ceiling value is reduced 10% annually as from 2013. However this does not mean that the instruments must necessarily be deducted. For the most part currently accepted debt instruments would mature in a relatively short period and would no longer compose the capital base anyway. The transitional period is long enough so that in most cases the limits imposed by the ceiling do not constitute an effective restriction. It should be pointed out that the subordinated debt that falls on the requirements set out in BIII, including that submitted the contractual changes to fall on the new requirements, will be fully recognized as PR.
Pursuant to MP 608/2013, the financial institutions6 and related entities can issue Financial Bills (Letras Financeiras - LFs) convertible into shares to replace the subordinated debts. The relevant changes introduced in the legislation that regulates the issuance of LFs7 are commented in the subsequent paragraphs below.
The conversion into shares cannot result from the initiative of the holder or the issuer of the LF. The LF convertible into shares can be used for purposes of composition of the PR of the issuer, subject to the conditions specified by CMN. The standards published by CMN may provide order of preference in the payment of holders of LFs, according to the characteristics of the credit instrument.
CMN may regulate: (i) the type of institution authorized to issue; (ii) the use of indices, rates or remuneration methodologies; (iii) the maturity, which cannot be less than one year; (iv) the conditions for early redemption of the credit instrument, which can only occur in competitive trading environment, subject to the minimum time limit of expiration; (v) the issuance limits, which are determined according to the type of institution; (vi) the maturity conditions; (vii) the situations in which occurs the suspension of payment of the agreed remuneration; and (viii) the situations in which occurs the extinction of the right of claim or conversion of the credit instrument into shares of the issuer.
For the purpose of preserving the proper functioning of the SFN, Bacen may determine, in accordance with criteria established by CMN, the extinction of debts evidenced in securities and other credit instruments allowed to compose the RF of the financial institutions or related entities, or the conversion of these securities or credit instruments into shares of the issuer, issued after March 1, 2013 or agreed upon in order to provide for this possibility. This extinction of debts or conversion into shares is final and irreversible and will persist even if performed improperly, and in any of these two hypotheses any disputes shall be settled in damages.
The extinction of debts, the conversion into shares or the suspension of payment of the remuneration stipulated in the securities or instruments are not deemed to be events of default or other factors that generate the anticipation of debt maturity in any legal business involving the issuer or another entity of the same economic-financial conglomerate as defined by CMN. The clauses that assign to the events described therein the following consequences are null and void: (i) anticipation of debt maturity. (ii) increase of the interest rates or other forms of remuneration; (iii) requiring the provision of guarantees or its increase; (iv) payment of any amount; or (v) another consequence to achieve practical effects similar to those referred to in items (i) to (iv), even if made through derivative contracts.
If the conversion into shares result in the possibility of transfer of a controlling interest of the issuer, the exercise of voting rights inherent to the shares resulting from the conversion and liable to change the control of the institution must be authorized by the competent government authorities.
Bacen expects the Additional Common Equity to be complied with in situations of normality in the economic cycle. The non-compliance will subject the institutions to restrictions on payments of bonus, profit participation and other deferred compensation tied to performance. The degree of restriction will be escalated in a manner proportional to the degree of inadequacy in meeting the Additional Common Equity, in order to allow for the recapitalization of the institution and the return to full compliance with the requirements and the Additional Common Equity.
In this sense, MP 608/2013 determines that the distribution of dividends provided for in articles 202 and 203 of Law No. 6404, of December 15, 1976 (the Brazilian Corporation Law)8 to the shareholders of financial institutions and other related entities shall be subject to the fulfillment of the prudential requirements established by CMN.
The changes in the current regulations are in accordance with the recommendations of BIII and are a consequence of the continuous movement of improvement of the prudential framework applicable to financial institutions.
1 The four CMN Resolutions are numbers 4192, 4193, 4194 and 4195, all dated March 1st, 2013.
2 The matter is regulated by Circulars numbers 3634, 3635, 3636, 3637, 3638, 3639, 3640, 3641, 3642, 3643, 3644, 3645, 3646, 3647 and 3648, all dated March 4, 2013.
3 The RPS considers only the exposure to credit risk for the purposes of capital requirements and a fixed value for the Additional Common Equity of credit unions, with the aim of reducing the regulatory cost but ensuring that credit unions have sufficient capital to withstand losses.
4 BIII introduced certain deductions known as "prudential adjustments" (ajustes prudenciais), which correspond to the deduction of assets that may compromise the quality of Common Equity as a result of their low liquidity, difficult evaluation or future income dependency to be realized. The major prudential adjustments are: tax credits arising from temporary differences that depend on generation of future taxable income or profits to be realized; investments in related entities; non-controlling interest in subsidiaries of the same conglomerate and deferred tax assets arising from tax losses and negative social contribution basis.
