Mexico - Financial Sector Restructuring Adjustment Program Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. P-6616-ME REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN IN AN AMOUNT EQUIVALENT TO US$1,000 MILLION TO NACIONAZL FINANCIERA, S.N.C WITH THE GUARANTEE OF THE UNITED MEXICAN STATES FOR A FINANCIAL SECTOR RESTRUCTURING PROGRAM MAY 24, 1995 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS Currency Unit = New Peso (NP) US$1.00 = 5.885 New Pesos (May 22, 1995)' FISCAL YEAR January 1 - December 31 ABBREVIATIONS AND ACRONYMS ABM Asociacion de Banqueros Mexicanos (Mexican Bankers Association) BANOBRAS Banco Nacional de Obras y Servicios (National Public Works Bank) CD Certificate of Deposit CETES Mexican Treasury Bills CNB Comision Nacional Bancaria (National Banking Commission) CNBV Comision Nacional Bancaria y de Valores (resulting from merger of CNB and CNV) CNSF Comision Nacional de Seguros y Fianzas (National Insurance and Bonding Commission) CNV Comisi6n Nacional de Valores (National Securities Commission) CONSAR Comision Nacional del Sistema de Ahorro para el Retiro (National Commission of the Retirement Savings System) DVP Delivery versus Payment DFI Direct Foreign Investment ESF Economic Stabilization Fund FAMV Fondo de Apoyo al Mercado de Valores (Securities Market Support Fund) FOBAPROA Fondo Bancario de Proteccion al Ahorro (Bank Fund for Savings Protection) FONATUR Fondo Nacional de Turismo (National Tourism Fund) FOVISSSTE Fondo para la Vivienda de los Trabajadores del ISSSTE (Govermment Workers' Housing Fund) FSAL Financial Sector Adjustment Loan (3085-ME) FSRL Financial Sector Restructuring Loan FSRP Financial Sector Restructuring Program FTAL Financial Technical Assistance Loan (3838-ME) GAAP Generally Accepted Accounting Principles IDB Inter-American Development Bank IDP Institutional Development Plans IMSS Instituto Mexicano del Seguro Social (Mexican Social Security Institute) INDEVAL Instituci6n para el Deposito de Valores (Securities Depository Institute) INFONAVIT Instituto del Fondo Nacional de la Vivienda de los Trabajadores (National Workers' Housing Fund Institute) ISSSTE Instituto de Seguridad y Servicios Sociales de los Trabajadores del Estado (Institute of Security and Social Services for Government Workers) NAFIN Nacional Financiera, S.N. C. NAFTA North American Free Trade Agreement PECE Pacto de Estabilizacion y Crecimiento Economico (Economic Stabilization and Growth Pact) PROCAPTE Programa de Capitalizacion Temporal (Temporary Capitalization Program) PROSSE Programa de Servicios Sociales Esenciales (Program of Essential Social Services) SAR Sistema de Ahorro para el Retiro (Retirement Savings System) SECOFI Secretaria de Comercio y Fomento Industrial (Ministry of Commerce and Industrial Development) SHCP Secretaria de Hacienda y Credito Publico (Ministry of Finance and Public Credit) SIC Sistema Iniernacional de Cotizaciones (International Share Quotation System) SOFOL Sociedad Financiera de Objero Limitado (Limited Purpose Bank) SPEUA Sisrema de Pagos Electr6nicos de Uso Ampliado UDI Unidad de Inversion (Investment Unit) VAT Value Added Tax ' Conversions in the text of this report are hased on NP6 per US dollar.  FOR OFFICIAL USE ONLY MEXICO FINANCIAL SECTOR RESTRUCTURING PROGRAM TABLE OF CONTENTS Pare No. LOAN AND PROGRAM SUMMARY.11i I. MACROECONOMIC CONTEXT.1 A. Causes of the Crisis.1 B. Government Response .2 C. Prospects .2 II. THE FINANCIAL SECTOR 3 A. Background .3 B. Recent History (Nationalization, Consolidation and Re-privatization). 3 C. Sector Policy Since Privatization .4 D. Problems of the Banking System Before the Crisis. 7 E. Impact of the Devaluation on the Banking System .11 F. Recent Govemnment Measures .15 Hi. THE GOVERNMENT'S FINANCIAL SECTOR RESTRUCTURING PROGRAM ..17 A. Actions Already Taken by the Govermnent .17 B. Principles Guiding the Government's Program .18 C. Maintaining Operations and Containing Losses .18 D. Policy and Institutional Reforms .24 E. Development Banks .27 IV. BANK GROUP STRATEGY IN MEXICO'S FINANCIAL SECTOR .28 A. The Bank .28 B. The IFC .30 C. Coordination with the IMF .31 V. THE PROPOSED LOAN ..31 A. Background .31 B. Tranching and Conditions . 31 C. Implementation Arrangements .34 D. Procurement and Disbursement .34 E. Accounts and Audit .35 F. Monitoring and Reporting .35 G. Benefits and Risks .36 VI. RECOMMENDATION .37 This report is based on the findings of joint IBRD/IDB missions that visited Mexico from March 6-10 and April 2-8, 1995. The IBRD team included: Sri-ram Aiyer (Director, LAT, Mission Leader); Surendra K. Agarwal (AF2DR); K.K. Framji (AF4CO); Roy Karaoglan (IFC); Thomas S. Glaessner (LA2PS); Mike Lubrano (LATPS); Daniel Crisafulli (LA2PS); and Miguel Navarro (LA2PS). Arist6bulo de Juan, Peter Jones and T. N. Dinh were consultants to the IBRD team; Jorge Serraino assisted in the processing of the report. The IDB team included: Hans U. Schulz; Kim Staking; Jorge Requena; Emilio Cueto; and Adolfo Diz (consultant). Messrs. Edilberto L. Segura and Robert M. Lacey are the IBRD Department Director and Division Chief, respectively, for this operation. This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  -ii- MEXICO FINANCIAL SECTOR RESTRUCTURING PROGRAM TABLE OF CONTENTS (contd.) Page No. ANNEXES I. Government's Letter of Financial Sector Development Policy (with three attachments: Policy Matrix; Operating Guidelines for Bank Restructuring; and Statement on Development Finance Entities) ................................. 38 H. Matrix of Policy Actions .................................................. 64 III. Key Economic Indicators . ................................................ 75 IV. Balance of Payments . .................................................. 77 V. External Capital and Debt (including External Financing Requirement) .................. 78 VI. Aggregate Data on the Mexican Banking System ................................. 79 VII. Summary of Principal Financial Sector Legislation ............................... 88 VIII. Significant Differences between CNB's Accounting Practices for Banks and Generally Accepted Accounting Principles in the United States ..................... 92 IX. Structure and Powers of FOBAPROA ........................................ 96 X. English Translation of PROCAPTE Scheme (Banco de Mexico Circular of February 24, 1995) ................................. 98 XI. Principles of Corporate Debt Restructuring under the UDI Scheme .................... 101 XII. Legal/Regulatory Obstacles to Securitization and Secured Lending .................... 109 XIII. Status of Bank Group Operations in Mexico ................................... 111 XIV. Supplementary Data Sheet . ............................................. 115  -iii- MEXICO FINANCIAL SECTOR RESTRUCTURING PROGRAM LOAN AND PROGRAM SUMMARY BORROWER: Nacional Financiera, S.N.C. (NAFIN) GUARANTOR: United Mexican States AMOUNT: US$1,000 million equivalent TERMS: Repayment in 15 years, including 3 years of grace, at the standard variable rate OBJECTIVES: The proposed loan would support the Government of Mexico's Financial Sector Restructuring Program (FSRP), which is designed to: (a) restore the solvency and soundness of Mexico's banking system, restructure banks, and improve confidence in the financial system; (b) reform the accounting standards and prudential regulations for banks, and strengthen supervision to prevent future recurrence of systemic problems; (c) improve discipline in the provision of liquidity by the Banco de Mexico (Central Bank); and (d) initiate reforms in development bank lending, accounting practices and regulation of financial groups, and the deposit protection system. DESCRIPTION: The loan will support actions to: (a) improve discipline and manage systemic risks in the provision of liquidity support by the Central Bank and resources from development finance entities; (b) determine the health of the banking system, inclusive of diagnostic studies, with the assistance of independent auditors, of banks and financial groups intervened by the former National Banking Commission (CNB) and the newly merged National Banking and Securities Commission (CNBV), banks and financial groups that have come under the control of the bank support fund (FOBAPROA), and banks entering the temporary capitalization program (PROCAPTE); (c) restructure troubled banks with the assistance of investment banking advisers; (d) reform accounting standards and prudential regulations for banks; (e) strengthen bank supervision; (e) improve the regulatory framework to facilitate corporate work-outs and debt restructuring; (f) remove obstacles to securitization and secured lending; and (g) formulate a revised set of prudential regulations for brokerage houses, and a revised scheme for deposit protection. BENEFITS: Immediate actions included under the program will help contain the losses of the banking system while enabling continued functioning of the credit and payments system which is essential for the real sectors. Successful implementation of the program will lead to increased confidence in the financial  -iv- system, and restructuring of banks will restore their financial soundness and operating efficiency. The revision in accounting practices and disclosure requirements will improve the quality of information on banks, thereby enabling early recognition of future problems besides allowing market regulation. Improvements in prudential regulation and supervision and the legal/regulatory framework for lending will lead to a more efficient, sound and stable financial system. Together these actions will enable the financial system to mobilize increasing amounts of domestic and foreign capital. RISKS: The principal risks are: (i) failure to maintain a satisfactory macroeconomic framework and the resulting continuation of high inflation and interest rates; (ii) political intervention in the implementation of policy and institutional reforms in the financial sector or in decisions on restructuring of banks; and (iii) shortage of technical capacity in government entities or poor coordination among them leading to delays in implementation. These risks are mitigated by the Government's strong support for the program. The loan contains safeguards to stop disbursement in the event of deteriorating macroeconomic conditions or unsatisfactory performance under the program. The implementation of diagnostic studies and establishment of a transparent framework and criteria for restructuring of banks will reduce the risks of political intervention. Provision of technical assistance under the recently approved Financial Technical Assistance Loan (FTAL) will help ensure timely availability of the additional skills required for implementation. To improve coordination among Government agencies, an ad hoc Financial Sector Working Group has been established with participation from the CNBV, the Central Bank and the Ministry of Finance and Public Credit. POVERTY CATEGORY: Not Applicable. COFINANCING: The Inter-American Development Bank is processing a parallel Sector Adjustment Loan in the amount of US$750 million with conditionality identical to this loan. ESTIMATED DISBURSEMENT: The loan will be disbursed in two equal tranches. The first tranche will be disbursed upon loan effectiveness, and the second will be released upon compliance with tranche release conditions expected to occur about 9 months after effectiveness (March/April 1996). Retroactive financing up to an amount of US$200 million will be permitted for eligible imports made before the date of the loan agreement and after March 9, 1995. IDENTIICATION No: MX-PA-40497  REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO NATIONAL FINANCIERA, S.N.C. WITH THE GUARANTEE OF THE UNITED MEXICAN STATES FOR A FINANCIAL SECTOR RESTRUCTURING PROGRAM 1.1 I submit for your approval the following report and recommendation on a proposed Sector Adjustment Loan to Nacional Financiera, S.N.C. with the guarantee of the United Mexican States for the equivalent of US$1,000 million in support of a program for restructuring of the financial sector. The loan would be at the Bank's standard variable interest rate with a maturity of 15 years, including three years of grace, and would be disbursed in two tranches of US$500 million each. The Inter-American Development Bank (IDB) is cofinancing the program with a Sector Adjustment Loan in an amount equivalent to US$750 million, to be disbursed in two tranches. I. MACROECONOMIC CONTEXT 1.2 Facing near-depletion of its foreign exchange reserves, Mexico was compelled on December 20, 1994 to allow the peso to depreciate beyond the limits of the band that it had previously defended. A currency crisis has ensued and, as a result, the economy is contracting sharply this year. This section summarizes a more complete discussion of recent economic developments which appears in the 1995 Country Assistance Strategy (Report No. 14518, May 22, 1995). Key economic indicators, and information on balance of payments and financing requirements, respectively, are given in Annexes III. IV and V. A. Causes of the Crisis 1.3 The Mexican crisis was precipitated by a year-long series of domestic and external shocks. First, with 1994 a presidential election year and the economy in recession in the second half of 1993, the Government approved an expansionary budget for 1994. Then on January 1, 1994 the Chiapas revolt erupted, followed by several other political disturbances, including the assassination of the Presidential candidate of the ruling party, which increased uncertainty about the outcome of the August presidential election. On the external front, increases in U.S. interest rates beginning in February 1994 made U.S. assets relatively more attractive than before. 1.4 The negative reaction of investors to these shocks and the peso devaluation has been sharp, reflecting both the relative vulnerability of the economy when the shocks began and the macro policy response in 1994. Since 1987, Mexico had pursued a plausible but high-risk economic strategy, the main elements of which were: (i) the use of the exchange rate as a nominal anchor, which successfully reduced inflation to single-digit levels; and (ii) an aggressive program of structural reforms, designed to attract productivity-enhancing investment and thereby strengthen Mexican competitiveness. The risks were that this exchange rate policy would cause a real appreciation of the peso, and that the current account deficit would therefore grow and have to be financed by increasing foreign capital inflows. However, the Government believed firmly that increased investment and productivity gains would improve the economy's competitiveness sufficiently to bring the current account deficit back down to a sustainable level over time.  -2- 1.5 As expected, the real exchange rate did appreciate strongly, but sufficient increases in investment and productivity failed to materialize. Further, although important structural changes were made, other refonns proceeded too slowly to have the desired impact on productivity and competitiveness. Absent rapid productivity gains, the peso appreciation made it increasingly difficult for Mexico to compete internationally, and so the current account deficit ballooned from an average of 3 percent of GDP in 1989-90 to 7 percent in 1992-94, with no indication that a decline was beginning. 1.6 Although such large current account deficits would not be sustainable in the long-term, prior to 1994 Mexico was able to rely on surging private foreign capital inflows to finance them. Then in 1994, foreign capital inflows slowed -- responding to the shocks and to growing concern over the sustainability of Mexico's economic strategy -- and fell far short of the level needed to finance the current account deficit, so that reserves declined precipitously. B. Government Response 1.7 Following the December devaluation, financial markets were unsettled by the Government's initial delays in announcing an economic program, and again by the limited scope of the program that was eventually announced on January 3, 1995. Recognizing the need for a more comprehensive economic program, the Government announced a revised program on March 9, which included strong fiscal and monetary adjustment, a program to deal with problem banks and prevent future banking problems, and a strengthening of the social safety net, with the program supported by a large international financial package. C. Prospects 1.8 Although important risks remain, financial markets have begun to respond positively. Mexico's macroeconomic strengths -- a competitive real exchange rate, a balanced government budget, a manageable ratio of debt to GDP, a vigorous export sector, and the North American Free Trade Agreement (NAFTA) -- are permitting a delicate stabilization with a projected current account deficit of under 1 percent of GDP in 1995. Mexico's economic program is based, correctly, on the premise that the immediate problem is largely one of short-term cash- flow, and not of insolvency, and so its first objective is to restore stability by rebuilding international confidence. The program's international financial support package will enable the Government to convert its large portfolio of short-term debt to longer maturities. Moreover, the crisis has led the Government to accelerate structural reforms in the areas of infrastructure privatization, decentralization of public services, the legal and judicial systems, and the design of social programs. 1.9 The key risks for medium-term economic recovery are long-standing problems that have been exacerbated by the crisis: the fragility of the banking system, the slow pace of certain structural reforms, and the social pressures arising from rising unemployment and poverty. If not addressed adequately, any of these risks could erupt and so undermine economic recovery and investor confidence. The proposed PROSSE (Programa de Servicios Sociales Esenciales - - Program of Essential Social Services) aims to improve the social safety net and so ease social tensions, while the Bank's policy dialogue with Mexico is initended to assist Mexico's program of structural reform. Finally, strengthening the banking system is precisely the objective of this loan. Assuming that each of these risks can be contained (as discussed in the Country Assistance  -3- Strategy), economic growth is expected to resume and the risks will gradually diminish. II. THE FINANCIAL SECTOR A. Background 2.1 Structure and Size. Mexico's financial sector comprises 34 commercial banks, 7 development banks and several trust funds operating at the second tier level, over 340 credit unions, 28 securities brokerage houses that are members of the Mexican Stock Exchange, 44 insurance and re-insurance companies, 19 bonding companies, 28 warehousing companies, 60 leasing companies, 58 factoring companies, 45 foreign exchange houses and a number of other non-bank institutions. 2.2 As of December 1994, total assets and total deposits of the banking system were NP857 billion and NP414 billion, respectively. Total outstanding loans amounted to NP594 billion. At the end of 1994, the three largest commercial banks accounted for 70% of commercial bank assets, received 72% of commercial bank deposits and operated 65% of commercial bank branches. Annex VI contains aggregate data on Mexico's commercial banks and on their performance. B. Recent History (Nationalization, Consolidation and Re-privatization) 2.3 Commercial Banks. In September 1982, Mexico nationalized 58 of its 60 private commercial banks.2 Thereafter, the banking sector went through a major consolidation and restructuring process: 9 institutions were closed or liquidated, 20 regional institutions were merged with mid-size banks, and by 1986 only 18 commercial banking institutions remained (6 national banks, 5 regional and 7 multi-regional banks). In addition, the non-bank financial holdings of the commercial banks were returned to private ownership. The nationalization of banks granted the Government a monopoly on the provision of banking and credit services. Coupled with administrative actions to merge and downsize development banks and trust funds, this led to a fall in commercial bank credit extended to the private sector from 40 percent of total bank credit in 1980-81 to only about 25 percent in 1986. During the 1985-1987 period, the Government used commercial banks to finance the public sector deficit. 2.4 From 1988 to 1992, as Mexico's public finances began to improve and the Government's demand for funds decreased, the Government introduced a wide range of financial reforms culminating in the re-privatization of commercial banks in 1991-1992. 