Brazil should boost supervision of its banking system to avoid against credit bubbles that could form as a result of fast credit growth and falling interest rates, the International Monetary Fund said.

Credit that has doubled as a percent of gross domestic product in the last decade has helped spur economic growth but is also showing signs of straining households, the IMF said in a report Tuesday about the health of Brazil’s financial system. In prime housing markets like Sao Paulo and Rio de Janeiro, prices have jumped as much as 30 percent annually in recent years, the Washington-based lender said.

“There is a risk that the financial system may become a victim of its own success,” Dimitri Demekas, head of the team that conducted the assessment, said in a statement on the IMF’s website.

Brazil has cut interest rates to record low this year and loosened reserve requirements to spur car purchases even as consumer default levels hover near a 30-month high and growth remains weak. Tuesday, HSBC became the latest bank to reduce its 2012 growth forecast, to 1.7 percent from 2.5 percent. Consumer confidence in Brazil fell in July for the third month in a row, according to the Getulio Vargas Foundation.

While regulation in Brazil overall remains strong, and systemic risk low, a turbulent global economy and investors’ search for greater returns as borrowing costs fall may lead to the buildup of asset price bubbles in the world’s largest emerging market after China, the IMF said.

Brazil should improve tools used to determine consumers’ credit worthiness and increase the availability of long-term financing, the IMF said.

Other recommendations include strengthening the central bank’s ability to provide emergency funding to banks in the event of a crisis and tightening the criteria used to provide assistance to banks by the nation’s private deposit insurer, known as FGC.

Consumer default rates in June fell for the first time in three months, to 7.8 percent from a 30-month high of 7.9 percent in May, as banks heeded President Dilma Rousseff’s call to lower borrowing costs while being more conservative about who they lend to.

The IMF cited rising delinquency rates a sign of “financial distress” among households, where average debt servicing costs are equal to a “high” 23 percent of incomes. Although debt levels seem sustainable as income levels rise and employment remains strong, a cyclical downturn could put more borrowers under stress, the IMF said.

While an increase in housing prices in major cities has been “very large,” an eventual decline in values would be mitigated by the low proportion of mortgage loans in banks’ credit portfolios, the IMF said.

Brazil’s gross domestic product expanded at a 0.8 percent annualized rate during the first quarter, half the pace of the U.S. The central bank expects 2012 growth to reach 2.5 percent, while economists surveyed by the bank forecast 1.9 percent growth this year. 

Tuesday’s Financial System Stability Assessment of Brazil’s banks is part of an effort by the IMF started in the wake of Lehman Brothers Holdings Inc.’s collapse to step up surveillance of the world’s biggest financial systems. 

(Bloomberg)