Credit risk transfer in Brazil: bridging the gap in regard to synthetic instruments

Maurício Santos

Cescon Barrieu, Rio de Janeiro
mauricio.santos@cesconbarrieu.com.br

Marianno Cunha

Cescon Barrieu, São Paulo
marianno.cunha@cesconbarrieu.com.br

In Brazil, running a credit business is not a simple task. Low recovery rates and complex taxation are only some of the material issues affecting such activities, not to mention the macroeconomic challenges of a typical emerging economy.

To deal with this challenging scenario, variable interest rates and shorter maturities are commonplace in regard to bank assets. Selling exposures is also a must in the day-to-day life of any risk manager. Yet, the local market in Brazil is working its way towards the global trend of transferring risk synthetically.[1]

Of note, the number of private credit funds has increased substantially in Brazil within the last few years and has become an important source of liquidity for banks willing to sell exposures, particularly non-performing loans. Offshore players are also well-positioned to get involved in such activities, either by funding local asset managers focused on private credit strategies or investing directly in securities that represent credits or securitisations thereof, as both of these alternatives enjoy favourable tax treatment under Brazilian law.

In this article, we provide an overview of the key legal matters relating to credit risk transfers in Brazil. We also delve into the alternatives to transfer risk either as a straightforward change of ownership or in synthetic form, including their shortcomings and the expected developments. The last section provides some brief conclusions.

For the purposes of simplification, we use the example of a bank acting as a risk transferor in this article, although similar requirements apply to other financial institutions engaged in credit business in Brazil.

Key legal matters[2]

The paragraphs below summarise the key legal matters associated with the transfer of credit risk by banks in Brazil. The extent to which they apply to a certain case will heavily depend on the transfer structure selected from among those described below.

Transferability

Under Brazilian law, a creditor is free to transfer a credit right, unless it is against the nature of such right, the law or contrary to an agreement with the debtor.[3]

In the banking space, the regulations provide more flexibility in regard to transactions wherein the transferee is a party that is involved in the financial system, for instance, the rules allow recourse against the transferor and whatever payment mechanics fit best. When the transferee is from outside the financial system, however, regulations forbid such a recourse against the transferor and only admit the payment of the purchase price as a single lump sum at closing.[4]

On the contractual side, the borrowers’ consent is usually built into the language of credit instruments, although careful assessment is advisable for positions involving large borrowers that may have bargained for carve-outs, such as limiting consent to transfers within the lender’s group.

As a general note, loan participations are not expressly regulated, but likewise are not prohibited, by Brazilian law. While parties are free to enter into unregulated contractual arrangements with similar effects, participation agreements are not frequently seen in the local market. Instead, they are more commonly used in certain cross-border arrangements governed by foreign law. The closest equivalent under Brazilian law is the so-called linked transaction (operação ativa vinculada), as detailed below.

Bank secrecy

The Brazilian Bank Secrecy Act covers credit transactions, so any related disclosure requires the borrower’s previous and express consent, unless an exemption applies.[5]

One main exemption covers the sharing of information with the public credit bureau (Sistema de Informações de Créditos or SCR), which provides valuable input to financial institutions and, therefore, fosters risk transfers within the financial system.

Conveying information as an aggregate, anonymous set of data (eg, the delinquency rate of a large portfolio) is also another way to legally disclose information, even when a statutory exemption to do so does not exist.

A violation of bank secrecy is a criminal offence in Brazil, so the usual legal approach towards this matter is conservative.

Registration and reporting

Brazilian law requires the registration of credit transfers as a condition for their effectiveness against third parties, although an unregistered transfer is still valid and effective between the contracted parties. Absent such registration, the transferor must give notice to the borrower to ensure that, from then on, the borrower knows that it owes the relevant amounts to the transferee.[6]

The market practice varies across different products, for eg, to save costs, registration is typically not made at the outset of transfers of large consumer portfolios.

A transferor bank must also report transfers to the SCR and an additional registration may be required for certain types of credit (eg, auto loans, credit card receivables).

Existing alternatives: shortcomings and the road ahead

Plain vanilla sales

Traditional sales (particularly in regard to non-performing loans) have increased in recent years as a local secondary market has evolved, while banks have improved their asset recovery departments to restructure portfolios and invest in new opportunities.

A particular feature of the Brazilian credit market is that a portion of it operates as a bond business pursuant to which banks provide credit by purchasing an entire issue and holding it until maturity, unless a trading opportunity or a restructuring need arises. So, the corresponding transfers take the form of bond trading.

Another major portion of the market is in the form of bank credit notes (cédulas de crédito bancário or CCBs), which are issued by borrowers and entitles banks with a right readily enforceable in court, despite any judicial ruling on its existence or amount.[7] Subject to certain criteria, banks’ selling efforts with respect to CCBs are exempted from securities law (hence, offering registrations), so simply selling the CCBs is another frequent alternative to offload credits onto the market.

Securitisation

Securitisation via an investment fund

A frequent alternative to deleverage positions is seeking third-party funding by forming an investment fund to purchase credits (so-called fundo de investimento em direitos creditórios or FIDCs).[8]

Such a fund is notably tax efficient as capital gains and earnings are not taxed at the fund level and only distributions to investors are subject to taxation. The regulations also offer substantial flexibility, but the ongoing costs of the vehicle make it more suitable for medium/large securitisations. For instance, it is widely adopted in the Fintech space to raise funding from institutional investors.

