small firms – with two exceptions<sup>45</sup> – and should therefore be allocated to Retail (as opposed to Corporate).

As a result of the aforementioned allocation mechanism, the Retail business line accounts for 50 percent of the banking system’s gross loans (39 percent and 11 percent are loans to individuals and small firms respectively), while Corporate and Government account for 48 and 2 percent respectively.

# **Allocation of Non-Performing Loans and Loan Loss Provisions**

Bacen’s monthly report on financial system credit operations is also used to measure non-performing loans (NPLs) and allocate loan loss provisions (LLP) by business line. NPLs are defined based on Bacen regulations as those loans whose credit ratings are D- H, which are loans representing higher levels of credit risk and/or are already in arrears for more than 60 days. The NPL ratios for some loan types (e.g., individuals, housing, public sector, rural, etc.) can be explicitly derived from the report, while assumptions are made for all other types such that the overall estimated NPL rate for the banking system is consistent with that reported in the Bacen report (8.1 percent as of end-2007<sup>46</sup> ).

Once the volume of NPLs by business line is calculated, the reported LLP – found in both the balance sheet and income statement – of the banking system are allocated in the same proportion as their respective NPLs. It could be argued that retail loans, which are generally unsecured, have lower recovery rates and should therefore have proportionally higher LLP than their corresponding figure for default rates; however, to the extent that ratings and their corresponding LLP already reflect collateral coverage (i.e., they measure Expected Loss and not just Probability of Default), this problem should not arise.

As a result of its higher NPL rates, the Retail business line accounts for 68 percent of LLP even though it only has 50 percent of gross loans. By contrast, Corporate accounts for 31 and 48 percent of LLP and gross loans respectively, while Government represents 3 and 2 percent of LLP and gross loans respectively.

# **Allocation of Interest Income on Loans**

Two types of data are required in order to estimate and allocate interest income on loans by business line:

- Average 2007 volume of performing loans by business line – this is estimated by appropriately ‘scaling down’ the volume of performing loans that had been previously calculated for end-2007

- Average interest rate by type of loan during 2007 – this is estimated based on rate information found in Bacen’s report on financial system credit operations<sup>47</sup> .

> 45 Those exceptions are earmarked rural lending (assumed to be divided equally between Retail and Corporate based on interviews) and first-tier direct BNDES lending (assumed to consist entirely of Corporate loans from interviews).

> 46 Loans rated categories D and higher.

> 47 The average interest rate by type of loan is effectively a weighted average of rates of different maturities. Corporate non-earmarked loans in domestic currency are assumed to be based on a spread over the CDI rate, while all foreign currency loans are assumed to be priced off the US Libor. In the case of earmarked

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