By The Sharp Fintech’s research team: This article talks about the challenges faced by a foreign investor when deciding to enter the Brazilian financial market, be it with a banking business or a similar one.
The Brazilian financial market entails several peculiarities that are not present in other developed markets but offer in turn great investment opportunities. Having a solid business plan, covering financial, operational and business-related aspects is key, due to the fact that it will demand a thorough market and products research and understanding.
Besides that, relying on local expertise in order to avoid unnecessary steps and not to neglect pivotal pre-inception aspects is key.
One key aspect, as per our experience, is that one should not underestimate the very relevant effort of operationally putting up a banking (or similar) business here in Brazil. This has mainly to do with the local peculiarities of our markets and products and the local tax and regulatory environment.
In a nutshell, the application (especially the preparation and filing of a Business Plan) and regulatory follow-up should be seen as some 20% of the overall required work (i.e. the “tip of the iceberg”), whereas the operational implementation will require the great amount of effort.
Application
The first step of getting a license is to disclose this intention to the regulators at the Brazilian Central Bank (BCB), preferably with senior management being present in the meetings with senior BCB officers.
This will require in the following weeks the delivery of a detailed business plan containing not only an analysis of the bank’s perception of the economic environment but mainly the business lines it intends to run in Brazil, forecasts of the expected increase over time in volume of clients, amounts involved, margins per product, capital allocation and non-performing loans. Besides, a depth analysis of the infrastructure envisaged for dealing in Brazil disclosing the functions and headcount forecasted accompanied by an analysis on IT systems (local x global), risk management, operations structure and other support areas description. The preparation of such a business plan will require the availability of decision-making senior officers to interact with local experts in the search for the most efficient model considering business priorities applied to the local regulatory environment.
Follow-up of a licensing process
This has to happen with the close monitoring and dynamic process of discussions with the BCB about the Business Plan and its assessment by them on several aspects. This is done in combination with the legal and/or regulatory advisors/experts that will lead this process from the formal and regulatory point of view. Important to mention that in parallel the license approval process requires a presidential decree[1], which is a must in order to get the license from Central Bank. This will require visits to the BCB in Brasilia and São Paulo offices in order to follow up on this, although more from the regulatory and legal perspective. An alternative that might speed up the process is to acquire an existing foreign license (already approved by presidential decree) and in parallel apply to the BCB either to adjust the scope or to immediately act as the new foreign entity.
Aspects to be considered arising from this alternative are related to potential liabilities mainly in the labor and fiscal areas of the existing financial institution, which license is being acquired. Nevertheless, depending on the case (maybe a shell license) it might work as a shortcut with limited risks, depending on the quality of the due diligence process.
Normally, the option for an existing license will reduce the time-to-market.
Operational implementation process
Here is the bulk of work especially if the investor intends to start from scratch.
It implies from defining the location (solving issues such as transport facilities, communication, infrastructure) to compliance with local peculiarities such as making available in Portuguese all manuals describing every process and product plus pieces of evidence of local credit approval, for example. Besides, although Brazil is quite developed in financial instruments (e.g. OTC transaction must be registered in a clearinghouse, therefore reducing the operational risk), the local market has specific aspects that are different from any place in the world (e.g. local money market deals are traded and calculated per business days, transactions in BRL are calculated based on compound rates). This implies in a specific IT and product description approach solving issues about which system should be chosen according to each product. The good news is that there is a reasonable range of local vendors that provide acceptable systems to register, process and accrue interest.
It is important to mention that even the simpler structure in Brazil will require one FTE (or third parties) for each of at least the following areas:
- Risk Management
- IT systems/infrastructure
- Operations/B.O.
- Accounting/tax/regulatory reporting
- Compliance/audit
- Project Management
Here is where local experts could add the most value to the process: A sound support to the full operational implementation of the new business in Brazil.
Funding alternatives
On the funding profile, Brazil offers a myriad of instruments where asset product strategy is key to define specific funding products. One peculiar aspect of the Brazilian market is that local liabilities (and so many assets) are traded at a percentage of a floating rate benchmark.
