This in turn would have raised growth by about one percentage point, similar to the gains from the improvement in the enforceability of contracts.

# 4. The Deternminants of Net Interest Margins

Brazil exhibits not only a low level of financial intermediation, but also one of the highest net interest margins in the world (Table 1): over the 1988-95 period, margins in Brazil were twice as high compared to other middle-income developing countries. Overhead costs and taxes were also much higher in Brazil than in other comparable countries. In the following we analyze the relationship of the determinants of the level of financial intermediation and net interest margins.

Net interest margins can be measured in different ways, by either considering the ex-ante spread between deposit and lending rates, or by focusing on the ex-post difference between actual interest revenue and cost. There are methodological advantages and disadvantages of both measures. Ex-ante spreads partly reflect credit risk, which varies significantly across classes of firms and countries. Furthermore, it is unclear to what extent quoted rates reflect actual transactions. Ex-post spreads capture actual net interest income, and thus reflect actual transactions and correct for the differences in rates charged to borrowers. While ex-post margins also include the actual degree of defaults, they can be distorted if interest income and loan loss reserving associated with a particular loan occurs in different periods. Neither measure takes into account fee-based income, which is gaining in importance for banks both in developed and developing countries. And both measures depend on accurate reporting and good quality financial information.

Table 3 presents the net interest margins and fee based income as share of total assets for the past years for the three largest banks in Brazil, which account for more than 50% of the private banking sector. While net interest margins have come down recently, fee income as share of assets has increased. Increasing the fee-based income has been one way for Brazilian banks to replace the float income they lost as inflation has come down in recent years. But by standards of most countries, these margins are still very high. Contributing factors include the very volatile macro-economic environment in which Brazilian banks have had to operate, the high reserve requirements and obligatory lending Brazilian banks have been subject to, the weak judicial systems, a protected banking system, and high financial intermediation taxation.

Table 3: Net interest margins and fee income for Brazilian banks

||1995|1996|1997|
|---|---|---|---|
|Net interest margin / Assets|14.5%|10.5%|9.5%|
|<br>Fee income / Assets|3.3%|4.5%|4.4%|

Note: The numbers are unweighted averages for Unibanco. Bradesco and Itau, the largest three private banks. Source: ABN-AMRO The recent Central Bank study has identified credit risk, taxes and overhead costs as the main determinants of the high ex-ante spreads in Brazil. Delinquency was identified as the largest component of the interest rate spread, with direct and indirect taxes constituting the second largest component (Figure 1). These results confirm the importance of legal and judicial reform 7