Banking barricades: central banks brace for the impact of covid-19

Banking barricades: central banks brace for the impact of covid-19 Credit: shutterstock/Andy Dean Photography

When it comes to the effect of covid-19 on the economy, one word comes to mind: devastating. While governments are taking action to protect people against the public health crisis, Latin America’s central banks are putting measures in place to brace for the economic impact of the pandemic.

According to the World Bank, Latin America’s combined GDP, which only grew marginally in 2019, is expected to shrink 4.6% in 2020 (excluding Venezuela) — a decline deeper than the one experienced during the 2009 financial crisis. Before turning to the IMF for a lifeline to finance their expenses and debt repayments — some have already done so — countries are implementing fiscal relief measures through their central banks to try to kickstart their economies. “Financing from the fund is on high demand, but it will be a last-resort lender in a lot of cases,” says partner Gabriel Gomez-Giglio from Baker McKenzie (Argentina).

Central banks – financial institutions with privileged control over the production and distribution of nations’ money and credit – can offer various solutions and are trying to ease the burden of covid-19. By implementing measures such as lower interest rates, cheaper loans and extending tax payments, central banks can increase market liquidity and help keep economies going in a time of crisis. Many of these measures have been documented in Latin Lawyer's covid-19 information hub, which is available to read here.

Helping hands for SMEs

Argentina has received praise for its response to covid-19, but the country is arguably set to feel the economic effects of the virus more intensely than others in the region. When President Alberto Fernández shut borders, businesses and most transport systems in late March, Argentina was already in a deepening recession. That same month, the country pressed pause on its offer to restructure billions of its international debt with bondholders.

Argentina’s Central Bank has enforced regulations designed to help the most vulnerable in the business sector, small to medium-sized enterprises (SMEs). “The Central Bank is encouraging commercial banks to grant credit lines to SMEs, which were heavily hit by the local recession and reduced commerce during lockdown,” says Baker McKenzie’s Gomez-Giglio.

Efforts include the implementation of a special US$3.5 billion credit line for SMEs at an annual interest rate of 24% (below the national inflation rate, which reached 47% in March according to Trading Economics). This is aimed at financing working capital, including salaries or processing of cheques. To increase the lending capacity of financial institutions, the Central Bank has requested they issue treasury bills – a type of government-backed debt obligation with a maturity of one year or less. This would provide banks with capital and facilitate their lending under the programme.  

Argentina’s Central Bank has also reduced the fractional reserve of US dollars that local financial institutions have deposited at the Central Bank. While this reduces deposits held by the Central Bank, it also allows banks to provide more cash withdrawals to customers and to increase the circulation of US dollars in the local foreign exchange market.

However, the US$3.5 billion loan programme has some complications. Given Argentina’s interest rate is below its inflation rate, law firm partners say banks are reluctant to grant financing, while many companies cannot meet the banks’ conditions, making it tricky for them to obtain the loans. As a result, many SMEs turn to supply-chain financing, an alternative form of short-term loan where SMEs finance suppliers’ invoices with a bank loan, providing short-term credit to ramp up working capital and liquidity to both the SME and the supplier.

The advantage of this approach is that suppliers gain quick access to money they are owed, while buyers get more time to pay off their balances – but the complexity of such contracts is that businesses can be crippled financially and left struggling to survive. This is because such loans are expensive and securitised by the SME’s business. If the SME is subsequently late in its repayments and becomes insolvent, the bank can take possession of the business, sell it and use the proceeds to repay the loan. “Since not all SMEs can apply for bank loans, some have no alternative but to agree to their own financings with their suppliers,” says Carlos Alfaro, partner at Alfaro Advogados. “Inevitably, the companies unable to obtain bank loans will close. Even if they do not go bankrupt, they will incur losses without working capital, and be left unable to self-finance.”

Neighbouring Paraguay’s Central Bank has appointed local development bank Agencia Financiera de Desarrollo (AFD) to manage a US$109 million fund (known by its acronym FOGAPY in Spanish), to provide low-interest-rate financing to SMEs and offer guarantees to support companies’ loan applications. On top of this, the Ministry of Finance, AFD and the Central Bank have jointly added another US$100 million to an existing SME’s reserve fund to support these entities’ financing applications, ramping up the fund’s total amount to US$500 million.

