Banking Behaviour and the Brazilian Economy After the Real Plan:
a Post-Keynesian Approach*
Luiz-Fernando de Paula** and Antonio J. Alves, Jr***
Abstract: This paper aims at analysing  from a Post Keynesian approach - the Brazilian banking
behaviour in the current phase of the business cycle that is at the semi-stagnation state of the
economy. According to the Post Keynesian approach, banks are economic agents that have
liquidity preference determined strongly by their expectations under uncertainty, managing their
portfolio according to the trade-off between liquidity and profitability. We argue that banking
behaviour in Brazil has been determined by the specific institutional-macroeconomic context of
the current phase of the Brazilian economy, with banks taking advantage of the high rates of
interest and the conditions in which government has managed its internal debt. But at the same
time banking strategies are determinant of the current phase since portfolio allocation has been
dominated by a short-termist behaviour and high liquidity preference that have resulted in low
credit supply and high banking spread.
Key words: Banking behaviour, public debt, Brazilian economy, Post Keynesian economics
JEL classification: E4; E6; G2

* The paper is the outcome of research as part of the Money and Financial System Group (www.ie.ufrj.br/moeda)
pursued at the Institute of Economics, Federal University of Rio de Janeiro. Financial support from the National
Research Council (CNPq) and the Research Foundation of the State of Rio de Janeiro (FAPERJ) are gratefully
acknowledged. We are very grateful to Philip Arestis, Fernando Ferrari-Filho, José Luís Oreiro Alfredo Saad-Filho,
and an anonymous referee for many helpful comments on an early version of the paper. All remaining errors are, of
course, our responsibility. Published in Banca Nazionale del Lavoro Quarterly Review, n. 227, pp. 337-365,
December 2003.
** Associate Professor of Economics at the University of the State of Rio de Janeiro. Email:
lfpaula@alternex.com.br.
***Associate Professor of Economics at the Rural Federal University of Rio de Janeiro. Email:antonioj@ajato.com.br

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Banca Nazionale del Lavoro Quarterly Review, n. 227, pp. 337-365, December 2003.
1 Introduction
In the recent past the Brazilian economy has been marked by a ‘stop-go’ trend. High
banking spreads and low credit-to-GDP ratios have contributed to economic growth below the
economy’s potential. The switch from an exchange anchor regime to a floating exchange regime
in January 1999, which marked the end of the Real Plan, was expected to reduce external
vulnerability and bring down interest rates, thus enabling the economy to overcome
macroeconomic constraints and move towards more sustainable growth. Such, however, has not
been the case, since there are still some severe macroeconomic constraints hindering economic
recovery.
This paper intends to analyse the behaviour of the Brazilian banks in the current phase of
the business cycle, with the economy in a state of semi-stagnation. We argue – taking a Post-
Keynesian approach – that banking behaviour has been determined by the specific institutional-
macroeconomic context of the current phase of the Brazilian economy, with banks taking
advantage of the high rates of interest and the conditions in which the government has managed
its internal debt. But at the same time, the banking strategies are determinant of the current phase
since portfolio allocation has been dominated by short-termist behaviour and high liquidity
preference which have resulted in low credit supply and a high banking spread.
In this paper, we concur with Minsky (1985) that in order to understand the economy
correctly it must be borne in mind that “a capitalist economy with sophisticated financial
institutions is capable of a number of modes of behaviour and the mode that actually rules at any
time depends upon institutional relations, the structure of financial linkages and the history of the
economy” (pp.26-7). In fact, one current institutional specificity of the Brazilian economy is the
size and composition of the public debt - predominantly indexed and shorter-term bonds. As we
show in this paper, the environment has favoured the adoption of a short-termist but profitable
posture by the banking sector in Brazil. As a result, the bank trade-off between liquidity and
profitability – that is, the starting point of the liquidity preference approach – does not apply to
the current Brazilian case because of specific features of the institutional-macroeconomic
environment.
The paper is divided into four sections plus this introduction. Section 2 analyses banking
behaviour according to the Post-Keynesian liquidity preference approach. Section 3 examines
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Banca Nazionale del Lavoro Quarterly Review, n. 227, pp. 337-365, December 2003.
some macroeconomic constraints on economic growth in Brazil, focusing particularly on public
debt. Section 4 analyses banking behaviour and the determinants of banking spread in Brazil after
the end of the Real Plan. Finally, Section 5 summarises the main arguments developed in the
paper.
2 Banking behaviour and credit supply: the liquidity preference approach
According to the Post-Keynesian approach, banks – like any other capitalist business –
take their portfolio decisions on the expectation of greater profit, in the light of their liquidity
preference and appraisal of financial wealth in an uncertain world. Banks are economic agents
whose liquidity preference is largely determined by their expectations under Knight-Keynes’s
non-probabilistic uncertainty1, and who manage their portfolio according to the trade-off between
liquidity and profitability. Their position on the liquidity preference scale reflects the caution
inherent to uncertain results of banking activity vis-à-vis portfolio returns. The liquidity
preference approach explains the balance sheet strategy, rather than the choice of particular
liabilities according to the banks’ perception of risks and profit opportunities: “For a give state of
expectations, banks’ liquidity preference will determine the desired profile of the assets they
purchase and their prices; that is, the rate of returns each type of asset must offer to compensate
for their degree of illiquidity” (Carvalho 1999, p. 132). Banks with liquidity preferences do not
accommodate the demand for credit passively; rather they compare expected returns and liquidity
premiums for all purchasable assets. This means that credit supply may be curtailed because of
the banks’ increased liquidity preference, regardless of the ‘true’ risk attached to commercial
lending. Credit rationing would therefore arise quite independently of the expected returns on
capital investment projects (Dow 1996, pp. 503-4).
According to the Post-Keynesian approach, banks are seen as active agents dynamically
managing the two sides of their balance sheet. This means that they do not consider their
liabilities as externally determined according to customers’ preferences ; rather, they seek to
influence customers’ preferences through liability management and financial innovations2. Thus,
modern banks set out to act dynamically on the liability side of the balance sheet, making
vigorous efforts in search of new deposits and/or managing their reserves , which means that the