SELIC is the benchmark interest rate released in the local FOMC (called COPOM) and accrues all floating Government debt/ Brazilian Treasuries (LFT). Besides this, there is the still most important benchmark, the CDI (an annual rate daily calculated based on the average local money market interbank transactions) which remains as the most important reference rate in Brazil. This is the Fund industry benchmark on Fixed Income and the bank’s industry benchmark for business in general mainly on the funding side.
CDs (Certificate of Deposits) – Local CDs represent the most important source of funding in the Brazilian banking industry. Typical CD investors are companies, investment/pension funds, and individuals. CDs have been quoted on a spread basis over local benchmark for expressive amounts (the floating CDI interbank rate above mentioned). The negative aspect of this product is that, unless explicitly mentioned, CDs are allowed to be redeemed (and usually are redeemed) much earlier than maturity. This constitutes an important issue for ALM management. Additionally, over the specific/relevant amount (higher than the scope herein) it demands the issuer a deposit reserve at the BCB.
CDIs (Interbank Deposits)– Interbank deposits are also an important source of funding and liquidity for banks due to either the usually large size of deal tickets or the fact that they offer a stable source of funding with no early redemption allowance. This will surely represent a stable and important source of funding or, at least, the range of approved credit for the entity. The relevant aspect to be considered in a business plan is the cost.
LFs (Letras Financeiras)– This is a more recent form of funding for local banks. It is intended to be compared to a debenture (this an instrument particularly issued by non-financial entities). Its minimum tenor maturity is of 24 months and does not allow early redemption. Although the market has increased recently, the scale is still concentrated in a few issuers (big banks in Brazil).
DPGEs (Depósito a Prazo com Garantia Especial)– Basic for the second-tier banks. It represents a mid/long term funding backed by FGC guarantee. Banks have a limit to issue it and must pay a premium to FGC (the guarantor) on top of the issuing price (premium is also above the CDI benchmark). It is limited to a BRL 20 m per investor.
LCAs/ LCIs (Letras de Crédito do Agronegócio / Letras de Crédito Imobiliárias)– If the bank keeps an asset portfolio that includes agricultural loans or real estate-related assets it can raise funds backed on the respective assets (asset-backed securities). Given these are key sectors for the government there is a withholding tax exemption in the case investors are private individuals. Given the higher nominal interest rate in Brazil, it represents an important saving that is typically split between bank and investor. Brazil is the largest country in the world in terms of agricultural land and very competitive in this field. Not surprisingly, some large corporates have an interest in this field. This might be an important topic to discuss in a strategic plan.
External Funding for Trade Finance or Working Capital either group-funded or third-party funded – As an international bank, trade finance deals tend to be important depending on the focus at its local market. Therefore, a substantial portion of the funding would be represented by external facilities to either finance typical trade-related transactions (pre/post export shipment here entitled as ACC/ACE loans and import finance as well) or even working capital (deals indexed to USD but settled in BRL). It will be a strategic discussion on where to book as you may find reasons on both sides. The product constitutes a stable source of funding on a key segment in Brazil. On top of head office funding (whose cost we do not know), a credit spread would be applied (Libor+) as funding is borrowed from a correspondent bank. As a policy to reduce both head office dependency and country risk exposure, many foreign banks are developing also a third-party funding strategy in Brazil.
Furthermore, having access to external funding is extremely important in emerging markets as arbitrage opportunities usually arise.
We stress out the importance of having a flexible and skilled team in Brazil as funding strategy varies quickly offering opportunities that a bank with good credit standing can capture and increase earnings without incurring additional risks/taking proprietary trading positions.
Relevant market and regulatory requirements for the IT systems
The choice for a determined systemic landscape is fully connected with what kind of products the entity will wish to deal with. There is no ‘full-fledged’ global banking system (at least no that we know of), which caters for all kinds of lending, investment, funding and derivatives instruments, for example, with modules or a product palette that you can turn on as you enter determined markets. Therefore, the option for local solutions will mean at least 2 or 3 different vendors.
On the other hand, global applications will have to be ‘tropicalized’. This means a very relevant effort of adopting international standards to local peculiarities, which are not few.