5 Bacen studies indicate that in credit growth scenario and retention results based on the average of recent years, the SFN as a whole will maintain higher capital than the values required by the new structure of BIII. These simulations do not indicate any need for Additional Common Equity for the SFN as a whole from 2014 to 2019, beyond those values resulting from the current practice of withholding results. Even lowering the estimate for the individual institutions level, no bank would need to raise capital in 2013, 2014, 2015 and 2016. Nevertheless, as from 2017, due to the diversity of portfolios, there are banks that need to raise some small amounts of capital. Together, those few banks would need about R$ 2.9 billion in 2017, R$ 5.1 billion in 2018 and R$ 6.7 billion in 2019. This represents added up to 2019 about R$ 15 billion, which corresponds to approximately 2% of the PR of the SFN in December 31, 2012 (R$ 697 billion).
6 The institutions authorized to issue LFs are the following: (i) multiservice banks (bancos múltiplos); (ii) commercial banks (bancos comerciais); (iii) development banks (bancos de desenvolvimento); (iv) investment banks (bancos de investimentos); (v) savings banks (caixas econômicas); (vi) mortgage companies (companhias hipotecárias); (vii) loan, finance and investment companies (sociedades de crédito, financiamento e investimento); (viii) real estate loan companies (sociedades de crédito imobiliário); and (ix) the Brazilian Development Bank (Banco Nacional de Desenvolvimento Econômico e Social – BNDES).
7 The LF was created by Provisional Measure No. 472, of December 15, 2009, which was approved by the Brazilian Congress and converted into Law No. 12249, of June 11, 2010 (Law 12249/2010), and is now amended by MP 608/2013. It is a credit document that constitutes a promise of payment in cash, issued in the registered form, which may be transferred to third parties and it is freely negotiable. It must be exclusively issued in book-entry form, through the registration in a registry and financial settlement of assets system authorized by Bacen.
8 Articles 202 and 203 of the Brazilian Corporation Law establishes that:
"Article 202. In every fiscal year, the shareholders shall be entitled to receive as a compulsory dividend the portion of the profits as may be stated in the bylaws or, in the event the latter is silent in this regard, the amount to be determined as follows:
I – half of the net profit as increased or reduced by:
a) the amount intended to form the legal reserve (Article 193); and
b) the amount intended to form the reserves for contingencies (Article 195) and any written-off amounts of the same reserves formed in previous fiscal years;
II – the payment of dividends provided for in item I may be limited to the amount of net profits realized during the fiscal year, provided that the difference is recorded as a reserve for realizable profits (Article 197);
III – profits registered in the reserve of realizable profits, when realized and not absorbed by losses in subsequent fiscal years, shall be added to the first dividend declared after their realization.
Paragraph 1. The bylaws may prescribe the dividend as a percentage of the profits or of the capital, or establish other criteria for its determination, provided they are prescribed adequately and in detail and do not subject the minority shareholders to the discretion of the administrative bodies or of the majority.
Paragraph 2. Whenever the bylaws are silent and the general meeting resolves to amend the bylaws in order to regulate compulsory dividends, the compulsory dividend may not be less than twenty-five per cent (25%) of the net profit as adjusted in accordance with item I of this Article.
Paragraph 3. As long as no present shareholder opposes to it, a general meeting may resolve to distribute a dividend which is less than the compulsory dividend prescribed by this Section or to retain the entire net profit, in the following corporations:
I – publicly-held corporations which have gone public exclusively to raise capital by issuing non-convertible debentures;
II – closely-held corporations, except those controlled by publicly-held corporations not in compliance with the provisions of item I.
Paragraph 4. - The dividend prescribed by this article shall not be compulsory in a fiscal year in which the administrative bodies notify the general meeting that its payment would be incompatible with the financial standing of the corporation. The audit committee, if in operation, shall deliver an opinion on any such notice and, in a public corporation, the officers shall forward to the Brazilian Securities and Exchange of Commission, within five days of holding the general meeting, an explanation justifying the notice.
Paragraph 5. - The profits which are not distributed by virtue of paragraph 4 shall be attributed to a special reserve and, if not absorbed by losses in subsequent fiscal years, shall be paid as dividends as soon as the financial situation of the corporation permits such payment.
Paragraph 6. The profits which are not allocated pursuant to Sections 193 to 197 shall be distributed as dividends.
Article 203. The provisions of articles 194 to 197 and of article 202 shall not impinge on the right of the preferred shareholders to receive the fixed or minimum dividend for which they have priority, including overdue dividends, if cumulative."
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.