1 Non-probabilistic uncertainty refers to economic phenomena for which “there is no scientific basis on which to
form any calculable probability whatever. We simply do not know” (Keynes 1973, p. 114).
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Banca Nazionale del Lavoro Quarterly Review, n. 227, pp. 337-365, December 2003.
funds financing their assets are strongly conditioned by the banks’ own behaviour. Therefore,
rather than passively receiving funds according to their customers’ individual preferences, the
banks seek to intervene in these choices in various ways, promoting shifts in their liability
structure so as to take advantage of the profit opportunities in their business.
The banks play an important and contradictory role in the business cycle since their
behaviour is able to amplify economic growth during the upturn of a cycle, while it can amplify
the downturn in times of crisis. Thus, during the upturn banks have an important role to play in
meeting business demand for credit. Bankers respond to optimistic views on the viability of
firms’ debt structure typical of a period of euphoria by increasing their lending in order to meet
the firms’ credit demand . As firms with expectations and motivations of their own, banks
behave in ways that are vital in determining the financial conditions of a capitalist economy.
From the point of view of the bank portfolio, when their expectations become more optimistic
during the upturn (that is, their degree of confidence in their own expectations increases), the
banks prefer monetary returns over liquidity. Consequently, they decrease the ratio of liquid to
illiquid assets in their portfolios, thereby increasing the proportion of advances to customers –
and particularly long-term loans – in the banks’ portfolio. Efforts to achieve greater profits in
the business cycle upturn may lead banks to adopt a more speculative posture: a banker will seek
to obtain higher monetary returns by accepting longer-term and/or riskier assets and, at the same
time, finding ways to reduce the rate of return on deposits by offering safety promises and other
special guarantees to their customers. As a result of these banking strategies, credit supply
increases in order to support agents’ expenditures, thus meeting the necessary condition for
increase in the level of economic activity.
At the same time, in order to leverage their assets, the banks make active use of liability
management techniques so as to modify the liability structure of their balance sheet while
expanding the volume of deposits obtained from customers. This can be done in two ways:
reserve management and financial innovations. In the first case, banks seek to induce their
customers to apply their resources in low-reserve absorption liabilities, e.g. by managing time
deposit interest rates and in other indirect ways that work to redirect customers’ preferences
(publicity, bonuses, prizes to customers, etc.). In this way they have more funds available to lend.
In the second case, banks try to adopt a more aggressive strategy to leverage funds by exploiting
new products and services (or existing products in new ways), seeking to attract new funds so as