2.5 To establish a clear legal and regulatory framework for the provision of banking and non- banking financial services by the private sector, a new Credit Institutions Law was adopted in 1990. The Financial Groups Law was also enacted in 1990, allowing for the establishment of a conglomerate banking regime permitting separate commercial banking, brokerage and other financial service companies to be controlled by a single holding company. (Annex VII describes the key laws governing Mexico's financial sector.) At the same time, several measures were taken to deregulate important areas of the Mexican financial system: (i) liberalization of deposit 2 The two exceptions were Banco Obrero, controlled by Mexican labor unions, and Citibank, the only foreign bank then allowed to operate branches in Mexico.  -4- and lending interest rates; (ii) elimination of reserve requirements; (iii) elimination of the liquidity coefficient; and (iv) elimination of regulations requiring commercial banks to hold long- term government paper until maturity. 2.6 On June 28, 1990, the Constitution was amended to remove banking from the list of activities reserved for the state, thus allowing for the re-privatization of the commercial banks. By July 1992 controlling shares of the 18 institutions previously owned by the Government had been auctioned for US$12.5 billion equivalent. Eleven commercial banks were acquired by securities brokerage houses and the rest were bought by industrial groups or individuals. Currently, 13 of these banks are subsidiaries of financial groups.3 Non-bank financial services also benefitted from liberalization policies. Regulation of insurance premiums and policies was simplified, as were the rules governing mutual funds. Following the market crash of October 1987 (in the U.S. and Mexico), the laws governing Mexican capital markets were modified with the aim of reducing transaction costs, boosting transparency, and providing stronger penalties against insider trading. Reforms were enacted to liberalize pricing, permit product innovation, and rationalize taxation policies for the entire financial sector. 2.7 Development Banking. As of December 1994, assets of the development finance entities (DFEs) were about NP369 billion equivalent, with outstanding credits of NP294.2 billion equivalent. The sector is composed of seven development banks (NAFIN, BANCOMEXT, BANCOMINT, BANRURAL, BANOBRAS, FINASA and BANJERCITO) and several trust funds operating at the second-tier level (including FIRA, FONAVIT, FONATUR, FOVI and FIDEC). These banks and funds are assigned to sectors, with substantial overlap.' While the institutions depend on the Ministry of Finance and Public Credit (SHCP) and are subject to regulation by the National Banking and Securities Commission (CNBV), the trust funds are under the auspices of the Central Bank. 2.8 In recent years, the public development banks have aggressively shifted their operations from the first-tier to the second-tier level. The outstanding financial resources for the consolidated development finance sector (including trust funds) to private financial institutions grew from NP21.8 billion at the end of 1990 to roughly NP123.9 billion by 1994. Of this total, NP107.6 billion was held by commercial banks.' This compares with the total capitalization of the commercial banking sector of NP44.7 billion, and does not include liquidity provided through interbank and other short term operations, portfolio finance investments or loan guarantee programs. During the recent crisis, some DFEs increased their provision of liquidity to commercial banks, operating daily volumes of several hundred million dollars. C. Sector Policy Since Privatization 2.9 Financial Conglomerate Model. With the enactment of the Financial Groups Law in Excluding two banks, Union and Cremi, which were intervened in September 1994. Besides acting as a fiscal agent for international loans of the Federal government, NAFIN provides first and second-tier financial services to small and medium sized companies in industry, commerce and services. BANCOMEXT promotes extemal trade; BANCOMINT - domestic commerce; FIRA and BANRURAL - agriculture; FOVI - housing; FIDEC - commerce; and FONATUR - tourism. I Equivalent to approximately 16% of total commercial bank credit outstanding to the non-financial private sector.  -5- 1990, Mexico adopted the financial conglomerate model followed in one form or another by numerous European countries, including Germany, Spain and the U.K. Under the Financial Groups Law, commercial banking, securities brokerage, investment banking, leasing, factoring, foreign exchange, mutual fund management and insurance activities may be conducted by separate subsidiaries of a common holding company. In addition, a number of non-bank financial services, such as leasing, factoring, and trading in debt instruments, may be carried out directly by the commercial bank subsidiary of a financial group. This model was adopted to make Mexico's financial system more efficient and competitive, permitting financial groups to exploit economies of scale and scope, enter new markets and cross-market services. The NAFTA chapter on financial services and the Financial Groups Law both provide for the possibility of foreign-controlled financial groups with the same basic conglomerate banking structure as domestic financial groups. 2.10 As noted above, the adoption of the conglomerate banking model resulted in substantial concentration in the financial services markets. The purchase of privatized banks by groups with substantial holdings in other financial services industries (particularly brokerage and insurance) clearly raised competition concerns for the Government. The Government has sought to mitigate the negative effects of this concentration by permitting limited foreign competition, by deregulation and by fostering greater exchange of information among financial service providers (for example, through the encouragement of credit information bureaus). 2.11 Foreign Participation and Competition. The Credit Institutions Law, the Capital Markets Law and the Financial Groups Law provide for a special category of foreign-controlled fmancial holding companies, commercial banks and brokerage houses, where provided for by treaty (e.g., NAFTA). Foreign-controlled commercial banks are ordinarily subject to individual and aggregate market share limitations. Initially, no single foreign-controlled bank may represent more than 1.5% of the capital of the banking system and all foreign banks taken together may have no more than 8%. The aggregate ceiling will gradually increase to 15% by 1999. After January 1, 2000, the market share limits will no longer apply. However, the treaty provides that Mexico may take certain safeguard actions to prevent a surge of competition from foreign-controlled financial entities. 2.12 The Government expected that gradually increased competition in financial services from foreign-controlled entities would provide incentives for Mexican-controlled commercial banks to become more efficient, adopt new techniques and technologies and gradually reduce intermediation costs. Even after privatization in 1992, bank intermediation spreads in Mexico remained extremely high, averaging 8% through 1993, declining to about 6% in 1994 following conclusion of NAFTA. The charters for the first foreign-controlled financial institutions and holding companies were approved beginning in August 1994. Thus, the direct effects of foreign competition on the Mexican financial services industry were not yet apparent before the December 1994 devaluation. 2.13 On February 15, 1995, in the aftermath of the devaluation, Mexican laws were modified to permit foreign individuals and companies as a group to hold up to 49% of the voting shares of a Mexican-controlled financial holding company, commercial bank or brokerage firm. More importantly, as an incentive for foreign financial institutions to come to the rescue of undercapitalized Mexican banks, the amendments now permit foreign financial institutions to purchase a controlling interest in a Mexican commercial bank with a market share of up to 6%,  -6- four times higher than the initial NAFTA limitations (Annex VII). Thus far, only Spain's Banco Bilbao Vizcaya has expressed interest in taking advantage of the amendment, and is currently negotiating to increase its substantial minority stake in the Probursa - Mercantil financial group to majority control. 2.14 Improved Regulation. Since the privatization of the commercial banks, the Government has taken several important steps to further modernize the framework for regulation of the financial sector. In June 1993, the Constitution was amended and legislation went into effect to grant the Central Bank far greater autonomy with more clearly defined functions (e.g., in the conduct of monetary policy and regulation and supervision of the payments system and foreign exchange market). In July 1994, legislation was enacted creating the National Commission for the Retirement Savings System (CONSAR), with responsibility for supervising Mexico's retirement savings system. 2.15 Refinements were also made to the principal legislation governing the financial sector. Amendments to the Credit Institutions Law and the Financial Groups Law effected in July 1993 broke down some of the divisions between the services that could be provided by different entities in a financial group, permitting a greater variety of services (including leasing and factoring) to be offered by commercial banks. The laws governing the operation of insurance companies, bonding companies and auxiliary credit institutions (e.g., warehouses) were modified in the same month to clarify the capital adequacy requirements for such entities. In July 1993 and in the following year revisions were made to the Capital Markets Law to encourage greater competition (liberalization of brokerage firm operations abroad and introduction of a system for quotation of securities originally issued abroad). 2.16 The authorities with jurisdiction over the financial sector (the Central Bank, SHCP and the Commissions) have also issued important new regulations over the past few years in such areas as regulatory treatment of newly-introduced financial instruments (including exchange coverage contracts), marketing of financial services (including mutual funds) and securities trading practices of banks and brokerage firms. The authorities have also taken limited steps to encourage greater competition to minimize the negative effects of Mexico's highly concentrated market for financial services. In February 1995, new regulations were issued by SHCP to foster the development of credit information bureaus (which maintain data on credit transactions). The goal is to require the sharing of information on individual and corporate credit transactions, formerly treated as proprietary by financial institutions. 2.17 Merger of Commissions. The Mexican financial system is regulated and supervised by the SHCP, the Central Bank, the National Banking and Securities Commission (CNBV, created out of the merger of the National Banking Commission (CNB) and the National Securities Commission (CNV)), the National Insurance and Bonding Commission (CNSF) and CONSAR. The primary regulators for commercial and development banks are the Central Bank and the CNB, with the latter taking primary responsibility for supervision of banks and enforcement of applicable laws and regulations. Following the recent merger of the CNB and CNV, (para. 2.20), the merged body (CNBV) is now responsible for supervising virtually all financial holding companies as well as banks and brokerage firms. This should permit more efficient and effective supervision of financial groups.  -7- 2.18 Effective supervision requires comprehensive inspection procedures covering all aspects of bank operations, skilled and experienced supervisory staff, and an institutional development strategy. The adoption of the financial conglomerate model and the privatization of the commercial banks took place before a strengthened supervisory infrastructure could be put in place. In particular, CNB staff were inexperienced in the types of deregulated activities in which banks were now permitted to engage. It was also recognized by the Government that consolidated supervision of financial groups as a whole needed to be strengthened. In April 1994, the CNB was substantially reorganized and an institutional development plan was initiated to rationalize responsibility for on-site and off-site supervision and to modernize the training of inspectors and other staff. Implementation of the institutional development plan also involved the hiring of a substantial number of new staff at the management level. The Financial Sector Technical Assistance Loan (Loan No. 3838-ME) signed in March 1995 is to assist the Banking and Securities, and Insurance and Bonding Commissions to modernize regulations and supervisory techniques and improve permanent training programs for their staffs. 2.19 The CNB had a staff of about 110 full time on-site examiners for commercial banks at the time of its merger with the CNV (para. 2.20). Additional examiners are employed in the Commission's off-site and special supervision departments. Since the reorganization of the CNB in April 1994, on-site examiners typically work in teams of approximately 25 and conduct annual examinations of each of the 18 principal commercial banks. The examination staff of the CNB has been receiving intensive training under the direction of a Field Office Supervisor of the U.S. Federal Deposit Insurance Corporation (FDIC) seconded to the CNB since October 1994 under the FTAL. In light of the increased demands being made on the examination staff, the FTAL will support additional training in on-site and off-site supervision for CNBV staff from the U.S. FDIC, Office of the Comptroller of the Currency (OCC) and the Federal Reserve System. 2.20 In early December 1994, for the purpose of improving the effectiveness of the supervisory authorities, the Government announced that the CNB and the CNV would be merged. The merger became effective on May 1, 1995. The President of the CNB was appointed President of the CNBV, the new body resulting from the merger. The merger is expected to facilitate consolidated supervision of financial groups and to better employ human and technological resources in financial sector supervision. D. Problems of the Banking System Before the Crisis 2.21 Rapid Growth. Prior to the peso devaluation, and in the aftermath of the re- privatization of the banks during 1991/92, the Mexican commercial banking system had gained in depth and had recorded significant growth. Between 1991 and 1994, aggregate assets of commercial banks (including intervened banks, see para. 2.48) increased by 111.3 % in nominal terms, or by 64.6% in real terms, equivalent to a real annual growth rate of 18.1 %. In 1994, assets of the commercial banking system averaged NP735 billion, equivalent to 58.8% of GDP, as compared to a ratio of 42.5% in 1991. By the end of 1994, aggregate bank assets reached the record level of NP857 billion. However, as a result of the steep devaluation of the peso in December, aggregate bank assets decreased by 25% in U.S. dollar terms, from the equivalent of US$215 billion at the end of September 1994 to about US$161 billion by year-end. 2.22 The growth rate of the banks' loan portfolios was even higher than that of assets. During the three-year period 1991-94, aggregate gross loans (excluding discounted loans) increased by  -8- 142.9% in nominal terms, or by 89.2% in real terms, equivalent to an annual real growth rate of 23.7%. This is equivalent to at least eight times the rate of growth of real GDP during the same period. 2.23 High Ratio of Loans to Deposits. Although deposit mobilization also improved significantly during the period under review, with the ratio of average deposits to GDP increasing from 21.4% in 1991 to 31.3% in 1994, the rate of growth of the loan portfolios outstripped that of deposits. Consequently, the ratio of loans to deposits increased steadily from 94.1% at the end of 1991 to 113.8% by 1993, and still further to 124.0% by 1994. This resulted in an increasing reliance on interbank funding, the bulk of which consisted of lines of credit from foreign banks. In fact, the aggregate amount of interbank borrowings increased from the equivalent of NP34 billion at the end of 1991 (of which NP23 billion were denominated in foreign currency) to NP124 billion at the end of 1994, of which the equivalent of NP92 billion (US$17.3 billion) were denominated in foreign currency. These figures imply that the ratio of aggregate interbank borrowings to aggregate shareholders' equity increased from 155 % in 1991 to 278% by 1994. 2.24 Deterioration in Loan Portfolio Quality. The rapid rate of growth of loan portfolios, coupled with the banks' generally lax monitoring guidelines and procedures, and with the ineffective supervision undertaken by the CNB (until mid- 1994), resulted in a noticeable deterioration in loan portfolio quality. Whereas at the end of 1991, aggregate past due loans (including both principal and interest) of commercial banks (excluding Union and Cremi), accounted for 4.09% of gross loans (including discounted loans), by the end of 1993 the ratio stood at 7.25%. During the first half of 1994, the ratio increased further to 8.30% before decreasing to 7.33% by year-end (see Table 2.1 on the following page), largely due to a 27% increase in gross loans during the second half of the year. At the same time, the ratio of non- performing credits (defined as the 3 lowest of the 5 credit categories)6 to gross credits (which include loans plus off-balance sheet exposures) increased steadily from 5.20% at the end of 1991, to 6.65% by 1992, to 8.15% by 1993, and finally to 8.80% by 1994. 2.25 The above two indicators of loan quality understate the extent of the deterioration of the loan portfolios. The ratio of past due loans to gross loans reflects the amount of arrears, rather than the amount of outstanding loans affected by arrears, which is usually significantly larger, especially for installment loans. The ratio of non-performing credits to gross credit risks is also understated to the extent that, in practice, banks tend to upwardly adjust the overall classification of their major debtors, in order to reduce the amount of loan loss provisions to be made. Secondly, rollovers or rescheduled loans, which should be presumed problem loans in most cases, are classified as performing loans or loans with minimal risk. Because of these shortcomings, published classifications do not accurately represent the true risk profiles of the banks' loan portfolios. 2.26 Inadequacy of Loan Loss Provisions. Mexican banks generally have not allocated sufficient provisions to cover their actual and potential loan losses (see Table 2.1 on the following page). 6 The five categories are: minimal risk (A); low risk (B); moderate risk (C); high risk (D) and loss (E), with the latter three categories considered as the non-performing component of the portfolio.  -9- Table 2.1: Deterioration in Loan Portfolio Quality and Inadequacy of Loan Loss Provisions of Commercial Banks', 1991-94 (in million of NP and percentages, as of year-end) 1991 1992 1993 1994 Gross loans2 240,153 336,907 421,126 594,205 Past due loans 9,828 18,757 30,527 43.544 Loan loss provisions 4,994 9,072 13,045 20,849 Equity 21,336 28,802 37,383 44,667 Ratios (%) Past due/Gross loans 4.09 5.57 7.25 7.33 Non-Performing credits/Gross 5.20 6.65 8.15 8.80 credit risks3 Provisions/Gross loans 2.08 2.69 3.10 3.51 Provisions/Past due 50.81 48.37 42.73 47.88 Open loan exposure4/Equity 22.66 33.62 46.77 50.81 Open loan exposure/Adjusted 40.86 53.97 71.47 73.91 stockholders' equity' Net capital/Risk-weighted assets 7.73 9.01 9.94 9.60 l Aggregates exclude two banks, Cremi and Union, which were intervened in September 1994. 2 Including discounted loans. 3 Gross credit risks include gross loans and off-balance sheet risks (i.e., discounted loans, guarantees and irrevocable letters of credit). Non-performing credits comprise loans classified in categories C, D, and E. Figures of gross and non-performing credit risks actually relate to the preceding quarter. 4 Open loan exposure is defined as the difference between past due loans and loan loss provisions. 5 Defined as stockholders' equity less revaluation surplus. Source: CNB Although aggregate loan loss provisions increased from NP5.0 billion at the end of 1991 to more than NP13.0 billion by 1993, the ratio of provisions to past due loans actually decreased from 50.8% to 42.7% during the two-year interval. The coverage decreased further to 40.7% by the end of September 1994, before rebounding to 47.9% by year-end, primarily in response to the adverse effects of the peso crisis. 