It also works as a bankruptcy-remote structure due to the absence of a legal personality under Brazilian law.

The banking regulations, however, contain several limitations in regard to a credit transfer to a FIDC. For instance, a transferor bank may not purchase a senior tranche of the fund, the market practice is to fill in this tranche with institutional investors, while the transferor’s skin in the game is in the form of a subordinated tranche.[9]

Recently, a change in the applicable regulations has enabled the offering of FIDCs directly to retail investors, although this new funding source is still in its early stages.

Securitisation via a special purpose company

A securitisation may also be centred on a special purpose company (so-called companhia securitizadora de créditos financeiros) that acts as issuer of asset-backed securities.[10] This vehicle typically issues fixed-income instruments (bonds), as opposed to the variable payoff of quotas issued by investment funds.

Bankruptcy remoteness is based on constituting a separate estate for each issue, as well as a set of regulatory limitations in terms of the ability of this securitiser to do business.[11]

Unlike FIDCs, this securitiser is taxable, like any other company. The setup and ongoing costs of such a structure are also non-negligible.

Linked transactions

As discussed earlier, loan participations are not expressly regulated under Brazilian law.

There are similarities, however, with so-called linked transactions (operação ativa vinculada), whereby a bank (lender) issues a debt instrument (eg, a term deposit or leasing bond) to raise funds involving a third party (financer) and uses the proceeds to provide finance to a customer (borrower).[12]

The asset and liability sides are linked contractually on a back-to-back basis, so that credit events affecting the borrower do not harm the intermediary bank, but rather impact the credit right owed to the financer. Accordingly, the credit transaction with the borrower is exempt from lending limits in regard to large and concentrated exposures.[13]

Yet, certain restrictions (eg, provisions for loan losses) apply to the bank, which makes this structure not entirely efficient.

A change to the applicable rule is a long-awaited demand of market participants.

CCCBs

As described above, a sizable portion of credit transactions in Brazil is documented as bank credit notes (CCBs).

Also, one or more CCBs (or a fraction thereof) may be repackaged into a CCB certificate (certificado de cédula de crédito bancário or CCCB). Once this certificate is issued, the bank becomes the custodian of the underlying CCBs and must collect and pass along all the due amounts to the certificate holders. The underlying CCBs and amounts collected are protected against seizure, and public selling efforts are exempt from securities law like in the case of CCBs.[14]

These features make CCCBs a valuable alternative for shifting credit risk, while still preserving the structure of the underlying transactions and the corresponding bank–customer relationship. The existing regulations, however, only cover transactions in the form of CCBs, which is a significant limitation to the widespread adoption of such certificates for risk transfers in general.

Credit derivatives

Credit derivatives have been regulated in Brazil since the early 2000s, although an active market has never existed. The key obstacle has been in the form of the market consensus that the regulations only admit financial institutions as protection buyers.

This scenario is changing, however, as a wide-ranging revamp is underway and the new regulations are more strongly connected to international practices on credit default swaps.[15]

Among other changes, the new rules incorporate a standardised taxonomy, allow a larger set of potential protection buyers, as well as admitting intragroup credit derivatives (even with foreign counterparties) and have added more flexibility in regard to the eligibility requirements for underlying assets.

Time will only tell whether an active market becomes the reality, but credit derivatives may play a vital role in addressing the long-term funding needs in Brazil, as is the case in regard to infrastructure financing.

Structured notes

The so-called certificado de operações estruturadas (COE) was conceived to be the structured note for the Brazilian market and, as such, it offers the payoff in terms of a zero-coupon bond with an embedded derivative.

Until the end of last year, its use as a credit-shifting instrument was limited by the relevant regulations and was non-existent in practice. The reform in regard to credit derivatives also resulted in a new rule for COEs in Brazil that, among other innovations, created a new type of COE in reference to credit risk and intended to function as a credit-linked note (the so-called COE de risco de crédito).[16]  The prudential regulations were also amended to ensure that this new instrument promotes the desired capital relief.

Like the case of credit derivatives more broadly, it is yet to be seen whether the introduction of these notes will turn into an effective synthetic instrument for participation arrangements in Brazil.

Credit insurance

In general, shifting risk via credit insurance is still in its infancy in Brazil’s banking sector. At the core of the challenges faced in this regard, market participants want a more nuanced approach towards capital relief and greater alignment between bank and insurance regulators.

Brief conclusions

As detailed above, the existing options in regard to the transfer of risk in Brazil are either straightforward sales or a few instruments designed to shift risk synthetically. Institutional investors close some of these gaps by offering fresh money to high-yield or otherwise distressed borrowers, although there is still room for improvement in regard to the existing regulatory framework. Fortunately, building the bridge between traditional and more innovative structures is a project that has now been set in motion.

In this context, international players may also play a significant role in this new reality by sharing their experiences and will later reap the benefits of a more efficient credit market in Brazil.

This article was prepared for information purposes only and the content included herein is not meant to provide legal advice with respect to any specific matter. We do not undertake to update, supplement or modify the information contained herein.