2 See, in this connection, Minsky (1986, Ch.10) and Wray (1990).
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Banca Nazionale del Lavoro Quarterly Review, n. 227, pp. 337-365, December 2003.
to enhance their ability to respond to an increase in the demand for credit. In periods when the
business prospects are good, financial innovations emerge as a result not only of the financial
institutions’ efforts to bypass monetary authority restrictions, but also of endeavour to raise
funds from their customers to finance their assets.
The increase in the degree of leverage leads banks to seek new ways to borrow funds so
that they can respond rapidly to an increase in the demand for credit and take advantage of
opportunities for profit during periods of greater business optimism. Thus, as a result of the
strategy of expanding their portfolio, banks boost their leverage, thereby increasing the use of
external funds to acquire assets. In fact, greater leverage and a wider asset-liability gap constitute
a riskier position, once feared by banks, but now part and parcel of bank strategy. Even the more
conservative banks, driven by competition and lower perceived risk, need to expand their
lending if they do not want to lose their share of the market3. The leverage factor affects the
volume of a bank’s funds directly, but at the same time increases the fragility of its balance sheet.
Therefore, liability management techniques and financial innovations play a crucial role in
banking strategy during the growth trend of the business cycle: they can reduce the requirement
for reserves and also expand the volume of external funds to increase loan leverage.
While the banks play a crucial role in accommodating the firms’ credit demand in the
upturn of the business cycle, a darker role awaits them during the downturn, amplifying the
incipient crisis. We now see them adopting a defensive strategy leading to credit rationing,
which can balk debt rollover for non-financial firms. When the crisis begins, uncertainty is high
(the agents’ state of expectation deteriorates), and the banks’ expectations for the future grow
bleak. The flows of expected yields are reduced as the financial institutions expect a decrease in
returns on their loans due to declining business profits. In this context the banks will re-rate
customer risks – generally upwards. As the perceived risks grow and are incorporated into the
risk premium, higher interest rates increase the cost to firms of refinancing their loans, just when
the need is most pressing. The banking system as a whole, seeking to recover its loans, refuses to
rollover the major part of the firms’ debts , and the resulting increase in bad loan figures shows

3 According to Kregel (1997, p. 545), “the decision to lend would in this case be based primarily on convention or
average opinion (…), which means by reference to the types of projects other banks are financing (…) Thus, over
time, bankers will be lending to borrowers they previously would have refused (or would have lent only at higher
margins of safety), and they will be concentrating lending to projects in particular areas simply because everyone
else is doing so”.
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Banca Nazionale del Lavoro Quarterly Review, n. 227, pp. 337-365, December 2003.
banks that the time has come to ration credit. Consequently, bad loans snowball at the
macroeconomic level.
Financial institutions generally express their preference for greater liquidity by orienting
their portfolios to less profitable but more liquid assets. Credit supply thus tends to decline ,
while the banks are likely to reduce the average term of their assets and adopt a more liquid
position by holding surplus reserves and/or purchasing highly liquid assets, such as government
securities. They will also cut down the percentage share of advances to customers in their
portfolio, and longer-term loans in particular. At the same time bank leverage also decreases,
because net worth also increases in percentage terms, expressing the banks’ greater caution under
adverse economic conditions. Broadly speaking, as the business and economic outlook clouds
and perceived risk grows , banks seek to avoid mismatching assets and liabilities, thereby
reducing their exposure to banking risks. At the same time they tend to become more cautious in
supplying loans and ask for greater collateral in this sort of operation.
In other words, as expectations grow bleaker, the banks tend to adopt more conservative
financial postures. The growing perceived risk whets in the banks’ liquidity preference, which
has serious impact on the structure of their portfolios. Thus, as the banks prefer liquidity over
greater profitability, they tend to choose more liquid and less risky assets. Summing up, banks
with liquidity preference cannot accommodate demand for credit passively in case liquidity
premiums increase vis-à-vis expected monetary returns. In these circumstances, the possibility of
economic growth is limited by restraints in financing.
3 Brazilian economic growth and public debt: some macroeconomic constraints
The period following implementation of the stabilisation plan known as the Real Plan –
that is, from July 1994 onwards – was striking for a remarkable reduction in inflation, even after
the major devaluation of January 1999. After two years of economic growth (1994-95) resulting
from the initial effects of this stabilisation plan based on an exchange rate anchor4, GDP

