Brazil's economy is weak but the banks are strong. That is the popular belief among investors. The banks are well-capitalized and liquid, with high profits. Brazil's banking sector has been restructured and balance sheets cleaned up. While investors fret over the government's failure to sort out public finances they can rest assured that the financial system is solid. Right?
Well, not exactly. The reason Brazilian banks are seen as strong is that their credit exposure is low and their dollar liabilities are matched. But the banks hold 25% of their dollar assets in dollar-indexed government securities and around half of total assets are in government paper. The argument about the strength of Brazil's banks only holds good as long as you believe that the government will not default on or restructure its domestic debt.
Following the real's devaluation the government's fiscal predicament has worsened. The government's debt is predominantly short-term domestic debt of which 60% is indexed to the overnight rate and over 30% is dollar indexed. So the effect of high interest rates and a devaluation is to escalate debt servicing costs.
As long as the government can keep its head above water the banks will enjoy high and increasing profits.