2.27 One important indicator of the adequacy of a bank's portfolio provisions is the ratio of its open loan exposure (i.e., the difference between the level of past due loans and that of provisions) to its stockholders' equity. As shown in Table 2.1, the ratio for the commercial banking system as a whole (excluding Cremi and Union) more than doubled during the period under review from 22.7% at the end of 1991 to 50.8% by 1994. And if the banks' equity is adjusted downward by excluding the revaluation surpluses, the ratio of open loan exposure to equity increases significantly, from 40.9% at the end of 1991 to 73.9% by 1994. These ratios imply that even prior to the peso crisis, the level of the Mexican banks' provisions was inadequate. However, an accurate estimate of the shortfall in the banks' provisions cannot be derived without obtaining additional information relating to the true risk profile of the banks' loan portfolios, the aging of arrears, and the amount of loans affected by arrears (para. 2.25).  -10- 2.28 Overstated Capital Adequacy Ratios and Profitability. Notwithstanding the shortfall in the banks' provisions, the banks' capital adequacy ratios improved during the period 1991- 1994, in response to the phased raising of the minimum required ratio of net capital to risk- weighted assets, from 6% at the end of 1991 to 7% by the end of 1992, and then to 8% by the end of 1993. As shown in Table 2.1 above, the average ratio increased from 7.73 % at the end of 1991 to 9.94% by 1993, and still further to 10.27% by the end of September 1994, before decreasing to 9.60% by year-end, due to the losses incurred during December in the wake of the peso devaluation. 2.29 Financial statements of Mexican banks are prepared in accordance with CNBV guidelines which are based on Mexican Generally Accepted Accounting Principles ("Mexican GAAP"). These differ in a number of important respects from U.S. GAAP, including the definition and treatment of non-performing loans, of provisions and of the accrual of interest income on loans (Annex VIII). The main shortcoming of the Mexican banks' financial statements is the overstatement of bank profits, and hence of stockholders' equity. In addition to underprovisioning (paras. 2.26 and 2.27), two other factors distorted the banks' profitability ratios, namely, the accrual of interest on past due loans and the creation of loan loss provisions through a charge on capital reserves without passing through the income statement, which together resulted in overstating profits by some 40% during 1993-1994. It is estimated that during the two-year period 1992-1993, the amount of provisions created through capital charges totalled at least NP2.8 billion, which is equivalent to about 35 % of the additional net provisions made by the banking system during the period, and to more than 18% of the net profits (including undistributed earnings from subsidiaries) generated by the system. 2.30 During 1993 and 1994, the amount of past due interest outstanding of the whole banking system (including all intervened banks) increased by about NP9.3 billion, to reach NP14.2 billion, which is equivalent to 25.7% of the system's past due loans. (Table 2.2 below.) This increase in past due interest accounted for 13.5 % of the system's net interest income during the same period. Consequently, the banks' reported figures on net interest income are overstated. However, since banks are required to make provisions on their past due interest, presumably averaging about 48% of amounts past due, the extent of the overstatement of net operating income is reduced. Nevertheless, it is estimated that the banks' overstatement of net operating income during 1993 and 1994 was of the order of NP4.8 billion, equivalent to almost 40% of the system's aggregate net profit. Table 2.2: Evolution of Past Due Interests of Commercial Banks, 1992-94 (in million of NP, as of end year/month) Dec June Dec June Dec 1992 1993 1993 1994 1994 Past due principal 14,729 21,434 24,362 31,044 40,888 Past due interest 4,862 6,836 8,320 10,581 14,1562 Past due loans' 19,591 28,270 32,682 41,625 55,0442 These figures are higher than those indicated in Table 2.1, since they include Cremi and Union. 2 Partly estimated. Source: Derived from data published by CNB and the Direcci6n de Investi2aci6n Econ6mica. Banco de Mexico. 2.31 Supervision. The institutional development plan initiated by the then CNB in mid-1994 (para. 2.18) was only just being implemented by its new management when the devaluation  -11- occurred. Thus, important deficiencies in banking supervision remained, although some improvements have been achieved since. Although the basic framework for implementing new policies and procedures for bank inspections is in place, there is not yet an adequate number of sufficiently trained and experienced inspectors to be fully effective. In particular, the CNBV's capacity to assess the level of risk in individual bank portfolios and the quality of banks' risk management needs to be improved. Since the devaluation, the former CNB and the recently merged CNBV's focus has been principally on asset quality and it has received technical assistance from the World Bank, foreign bank supervisors and others to improve its staff's capacity in this area. However, in the longer term, staff will need to improve their skills in treasury management (interest rate and foreign exchange rate risks), securities activities (market risk and market practices) and international financial activities. Improvement of the overall supervision of financial groups should also be a priority. The CNBV does not yet conduct formal consolidated supervision of financial groups or apply a capital adequacy rule for holding companies. These important regulatory and supervisory tools remain to be adopted. E. Impact of the Devaluation on the Banking System 2.32 The banking system was severely shaken by the peso crisis following the December 1994 devaluation. The two immediate adverse effects were the foreign exchange losses incurred by several banks on account of their open short positions, and the impairment in the value of the banks' investments (consisting mainly of fixed-income securities) resulting from the sharp rise in interest rates which followed the collapse of the peso. In addition to these losses, banks are facing, on the one hand, significant liquidity pressures which substantially increase their funding costs and, on the other, an accelerated deterioration in the quality of their loan portfolios, the extent of which will depend on the duration of the excessively high interest rates currently prevailing. 2.33 Exchange Losses. Mexican banks are subject to two fairly restrictive limits on the relative size of their foreign currency-denominated liabilities and their net open foreign currency exposure. Under prevailing regulatory guidelines, banks are required to limit their foreign currency liabilities to no more than 20% of total liabilities, and their net open short or long foreign currency positions to 15% of their net capital. Despite these restrictions, and despite the fact that some banks recouped part of their losses by converting their net short positions into net long positions shortly after the devaluation, but before the further collapse of the peso, the net foreign currency losses incurred by the banking system were not negligible. Published financial statements indicate that at least eight banks (including the three largest) recorded significant fourth quarter losses. For the system as a whole, fourth quarter foreign exchange losses totalled about NP4.6 billion, equivalent to more than 10% of equity. No additional foreign exchange losses are anticipated in 1995, unless banks speculate on currency markets, since data published by the Central Bank indicates that at the end of 1994, the commercial banking system had an aggregate net long position of US$911 million. 2.34 Interest Rate Exposure. The banks' aggregate investment portfolio increased by about 84% in 1994 to reach the level of NP85.9 billion at year-end. The bulk of these investments consisted of fixed-income securities (NP55.8 billion), whose market value has been impaired by the significant hike in interest rates. In the aftermath of the peso devaluation, the CNB issued in January 1995 a new regulation requiring banks to value their securities at market prices and to disclose their unrealized gains or losses on their financial assets and liabilities in their off-  -12- balance sheet accounts as of end-1994. Published financial statements indicate that only Banamex realized losses on its securities portfolio, totalling NP869 million, equivalent to 7.9% of its equity at year-end. Most of the other banks showed unrealized gains, since the valuation method adopted by CNB (which differs from U.S.GAAP) takes into account both financial assets and financial liabilities. Thus the banking system, excluding Banamex, showed an aggregate unrealized gain of NP209 million, equivalent to 0.6% of equity. Including Banamex, the losses (both realized and unrealized) amounted to NP660 million, equivalent to 1.5% of the system's equity at year-end. 2.35 Liquidity Problems. At the end of 1994, aggregate deposits with the commercial banks (excluding Union and Cremi) totalled NP413.9 billion, of which 18.3% was denominated in foreign currency and 73.6% consisted of time deposits. The latter comprised promissory notes (NP164.6 billion), fixed deposits (NP89.2 billion), bank bonds (NP38.0 billion), and subordinated obligations (NP13.0 billion). About 15.6% of time deposits, or the equivalent of NP65.4 billion, were raised by the 13 banks that operated branches (28 in total) outside Mexico. The bulk of these time deposits consisted of U.S. dollar-denominated CDs, which reportedly amounted to about US$8 billion. 2.36 As a result of the peso crisis, the banks have come under heavy liquidity pressure, as they are finding it extremely difficult to roll-over maturing CDs. In fact, during the first three months of 1995, aggregate foreign currency-denominated deposits with the commercial banks (including Union and Cremi), decreased by 23% or by more than US$3.5 billion, to stand at end-March 1995 at US$11.8 billion, which is equivalent to 15.8% of total deposits. 2.37 The pressure on the banks was for awhile compounded by the Government's difficulty in dealing with the Tesobono problem. The liquidity assistance provided by FOBAPROA to the commercial banks (para. 3.5), which amounted to US$3.3 billion during the first quarter of 1995, has significantly improved the banks' liquidity position. However, the liquidity crunch will have significant adverse effects on the banks' average cost of funds and, hence, on their profitability during the first half of 1995. 2.38 Loan Portfolio Quality. As a result of the rapid rate of growth of their loan portfolios during a period of relatively slow economic activity in the country, Mexican banks were already saddled with high levels of non-performing loans when the peso crisis ensued (para. 2.24). The banks' concern with the rapidly deteriorating quality of their loan portfolios is reflected in the additional loan loss provisions made. In fact, aggregate new loan loss provisions made during the fourth quarter of 1994 amounted to more than NP5.3 billion, as compared to NP5.5 billion for the first three quarters combined. As a result of these heavy charges, coming on top of the foreign exchange losses, the impairment in the value of the securities portfolio, and the unrealized losses from the banks' subsidiaries, the banking system (excluding Cremi and Union) recorded during the fourth quarter of 1994 an aggregate loss before tax of NP3.5 billion, which is, equivalent to 43% of their profit (before tax) during the first three quarters of the year, and to 7.9% of the equity at year-end. 2.39 Since most loans are repriced monthly, the prevailing high interest rates have quickly diminished borrowers' ability to service their debts. As part of the Government's revised economic program, monetary policy was tightened substantially, causing nominal interest rates on peso-denominated Treasury bills to rise to an average of 70 percent for the first four months  -13- of the year. Yet in real terms, these interest rates are low, since the rate of inflation in the four months of 1995 was equivalent to 84 percent on an annualized basis. Since mid-April, interest rates on short-term Government obligations have declined from a peak of more than 80% to a current rate under 60%. It has been projected that the economic program will steadily restore confidence and reduce inflation to less than half of current levels by the end of the year, so that nominal interest rates should fall by a similar magnitude. Should inflation remain stubbornly high or confidence resume only very slowly, high nominal interest rates would continue to exert a negative impact on bank loan portfolios. 2.40 The accelerated deterioration in the quality of the loan portfolios of 19 major commercial banks is illustrated in Table 2.3 below. In fact, the ratio of past due loans to gross loans (including discounted loans) of the group (which excludes Cremi and Union), increased from 7.4% at end-1994 to 8.4% by the end of January 1995, and further to 9.3% by the end of February 1995. If Cremi and Union, whose combined gross loans at the end of February 1995 stood at NP35.8 billion, of which 41.6% was past due, are included in the group, the ratio of past due loans to gross loans increases to 11.1 %. Although banks increased substantially their loan loss provisions during the first two months of 1995 by an aggregate amount of NP7.9 billion, the ratio of provisions to past due loans remained inadequate at the end of February 1995: it stood at 50.5% for the group of 19, and at 45.7% if Cremi and Union are included. The increasing inadequacy of the banks' loan loss provisions is demonstrated by the jump in the group's ratio of open loan exposure to equity, from 53.4% at the end of 1994 to 74.3% by the end of February 1995. Table 2.3: Accelerated Deterioration in Loan Portfolio Quality of Selected Commercial Banks' (in million of NP and percentages) End Dec End Jan End Feb 1994 1995 1995 Gross loans2 587,012 602,533 611,834 Past due loans 43,491 50,477 56,9244 Loan loss provisions 20,813 22,466 28,735 Equity 42,436 42,578 37,9265 Ratios (%) Past due/Gross loans 7.41 8.38 9.306 Provisions/Gross loans 3.55 3.73 4.70 Provisions/Past due 47.86 44.51 50.487 Open loan exposure3/Equity 53.44 65.79 74.33 Net capital/Risk-weighted assets 9.40 8.66 7.75 l Aggregates relate to the largest 19 banks (excluding Cremi and Union, which were intervened in September 1994), accounting at the end of 1994 for 95.0% of the system's equity and for 98.8% of the system's gross loans (excluding Cremi and Union). 2 Including discounted loans. 3 Open loan exposure is defined as the difference between past due loans and loan loss provisions. 4 With Cremi and Union, past due loans amounted to NP71,818 million new pesos. 5 Partly estimated. 6 Ratio increases to 11.09% if Cremi and Union are included. 7 Ratio decreases to 45.70% if Cremi and Union are included. Source. CNB  -14- 2.41 Eroding Capitalization. The significant new loan provisions taken and the increased funding costs have impacted negatively on the banks' capital position. During the first two months of 1995, the aggregate equity of the group of 19 banks decreased by NP4.5 billion or by 10.6%. Consequently, the group's average ratio of net capital to risk-weighted assets decreased during the interval from 9.40% to 7.75%. In fact, at the end of February 1995, 9 out of the 19 banks had ratios below 8%, as compared to only 3 at the end of 1994. The latest statistical data show that the banks' aggregate past due loans (including Cremi and Union), increased to around NP80 billion by the end of March 1995. This highlights the system's need for additional capital, which is supported by the Government's recent actions. The scarcity of capital would become considerably more acute if the prevailing high lending rates were to continue for a relatively long period of time, and the recession deepen. 2.42 Estimates of Potential Bank Portfolio Losses and Fiscal Impact. Estimating the overall cost of bank restructuring (including cleaning-up non-performing portfolios and recapitalizing banks) is important for the design of appropriate fiscal policy and for ensuring the preparedness of the authorities in responding to the financing requirements of bank restructuring. Any such estimate, however, is likely to be extremely tentative for several reasons. First, it is difficult to quantify potential losses of individual banks prior to completion of detailed portfolio audits, which are scheduled to start shortly. Second, it is difficult to estimate the extent to which such losses might be subsequently recovered (through loan collections and/or sale of assets), since these recoveries would depend on the macroeconomic outlook as well as the effectiveness of the recovery efforts to be pursued by the authorities and the banks. Third, it is equally problematic to estimate the magnitude of capital injection which could be expected from the private sector (existing and/or prospective shareholders) as the bank restructuring program unfolds, and which would correspondingly reduce the ultimate losses. Fourth and finally, in the present dynamic Mexican context, the condition of banks and firms is likely to change rapidly, and some losses will reveal themselves only over time. For these reasons, the loss estimate given below will need to be updated from time to time to reflect changing circumstances, and to take account of up-to-date information as it becomes available, in particular the results of diagnostic audits. 2.43 The loss estimate presented in Table 2.4 on the following page is based on available actual data as of end-March 1995 (i.e., gross loans outstanding, reported past due loans, actual provisions), supplemented by a number of adjustments (to take account of under-reporting and assets classification guidelines, etc.) and assumptions (e.g., 20% increase in gross loans, varying percentage increases in past due loans between March and September 1995). The basis for adjustments and underlying assumptions are explained in the footnotes to the Table. The data shows that, as of end-March 1995, the likely shortfall in portfolio provisions for the banking system (after some necessary adjustments), would range from NP24 billion to NP48 billion, with the median estimate at around NP36 billion (US$6 billion equivalent). Projections of the potential shortfall in provisions for the situation as of end-September 1995, based on varying assumptions of deterioration of the portfolio for planning purposes, show that this could increase from NP38 billion to NP96 billion, with the median estimate at NP65 billion (US$11 billion equivalent). 2.44 The Government will seek to mitigate the fiscal as well as the monetary impact of banking system losses through the application of appropriate financial modalities in carrying out the bank restructuring program (e.g., in cleaning up portfolio losses and recapitalizing banks).  -15- Table 2.4: Potential Loan Portfolio Losses of Commercial Banks (in billion of NP) Low Scenario Intermediate Scenario High Scenario End March 1995 Gross loans (1) 666.0 666.0 666.0 Reported past dues (1) 80.0 80.0 80.0 Actual Provisions (2) 48.0 48.0 48.0 Adjusted past dues (3) 120.0 140.0 160.0 Shortfall in Provisions 24.0 36.0 48.0 Percentage of Gross loans 3.6 5.4 7.2 End September 1995 Projected Gross loans (4) 800.0 800.0 800.0 Assumed Increase in Past 20.0 35.0 50.0 dues (%) Projected past dues 144.0 189.0 240.0 Required Provisions 86.4 113.4 144.0 Potential Shortfall in 38.4 65.2 96.0 Provisions (5) Percentage of Gross loans 4.8 8.2 12.0 1 Including Cremi and Union. Gross loans include discounted loans, partly estimated. 2 As required by prevailing prudential regulations (60% of past due loans). 3 Taking into account loans affected by arrears (rather than the amount of the arrears), revised loan classification guidelines, and rollovers. 4 Assumed to be 20% over end-March level. 5 Assuming, conservatively, that no additional provisions will be made during March-September 1995. These modalities are discussed in the "Operating Guidelines for Bank Restructuring" (Attachment II of Annex I) and in paras. 