A survey carried out by the Association of Paraguayan Entrepreneurs (Asepy) revealed that 61% of local SMEs have temporarily closed their operations over the course of the covid-19 pandemic – but FOGAPY should help them survive until the economy begins to stabilise again. “We advise a lot of financial clients, and the common thread throughout our interactions is that banks need to engage with their clients to try and understand the financing they might need under this new scenario,” says Carlos Vouga, managing partner at Paraguay’s Vouga Advogados.

While many local lawyers approve of FOGAPY, some say the Central Bank should implement more long-term measures, such as extending deadlines for payments of loans. “They should ease certain conditions and requirements for SMEs, as they account for a sizeable part of Paraguay’s economy,” explains Vouga. “Without this aid, most of them will likely experience serious financial hardship.”

Meanwhile, Mexico’s Central Bank has put together special aid packages and regulations for commercial and development banks. The bank has set up a covid-19 crisis support fund of 750 billion Mexican pesos (US$30.7 billion), of which 250 billion pesos (US$10.4 billion) is earmarked for SMEs. If needed, the Central Bank is prepared to add another 100 billion pesos (US$4.1 billion) in support to SMEs. The funds will be granted through commercial or development banks.

“The Mexican Central Bank takes action when it comes to liquidity, exchange rate and purchase power, which is what they do to stay stable when things are hard,” notes Juan Sancho Rodrigo, partner at González Calvillo, SC. A good purchasing power rate – which indicates the goods and services one unit of a currency can buy – indicates an economy is working well. Unsurprisingly, purchasing power during the covid-19 pandemic is taking a hit. “But this additional liquidity and special SME fund is supplementary liquidity and is in addition to what central banks usually do.”

In a similar vein, the Central Reserve Bank of Peru (BCRP) has put together a liquidity relief programme named Reactiva Peru, which will inject 60 billion soles (US$17.5 billion) into the local economy. The amount will serve as a guarantee for new loans to pay for the working capital of companies facing short-term issues, including paying salaries and suppliers. "As of today, around half of that amount has already been awarded to the country's local banks and financial institutions to then be disbursed to those companies in need," says partner Diego Peschiera at CMS Grau. "The amount is totally unprecedented in Peru."

To guarantee the loans, the BCRP purchases credit from financial institutions, with an agreement that the financial institutions will repurchase the credit at a later date: also known as a repurchase agreement (repo). The programme works through a private auction. “The auction mechanism was designed to generate competition among the Peruvian financial entities to obtain low-interest rates in the subsequent credits granted to the public,” says Sergio Oquendo, partner at Muñiz, Olaya, Meléndez, Castro, Ono & Herrera. The institution that offers the lowest interest rate to borrowers will win the bid and enter into a repo with the BCRP. This then injects liquidity into the financial system quickly, so that financial institutions can continue to grant loans.

Balancing the books

The Brazilian Central Bank has paid a lot of attention to helping local banks maintain a robust balance sheet by issuing an onslaught of macroprudential measures to mitigate the impact of covid-19 on the whole financial system.

One such measure is to reduce the mandatory threshold for banks’ capital conservation buffers. These buffers are an additional sum of capital which sit on top of banks’ reserves – so when a crisis hits and starts eating into the buffer, the bank, for a time, is safeguarded. However, as banks are facing a poor economic environment due to the covid-19 pandemic – putting pressure on their asset quality, liquidity and profitability – the Brazilian Central Bank has reduced the current capital conservation buffer from 2.5% to 1.25% until March next year.

The measure should help to reduce banks’ excess credit growth, which often happens when a financial system faces risks – in this case, the pandemic. By reducing the buffer, banks have greater access to existing cash deposits to grant loans, rather than relying on credit. “Such measures help to reduce expenses, preserve a robust balance sheet and allow banks to continue to function during the pandemic with the minimum impact possible to their employees and other stakeholders,” says partner Larissa Arruy from Mattos Filho, Veiga Filho, Marrey Jr e Quiroga Advogados. However, the downside is that decreasing buffers means many banks are leaving their bottom lines vulnerable.

