Key Takeaways
- Starting in January 2025, financial institutions in Brazil will be required to implement new regulatory measures. These include adopting a new methodology for determining provisions for credit losses, implementing a revised calculation for operational risk in regulatory capital adequacy, and complying with significant modifications in tax accounting rules aiming to reduce deferred tax assets (DTAs).
- The objective of these changes is to strengthen the risk management practices of financial institutions and align them with international accounting standards.
- However, we believe that the implementation of these regulatory changes will not be without its challenges. Financial institutions will need to navigate through a complex web of new rules that may increase provisions and squeeze capital metrics.
Overhauling Calculations Of Provisions
The Brazilian central bank's 2021 Resolution 4,966 incorporates the adaptation of the International Financial Reporting Standards (IFRS 9). One of the resolution's significant changes is the new methodology for determining provisions for credit losses. This deviates from the existing provision credit model requirements that have been in force since the 1999 Resolution 2,682.
The revised methodology represents another step in aligning Brazil's banking regulations with international best practices in accounting standards. However, implementing it introduces a new level of complexity. This is because the new rules will be based on expected losses, requiring the accounting of forward-looking parameters and scenario modeling. While the new methodology aims to enhance risk management practices, it will also require financial institutions to adapt their processes and systems to comply with the new requirements that will be validated and monitored by the regulator. In addition, we believe that the implementation of the new rules will be difficult because of comparison of new parameters with historical data across banks that use different credit models.
The new model will require provisions based on expected losses for performing and nonperforming loans. Moreover, banks will also be required to calculate minimum provisions requirements for nonperforming loans based on the central bank's guidance (see chart 2). The final provision expenses for overdue loans will be determined by taking the higher of the two calculations.
We believe the overall impact of the new model will depend on each bank's credit portfolio and how provisions are made in the existing model. Banks that are more focused on personal loans, and incorporate less expected losses into their provision needs are more likely to face a higher impact, because the new model will require more provisions. Still, we believe a manageable impact on the system due to already high provision coverage levels.
Chart 1
Chart 2
New Rules Will Cause Operational Risk-Weighted Assets To Edge Up, But Overall Impact Should Be Manageable
The Resolution 356, which will be implemented early next year, changes the calculation of operational risk for regulatory capital adequacy. This change introduces the Business Indicator Component (BIC), which serves as a measure based on revenue size and economic activity. The BIC will be used as a proxy for operational risk, replacing the previous approach that used capital charges to operating revenue under the Basel Basic Internal Approach.
We expect the BIC measure will affect less than 1% of the overall capital adequacy in the Brazilian financial system. While we expect the new rule to result in higher operational risk capital charges of up to 20%, it is important to note that credit risk remains the primary risk for capital adequacy in Brazil, representing 85% of total risk-weighted assets. Operational and market risks, represent 10% and 5%, respectively.
Chart 3
New Tax Accounting Rules Will Reduce DTAs
The worsening credit market and economic conditions in Brazil since the pandemic have led to an increase in loan-loss reserves for banks. This was a result of deteriorating asset quality, which required banks to set aside more provisions for potential losses. Therefore, DTAs--resulting from temporary differences--have spiked. This has been particularly so among large banks, as they typically have a higher coverage ratio (loan-loss reserves to nonperforming loans). As of June 2024, DTAs among the five largest banks in the country reached a historically-high level of R$350 billion, a 38% increase from the pre-pandemic level. Among these banks, Banco Bradesco S.A. and Banco Santander (Brasil) S.A. had the highest growth with 58% and 56% each, followed by Itau Unibanco S.A. (43%), Caixa Economica Federal (36%), and Banco do Brasil S.A. (2%).
DTAs typically stem from the bank's tax loss and then carries it forward to reduce taxable income in future years, or from a temporary mismatch between an accounting expense and the related tax deduction. Brazilian banks have historically posted high DTAs from temporary differences due to an accounting discrepancy between the jurisdictional tax book and the income accounting book in the treatment of loan-loss reserve expenses, which are not tax deductible. Essentially, banks generate DTAs from credit provisions because they're classified as an expense for tax purposes only when a credit loss occurs. This type of DTA represents around 60% of total DTAs and 50% of the five largest banks' total equity. In response, the government and the central bank approved the Regulation 14,467, which will nullify this discrepancy in 2025. The new tax accounting rules will also treat credit provisions as expenses for tax purposes.
We view this measure as positive, since it will gradually reduce the volume of DTAs in the financial system. Moreover, the new regulation was revised to extend the time horizon that banks have to use the existing balance of DTAs from credit provisions from three years to seven years, with the possibility to extend it to 10 years, if needed. We believe the new timeframe should mitigate potential losses that could arise if banks were not able to generate sufficient taxable revenues within the timeframe.
Chart 4
Favorable, But Complex, Regulatory Changes
We believe the implementation and compliance with new regulations will likely require significant investments in technology and financial infrastructure. The primary objective of these changes is to enhance financial stability and risk management practices, aligning them with international accounting standards. However, they will also introduce a certain level of uncertainty and complexity for banks as they navigate the implementation of the new guidelines. We also expect smaller financial institutions to face difficulties in meeting the new regulatory standards due to limited resources and capacity compared to larger institutions.
Nevertheless, we believe that these developments an evolving regulatory environment is an important step towards aligning the Brazilian financial sector with international best practices in order to develop a robust banking sector in Brazil. We also believe the central bank will continue monitoring all the impacts from potential changes, and may phase out the implementation when needed to mitigate the economic impact on the financial system.
This report does not constitute a rating action.
| Primary Credit Analyst: | Guilherme Machado, Sao Paulo + 30399700; guilherme.machado@spglobal.com |
| Secondary Contact: | Sergio A Garibian, Sao Paulo + 55 11 3039 9749; sergio.garibian@spglobal.com |
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