3.19 - 3.21. It is envisaged in particular that, while paying attention to the liquidity needs of restructured banks, the Government would minimize cash injection and instead issue bonds with maturities spread over several years. The median estimate of banking system losses of NP65 billion (approx. US$11 billion) would correspond to 4.0% of projected 1995 GDP while the high scenario loss estimate of NP96 billion (US$16 billion) would amount to 5.9% of GDP. The magnitude of banking system losses in relation to GDP for some other countries which have faced similar problems to Mexico are as follows: Ghana 6%, Hungary 10%, Finland 8%, Sweden 4.5%, and Norway 4%. If spread out over ten years, the annual burden of the high scenario losses for Mexico, including principal and interest (at 10% p.a. real), would be manageable as it would represent 0.9% of projected 1995 GDP. F. Recent Government Measures 2.45 Strengthened Supervision. After the CNB was reorganized in mid-1994, it began to perform its duties of regulating and supervising banks with increased vigor. Thus, even before the December 1994 devaluation and the ensuing financial crisis, the CNB had intervened in two  -16- banks along with the financial group controlling such banks. A third financial group was intervened in February 1995 following inspection of its commercial bank by the CNB. (para. 2.50) 2.46 Role of FOBAPROA. Many of the Government's programs for providing support to the banking sector are channelled through FOBAPROA, the support fund for banks administered by the Central Bank. As described in Annex IX, FOBAPROA's role goes beyond simple deposit insurance. The fund has broad powers to extend credit to banks to permit them to meet their obligations to depositors and other liability holders. Since the December 1994 devaluation, FOBAPROA has maintained a dollar liquidity window for commercial banks (para. 3.5) and is the entity through which the Government administers the PROCAPTE scheme (paras. 3.12 - 3.13). 2.47 Credits granted by FOBAPROA to assist a bank in meeting its obligations to the public are referred to as "preventive support." FOBAPROA's operations are funded through annual and special contributions from commercial banks and from lending extended to FOBAPROA by the Central Bank. In return for preventive support (other than through PROCAPTE), FOBAPROA may require a pledge of the shares of the bank receiving such support, or of its financial holding company. FOBAPROA is also empowered to exercise the voting rights of shares that have been pledged to it. If amounts extended as preventive support are not repaid or if serious undercapitalization or irregularities are uncovered in a bank, FOBAPROA may vote the shares it has received in pledge, take majority control of the bank or financial group, replace management, write down the bank's capital in accordance with the results of a full audit and sell the bank. 2.48 Interventions. In June 1994, as a result of the discovery of irregular transactions in the course of regular bank inspections, the CNB ordered the administrative intervention of Banca Cremi and Banco Union, both commercial bank subsidiaries of the Grupo Financiero Cremi- Union. On September 6, 1994, after discovering numerous additional irregularities and evidence of fraud involving related party transactions affecting the soundness and solvency of these banks, the CNB removed the management of both banks and appointed a management intervenor for the group and its subsidiaries.7 Since the appointment of the intervenor, losses of NP4,750 million from bad loans, fraud and the effects of the devaluation have been recognized and an additional NP2,350 million of capital were injected by FOBAPROA. The board of directors of the CNB approved the creation of an intervention committee to assist in resolving the intervened subsidiaries of Grupo Financiero Cremi-Union. The committee's goals include reassuring depositors and creditors that the intervened banks, with the support of FOBAPROA, will continue to comply with their obligations. 2.49 On February 16, 1995, immediately upon the effectiveness of the amendments to the Credit Institutions Law and Financial Groups Law clarifying FOBAPROA's power to vote the shares of financial institutions pledged as collateral for preventive support, this was done to ' The CNB take-over of Cremi-Union was the first such intervention since the privatization of the banking system. Earlier in 1994, the CNB and FOBAPROA negotiated an arrangement with Banco Obrero (a bank owned by Mexican labor unions, which was never nationalized) under which FOBAPROA made a capital infusion of NP 300 million in exchange for a majority interest. Inspections of Banco Obrero had exposed insufficient capitalization and certain past management deficiencies.  -17- effect a reduction of capital of each of the banks to zero and to issue to FOBAPROA new shares of capital stock in exchange for its preventive support. Thus, the original shareholders of the financial group and its subsidiary banks lost their entire equity in these entities and FOBAPROA became their sole shareholder. 2.50 In February 1995, the CNB ordered an immediate management intervention of Grupo Financiero Banpais - Asemex after inspections turned up sharply increased past due loans, a shortage of capital and irregular related party transactions. An intervenor and an intervention committee were appointed. The real condition of the financial group's bank (Banpais) and its other subsidiaries is currently being determined. Although this process is not yet complete, losses of approximately NP4,000 million are expected to be recognized. III. THE GOVERNMENT'S FINANCIAL SECTOR RESTRUCTURING PROGRAM A. Actions Already Taken by the Government 3.1 During the first quarter of 1995, the Mexican authorities overseeing the banking system (the Central Bank, CNB, and SHCP) initiated a number of actions to mitigate the negative impact of the peso crisis on the banking system. These included provision of liquidity, intensive inspections of banks resulting in increased provisions, and a temporary recapitalization scheme for banks. Since that time, in discussions with the Bank, these actions have been coordinated into an integrated program, and additional safeguards and policy reform measures identified to restructure the financial sector. The technical assistance necessary to enhance the authorities' capacity to manage and implement this far reaching program has also been reviewed. The Government has now put into effect a number of holding actions to reduce Central Bank credit risk in liquidity provision, and systemic risk in the payments process, and to contain losses and minimize risky behavior by troubled banks. The latter include: (i) prohibition of dividend payments by PROCAPTE banks; (ii) strict enforcement of the 8% capital adequacy rule; (iii) increased provisions; (iv) separate reporting of rollovers; and (v) limits on new lending and large exposures. The Government will keep these holding actions in effect throughout implementation of the program. In addition, the CNB will use moral suasion to restrict dividend payments by other banks in 1995. The CNB has also prepared an inventory of additional operating restrictions to be required of banks by the supervisory authorities, depending on the particular circumstances of individual banks (e.g., discontinuation of lending to adversely classified borrowers, limitation on new lending, establishment of internal control mechanisms, sale of non- core assets). These holding actions are shown in Box II of the Matrix of Policy Actions (Annex II) and in an annex to the Operating Guidelines for Bank Restructuring (attached to Annex I hereto). 3.2 The actions outlined above are being carried out during a time when the Government is also engaged in a major effort to build up the institutional capacity of financial sector authorities, particularly the CNBV. As noted earlier, in April 1994, the CNB was substantially reorganized and an institutional development plan was initiated to rationalize responsibility for on-site and off-site supervision and to modernize the training of inspectors and other staff. Implementation of the institutional development plan has also involved the hiring of a significant number of new staff at the management level. The CNB has recently been merged with the CNV (para. 2.20), so as to enable the consolidated supervision of financial groups including banking institutions and  -18- to achieve greater efficiency and coordination. The FTAL (Loan No. 3838-ME), signed in March 1995, is to assist CNBV and the Insurance and Bonding Commissions to modernize regulations and supervisory techniques and improve permanent training programs for their staffs. B. Principles Guiding the Government's Program 3.3 The Government's program is guided by several important principles: (a) the need to ensure the continued functioning of the credit and payments system while taking strong measures to contain losses; (b) taking decisions on recapitalization of selected banks after determining their financial condition; (c) putting in place a transitional program for recapitalization of banks to avoid further instability and allow time for shareholders to infuse additional capital; (d) requiring diagnostic studies for intervened and PROCAPTE banks for clear recognition and sharing of losses; (e) formulating and adopting a comprehensive set of guidelines ("Operating Guidelines"), setting out the basic principles and methodology for bank restructuring, including the treatment of bad assets; (f) promoting credibility and market confidence through transparency in the procedures followed; (g) restructuring loans of potentially viable borrowers in the real sectors facing short term liquidity problems; and (h) reforming and modernizing the policy and institutional framework to enable the mobilization of increasing amounts of domestic and foreign capital, while putting the system on a sound footing to prevent future recurrence of similar problems. 3.4 The Government's program to restructure the financial sector is embodied in the attached Letter of Financial Sector Development Policy (Annex I), and described in the following paragraphs. The Letter of Financial Sector Development Policy is supplemented by three substantive technical papers: a Policy Matrix; the Operating Guidelines for Bank Restructuring; and a Statement on Development Finance Entities. C. Maintaining Operations and Containing Losses 3.5 Provision of Liquidity to Banks. In the aftermath of the December 1994 devaluation, a number of Mexican commercial banks experienced extreme difficulty in renewing their maturing dollar obligations. The Government responded by establishing in early January 1995 a special window (as part of FOBAPROA) to provide short-term dollar liquidity at interest rates of up to 25%, secured by acceptable collateral. The total outstanding balances drawn by 10 of the commercial banks were about US$3.3 billion by March 31, 1995. After the December 1994  -19- devaluation, the Central Bank began providing peso liquidity on an unsecured basis through special credit auctions as some banks were experiencing a shortage of eligible collateral. Outstanding balances stood at the equivalent of US$3.0 billion by March 31, 1995 and 15 banks had participated in such auctions. 3.6 In order to ensure that liquidity provision does not become a means to delay revelation of insolvency, since March 20, 1995 the Central Bank requires banks to post Government securities, NAFIN securities, and loans provided to prime borrowers as collateral in peso credit auctions. This provision will remain in place throughout the implementation of the program, and liquidity support from the Central Bank will take account of solvency considerations. The Government has also agreed to undertake studies to reform development bank lending to serve as a basis for the preparation of action plans for implementation (para. 3.32). 3.7 The Payments System and Daylight Overdrafts. The volume of intra-day credit or daylight overdrafts extended to commercial banks by the Central Bank immediately after the devaluation was unlimited. Thus, during the day its credit risk grew as the liquidity crisis worsened and some banks maintained daylight overdrafts greater than several times their capital. An organized system of risk safeguards was not in place to prevent the failure of one bank (e.g., with large peso daylight overdrafts) from causing a potential systemic problem. To improve operation of the payments system while implementing explicit safeguards to reduce its credit risk, a Circular issued on March 3, 1995 requires pricing of Central Bank intra-day credit on a real time basis, pledging of collateral by banks that maintain large and frequent daylight overdrafts with the Central Bank, and debit caps for the portion of daylight overdrafts not subject to collateralization. Finally, the Central Bank has indicated that commercial banks will be required to hold special non-interest earning clearing balances if daylight overdrafts are deemed to be too frequent. These actions will limit both credit risk and systemic risk. They will make solvency problems at commercial banks more apparent, triggering early decisions on continued intra-day or longer-term liquidity support. 3.8 To limit the risk of contagion through interbank transactions, the Central Bank issued a circular in March 1995 establishing the Sistema de Pagos Electr6nicos de Uso Ampliado (SPEUA), a special clearing house for settlements of large value payments between Mexican commercial banks or between them and their foreign correspondents.8 The system for netting of payments over this system (i.e., multilateral netting), combined with the imposition of bilateral credit limits, will substantially reduce the risks of contagion within Mexico's financial system. The Central Bank will also eliminate FOBAPROA coverage of settlements through SPEUA by March 1996. This will reduce the risk that participants in SPEUA do not implement proper risk safeguards because of the government's (FOBAPROA) guarantee of all bank liabilities (paras. 2.46 and 3.26). These measures, taken together, substantially minimize the systemic risk arising from inter bank transactions. 3.9 Intensified Inspection. In order to quickly assess the health of the banking system, beginning January 1995, the CNB initiated a program of intensified on-site inspection of 8 The hardware and software of SPEUA are provided by the Central Bank while the risk safeguards are implemented by the commercial banks participating in the transfer of large value payments over the system.  -20- commercial banks based on the CAMEL9 system focussed on asset quality and provisions. These are being done on a targeted basis, beginning with the more vulnerable banks. This has revealed the precarious financial situation of some banks, whose capital would drop below the 8% required under the regulations if they were to set aside adequate provisions. Under the program, the CNBV expects to complete on-site inspections of all but four privatized banks by September 30, 1995, and the remaining four by December 31, 1995. The CNBV will continue to conduct such on-site inspections annually. Satisfactory progress in the completion of annual on-site inspections of banks is a requirement for the release of the Second Tranche. 3.10 Monitoring Rollovers/Reschedulings/Large Exposure. In order to prevent troubled loans from being automatically rescheduled with interest being capitalized and enabling banks to avoid provisions on them, on January 11, 1995, the CNB required all banks to separately identify roll-over loans for monitoring. In addition, the CNB required banks to maintain or reduce large exposures to return to compliance with applicable prudential regulations. 3.11 Increased Provisions. On February 22, 1995, the CNB required all banks to increase the level of provisions to the higher of: (a) 4% of the loan portfolio; or (b) 60% of past due loans; or (c) provisions required from quarterly loan classification. This led all banks to raise provisions, but in doing so, several banks fell short of the requirement for 8% capitalization. 3.12 Temporary Recapitalization Program (PROCAPTE). On February 24, 1995, the Government introduced a program for temporary recapitalization (PROCAPTE, administered through FOBAPROA), for those banks which are unable to mobilize additional equity capital from existing shareholders to meet the 8% requirement. The principal characteristics of the PROCAPTE scheme are set out in Annex X. The program involves the issuance of subordinated convertible debentures up to an amount sufficient to raise each participating bank's net capital to 9% of its risk-weighted assets. The proceeds from the issuance are deposited in a special account in Banco de Mexico that carries an interest rate equal to that paid on the debentures. Whenever in the future a participatory bank's capitalization ratio falls below 8.5 %, FOBAPROA will subscribe for an additional amount of subordinated convertible debentures sufficient to restore the bank's 9% level. If, however, a bank's capitalization ratio exceeds 9%, the bank has the option to redeem (partially or in full) the subordinated debentures held by FOBAPROA. FOBAPROA is required to convert the subordinated debentures outstanding at the end of five years into equity. However, the convertibility feature could be invoked earlier by FOBAPROA if a participating bank's equity capital falls below 2% of its risk-weighted assets, or if bank's capitalization (excluding the PROCAPTE obligations) varies more than 25 % from the trend of average capitalization of all the banks participating in the program. Following discussions with the Bank, it has been agreed that FOBAPROA will, in any event, exercise the conversion and take over the ownership of any bank whose capital falls below zero percent. 3.13 Six of the nine banks that had deficient capitalization ratios at the end of February (i.e., Serfin, Comermex, Internacional, Centro, Confia and Oriente), joined the scheme at the end of I Capital adequacy; Asset quality; Management; Earnings; and Liquidity, asset and liability management.  -21- March10. The combined equity of these six banks, which amounted to NP10.2 billion at the end of 1994 (equivalent to 22.8% of the system's total equity), decreased by almost NP3.0 billion during the first two months of 1995. Consequently, the group's average capitalization ratio declined from 8.13 % to 5.82% (Table 3.1). During March, four of the six banks managed to raise only a small amount of capital privately, totalling NP443 million. As shown in Table 3.2, the PROCAPTE obligations issued totalled NP6.5 billion, thereby enabling the banks to raise their average capitalization ratios to 9.60%. Table 3.1: Ratio of Capital to Risk-Weighted Assets of PROCAPTE banks (in percentages) Bank End December End February End March 1994 1995 1995 Serfin 7.99 4.84 9.77 Comermex 7.95 6.86 9.70 Internacional 8.40 6.74 9.37 Centro 8.08 7.91 9.60 Confia 8.55 6.60 9.06 Oriente 9.14 -0.79 9.00 Group of six 8.13 5.82 9.60 Table 3.2: Increase in Equity of PROCAPTE banks during March 1995 (in million of NP) Bank New capital Convertible PROCAPTE Increase in injection debt obligations equity Serfin 240 -- 3,200 3,440 Comermex 30 -- 1,400 1,430 Intemacional 700 700 Centro -- 452 452 Confia 28 35 425 488 Oriente -- 110 311 421 Total 298 145 6,488 6,931 3.14 Debt Restructuring - UDI Scheme. The doubling of the NP-dollar exchange rate, the fourfold rise in interest rates, and the onset of recession are making it difficult for corporate borrowers in the non-export sector and many other debtors (e.g., consumers, home owners, state and municipal governments) to service bank loans. To minimize the risk of bankruptcy of firms that are viable in the long-run, the Government is: (a) reviewing means to reduce legal, tax, and 10 Of the remaining three banks, one (Banpais) had already been intervened in February 1995, another (Mexicano) raised enough capital through a share capital increase and issuance of subordinated debt to improve its capitalization ratio above the 8% level, and a third (Probursa) was granted an additional month to meet the minimum capital adequacy requirement since negotiations with a foreign financial institution regarding a substantial capital injection had reached an advanced stage.  -22- regulatory impediments to voluntary debt restructurings; and (b) actively promoting debt restructurings, given the acute nature of the crisis. The Government has introduced a number of Support Programs (Programas de Apoyo) to permit the restructuring of loans on the balance sheets of commercial banks and some development banks up to an aggregate ceiling of NP 170 billion (or about US$ 28 billion) including loans for: (a) industry; (b) housing; (c) states and municipalities; and (d) certain development banks loans. (Annex XI.) These programs use the Unidad de Inversion (UDI), a real unit of account. The Central Bank periodically adjusts the UDI's NP value based on an index of national consumer prices. Short-term NP-denominated, nominal interest rate loans would be converted into long-term UDI-denominated loans that have constant real interest rates, whose use is aimed at eliminating the inflation-uncertainty component of floating peso interest rates. The Government will lend funds to the banks to finance the restructured loans at a real rate of 4 percent (UDIs+4%) and borrow from the banks at market determined nominal interest rates based on the 28 day CETES rate. Thus, if the ex-post real CETES interest rate is higher than 4 percent (as is likely, particularly in the short-term), there will be a subsidy which will translate into a fiscal cost. 3.15 The Government has analyzed the potential fiscal cost of the UDI scheme, taking into account its inflationary impact. Additionally, the Central Bank has issued a circular to banks setting out basic criteria, modalities and procedures for the UDI scheme. It has been agreed that beginning January 1, 1996, CNBV will review the classification of assets in the UDI trusts as they evolve, and re-classify them every quarter, and require banks to build necessary provisions immediately. The CNBV will also, before March 31, 1996, (i) analyze the initial implementation experience of the UDI scheme and associated fiscal costs, and formulate changes, as appropriate; (ii) review the results with the Bank; and (iii) implement the revised scheme. 3.16 Legal/Regulatory Framework for Corporate Workouts. Containing the real impact of financial distress requires preventing closure of illiquid but ultimately solvent enterprises as well as efficient winding up of insolvent businesses. Unfortunately, the Mexican legal/regulatory framework is not conducive to corporate restructuring. Bank regulatory provisions limit the options available for restructuring. Legal, notarial, re-registration and other costs associated with restructuring can also be quite high. Bankruptcy reorganization procedures are outdated, time-consuming, costly and seldom lead to efficient workouts. There is also a general lack of confidence in how well the court system is equipped in terms of skills and processing capacity to handle what may turn out to be a large number of defaults. 3.17 The Mexican Bankers Association (ABM) has established a committee to develop initiatives for removing legal/regulatory obstacles to corporate restructuring. These include means of more rapidly and cheaply notarizing restructured loan and security agreements, facilitating registration of amended mortgages and initiating pre-default consultations among creditors. The ABM is also developing an arbitration procedure for resolving disputes among creditors in corporate restructurings. The Government recognizes that legal and regulatory changes are desirable to facilitate re-organization of troubled enterprises. The Ministry of Commerce has already begun work on improving the bankruptcy code. Accordingly, the Government will conduct a study of the obstacles to voluntary corporate debt restructuring (including recognition, execution and enforcement of out-of-court workouts and arbitration awards), review the findings with the Bank before December 31, 1995 and agree with the Bank on a plan of action by March 31, 1996 for removing unnecessary impediments to voluntary debt  -23- restructuring, through appropriate changes in regulations and/or the legal framework. 3.18 Diagnostic Studies of Banks. The inspections by the CNBV provide better information than was available hitherto on a bank's financial condition including capital adequacy under present Mexican accounting standards. However, the CNBV's inspection capacity is limited and its staff lacks experience in some technical areas (para. 2.31). In order to obtain accurate and consistent financial information, uniform accounting standards, consistent with U.S. GAAP, for loan classification and provisions need to be applied. Availability of such information is also essential for banks to be able to mobilize equity capital from the financial markets. Therefore, under the program, the CNBV has agreed to recruit an independent auditing firm under terms of reference acceptable to the Bank to assist the CNBV in conducting detailed diagnostic studies of intervened and PROCAPTE banks, and initiate the diagnostic study of at least one intervened bank before Effectiveness. The CNBV will complete the diagnostic studies and review results with the Bank: (a) by September 30, 1995 for two intervened banks; and (b) by December 31, 1995 for all intervened banks and PROCAPTE banks as of May 31, 1995. The CNBV has also agreed to initiate diagnostic studies of banks (not in the PROCAPTE/FOBAPROA programs as of May 31, 1995) within 90 days of their joining PROCAPTE or being intervened by CNBV or coming under the control of FOBAPROA, to complete such studies within a maximum of four months from the starting date, and to review the results with the Bank. Reviews of the results of the completed diagnostic studies with the Bank are requirements for the release of the Second Tranche. 3.19 Bank Restructuring. The initiation of detailed diagnostic audits for selected banks (para. 3.18) constitutes only the first step in formulating and implementing a comprehensive bank restructuring program. The Government recognizes the need to put such program on a sound, methodical and transparent basis. For that purpose, and following discussions with the Bank, it has formulated and approved a framework document entitled "Operating Guidelines for Bank Restructuring" (attached to the Letter of Financial Sector Development Policy, Annex I). The document (and the three technical papers annexed to it) sets out the main objectives, methodology and criteria for the restructuring of troubled banks. The four principal objectives of the restructuring framework are: * to minimize the overall fiscal cost while adequately meeting the financial requirements of the restructured banks; * to ensure an attractive environment for both domestic and international investors to participate in the capitalization of banks; * to limit (financially and over time) the role of the public sector in the bank recapitalization process; and * to promote the consolidation of the banking system through selective mergers or liquidations. 3.20 Experience demonstrates that for the rehabilitation of troubled banks to be successful, three goals should be pursued: first, losses should be covered in full, both in terms of stocks and of income flows; second, management responsible for the losses should be changed; and third, ownership structure should be changed. Experience also shows that successful bank  -24- restructuring usually entails: (a) on a system-wide basis, some consolidation through selective mergers or liquidations; and (b) at the level of individual banks, significant reduction in operating expenses through staff retrenchment and rationalization of the branch network. 3.21 The bank restructuring program should therefore encompass: (a) the closure and liquidation of those banks identified as fundamentally non-viable; (b) the merger of banks in order to improve their financial condition and operating efficiency; and (c) the organizational/managerial restructuring and recapitalization of troubled but potentially viable banks. In all these cases, two of the most important issues facing the authorities are the method of financing losses (including loss allocation between the Government and other parties) and the treatment of non-performing loans. To render a bank more attractive to prospective investors the non-performing loans would likely have to be removed from the bank's balance sheet. In the case of the Mexican banks that have already been intervened or those that would be intervened in the future, FOBAPROA could purchase these loans at book value (i.e., gross value less provisions already taken), thereby itself taking the loss. These assets should then be recovered or sold as quickly as possible, through auctions, securitization or any other appropriate market mechanism. The assets could either be lodged with the new bank or alternatively in a special trust fund (fideicomiso) for recovery or liquidation. A performance-based commission could be envisaged as an incentive for the recovery institution. An alternative method could be the creation of a "bridge bank" for every intervened bank. The "bridge bank" would take over the sound portion of the bank's portfolio, and then be sold as a clean bank, while the bad assets, contingencies and litigation liabilities are left in the bad bank for liquidation. The financial modalities/instruments to be used by the Government/FOBAPROA for cleaning up the banks' losses and their recapitalization should consist of an appropriate mix of cash and non-cash (offsetting of cross assets/liabilities; issuance of medium-term bonds), which would take into account the fiscal implications for the Government as well as the liquidity needs of the restructured banks. These modalities for financing the bank restructuring program and for the treatment of non-performing assets are described in the technical papers of the "Operating Guidelines" (Annex I - Attachement II). 3.22 The Operating Guidelines for Bank Restructuring (with its technical papers) have been approved by the Government prior to Board Presentation. Recruitment of investment banks and/or specialized consultants to assist in preparing specific restructuring plans for individual banks will be a condition of Effectiveness. The Government will submit and review with the Bank, restructuring plans including implementation strategies, approved by CNBV, SHCP and FOBAPROA, by September 30, 1995 for two banks under FOBAPROA control, and for any remaining banks within three months of the date of FOBAPROA taking control. Submission of the restructuring plans prepared in accordance with the Operating Guidelines, including implementation strategies, and approved by CNBV, SHCP and FOBAPROA, for all banks under FOBAPROA control, for review with the Bank, and continued satisfactory implementation of these plans are conditions of Second Tranche release. D. Policy and Institutional Reforms 3.23 Revision of Accounting Standards and Disclosure. Financial statements of Mexican banks are prepared in accordance with CNBV guidelines, which differ significantly from U.S. GAAP. The principal differences are in the treatment of interest income on loans (and on rescheduled debts), and repurchase agreements, valuation of fixed assets, disclosure  -25- requirements, and the definition of non-performing assets. The accounting procedures used are thus not internationally comparable. In November 1994, CNB began preparation of draft guidelines reconciling Mexican and U.S. GAAP, with assistance from the Bank and in consultation with the U.S. Federal Reserve, FDIC and the corresponding bodies in Canada. The draft guidelines are now being discussed with the Mexican Institute of Public Accountants and Auditors after which they are to be reviewed with the Mexican Bankers Association. The Government recognizes the need to adopt uniform accounting principles for banks consistent with U.S. GAAP for use by auditors. It also plans to revise the accounting standards for financial groups. Therefore, under the program, the CNBV will formulate uniform accounting principles (including consolidation of financial statements), consistent with internationally accepted principles (U.S. GAAP) and acceptable to the Bank, and consistent across all transactions and activities, for financial statements and regulatory reports of banks by Effectiveness; and it will issue the revised standards to banks by September 30, 1995, requiring them to use the new accounting standards beginning January 1, 1996 for completion no later than year end-1996 accounts. Implementation will also be a condition for Second Tranche release. The CNBV will require auditors to strictly follow the guidelines for conducting audits issued under Circular 1222 of November 14, 1994 for banks, and under Circular 10-165 of January 4, 1993 for brokerage firms, and monitor auditors' performance, beginning with the audits of 1994 accounts. The CNBV will: (a) formulate, by September 30, 1995, draft acceptable uniform accounting principles, consistent with internationally accepted principles (U.S. GAAP) and consistent across all transactions and activities, for financial statements and regulatory reports non-bank financial institutions that are affiliates of financial groups with bank affiliates; and (b) issue these by December 1, 1995. The issuance of revised acceptable accounting standards for non-bank financial institutions is a condition of Second Tranche release. The CNBV has agreed to strengthen disclosure by banks to supervisory authorities requiring banks to submit new regulatory reports and special reports, and review progress with the Bank by September 30, 1995. The CNBV will also continue the ongoing efforts to improve disclosure to the public, and review progress with the Bank by September 30, 1995. In addition, the CNBV will complete by March 31, 1996, a study of ways to improve real estate appraisal standards, and to identify an institution that can undertake the regulation of appraisers. 3.24 Reform of Prudential Regulations. Prevailing prudential and supervisory regulations applicable to Mexican banks and financial groups need strengthening. Prudential regulations do not apply to financial groups, and conglomerates are not required to publish consolidated financial data, and submit consolidated regulatory reports; this has often led to regulatory and supervisory "arbitrage. " The recent crisis has also highlighted weaknesses in such areas as asset classification, valuation standards for trading portfolios, troubled debt restructuring guidelines, capital adequacy standards for different entities within financial groups and on a consolidated basis for the entire group. Similarly, over the medium term regulations relating to large exposures on a group-wide basis, to consolidation of financial statements and reporting are also in need of substantial revision. There will be a need to formulate enforceable trading practice regulations in such areas as insider dealing, front running, dumping of securities (i.e., sale of securities by brokers to mutual and pension funds managed by such brokers or their affiliates), best execution of securities trades, and conflicts of interest. The new regulations should be conceived in a manner that promotes self-monitoring of financial groups by market participants or self-regulatory organizations such as the Mexican Stock Exchange. Finally, it is important to harmonize these standards to the degree possible with those adopted in other NAFTA countries and internationally.  -26- 3.25 To remedy the existing deficiencies in prudential regulations, the CNBV will issue supplemental internal instructions prior to Second Tranche release, acceptable to the Bank, for inspection of banks (including development banks), covering, inter alia, asset classification and provisioning, exclusion of defacto treasury stock (stock owned or financed directly or indirectly by related entities, or covered by repurchase agreements) for purposes of capital adequacy standards, composition of Tier I capital, large exposures and concentration, and related party lending. The CNBV will also, prior to Second Tranche release: (a) review with the Bank the need for the issuance of new prudential regulations for banks and issue such new regulations to the extent necessary; and (b) issue new prudential regulations with respect to capital adequacy standards for brokerage firms. 3.26 Deposit Protection Scheme. A savings protection scheme should primarily protect small, uninformed savers and accumulate reserves commensurate with potential risk. The present Mexican scheme leaves significant uncertainty regarding both the role and scope of the liabilities covered by FOBAPROA (the commercial bank support fund) and FAMV (the support fund for brokerage firms). While FOBAPROA is not a formal deposit insurance scheme and although there is no enforceable legal obligation of FOBAPROA or FAMV to support bank and brokerage firm liabilities beyond the funds' accumulated reserves, the Government has clearly indicated that the funds will support all bank and brokerage firm liabilities except subordinated debt (Annex IX). This sweeping support clearly reduces incentives for large creditors and depositors to monitor the performance of banks and brokerage houses. Moreover, the accumulated funds in FOBAPROA and FAMV clearly will not cover the losses of the current crisis. This means that fiscal expenditures will ultimately support the liabilities of failing banks and brokerage firms to the extent that depositors and other creditors are protected. Thus, over the medium term, Mexico needs to overhaul its current savings protection policy. 3.27 While the system needs to be changed in the medium term, the Government is rightly reluctant to do this in the midst of a crisis. Past experience in some other countries showed that reversing earlier pronouncements might instigate panic and capital flight, damaging economic recovery and financial development. Available data show that, in fact, deposits in Mexico's commercial banks rose by over 10% between end December 1994 and end March 1995. Peso deposits rose by 12% (from NP375.2 billion to NP422.8 billion), far exceeding 1.6% decline in foreign currency deposits (from NP 81.7 billion to NP80.4 billion equivalent) in the same period. Thus, during the remainder of 1995, the Government does not intend to change the coverage afforded to liability holders, although technical work towards reforms would begin. 3.28 The Government will complete by December 31, 1995, a study of liability coverage including a set of options for implementing an appropriate level of coverage for large liabilities of financial entities and their affiliates. The study will be reviewed with the Bank by March 31, 1996. The Government will adopt the revised protection scheme for phased implementation beginning January 1, 1997. 3.29 Modernization of Legal/Regulatory Framework for Lending. Although the overall framework for the financial sector was overhauled by the introduction of the Credit Institutions Law, the Capital Market Law and the Financial Groups Law and subsequent amendments, the Government recognizes that important shortcomings remain in the legal/regulatory framework for the business of mobilizing and allocating resources. Impediments to securitization restrict the amount of credit and other financing available to a number of sectors (in particular, housing  -27- finance). The lack of a comprehensive legal framework for lending secured by movable property distorts credit allocation and limits the availability of credit to small and medium enterprises. Unless remedied, these shortcomings will also importantly limit the scope for rapid improvement in the quality of credits originated by banks and the options available for restructuring and disposing of the assets of troubled banks. Details on the issues to be addressed to reform the framework for securitization and secured lending are in Annex XII. Under the program, the Government will conduct a study to identify remaining regulatory obstacles and legal impediments to asset securitization, and make the recommendations for removing such obstacles and impediments available to the Bank by December 31, 1995. Thereafter, CNBV and SHCP will initiate the process of removing such legal and regulatory obstacles. In the area of secured transactions, the Government will conduct a study to identify shortcomings of, and propose changes to, the legal/regulatory framework for secured lending and make recommendations available to the Bank by December 31, 1995. Thereafter, the Government will initiate the process of improving the legal/regulatory framework for secured transactions on the basis of such recommendations. E. Development Banks 3.30 Each development finance entity (DFE) in Mexico utilizes its own eligibility criteria to determine access of private financial institutions to its funds. The criteria used, which are generally lax, differ across DFEs and even within different units of the same institution. Exposure limits are established by each operating unit for its respective operations, but the total financial obligations outstanding are not monitored in a centralized and consistent manner. This facilitates access in amounts that by far exceed the capital of certain commercial banks and might absorb substantial portions of a bank's liabilities. For example, BANPAIS and Mercantil - PROBURSA" had outstanding obligations with NAFIN and BANCOMEXT in excess of 200% of their capital at the end of 1994. 