Brazil’s Central Bank has also created a special financing instrument for financial institutions in the form of debentures or notes; reinstated guaranteed deposit certificates (DPGEs); and limited financial institutions’ ability to distribute profits and increase managers’ compensation. “Banks are doing their best to grant a high degree of liquidity and transfer that to their clients,” says Guilherme Dantas, partner at Siqueira Castro Advogados. “We’re advising a lot of clients on how to structure and inject cash into an operation that doesn’t expose banks to covid-19 risks.”

Interest rates are another key point of concern for central banks across Latin America. Lowering interest rates can stimulate economic growth by encouraging borrowing and investing – but when rates are too low, it can trigger inflation. Brazil lowered its interest rate more than expected to a record low of 3% last week. In March, Mexico reduced its interest rates by 0.5 percentage points, from 6.5% to an annual rate of 6%. “Consumer spending is key in the economic balance in Mexico, and their needs are very different now. With people spending less, higher interest rates are not the answer. It is a very delicate balance to strike for the banks,” says Julián Garza, partner at Nader, Hayaux y Goebel in Mexico.

In March, Peru’s BCRP decreased its interest rate by 100 basis points, reducing it to 1.25% from 2.25% – it also adjusted the bank’s legal reserve requirements (encaje legal) in national currency from 5% to 4% and in foreign currency from 50% to 9%. Reducing the reserve requirement means the BCRP can now inject more money from its reserve into the economy and lend more money. “The BCRP has already approved specific regulations to ease the pressure on banks,” says CMS Grau's Peschiera. “The Peruvian banking system is very well regulated and solvent, and the banks are doing their best to keep business running during this period.”

ATMs: Attracting Too Many (people)

On an operational level, central banks across Latin America have ordered commercial banks to suspend administrative processes that usually take place in bank branches, as well as closing branches and requesting all filings and communications be done electronically. However, this comes with its own problems.

According to a study conducted last year by American Express, about two-thirds of Latin America still favour cash transactions over credit and digital payments. To prevent people having to leave their homes to access bank services, partner Guillermo Ferrero from Philippi Prietocarrizosa Ferrero DU & Uría (Peru) says that in the case of Peru an ideal solution would be for banks to ramp up digitalisation of their processes so that people can access services remotely. But, he says, “it is clear that the lack of a high penetration level of financial institutions in the entire financial market, promoted by informal businesses, creates hurdles for the those institutions to move in that direction.”

Closing ATMs and bank branches and moving banking operations online leave those who have no access to the internet vulnerable. Last month, a select few Argentine commercial banks reopened their branches to alleviate this, but most branches ended up with large crowds not obeying social distancing rules. “Banking was not declared an essential activity from the outset and should have been. This would have guaranteed banking security for those parts of the population that do not have cards to use ATMs or access to online banking,” says Carlos Alfaro in Argentina.

The Argentine Central Bank later introduced an electronic appointment system using the number on citizens' identification cards (DNI) to limit the volume of clients in bank branches. According to partner Carolina Zang from Zang, Bergel & Viñes Abogados, banks have had to proactively manage risks, regulations and capital to adapt to the constantly evolving covid-19 environment. 

Latin America’s central banks are under pressure, holding the weight of their country’s monetary policy and economic health on their shoulders amid the covid-19 pandemic. But short-term measures to support SMEs, book-balancing initiatives to help banks stay afloat, and operational measures to stay aligned with social distancing have for now provided temporary solutions at least. “So far, most measures have a timeframe of three months while quarantine was in place,” says Paraguay’s Vouga.

But he predicts central banks will have to look ahead as it becomes clearer covid-19 is likely to have a lasting impact for years to come. “It is now clear that banks will need to engage their clients to anticipate their financing needs way beyond what was originally forecasted, for years to come,” Vouga says.

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