OREANDA-NEWS. As several Brazilian states delay paying out public-sector salaries, pensions and benefits, banks could face a rise in impairments on loans extended to public sector employees, says Fitch Ratings.

Lending to public sector employees and pensioners is popular among Brazilian banks because it is viewed as low risk. Banks are able to deduct loan repayments directly from individuals' bank accounts, a practice locally known as payroll discount lending. Banks favour public sector employees because employment stability in the public sector is high and states have, until now, paid employees and pensioners promptly. Banking sector arrears on payroll discount loans extended to public sector employees reached 2.7% at end-March 2016, well below a comparative 5.8% for similar loans extended to private sector employees.

Payroll lending is particularly prevalent among smaller banks owned by the country's states, where this line of business can represent a large share of retail lending. Larger banks tend to have a more diversified retail customer base and payroll discount portfolios do not pose concentration risk.

But state budgets are now being hit by falling tax and other revenues, reflecting Brazil's deteriorating operating environment. We downgraded Brazil's sovereign rating to 'BB' with Negative Outlook in May.

Delayed payments to suppliers, employees and pensioners are becoming increasingly common among Brazil's states. Some states are repeatedly postponing payment dates, others are paying out salaries in instalments, and others are paying out only to lower-income employees and stalling payments to higher income earners. The courts are examining the legal framework of these actions but court procedures in Brazil can be protracted and we do not expect an outcome soon.

Payment delays could lead to a spike in impairments in payroll discount loan portfolios. Up to 30% of a public sector employee's salary can be used to service payroll discount loans and state employees often bank with state-owned banks, adding to concentration risk. As employees face a cash flow squeeze due to delayed state payments, they are more likely either to look for more expensive alternative loans or dip into their savings deposits, which could add to funding pressures at the state-owned banks.

Payroll discount loans represent 9% of the total BRL3.2trn (USD900bn) loans extended by Brazilian banks at end-March 2016. Sixty per cent of payroll discount loans are to public sector employees and pensioners, 33% to pensioners paid directly by the national social security institute and 7% are to private sector employees.

Brazilian regulations require banks to report loans overdue for more than 15 days. Maturities of payroll discount loans tend to be longer than for other unsecured consumer loans and although some state-owned banks are able to match loan-servicing dates with the timing of their intermittent salary disbursements, juggling dates in this manner is complex and at some stage, banks will have to recognize impairments.

Impairments in Brazil's consumer loans are rising for the first time in four years and we think this trend will continue through 2016. Disposable income levels are being squeezed by rising inflation and unemployment, higher indebtedness and increased borrowing rates.