3.31 The pricing of financial products offered by DFEs is based on administered rates and does not reflect risk differentials or market funding costs. In domestic currency, intermediaries of different credit quality have access to public funds at uniform rates that are generally below the opportunity cost of private sector funds. In addition, the respective rates are based on a flat or negative yield curve, thus undermining the development of medium and long term private sector funding. The spread to be charged by the intermediary to the final borrower is generally fixed at the second tier level12. 3.32 Overall, DFEs provide a rich variety of arbitrage opportunities to private financial intermediaries (FIs) through credit, liquidity and portfolio investment that have contributed to the lack of discipline and market clearance which partially accelerated the financial weakening of many private intermediaries during recent years. If unchecked, development finance could undermine the discipline of a rational resolution process. In addition, the fiscal impact of " BANPAIS has been intervened recently and Mercantil-PROBURSA is currently negotiating the sale of the majority shareholdership with a European bank in a move to avoid entering into PROCAPTE. 12 The credit unions generally do not operate a variety of financial products, which makes it much more difficult to charge a higher rate by adding fees on other products. Besides, they do not have significant private sources of funds and therefore cannot average out the interest rate charge on loans like commercial banks.  -28- uncollectible assets with weak private FIs could become a sizeable fiscal burden in the near term. Arbitrage opportunities among sources of capital from DFEs therefore need to be reduced and demand driven selectivity fostered, based on the principles of consistency, transparency and efficiency. Also, lending and other financial exposure of the DFEs should be limited to private FIs that demonstrate solvency. Prior to Effectiveness, SHCP will present terms of reference, satisfactory to the Bank, for studies of: (a) the impact of establishing risk-based exposure limits for the liabilities of each Fl to DFEs; (b) the establishment of eligibility criteria for Fl participation in DFE second-tier operations (such study to include an analysis of the impact of establishing rating requirements from qualified private agencies); and (c) the current interest rate policy in domestic and foreign currency, including an evaluation of its incentive structure and impact on financial markets and final borrowers. SHCP, prior to release of the Second Tranche, will also review results of the above studies with the Bank, prepare an action plan and take the necessary official action to implement such action plan. IV. BANK GROUP STRATEGY IN MEXICO'S FINANCIAL SECTOR A. The Bank 4.1 The Country Assistance Strategy paper being distributed along with this document sets out in detail the Bank Group strategy in Mexico. It also covers IMF and IDB activities. Annex XIII provides the status of Bank Group operations in Mexico. 4.2 The World Bank supported Mexico's adjustment program during the FY 1986-1991 period with loans totalling almost US$ 11.4 billion. Half of this amount was committed under sector adjustment loans in trade, finance, agriculture, transport, industry, and for an interest reduction loan linked to Mexico's external debt reduction package with commercial banks. The FY89 Financial Sector Adjustment Loan (FSAL) supported important policy reforms to deregulate Mexico's financial system, which proved critical to the recovery that ensued. The FSAL supported the deregulation of interest rates on deposits, elimination of forced lending, and reduction of the role of special trust funds as intermediation channels for Government resources and elimination of reserve requirements on peso deposits. The FSAL also supported efforts to begin to modernize banking regulation and supervision. Since FY 92, annual lending has averaged US$1.4 billion, with no adjustment loans proposed until now. By FY 91, adjustment lending fell to 25 percent of total commitments; and the forms of operations shifted to poverty reduction, human resource development and environment, while maintaining a strong program in infrastructure. 4.3 The Country Economic Memorandum: Fostering Private Sector Development in the 1990s (Report No. 11823-ME, May 16, 1994), addressed the remaining constraints to financial sector development in Mexico. The Bank, jointly with the IMF, subsequently undertook a review of the Mexican financial system. The Bank continued to develop this diagnostic work through informal sector work during FY93 and FY94. In the second half of 1994, the Bank prepared policy options papers for the incoming administration that addressed the financial sector, contractual savings and commercial law reform. 4.4 The $23.6 million equivalent Financial Sector Technical Assistance Loan (FTAL No. 3838-ME), approved on January 24, 1995 and signed on March 9, 1995, was intended to meet three interrelated objectives: (a) to improve the safety and soundness of the financial system  -29- through improved prudential regulation and supervision, and through greater incentives for self- regulation of market participants; (b) to support the development of the pension system; and (c) to strengthen public investment evaluation and budgeting. The loan was a logical extension of previous efforts to emphasize transfer of specialized human capital and institution building to support the modernization of Mexico's regulatory framework and supervisory capacity. The loan is designed to support a flexible program addressing the emerging issues of concern in development of the Mexican financial sector. The FTAL is being restructured in order to provide the technical assistance required to accelerate support in areas of immediate need such as inspections and diagnostic studies of banks and to assist the Government in selecting advisors to prepare bank restructuring plans. However, to ensure the implementation of the essential elements of the original FTAL program, as well as address technical assistance needs for the development of financial markets in Mexico in the medium-term (e.g., completion of consolidated prudential regulation and supervision across all financial intermediaries, improvements in contractual savings schemes inclusive of the SAR accounts, and further development of the legal and regulatory framework for asset-backed securities (securitization) and capital markets more broadly), a supplemental loan is also planned for the restructured FTAL. 4.5 The onset of the current economic crisis required the Bank to intensify its analytical and diagnostic work on the causes of the problems and their evolution, drawing upon experience of similar system wide operations in other countries. The objective was to ensure that the acceptable actions are taken by the Mexican authorities to restore the safety and soundness of the banking system. In collaboration with the Mexican authorities, the Bank assisted in identifying measures additional to those already initiated and in accelerating the schedule in order that the problem is managed and its eventual costs contained. The main focus was on ensuring that long standing regulatory, legal and institutional impediments are removed, to permit the financial system to more efficiently mobilize and allocate resources. This proposed first operation is aimed at dealing with the immediate problems through speedy recognition of the problems and potential losses through intensified inspections and diagnostic studies, and disposal of troubled banks. Subject to satisfactory progress of the immediate program, a follow-on operation of $500 million is planned during this calendar year to address medium term policy and institutional issues facing the sector including development of contractual savings. 4.6 The proposed operation is designed as an adjustment loan with two tranches. The proceeds of the loan are intended to help the Government support the cost of restructuring its financial sector so as to overcome the current crisis, to enable the continued functioning of enterprises in the productive sectors, and to lay the basis for the development of a healthier financial system. 4.7 In the context of recent experience in financial sector operations in Mexico and other countries, the Bank has drawn several important lessons that have been taken into account in designing the reforms under the proposed loan. The main lessons of recent experience relevant to this operation are the following: * Programs to restructure troubled financial institutions are successful only when designed to promote institution building, the strengthening of market forces, and improved oversight by reform-oriented governments.  -30- * Restoration of macroeconomic stability and early progress in implementing reforms are critical for establishing investor and consumer confidence. * Government ownership, project design, and quality at entry are enhanced when the Bank and the government have developed a close policy dialogue supported by strong economic and sector work. * Conditions for tranche release should be clearly defined and easily monitored for compliance. * Priorities for technical assistance should be carefully identified and supported with rigorous supervision. B. The IFC 4.8 In recent years, IFC's operational strategy in Mexico has supported the private sector in adapting to the opening of the economy and in re-entering the international financial markets. Although greater emphasis is presently being given to second-tier companies, IFC's investments in Mexico have in the past been primarily directed at the large corporate firms and have mainly involved capacity expansions and modernization. Mexico's capital markets, tourism, food processing, general manufacturing, and, to a lesser extent, petrochemicals have benefitted most from IFC's recent operational activities. Operations in infrastructure have remained modest due to the slow progress achieved by the Government in resolving outstanding regulatory issues. 4.9 The special problems confronting Mexico today will give IFC a unique opportunity to increase the pace of its investments in that country. Besides the opportunity to build on the corporate restructuring experience that IFC acquired in Mexico in the mid-1980s, the recent events will provide the Corporation with renewed opportunities to diversify its local equity at a time when these had become largely limited to quasi-equity transactions among second-tier and unlisted companies. Based on the emerging needs of the local private sector, the anticipated portfolio growth will be primarily driven by new investments in the general manufacturing, capital markets, and infrastructure sectors. The Bank and IFC will closely collaborate through the proposed loan to identify banks and companies for financial assistance. IFC is similarly working with the Bank through the proposed Infrastructure Privatization Technical Assistance operation in exploring ways to support the privatization process and to arrange financing and securitization for new investment projects. The IFC's Foreign Investment Advisory Service (FIAS) is providing advice to SECOFI on strengthening Mexican producers of parts, components and intermediate goods in the post-NAFTA context. 4.10 In the manufacturing sector, IFC will continue to give priority to second-tier companies. However, the special circumstances facing Mexico will also dictate that it provides selective support to those larger industrial groups which it had helped graduate to the international financial markets in recent years and which now face unusual investment financing constraints. In capital markets, IFC will focus on providing liquidity to give stimulus to sectors such as SMEs, infrastructure, and housing at a critical time when the Government's response to current economic imbalances is likely to be recessionary. Additionally, it will seek to enhance the Mexican securities markets through underwriting facilities and institution-building activities. In the infrastructure sector, IFC will respond to the Government plans to accelerate privatization  -31- in power, satellite communications, ports, airports, railways and highways. To that effect, it will assist the local private sector in remedying some of the financing constraints which have thus far adversely affected the pace of infrastructure privatization in the country. However, IFC's success in diversifying its activities in this sector will depend heavily on Government steps to establish shortly the regulatory framework required to attract private investors into infrastructure services. C. Coordination with the IMF 4.11 The Bank has been working closely with the IMF in monitoring the macroeconomic situation in Mexico and advising the Government in this area. Given the IMF's direct role in financing the stabilization program, their team has naturally led the dialogue on macroeconomic stabilization measures, exchange rate policy, and liability management issues. In fiscal policy, the IMF has concentrated on developing macro-level targets, while the Bank's sectoral background has enabled us to advise on sectoral policies. In the financial sector, the Bank has a lead role, due to our experience through our lending for banking sector reform in other coutries, and in preparing the FTAL. The IMF and the Bank will coordinate especially closely in implementing the Financial Sector Restructuring Loan, because of the inter-dependence of financial and macroeconomic stability. The impact of macroeconomic adjustment on social programs is of concern to both institutions, and the Bank is sharing with the IMF its analysis in this area during the course of the stabilization program. Finally, macroeconomic stability will depend critically on Mexico's ability to increase domestic savings and productivity. The Bank's planned analytical work in these areas will be shared with the IMF, so that it can feed into the evolving macroeconomic framework. V. THE PROPOSED LOAN A. Background 5.1 The proposed operation is a strong response to the current economic crisis, and would help ensure that acceptable actions are taken by the Mexican authorities to restore solvency and soundness of the banking system. The loan is also a critical element in the coordinated response of the World Bank, IMF, IDB, the US Treasury and other multilateral and bilateral lenders to assist Mexico in resolving its macroeconomic and financial sector crisis. The program design is an outcome of intensive discussions between the Bank and Mexico's financial authorities between January and April 1995. As noted earlier, it builds on significant actions initiated by the Government immediately following the crisis. Basic agreement on the strategic approach for program design was reached in early March 1995. The IDB staff also participated in discussions in Mexico City in March and April, and took the lead in the area of development banks and trust funds. The IDB is also preparing a separate project mainly to strengthen NAFIN's institutional capacity to carry out its many functions. B. Tranching and Conditions 5.2 Tranches. The proposed Bank loan of US$1,000 million is to be disbursed in two equal tranches of US$500 million each. The first tranche will be available for disbursement upon loan effectiveness. The second tranche is expected to be released about nine months following effectiveness. The tranching is based on the: (a) substantial policy and institutional reform  -32- measures taken by the Government to arrest further deterioration and restore solvency to the system; (b) associated costs already incurred to date and the anticipated costs in the immediate future; (c) balance of payments and financing needs for the rest of this year; and (d) need to provide a clear signal of support to the markets. 5.3 The Government's Letter of Financial Sector Development Policy (Annex I) and the Matrix of Policy Actions (Annex II) describe the program, actions already taken, and future actions for restructuring of the financial sector. The actions taken prior to negotiations and Board presentation, and the main conditions of loan effectiveness and release of Second Tranche are summarized below. 5.4 Before negotiation of the loan and presentation to the Executive Directors, the Guarantor has: (a) provided the Bank with a signed letter of Financial Sector Development Policy (para 3.4); (b) submitted to the Bank the approved "Operating Guidelines" for bank restructuring (para. 3.19); (c) created an inventory of operating restrictions for use by the supervisory authorities as necessary vis-a-vis selected banks depending on their individual condition (para. 3.1); (d) analyzed the estimated fiscal costs of the UDI scheme (para. 3.15); and (e) provided a statement on development finance entities (para. 3.4). 5.5 Conditions of Effectiveness. Before the effectiveness of the loan, in addition to ensuring continued implementation of the economic stabilization program described in the Letter of Financial Sector Development Policy, and progress in the execution of the FSRP, the Guarantor will have or caused to have taken the following actions, acceptable to the Bank: (a) recruited an independent auditing firm to assist in the preparation of diagnostic studies of banks, and initiated the diagnostic study of at least one intervened bank (para. 3.18); (b) recruited investment banks or specialized consultants or firms to assist in the preparation of restructuring plans of banks (para. 3.22); (c) formulated uniform accounting principles (including consolidation of financial statements) consistent with internationally accepted principles (U.S. GAAP), and consistent across all transactions and activities for financial statements and regulatory reports of banks (para. 3.23); and (d) furnished terns of reference for studies on: (i) the impact of establishing risk- based exposure limits for the liabilities of each Fl with regard to the DFEs; (ii) the establishment of eligibility criteria for FI participation in DFE second tier  -33- financial operations and the impact of establishing rating requirements by qualified private agencies; and (iii) the interest rate policy in domestic and foreign currency, including an evaluation of its incentive structure and its impact on financial markets and final borrowers (para. 3.32). 