4 The Real Plan was conceived on the same basis as the stabilization programs with exchange anchor implemented
in Latin America since the late 1980s, using a fixed or semi-fixed rate of exchange in combination with more open
trade policy as a price anchor. It differed from Argentina’s Convertibility Plan by adopting a more flexible exchange
anchor; that is, a typical currency board system, rather than pegging the domestic currency at one-to-one parity with
the U.S. dollar. At the launch of the Brazilian program, in July 1994, the government's commitment was to maintain
an exchange rate ceiling of one-to-one parity with the dollar. Moreover, the relationship between changes in
monetary base and foreign reserve movements was not explicitly stated, allowing some discretionary leeway. After
the effects of the Mexican crisis, the exchange rate policy was reviewed and in a context of a crawling exchange rate
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Banca Nazionale del Lavoro Quarterly Review, n. 227, pp. 337-365, December 2003.
evolution disappointed previous expectations of sustainable economic growth after price
stabilisation. Furthermore, the trend took a ‘stop-go’ pattern (Table 1).
Table 1
Brazil, GDP and Prices
Year
GDP Growth
Inflation Rate (*)
1994
5.85
2240.17
1995
4.22
77.55
1996
2.66
17.41
1997
3.27
8.25
1998
0.13
4.85
1999
0.81
4.59
2000
4.36
8.03
2001
1.42
7.40
2002
1.52
8.47
(*) Rate of change of implicit deflator.
Source: Monthly Bulletin of Central Bank of Brazil
In fact, the Brazilian economy has suffered the impact of a succession of crises: Mexico in
1995, Asian countries in 1997, Russia in 1998, its own crisis in late 1998 and early 19995 and,
more recently, crises in Argentina since late 2001. A wide range of factors have contributed to
shaping a very unstable macroeconomic context: the perception of marked external vulnerability
deriving from the need to finance high balance of payments current account deficits; semi-
stagnation in the economy; the central bank’s adoption of very high short-term interest rates and
the consequent growth in public debt.. Brazil’s current macroeconomic constraints stem mainly
from the period when an exchange rate anchor was adopted in a context of trade and capital
account liberalisation that had generated a notable degree of external fragility of the economy
and consequently some serious macroeconomic imbalances (for instance, high foreign debt,
rapidly growing internal public debt, and so on). Private sector expectations have dropped under
the impacts of various external shocks, the weak performance of the Brazilian economy, and the
very high rates of interest.
The 1999 switch from an exchange anchor to a floating exchange rate regime plus an
inflation target regime brought no significant improvement in the macroeconomic variables. One

band the nominal rate began to undergo gradual devaluation. In early 1999, however, after six months of speculative
pressure, the real was devalued and, some days later, the Brazilian government adopted a floating exchange rate. For
a general analysis of the origins and development of the Real Plan, see Ferrari-Filho and Paula (2003).
5 See Paula and Alves, Jr (2000) and Saad-Filho and Morais (2002) for an analysis of the 1998-1999 Brazilian
currency crisis.
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Banca Nazionale del Lavoro Quarterly Review, n. 227, pp. 337-365, December 2003.
might have expect that adopting a floating exchange regime would ease down the interest rate
more quickly in Brazil. Although the rate of interest did decline – after a period when the
overnight rate was hiked sky-high (to more than 40% p.a.) under the effect of the Asian crisis
until the devaluation of the real in January 1999 – it picked up again during 2001 (Figure 1), in
view of the turbulence on international markets (the Argentina crisis, the effects of 11 September
2001, etc.).
Fig. 1 Overnight rate (Selic)
3,50
3,00
2,50
2,00
1,50
1,00
0,50
May Sept
May Sept
May Sept
May Sept
May Sept
May Sept
Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Jan-01
Source: Central Bank of Brazil (www.bcb.org.br). Rates of interest are monthly.
Brazil’s very high rates of interest are the result of high country risk6 (due to marked
external vulnerability and the risk of fiscal insolvency) and of adopting an inflation-targeted
regime7 in a context of various macroeconomic constraints and a high level of internal debt. High
interest rates have had two effects: (i) they have constrained economic growth, through the price