For the onshore local markets and products, which present various peculiarities when compared to developed countries, some acceptable and relatively quick systemic choices can be found for:
- FX and Trade Finance
- Derivatives
- Lending
- Subsidized governmental lending programs
- Fixed income
- Trading
- Current accounts
- Draft discount
- Accounts Payable
- Credit and debit cards processing
When compared to robust tools, those systems are to be seen more as sub-optimal solutions. File interfaces in .txt format, lack of proper segregation, poor or even absent security modules, weak architecture, outdated or inexistent documentation etc. are common issues.
Notwithstanding, what makes them interesting is that beyond the systemic solution per se what banks seek is the service providing of the companies behind them. They constantly chase (practically on a daily basis) changes in the regulatory and tax environment and are very fast to offer the necessary patches for updates. Besides the core functionalities, they normally provide all derived reporting package needed for the local regulators, mainly the Brazilian Central Bank reports. Due to the more volatile local environment, this means great service. Having to maintain a dedicated development team for all necessary constant updates proves to be not economically viable.
The difficulty for international banks is therefore to adapt their global systems to the onshore processes. We have supported many studies during the last decades, which have shown that adapting global solutions for the onshore peculiarities ends up being very expensive, sometimes not economically viable. It seems to us that all investments in this front would deserve a profound analysis. On the other hand, global systems such as those focused on risk management and offshore operations do not pose an issue.
In a nutshell, following are the applications, which could be run locally or globally, in our view:
- Commercial and Trading applications: If we think about deal ticketing and position management systems, utilized by the Front, as e.g. Lending or Trading/Treasury applications, it is important that they provide the bank with the local peculiarities when it comes to product computation. Therefore, experience tells us that local solutions would be recommended. On the other hand, some international and robust Front Office applications for Treasury and Trading are being utilized locally, which could also be a choice (Fixed Income, and Derivative Instruments). Elements as 252 days count, compound interest rate computation, specific products that are not common in other markets in the world, etc. would have to be adapted.
- Registration and settlement: On the so-called ‘Back Office Systems’ is where we are quite adamant on recommending that local applications are chosen. The myriad of regulatory demands and product and markets peculiarities regarding local accounting standards, settlement, tax, derived regulatory reporting and so on represent a relevant operational and regulatory/legal risk. The local vendors provide the banks with a quite acceptable service of maintaining the applications up to date, which frees up bank’s resources that would have otherwise to chase all regulatory updates by themselves almost on a daily basis. From an investment perspective, we do not believe that the adaptation and maintenance of global application would pay off.
- Finance, Control, and Tax: For the local needs, no doubt about sticking to the local vendors for the generation of the complete set of financial statements (journals, BS, P&L, derived regulatory reporting, tax reporting, etc.). Nonetheless, for the head office reporting, the adaptation of global financial systems, when it comes to the financial statements, could be a solution. This means a however relevant investment of some years. Management Information Systems could be either local or global, depending also on what the entity demands in terms of global management accounts view.
- Risk Management: The global systems which normally embed the proprietary models are the best choice as e.g. for the market risk and credit risk managerial figures. For local market risk and credit risk reporting one should definitely opt for simple local applications, which do the trick easier. On the Operational Risk front, a locally adapted global solution could be interesting especially because of the fact that the incident reporting to the head office is quite important for the maintenance of a global database. Avoiding manual intervention would be desirable.
- Business Intelligence and CRM types of systems: This is the field where local vendors normally cannot compete with sophisticated international applications.
- Compliance and Auditing: The trick with compliance applications, especially when talking about client onboarding and anti-money laundering functions, is to interface it to the BO and Current Account systems. Therefore, in order to avoid increased investments in the adaptation of global solutions, we recommend looking into local solutions, but the first would also be an option.
- HR: If we divide this into 2 distinct functions, we would recommend opting for local applications when talking about payroll processing and global ones when dealing with managerial applications (employee’s static data, performance assessment, target setting, etc.).
No information on this article constitutes financial advice. The information is general in nature and does not take into account the reader’s circumstances, financial needs or objectives. Before acting on any information, the company’s own objectives should be considered, as well as its financial situation and needs. To the extent permitted by law, The Sharp Fintech shall not be considered liable for any direct, indirect and consequential costs, losses, damages, and expenses incurred in any way (including but not limited to that arising from negligence), connected with any use of the information contained on this article.
[1]Due to the foreign investor status. There is a project to eliminate a presidential decree demand, leaving it at the sole discretion of the BCB.
