Financial institutions in Brazil: Decree encourages foreign equity investment

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Maurício Teixeira dos Santos
Cescon, Barrieu, Flesch & Barreto Advogados, São Paulo
Mauricio.Santos@cesconbarrieu.com.br

Vinicius Sahione
Cescon, Barrieu, Flesch & Barreto Advogados, São Paulo
Vinicius.Sahione@cesconbarrieu.com.br

Alexandre Vargas
Cescon, Barrieu, Flesch & Barreto Advogados, São Paulo
Alexandre.Vargas@cesconbarrieu.com.br

Introduction

On 27 September 2019, the Brazilian government enacted Decree 10,029, a greatly anticipated measure that delegates powers to the Central Bank of Brazil to authorise foreign investors to hold equity in local financial institutions.

Considering the potential of Decree 10,029 to reshape the investment landscape in the offering of financial services in Brazil, this article explores the origins of the restrictions to foreign investment in local financial institutions and the outlook for the future in line with the Central Bank’s initiatives towards building a stronger and more efficient financial industry in Brazil.

Case-by-case authorisation by decree: uncertain and politically driven

Until the enactment of Decree 10,029, the incorporation of financial institutions by foreign shareholders and foreign investment in local financial institutions were subject to the issuance of a decree by the President of Brazil authorising such investment as being in the interest of the government, on a case-by-case basis.

The process to obtain such authorisation was uncertain in terms of timing and a mix of technical discussions and political lobbying. In short, it was usually initiated in the Central Bank, reviewed by the National Monetary Council (Conselho Monetário Nacional), the highest-ranking authority in the Brazilian financial and capital markets, only then being submitted for the government’s approval for the issuance of the decree, as described below:

• step 1: authorisation by the Central Bank;

• step 2: authorisation by the National Monetary Council;

• step 3: review of the request by the Office of the President’s Chief of Staff (Casa Civil);

• step 4: issuance of a decree recognising the government’s interest in foreign investors holding equity in the local financial institution (as required by the Brazilian Constitution); and

• step 5: authorisation to operate granted by the Central Bank.

Given the political component of the authorisation process, it was difficult to estimate the duration of the process (it could take years). Such legal uncertainty and a stringent regulatory landscape related to the incorporation of financial institutions for local players led to decades of concentrated financial and credit markets in Brazil, with few international players to counterbalance such issue.

In the past 20 years, an average of only six decrees were issued a year, whereas in the past ten years this average has dropped to three decrees a year. The number of authorisations granted is expected to increase significantly with the enactment of Decree 10,029.

Authorisation by the Central Bank: enhanced legal certainty

Under Decree 10,029, the entire authorisation process is delegated to the Central Bank. It will have the power to decide whether any given foreign investment is in the government’s interest, thus shortening the path to authorisation and greatly reducing the political component of the process.

The authorisation of foreign investors to hold equity in local financial institutions is now an additional step of the Central Bank’s standard process for the incorporation of financial institutions or transfer of corporate control, which equally apply to Brazilian residents who invest in financial institutions. This means the process is more technically driven, with less political intervention.

The direct effect of Decree 10,029 is to provide legal certainty and business perspective to foreign investors, bringing the investment process in financial institutions in Brazil closer to the best practices adopted in developed countries.

While in previous years the Central Bank has focused on stimulating the creation of Fintech companies to challenge incumbent players in the payments and credit industries, these institutions do not cover the full range of financial services. Decree 10,029 is a bold step towards opening the Brazilian financial system to foreign investment, in connection with several other measures designed to foster investment in Brazil and provide competitiveness to the economy in the international scenario.

Opportunities for foreign investment

In October 2018, to encourage the development of the credit Fintech industry in Brazil, a Decree was issued giving the Central Bank the power to authorise foreign entities to hold equity in local credit Fintechs (Sociedade de Empréstimo entre Pessoas (SEP), for peer-to-peer lending, and Sociedade de Crédito Direto (SCD), for own capital lending), in a similar format to Decree 10,029.^[1] To date, eight credit Fintechs have been granted authorisation to operate by the Central Bank.

Decree 10,029 widens the scope of the previous decree to cover foreign investment in all types of financial institutions in Brazil. The purpose of this measure is to promote the entry of new foreign players to compete with local banks and financial institutions. Relevant market opportunities can be found in sectors such as:

Retail banking

The retail banking industry is dominated by a handful of local players, with rare exceptions; several relevant international players have left the Brazilian retail banking sector over the past 20 years, which has only increased market concentration.

Credit

Banking spreads in the personal credit sector have decreased with increasing competition from the credit Fintechs, but businesses are largely dependent on public banks to access credit; Brazil has a huge demand for credit in areas such as agriculture, infrastructure and real estate.

Financial services in the capital markets

The offering of financial services in the capital markets is highly concentrated on local players, with a few exceptions – this concentration is even more pronounced among broker-dealers than investment banks.

Foreign exchange

The Brazilian foreign exchange market is dominated by the major banks and the foreign exchange spreads are among the highest in the world, especially those related to international credit card transactions.

By fostering competition in such sectors, the Central Bank expects an overall reduction in the cost of credit in the economy, including banking spreads and the cost of financial services offered to end users in Brazil. As is well known, banking spreads in Brazil are among the highest in the world. The interest rates for the most accessed credit lines averaged, in September 2019: (1) 116.3 per cent a year for personal credit; and (2) 47.6 per cent a year for business.^[2]

Despite high default rates being a significant component of the banking spreads, the Central Bank understands that an equally significant factor is the lack of competition. As such, the financial authority believes that the key to speed up the reduction of overall cost of credit is to promote the entrance of foreign players to compete with the local incumbents.

Future outlook: measures to open the economy

The initiative of easing foreign equity investment in local financial institutions (through Decree 10,029) is coupled with other projects led by the Central Bank within its ‘Agenda BC#’^[3] to attract foreign investment and, more broadly, to open the economy:

Foreign Capital Act

A legislative proposal was presented to Congress to repeal and replace the present foreign capital and foreign exchange legislation to modernise and simplify cross-border transactions in Brazil, thus creating a more favourable environment for doing business.

Fostering the Brazilian capital markets

A joint initiative was launched by the Central Bank, the capital markets and private insurance regulators with the goal of increasing the access of business to the capital markets, focused on improving capital markets instruments available for the private equity, real estate, hedging, derivatives and insurance industries.^[4]

Secondary markets for fixed income and government bonds

Measures have been introduced to encourage the creation of relevant secondary markets for fixed income and government bonds, thus increasing the economy’s liquidity, for which foreign capital is instrumental.

Conclusion

The reforms are a key step in attracting foreign investment. The present regulatory framework for foreign capital in Brazil is obsolete and requires urgent modernisation, since it still mirrors the restrictions imposed on foreign capital stemming from decades of high inflation and a weak currency (early 1960s to mid-1990s).

Other initiatives that are considered to be a priority by the Central Bank under the Agenda BC# are the creation of: (1) a ‘fast payments’ system; (2) an open banking system; (3) a permanent regulatory sandbox for Fintech companies; and (4) a permanent competition division to address competition and antitrust issues in markets regulated by the Central Bank, which is especially relevant due to the high degree of concentration in several of them.^[5]

The Brazilian financial system has undergone a significant transformation process in recent years and the Central Bank is eager to tackle fundamental hurdles to the attraction of foreign capital. Easing foreign investment in local financial institutions is an important first step in that direction, stimulating competition in the offering of financial services in Brazil and the overall reduction of the cost of credit in the economy.

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