Small and medium-sized banks in Brazil are prepared to face a possible worsening of the European crisis, but just in case, the “Fundo Garantidor de Crédito” (FGC) has plenty of ammunition to provide liquidity to the system. By statute, the FGC can use up to half of its assets of R$27.5B to provide liquidity to banks. Currently, only R$2B is committed for this purpose. The agency, which was created in 1995, is controlled by banks and recently has returned to the scene amid signs of weakening of the smaller banks. 
Last thursday, Moody’s downgraded Banco Cruzeiro do Sul to “Ba3” (three levels below investment grade) citing doubts over the sustainability of its revenue and funding. The bank, buffeted by a 47 percent profit decline and credit rating cut, is providing the latest signal smaller Brazilian banks are being hurt by higher borrowing costs. Bank executives deny that the bank would have accessed an emergency line of $ 3 billion to the FGC, saying that the bank is only anticipating a possible worsening of the external scenario by raising cash.
 
In 2008, after the collapse of Lehman Brothers, several small banks in Brazil were without access to resources. At the time, FGC had to provide liquidity to several of them. Still, the episode ultimately resulted in a movement of banking consolidation in the country, including the purchase of 50% of Banco Votorantim by Banco do Brasil, and 35% of Banco Panamericano by Caixa Economica Federal.
The FGC had to bailout Panamericano two years later, after having detected a fraud of over R$4 billion in the bank.

Issues ranging from weak transparency standards, slow consolidation and eroding profits are hampering investor confidence in the sector. At stake is the credibility of a model for the industry based on broader access and rapid disbursements that was for years labelled as “risk-free” by government officials. Despite the promising outlook for consumer and middle-market corporate lending in Brazil, so-called mid-cap banks are showing signs of strain following a rapid expansion of credit over the past eight years.
 
Mid-cap banks have sold more than $10 billion of dollar bonds since mid-2009, and much of those debts bear maturities of five years or less. The tight repayment schedule means that a dearth of capital could get even worse, analysts said. Revenue streams remain poorly diversified in the sector and there is little that can be done to improve it. Mid-cap banks rely on credit and trading income for about 88 percent of revenue, compared with 70 percent for the largest Brazilian banks, according to JPMorgan data.
 
As Brazil embarks on an interest-rate cutting cycle to fend off the impact of market turmoil, these lenders will have to turn more aggressive to retain clients and obtain cheaper, longer sources of funding. The sector is now too fragmented to fully capture the benefits of lower rates while remaining vulnerable to difficult market conditions. “Conditions could change marginally but the outlook won’t turn less worrisome just because of the rate-reduction cycle,” said a Sao Paulo-based bond investor who spoke on condition of anonymity. Mid-cap lenders were severely punished by central bank steps earlier in the year to arrest red-hot credit growth in the auto, payroll and consumer segments.
 
Capital requirements and policy measures could also bring in more headwinds for the sector. New capital rules based on the Basel III accord could depress solvency ratios for some of these lenders. More problems could arise if liquidity dries up as the central bank phases out a program to guarantee certain deposits. The so-called DPGE program was implemented two years ago to shore up deposits after the collapse of Lehman Brothers.
 
The future of the mid-cap bank sector is core to the development of Brazil‘s banking industry not only because of the systemic risk their weakness could pose, but also for their ability to foster competition in a market that is becoming more concentrated. But the fortunes of the industry, which grew at a break-neck pace once former President Luiz Inacio Lula da Silva allowed lenders to deduct monthly loan instalments from workers’ pay-check in September 2003, have soured since the bailout of Banco PanAmericano exactly a year ago.
 
The limited visibility and scant information about the circumstances of the PanAmericano rescue made it harder for investors to gauge whether peers were conducting similar accounting inconsistencies.

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