# **1. Introduction**

1. **Understanding the causes of high interest spreads and low access to credit in Brazil is an important task both for the financial community at-large and for country specialists** . The Brazilian financial system is by far the largest and arguably the most sophisticated in Latin America. Brazilian banks successfully navigated through several episodes of hyperinflation in the 1980s by creating sophisticated networks to reap the gains of float, while they have also adapted to the more stable environment of the last decade, and appear rather resilient to the current international financial crisis. However, the cost of financial intermediation, in terms of both absolute interest rates and spreads, remains among the highest in the world, and credit is rather scarce for a significant proportion of the economy<sup>1</sup> . Identifying and analyzing the various contributory factors, including the role played by the industry structure of banking services, is therefore an important exercise for policy purposes.

2. **An important feature of the high average lending rate is that it conceals important differences between the spreads charged to different types of clients** . The Central Bank of Brazil (Bacen) has released since 1999 a series of papers under the research program on “ _Juros e Spread Bancario_ ”, which quantify the various determinants of the spread through an accounting decomposition. According to this program, the main factors behind high interest spreads appear to be operational costs, the costs imposed by the government through explicit and implicit taxation (including unremunerated reserve requirements), and high returns. All these factors may be influenced by, as well as contribute to, the industry structure and degree of competition in different market segments. In particular, there exist large differences in rates between corporate and retail lending products, driving a wedge in access to credit between corporations and individuals or small firms. The extent to which those differences could be attributed to segmentation and market power in different segments is therefore an important question<sup>2</sup> .

3. **While other studies have attempted to assess the degree of competition in the Brazilian banking sector, they have not analyzed individual market segments** . For example, both Nakane (2001) and Belaisch (2003) perform such an analysis at the aggregate banking level and conclude that the Brazilian banking industry neither behaves as a cartel nor is it perfectly competitive, a finding that is not particularly useful for

> 1 Empirical results in the World Bank’s Investment Climate Assessment for Brazil (December 2005) suggest that firms of all sizes – particularly smaller ones – are credit constrained, with the cost of credit being the most commonly cited reason for not applying for a loan. Access to credit has improved in recent years due to a favorable macroeconomic environment, although its cost has not decreased significantly. 2 The World Bank (June 2006) also cites the industry structure and level of competition in specific market segments as potentially important – but still unexplored – issues in the debate on interest rates and spreads in Brazil. In particular, the report states that “ _the_ ‘ _largest bang for the reform’ buck in terms of reducing intermediation spreads would come, at this stage, from sustainable reductions in the SELIC rate...as the SELIC declines, these types of factors [implicit and explicit taxation, administrative and operational costs, competition, contract enforcement institutions] will increasingly become binding constraints to further reduction of intermediation spreads. Hence, reforms to tackle these micro factors should remain an important priority in the government’s reform agenda_ ”.

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