6 Bresser-Pereira and Nakano (2002) suggest that the causality between interest rate and country-risk may be inverse:
since short-term interest rates have been very high, foreign creditors believe that country-risk is high. According to
the authors, the rate of interest is high in Brazil because it serves multiple functions: to achieve inflation targets, to
limit exchange devaluation, to attract foreign capital, to roll over public debt, and to reduce trade deficits by curbing
domestic demand. See, also, in this connection, Oreiro (2002).
7 Under the inflation target regime, the Central Bank of Brazil operates monetary policy only to keep inflation low
and under control, while the levels of output and unemployment are determined on the supply-side of the economy.
In other words, the inflation target regime presupposes that there is a separation between the real side and the
monetary side of the economy, the well-known ‘classical dichotomy’.
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Banca Nazionale del Lavoro Quarterly Review, n. 227, pp. 337-365, December 2003.
of credit (loan rates) and entrepreneurs’ negative expectations; and (ii) they have increased public
debt, which is formed mainly by indexed bonds or short-term pre-fixed bonds. Indeed, the strong
demand for hedges against exchange devaluation and interest rate changes in turbulent periods
has influenced Brazil’s internal public debt. The Brazilian government has been obliged to offer
exchange rate and interest rate hedges to buyers of securities who charge high risk premiums to
roll over public debt8. As a result, since the end of 1998, more than 50% of the federal domestic
securities have been indexed to the overnight rate, while more than 20% have been indexed to
foreign exchange (Table 2). In addition, the ratio of federal domestic securities to GDP rose from
29.3% in December 1997 to 52.7% in December 2001 (Figure 2).
TABLE 2
Federal Domestic Securities by Type of Indexation as % of the Total, 1996-2001
End-of-
Foreign
Reference
Inflation
Overnight
Pre-set
Long-term
Other
Total
Period
exchange
rate*
rate

interest
rate

Dec-1996
9,4
7,9
1,8
18,6
61,0
1,4
-
100,0
Dec-1997
15,4
8,0
0,3
34,8
40,9
0,6
-
100,0
Dec-1998
21,0
5,4
0,4
69,1
3,5
0,2
0,5
100,0
Dec-1999
24,2
3,0
2,4
61,1
9,2
0,1
-
100,0
Dec-2000
22,3
4,7
5,9
52,2
14,8
0,0
0,0
100,0
June-2001
26,8
5,0
7,1
50,2
10,8
0,0
0,0
100,0
Dec-2001
28,6
3,8
7,0
52,8
7,8
0,0
0,0
100,0
(*) Average rate of private securities
Source: Monthly Bulletin of Central Bank of Brazil

8 According to data from BBV Banco Weekly Bulletin (30th August, 2002), the percentage share of federal domestic
securities in the financial market in June 2002 was: 34.5% held by commercial banks; 33.4% by investment funds
and pension funds; 19.1% as reserve requirements; 6.1% held by companies; 5.5% by individuals and others; and
1.4% by investment bank.
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Banca Nazionale del Lavoro Quarterly Review, n. 227, pp. 337-365, December 2003.
Fig. 2 Federal domestic securities/GDP
60,0%
52,7%
50,0%
47,0%
43,0%
40,0%
35,4%
29,3%
30,0%
22,6%
20,0%
10,0%
0,0%
Dec 1996
Dec 1997
Dec 1998
Dec 1999
Dec 2000
Dec 2001
Source: Central Bank of Brazil (www.bcb.gov.br)
Therefore, the behaviour of the domestic public debt in Brazil has proved particularly
vulnerable to changes in the interest or exchange rates. Reducing the public debt depends on
reducing the related financial burden by bringing down the interest rate or raising the exchange
rate, and/or boosting the primary fiscal surplus. Thus, the Brazilian government has been forced
to generate a high primary fiscal surplus (more than 3.5% of GDP9), which stands in the way of
any anti-cyclical fiscal policy while the fiscal effort itself is partly neutralised by increases in the
rates of interest or exchange. Here there is a dilemma of a kind: given the composition of the
public debt, while as lowering the interest rate reduces the financial cost of debt tied to the
overnight rate, it can at the same time have a negative impact on debt tied to the dollar by
depreciating the exchange rate.

9 Primary fiscal surplus increased from 0.24% of GDP in 1998 to 3.23% in 1999, 3.50% in 2000, and 3.75% in 2001,
according to BBV Banco Weekly Bulletin (30th August, 2002).
10

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Document Outline

• 2 Banking behaviour and credit supply: the liquidity preference approach
• References

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