5.6 Conditions of Second Tranche Release. Before release of the second tranche, in addition to ensuring continued implementation of the economic stabilization program described in the Letter of Financial Sector Development Policy, and progress in the execution of the FSRP, the Guarantor will have or caused to have taken the following actions, acceptable to the Bank: (a) reviewed with the Bank the results of all completed diagnostic studies for PROCAPTE banks and intervened banks (para. 3.18); (b) made satisfactory progress in executing CNBV's inspection program of banks and reviewed the results with the Bank (para. 3.9); (c) submitted to the Bank for its review the restructuring plans of banks under FOBAPROA control (including implementation strategies), prepared in accordance with the Operating Guidelines and approved by CNBV, SHCP and FOBAPROA (para. 3.22); (d) made satisfactory progress in the execution of the bank restructuring plans (para. 3.22); (e) issued regulations for revised uniform accounting principles (including consolidation of financial statements) for banks, consistent with internationally accepted accounting principles, for application beginning January 1, 1996 and completion no later than for year-end 1996 accounts (para. 3.23); (f) issued revised accounting principles (including consolidation of financial statements) for non-bank financial institutions that are affiliates of financial groups with bank affiliates, consistent with internationally accepted accounting principles (para. 3.23); (g) issued supplemental internal instructions, for inspection of banks (including development banks) covering, inter alia, asset classification and provisioning, exclusion of de facto treasury stock (stock owned or financed directly or indirectly by related entities, or covered by repurchase agreements) for purposes of capital adequacy standards, composition of Tier 1 capital, large exposures and concentration, and related party lending (para. 3.25); (h) reviewed with the Bank the need for the issuance of new prudential regulations for banks and issued such regulations to the extent necessary (para. 3.25); (i) issued new prudential regulations with respect to capital adequacy standards for brokerage firms (para. 3.25); and  -34- (j) (i) reviewed the results of the studies (para. 5.5(d)) with the Bank; (ii) prepared an action plan on the basis of such reviews; and (iii) taken all necessary official action for the implementation of such action plan on the basis of a phased implementation schedule (para. 3.32). C. Implementation Arrangements 5.7 Program Coordination. To ensure adequate coordination of all Government agencies responsible for financial sector regulation, supervision and resolution of troubled banks and timely implementation of the program, an ad hoc Financial Sector Working Group has been established by the Government. The President of the CNBV serves as Chairperson of the Working Group, which includes officials of the SHCP, the Central Bank (including FOBAPROA), the CNSF, and the CONSAR. The Working Group would also serve as the primary counterpart for all communications with the Bank regarding program implementation and would provide periodic progress reports to the Bank. 5.8 Technical Assistance. The FTAL is being redesigned to support the now urgently needed technical assistance support for implementation of the FSRP (e.g., for diagnostic studies, additional assistance from FDIC and OCC to the CNBV inspection teams, and design of restructuring plans for troubled banks). A coordinated, timely and transparent process is being established for the selection of investment banking advisors that will assist the CNBV and FOBAPROA in bringing intervened or FOBAPROA owned banks quickly to the point of sale. Assistance from such advisors should also enable the Government to transfer ownership at less cost than through other means. D. Procurement and Disbursement 5.9 No recent Country Procurement Assessment on Mexico is available. However, Mexico's procurement regulations (Ley de Adquisiciones y Contrataciones, December 1993), include a special provision authorizing the application of procurement procedures of international financial institutions in the procurement of goods, works and services financed by such organizations. Private sector procurement is generally conducted on the basis of competitive procedures. Loan proceeds would be used to finance the foreign exchange cost of general imports, with the exception of goods financed by other bilateral and multilateral agencies, luxury goods, military equipment and other goods specifically prohibited in a negative list defined under the Standard International Trade Classification or equivalent classification. Goods imported by public and private sector entities valued at US$10 million or more would be procured through simplified international competitive bidding procedures in accordance with Bank guidelines (January 1995), using Bank-issued standard bidding documents, and commonly traded commodities may be procured through other channels of competitive procurement acceptable to the Bank. Contracts for imports valued at less than US$10 million would be awarded by government entities following public sector procedures, and by other purchasers, in accordance with established commercial practice. For commodities under existing contracts, Bank retroactive financing would not exceed the average price per unit for such commodities as posted in the recognized international markets. All contracts above US$10 million will be subject to prior review by the Bank.  -35- 5.10 Disbursements would be made in two tranches. Nacional Financiera, S.N.C., the borrower and financial agent for the Loan, would be responsible for submitting withdrawal applications and would maintain separate records and accounts for all transactions under the Loan. Retroactive financing would be permitted for eligible imports as of March 9, 1995 up to a maximum of US$200 million equivalent. Retroactive financing is justified given the reform measures already undertaken by the Government. The aggregate value of expenditures for petroleum products and food-stuffs will not exceed US$50 million equivalent. The minimum contract size under the loan will be US$50,000 equivalent. Disbursements would be made against Statements of Expenditures (SOEs) for contracts below US$10 million. For contracts valued at US$10 million or more, disbursements would be made against full documentation. The minimum value for each SOE submitted would be US$10 million equivalent. Documentation for withdrawals under SOEs would be retained by NAFIN and made available for the required audit, and for review by the Bank during supervision. The loan closing date would be December 31, 1996. E. Accounts and Audit 5.11 NAFIN will maintain separate records and account for all transactions under the Loan. An audit report by independent auditors acceptable to the Bank will be submitted to the Bank within four months after the last disbursement under each tranche. Audit reports would include a separate opinion from the auditor with respect to withdrawals made against SOEs. F. Monitoring and Reporting 5.12 Monitoring of and reporting on the implementation of the overall program described in the letter of financial sector development policy will involve the follow-up of each of the program's multiple components. The assessment of the health of the banking system will require that relevant government agencies report on the findings of intensive inspections and diagnostic studies of individual banks. In cases where conditions relate to restructuring or sale of individual banks, monitoring will involve detailed reviews by the Bank of the restructuring plans for each institution. Monitoring of procedural changes and design of regulations will be undertaken through supervision and through periodic reports submitted to the Bank that indicate the status or represent drafts or final regulations. 5.13 Monitoring and reporting will be facilitated through the close coordination of activities and implementation agencies supported by the FTAL. Under the FTAL, technical assistance will be provided to. assist the Government in implementation of the overall program. To ensure a timely response, the ad hoc Financial Sector Working Group will coordinate compliance with all reporting requirements. Within the Bank Group (and the IDB), monitoring of the overall program will require intensive supervision, which will be provided by an inter-disciplinary team comprising both suitable Bank Group staff (at the Regional and Central level, and IFC) and external experts with requisite experience in specific areas (bank restructuring, asset management, financial workouts). A significant part of the supervision work will be carried out from the field, through the assignment of suitable staff to the Resident Mission in Mexico City. One important objective of supervision should be to help achieve a degree of integration of the overall program, apart from monitoring its individual components.  -36- G. Benefits and Risks 5.14 Benefits. Immediate actions included under the program will help contain the losses of the banking system while enabling continued functioning of the credit and payments system which is essential for the real sectors. Successful implementation of the program will lead to increased confidence in the financial system, and restructuring of banks will restore their soundness. The revision in accounting practices and disclosure requirements will improve the quality of information on banks, thereby enabling early recognition of future problems besides allowing market regulation. Improvements in prudential regulation and supervision and the legal/regulatory framework for lending will lead to a more efficient, sound and stable financial system. Together these actions will enable the financial system to mobilize increasing amounts of domestic and foreign capital. 5.15 Risks. The principal risks are: (i) failure to maintain a satisfactory macroeconomic framework and the resulting continuation of high inflation and interest rates; (ii) political intervention in the implementation of policy and institutional reforms in the financial sector or in decisions on restructuring of banks; and (iii) shortage of technical capacity in government entities or poor coordination among them leading to delays in implementation. These risks are mitigated by the strong support of the Government for the program. The loan contains safeguards to stop disbursement in the event of deteriorating macroeconomic conditions or unsatisfactory performance under the program. The Government's macroeconomic stabilization program is being supported by close collaboration with the IMF and an IMF Standby Agreement equivalent to 688 percent of quota. In the event of a significant setback in the results of this program (for example, if inflation or interest rates fail to decline in line with the trajectory envisaged in the program), the IMF would assist the Government in revising the program appropriately. The implementation of diagnostic studies and establishment of a transparent framework and criteria for restructuring of banks will reduce the risks of political intervention. Provision of technical assistance under the FTAL will help ensure timely availability of the additional skills required for implementation. To improve coordination among Government agencies, an ad hoc Financial Sector Working Group has been established with participation from the CNBV, the Central Bank and the SHCP. 5.16 Social Impact. In the short term there is likely to be some loss in employment in the privatized banks. However, as the restructuring program proceeds and the capital base of the banks improves, employment levels should stabilize. The employment losses come at a time of a downturn in economic activity in general and weak overall employment growth. The Government has taken measures to strengthen the social safety net, particularly with respect to support for the unemployed (1995 Country Assistance Strategy). The Government's Program of Essential Social Services is supported by a separate Bank loan (Report No. 14392-ME, May 22,1995). 5.17 Environmental Impact. There are no negative environmental impacts associated with this loan, which therefore, has an environmental rating of "C".  -37- VI. RECOMMENDATION 6.1 I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank, and recommend that the Executive Directors approve it. Richard H. Frank President ad interim Washington, D.C. May 24, 1995 Attachments   -38- ANNEX I Page 1 of 5 MEXICO FINANCIAL SECTOR RESTRUCTURING PROGRAM Government's Letter of Financial Sector Development Policy (English Translation of Original Document in Spanish) May 19, 1995 Particular Secretariat Mexico, D.F., Mexico MR. RICHARD H. FRANK President ad interim International Bank for Reconstruction and Development 1818 H Street, N.W. Washington, D.C. In the last few years, Mexico has carried out far-reaching structural and macroeconomic reforms which will make it possible to set the basis for the achievement of a sustained economic development. However, in recent years the improvement in economic performance has been accompanied by a reduction of private domestic savings and a persistent increase in the current account deficit, even though public finances remained at a healthy level. Moreover, even though the growth in exports, particularly manufactured goods, has been extraordinary, imports increased dramatically, stimulated by abundant private capital flows, the increase in real income, commercial liberalization, and the appreciation of the real exchange rate. At the beginning of 1994, the combination of adverse political events, increased interest rates in the U.S., and investor concerns over the sustainability of the exchange rate regime and the current account deficit began to generate pressures in the exchange and financial markets. In order to stem these pressures, the authorities raised interest rates, placed a greater amount of Tesobonos (Treasury bonds indexed to the exchange rate), implemented greater exchange rate flexibility within the floating band, and made use of international reserves. However, these measures calmed the markets only until early November. In the middle of that month, new pressures in the market and political events produced a substantial fall in international reserves that culminated in an exchange crisis and led to the floating of the Mexican peso after December 22. The change in the exchange regime did not contribute to a restoration of confidence and foreign investors in the market began to sell their holdings in financial instruments denominated in pesos, as well Tesobonos. Also, in the context of this speculative attack against the peso, concerns arose over Mexico's capacity to repay maturing short- term foreign obligations. Under normal circumstances, such obligations would have been renewed, but given the uhcertainty prevailing in the market, the Government found it difficult to place new securities at the same time as the maturity of the foreign currency liabilities of some commercial banks was approaching. At the end of December the new peso had devalued by 44 percent and the CETES interest rates reached a level in excess of 30 percent. For this reason, on January 3 of this year, the Unity Agreement to Overcome the Economic Emergency (Acuerdo de Unidadpara Superar la Emergencia Econ6mica) was signed. Despite the announcement of this Agreement, the markets did not react as expected, which contributed to the continued devaluation of the exchange rate. For this reason, on March 9, 1995, the Government of Mexico announced the Action Program to Strengthen the Unity Agreement to Overcome the Economic Emergency (Programa de Acci6n para Reforzar el Acuerdo de Unidad para Superar la Emergencia Econ6mica -- PARAUSEE). This agreement contains specific measures to strengthen the financial system.  -39- ANNEX I Page 2 of 5 In parallel, negotiations were conducted on a loan package with the international financial community to support the country's economic strategy. These culminated in obtaining an unprecedented financing for a total among of US$52 billion, of which the U.S. Treasury Department contributed US$20 billion, the International Monetary Fund US$17.8 billion through a contingent credit agreement (Stand-by), the Bank for International Settlements US$10 billion and the rest coming from other bilateral and multilateral sources. I. IMPACT OF THE ECONOMIC CRISIS ON THE BANKING SYSTEM Before the present economic crisis, the banking system already showed certain signs of weakness, among the most notable of which were the inadequacy of preventive reserves and the increase in non-performing loans, which became more acute with the economic crisis, further weakening the banking system. Accordingly, it was necessary for the Government to design a Program for Restructuring the Financial Sector (Programa de Reestructuraci6n para el Sector Financiero -- PRSF), with the objective of maintaining its stability and the effective functioning of the payments system. It is the Government's desire that such program be partially financed with resources from the World Bank and Inter-American Development Bank. The main short-term impacts of the economic crisis on the banking sector were the absence of liquidity in foreign currency and the deterioration of the quality of assets as a consequence of the increase in non-performing loans, as well as the decline in the value of securities held by the banks. As for the liquidity crisis, mechanisms were established to assure the timely performance of the obligations of the banks, without permitting such mechanisms to be used to hide insolvency problems of credit institutions. The uncertainty generated in the markets over the economic situation of our country made the refinancing of liabilities of banks in foreign currency difficult. In order to guarantee the timely repayment of these obligations, the Bank Fund for Savings Protection (Fondo Bancario de Proteccion al Ahorro -- FOBAPROA) established lines of credit in favor of the banks without sufficient resources to cover their obligations in foreign currency. For its part, the Bank of Mexico issued new criteria to limit its risk as lender of last resort, as well as to eliminate the risk of interbank contagion, requiring collateral from banks to cover their overdrafts if these are of important amounts. These policies are part of a permanent effort to make the payments system more efficient. The increase in interest rates and contraction of the economy have caused a substantial increase in the levels of non- performing loans of the banking system from 8.3 percent in September 1994 to 10.2 percent in March 1995'. It is* expected that the deterioration of non-performing loans will continue for some time. In virtue of the foregoing, the Mexican banking system recorded a significant decapitalization, for which it was necessary to adopt measures to guarantee the strength and solvency of the banking system which are contained in the Financial Sector Restructuring Program. H. ACTION PROGRAM TO STRENGTHEN THE UNITY AGREEMENT TO OVERCOME THE ECONOMIC EMERGENCY (PARAUSEE). To confront the economic crisis, the Mexican Government adopted the PARAUSEE, which contains, among others, specific measures to strengthen the financial system. The purpose of PARAUSEE is: to reduce the current account deficit to levels commensurate with the availability of external financing availability; to limit the inflationary impact of the devaluation; to maintain the Government's social programs; and to recover, in the shortest time possible, economic growth, price stability and employment levels. I These figures exclude Cremi and Uni6n.  -40- ANNEX I Page 3 of 5 The fundamental elements of this Program are: (i) an increase in the Value Added Tax (IVA) by 50 percent beginning April 1, from a 10% to a 15% rate (a zero percent rate is maintained for processed foods and medicines to protect the lower-income population); (ii) an increase in the price of goods and services provided by the public sector to reflect their cost structure after the devaluation (gasoline, electricity and other energy products); (iii) a reduction of programmable public spending by 9.8 percent in real terms, compared to 1994; (iv) the establishment of a limit of 2 percent limit of GDP on net loans granted by development banks to the private sector (half of its recorded level in 1994); (v) the protection of essential social spending; (vi) setting of a NPIO billion limit on domestic credit from the Banco de Mexico for 1995; (vii) maintenance of the floating exchange rate regime determined by the market; and (viii) deepening of structural change measures, particularly through privatizations of infrastructure and telecommunications. Even though inflation during the first semester will be high, with the implementation of this Program, the Government hopes a rapid deceleration will occur during the second semester with a rate of about 5 percent achieved for the last quarter with this pattern continuing during 1996. Similarly, an interest rate reduction is expected, as well as a surplus in the trade balance of US$5.4 billion, which will be reflected in a reduction of the current account deficit from approximately 8 percent of GDP during 1994 to 4.3 percent by the end of 1995. Even though negative growth in the economy is expected for 1995, recovery is expected for 1996. HIl. PROGRAM FOR RESTRUCTURING THE FINANCIAL SYSTEM (PRSF) During the first semester of 1995, the Mexican authorities have undertaken a series of measures to address the banking crisis. These include: higher preventive reserve requirements; a temporary capitalization program; a strengthening of overall financial institution supervision, including the merger of the National Banking and Securities Commissions into a single entity; reforms to financial legislation to increase foreign and domestic investor participation in holding companies, banks and brokerage firms, as well as their acquisition by foreign financial institutions; a reduction in the limit on related credits from 20 percent of total portfolio to an amount equal to net capital; creation of investment units; and establishment of asset restructuring schemes. Among the more noteworthy of these measures are: Temporary Capitalization Program: In response to the increase in reserve requirements for credit risks, and as a result of the decapitalization of the banking system, the Mexican Government, through FOBAPROA, established the Temporary Capitalization Program (Programa de Capitalizacion Temporal -- PROCAPTE). The purpose of PROCAPTE is to facilitate the capitalization of banks that have levels below 8 percent of risk assets. Under this Program, FOBAPROA will acquire mandatory convertible subordinated debentures issued by participating banking institutions in amounts sufficient to increase their capitalization to 9 percent. The subordinated debentures must be converted by the fifth year. However, FOBAPROA will be able to convert earlier if basic capital is less than 2 percent (excluding PROCAPTE debentures) or when the capitalization level deteriorates by a percentage greater than 25 % relative to the rest of the PROCAPTE banks. The duration of the program will be five years and there will be no fiscal impact. In practice, it has been observed that PROCAPTE has created incentives for voluntary capitalization by bank shareholders. Restructuring Program in UDIs: The Mexican Government, in coordination with the Mexican Bankers Association, has agreed to programs for restructuring into Investment Units (Unidades de Inversi6n --UDIs). The programs are based on the restructuring of credits in domestic currency into obligations denominated in UDIs with longer maturities. UDIs are units of account in which commercial contracts may be denominated, principally deposits and banking credit. Its main characteristic is the maintenance of its value in constant real terms, since UDIs are adjusted daily by inflation.  -41- ANNEX I Page 4 of 5 Restructuring credits into UDIs permits the elimination of accelerated anortization due to inflation and reduces significantly the cash flow that the debtors must pay, since in credits denominated in these units inflation is capitalized and debtors have to pay only the real interest rate, permitting very important cash flow relief. This will also translate into an improvement in the quality of the banks' credit portfolios. Finally, the fiscal impact of this scheme will be monitored and, if necessary, appropriate adjustments will be made. Additional Measures: At the end of 1994, in the interest of availing itself of international experience, the Mexican Government agreed with the World Bank on a technical assistance loan for the financial sector which will support supervision and regulatory activities. Notwithstanding the measures taken during the first semester of 1995, it is believed necessary to continue deepening the restructuring of the financial system to guarantee its strength and efficiency. Accordingly, the Mexican Government has adopted the PRSF and has decided to modify the above- mentioned loan in order to adapt it to new circumstances and support the PRSF. It is expected that the PRSF will include a first phase with the immediate technical and financial support of the World Bank and the Inter-American Development Bank. Additionally, a second phase is foreseen to give continuity in the medium term to actions to strengthen the banking system, which would be supported by these financial institutions and other bilateral creditors. The objectives of the PRSF are the following: (i) support the restructuring of those banks that require it, thereby containing the impact of the crisis and minimizing its fiscal costs; (ii) strengthen the capitalization of the commercial banks; (iii) modify accounting principles to make them consistent with international standards; (iv) reform prudential regulation to the extent necessary; (v) strengthen banking supervision; and (vi) change the regulatory framework in order to modernize the banking system. The principal measures contained in the PRSF are described in Annex I to this letter and include: 1) Holding actions: The CNBV has established measures to prevent banks from taking on excessive risks that may increase their losses. Such measures, which are described in Annex 1, will remain in force throughout the crisis. 2) Assessment of the banking system: In order to more quickly understand the current situation of the Mexican banking institutions, the CNBV has accelerated the conduct of on-site inspections, based on CAMEL procedures. Additionally, special diagnostic studies will be undertaken to provide a more thorough diagnosis of banks intervened by the CNBV, those under FOBAPROA control and those participating in PROCAPTE. 3) Banks restructuring: In order to correct the capitalization problems of some commercial banks and assure that they remain under private sector ownership, general restructuring criteria have been approved to be utilized in accordance with the particular circumstances of each bank, which are included in Annex 2 of this document. Specialized consultants will be hired to participate in the design and implementation of the plans for restructuring and sale. 4) Accounting principles and gualitv of financial information: Since accounting principles applied to the Mexican banks differ from international accounting practices, these principles will be modified to make them consistent with such practices. The foregoing will improve the quality of financial information available to the authorities and the general public. 5) Prudential regulation: In order to improve the security and soundness of financial institutions, compliance with prudential regulation in banking supervision will be strengthened. In addition, necessary modification will be made to such regulation so as to make it consistent with international practices. 6) Amendments to the legal regime: Studies will be undertaken to analyze the need for modifying the legal regime in order to: (1) determine the extent of FOBAPROA coverage in the future; (2) eliminate obstacles to restructuring and securitizing credits; and (3) facilitate secured transactions. 7) Development banking: The Government of Mexico believes it appropriate to achieve greater consistency in the application of criteria and, in general, improve the transparency of relations of development banks with commercial  -42- ANNEX I Page 5 of 5 banks. Accordingly, studies will be undertaken to analyze eligibility criteria, concentration of risk and interest rate policy in order to strengthen the development banking system. Annex 3 describes the actions taken in this area, as well as the expectations for the next few years. The Government of Mexico believes that the implementation of the PRSF will strengthen and continue the process of modernizing the banking system and that, taken together, these measures will contribute to placing the financial system in a healthy position that accords with a modern economy. In order to ensure the success of the program, close coordination among the responsible authorities will be maintained. Finally, it is of fundamental importance to underline the Government's willingness to carry forward the necessary changes that will allow for the development of a financial sector in general and for the banking system in particular, in such a way that these will support the national productive sector. Signed Guillermo Ortiz Minister of Finance Attachments   MEXICO INANCIAL SECTOR RESTRUCTURING LOAN Policy Matrix 1. MACROECONOMIC POLICY lFRAMEWORK Issues, Objectives and Action Program Prior Actions/Actions to be Taken 1. 3lecause of the unsustainable current accounit deficit, tlie Mexican peso was allowed to float *I. Satisfactory progress in implementing the macroeconomic on l)ecember 22, 1994. Willt the support of an IMF stantd-by arrangement, lthe Government is program announced on March 9, 1995. implementing a comprehlensive set of economic measures to stabilize the economy and improve confidence. The economic program covers tight fiscal and monetary policy; a floating exchange rate; acceleration of some structural reforms; and measures to address the financial sector's 2. Maintenance of the macroeconomic policy framework consistent difficulties; the program is being implemented with substantial financial support of the IMF, the with the objectives of the Financial Sector Restructuring Program U.S. and others. (FSRP) and throughout the FSRP. 11. IIOLO ING ACTIONS TO LIMIT FINANCIAL LOSSES Issues, Objectives and Action Program Prior Actions/Actions to be Taken 1. There could be substantial risks Ihat some of *1. CNBV prohlibitcd payment of dividends by banks jhat receive PROCAPTE/FOBAPROA funds. 4 the troubled banks could belhave in ways tiat *2. CNBV will use mnoral suasion to slop privatized' banks (outside PROCAPTE) from distributing dividends in would maginify and propagate financial losses. 1995. '3. Required banks with a capitalization ratio below 8% to raise additional capital or enter PROCAPTE. 2. CNBV has implemented a set of holding *4. Provisioning requirements for privatized banks increased to the greater of: (a) 4% of the loan portfolio; (b) actions to immediately address ithe financial 60% of past due loans; or (c) the provision required from loan classification (Circular 13254-1137, dated February difficulties and limit financial losses. 22, 1995). *5. Roll-over loans separated for enhanced monitoring to insure that banks do not automatically capitalize interest 3. Action Program: and thereby avoid provisions (Circular 1229, dated January 11, 1995). Keep holding actions in place at least until *6. Limits placed on new lending by PROCAPTE banks (i.e., the increase in the capitalization ratio due to cotnpletion of oin-site MACRO' inspectionis of tlhe PROCAPTE ftunids can not be used to extend new lending). healtIi of all banks, diagnostic studies of thie *7. CNBV has required banks to reduce large exposures and related party exposures. banks, and satisfactory preparation and *8. CNBV and FOBAPROA created an inventory of operating restrictions for use depending on the condition of implementation of bank restructuring plans. banks. * Actions already taken. 1. MACRO is the Spanish acronym of CAMEL (capital adequacy; assel quality; manatgeineti; earinings; and liquidity, asset and liability managemenit). 2. The ierni1tRiivalized banks' rerers to tihose baniks tlhat were returted to private ownership in 1991/92 and does not include baniks operating under new charlers granted since the  MEXICO FINANCIAL SECTOR RESTRUCTURING LOAN Policy Matrix X 111. DISCIIPLINE IN TIIE PRIOVISION OF LIQUIDITY SUPPORT AND OTfIER RESOURCES Issues, Objectives and Action Program Prior Actions/Actions to be Taken - 1. Achieve greater discipline and transparency in the *1. Banks required to post collateral in peso credit auctions per Banco de Mexico Circular telefax provision of liquidily and ollier resources to the financial 23/95, daled March 20, 1995. systenm 2. SIICP to prescnt terms of reference, satisfactory to the Bank, for studies of: (a) the impact of establishing risk-based exposure limits for the liabilities of each financial intermediary (Fl)4 to DFEs; 2. Action Program: (b) the establishment of eligibility criteria for Fl participation in DFE second-tier operations5 (such Policies, guidelines and procedures that will result in greater study to include an analysis of the impact of establishing rating requirements from qualified private discipline in the provision of liquidity and other resources to agencies); and (c) Ihe current interest rate policy in domestic and foreign currency, including an banks from (i) Banco de Mexico, and (ii) development finance evaluation of its incentive structure and impact on financial markets and final borrowers. entities (DFEs).3 3. SIICP to prepare an action plan on the basis of such studies and take the necessary ofricial action to implement such action plan. IV. MANAGEMENT OF TIIE CENTRAI, BANK'S CREDIT RISK AND RISK OF CONTAGION IN TIIE INTERBANK MARKET Issues, Objcctives and Action Program Prior Actions/Actions to be Taken i. 'riTe Central Bank liad borne substantial credit risk and exposure as lender of last *1 . Banco de Mexico lias implemenied a series of mcasures to reduce risk or resort due to inadequate controls on intra-day credit extended to banks. Tllere was contagion and the Central Bank's exposure to credit risk in extending daylight also risk of contagion from failuire by insolvent banks to perform thleir obligations to overdrafts. solvent institutions. Reform of Ilte intra-day market to make it a self-liquidating mechanism would eliminate the risk to the Central Bank and solvent participating *2. Banco de Mexico has undertaken measures: (a) under Circular-telefax banks. 16/95, dated March 3, 1995, regarding steps to reduce its credit risk6; (b) under Circular 2016/95, dated March 7, 1995, regarding steps to limit the risk 2. Action Program: of contagion in the inter-bank market7; and (c) under Circular 2017/15, dated A program of actions to reduce the Banco de Mexico's credit risk and risk of Match 10, 1995, requiring delivery versus payment in the trading of contagion in the inter-bank market. commercial banks liabilities. 3. The term development finance entities NAFIN, Bancomext, FIRA, FIDEC, and FOVI. 4. The term financial intermediary includes all institutions such as banks, leasing and factoring companies, credit unions, etc. 5. The term second-tier operations refers to loans, guaranlees, investment portfolio. interbank market operations and other risk assets of DFEs witl Fis. 6. Pricin of intra-da credilt,uenuirelrent of collateral for daylighlt overdrafts, debit caps for uncollateralized portion of daylight overdrafts, and requiring special non-ituterest earnumug emearung nsances, ii uaymIgl overdra are requenr. 7. Establishment of clearing house for large value transfers (Sistema de Pagos Electr6nicos de Uso Ampliado - SPEUA).  MEXICO FINANCIAL SECTORt RESTRUCTURING LOAN Policy Matrix V. ASSESSMENT OF IIEALTII OF TIIE BANKING SYSTEM Issues, Objectives and Action Program Prior Actions/Commitments 1. The peso devaluation and its aftermath have had a 1. Inspections: severe impact on the banking system. High interest (a) Completion of on-site MACRO inspections, focusing on asset quality, on a targeted basis: (i) by rates have affected both corporate and individual private September 30, 1995, for all privatized banks except four banks; and (ii) by December 31, 1995 for the borrowers. An accurate assessment of the true healtih of remaininig four privatized banks. banks is essential to develop measures to restore (b) Conduct aniual inspections tiereafter. solvency and soundness of financial institutions and 2. Diagnostic Studies: thereby improve confidence in the financial system. (a) CNBV or FOBAPROA will employ an independent auditing firn for assistance in diagnostic studies of 2. Action Program: banks. (a) MACRO inspections to verify asset quality and (b) For Intervened and PROCAPTE banks: CNBV and FOBAPROA to complete diagnostic studies provisions. Examiners from the US FDIC, OCC and (applying uniform accounting standards consistent with intemationally accepted standards (U.S. GAAP) and Federal Reserve to begin training CNBV staff by June loan classification) with the assistance of independent auditing firm(s) of (i) two intervened banks by 15, 1995 with financing under FTAL. Additional September 30, 1995; and (ii) all intervened banks and PROCAPTE banks as of May 31, 1995. technical assistance on supervision policy, asset (c) For Banks not vet in PROCAPTE: CNBV to (i) initiate diagnostic studies of banks (not in the classification criteria, manuals and training will be PROCAPTE/FOBAPROA programs as of May 31, 1995) within 90 days of their joining the PROCAPTE provided under the restructured FTAL. scheme, being intervened by CNBV or cotning under the control of FOBAPROA (without the bank going (b) Diagnostic studies to ensure an accurate assessmneit throughi PROCAPTE scheme); and (ii) complete suchi studies within four mtontihs froin the starting date. of the financial and operating condition of intervened and PROCAPTE banks. VI. RESTRUCTURING OF BANKS Issues, Objectives and Action Program Prior Actions/Actions to be Taken 1. In light of the deterioration in the financial condition of * 1. CNBV, SHCP and FOBAPROA have defined principles, processes, procedures, organizational banks, tightening of regulations on asset classification as arrangements, and methodologies for restructuring of banks including approaches to the treatment of well as inspectioins, and deterioration of thc enterprise non-performing loans ("operating guidelines"). sector, more banks may see their capital decline to levets (*I 2. SIICP has put itto effect the final operating guidelines (see Attachmenit 2). below the minimum limits, and their ownership could then 3. CNBV or FOBAPROA to retain/recruit investment banks and/or specialized consultants or firms to come under the control of FOBAPROA. assist in the preparation of restructuring plans of banks. 2. Legal changes to further liberalize shareholding by 4. The Government to prepare restructuring plans including implementation strategies in accordance domestic and foreign investors made on February 15, 1995. with the operating guidelines: (a) by September 30, 1995, for two banks under FOBAPROA control'; 3. The Government will prepare the bank restructuring plans and (b) for any remaining banks under FOBAPROA control within three months from the date of and implement thereafter agreed plans (i.e., liquidation, FOBAPROA taking control. The restructuring plans will be approved by CNBV, SHCP and merger, or offer for sale) for the intervened banks quickly in FOBAPROA. a transparent manner according to market mechanisms. 5. Implement the bank restructuring plans. S. Includimig PROCAF`TE banks, takeni over by FOBAPROA. s t  MEXICO FINANCIAL SECrOR RESTRUCTURING LOAN P'olicy Matrix . - VIl. CORPORATE AND OTIER DEBT RESTRUCTURING Issues, Objectives and Action Program Prior Actions/Actions to be Taken 1. Entcrprises havc been undergoing structural reforms over the past 1*j 1. Analyzed the estimated riscal costs of the UDI scheme (including subsidy and tax several years, and a significant number of smaller enterprises in particular revenue implications). were experiencing difficulties in 1994. Financial distress in the corporate sector expanided rapidly in early 1995 due to high interest rates and effects 2. (a) Conduct a study of obstacles to voluinary debt restructuring (includinig recognition, of the devaluation, and intensified due to a decline in the value of assets execution and enforcement of out-of-court workouts and arbitration awards); and (b) adopt used as collateral, and lack of access to alternative forms of financing. a plan of action by March 31, 1996 for removing unnecessary impediments to voluntary corporate debt restructuring, through appropriate changes in regulations and/or legal 2. The Government has introduced a series of loan restructuring programs framework. based on the Unidad de lnversi6n (UDI) to enable banks to refinance loans to viable borrowers facing liquidity problems. The programs include 3. Beginning January 1, 1996, CNBV to review classification of assets in the UDI trust as industrial loans, housing loans, loanis to states and municipalities, and loans they evolve, and re-classify every quarter, and require banks to build necessary provisions financed through developnment banks. immediately. . 3. Action Program: 4. CNBV to: (i) review by January 31, 1996 adequacy of criteria applicable to debt (a) Facilitate corporate and other debt restructuring based on sound restructuring; (ii) formulate changes, as appropriate; and (iii) issue a circular with guidelines and market discipline, with due consideration to fiscal costs. revisions, as necessary, to banks by March 31, 1996. (b) Continue work on improvements in guidelines for supervision of restructured debts. 5. Before March 31, 1996: (i) analyze the initial implementation experience of the UDI (c) Keep continuing watch during inspections of 1995 on the sound use of scheme and associated fiscal costs; (ii) formulate changes, as appropriale; and the UDI scheme by banks. (iii) publicize the revised scheme.  MEXICO FINANCIAL SECTOR RESTRUCTURING LOAN Policy Matrix VIII. STIANDARtDS FOR ACCOUNTING, DISCLOSURE AND QUALITY OF FINANCIAL INFOItMATION Issues, Objecfives anid Action Program Prior Actions/Actions to be Taken 1. Mexican Cenerally Accepted Accounting Principles 1. CNIBV to forimitlate uniform accouniting principles (includinig consolidation of financial statements), (GAAIP) differ in some significanit respects from consistent with interinationially accepted principles (U.S. GAAP) and consistent across all transactions and inierniationally acccptcd stanidar(ds (U.S. GAAIP). The activities, for finaicial stateinenits and regulatory reports of banks. principal (liffercnces for bank accouniing are in the treatment of interest income on loans (and on restructured 2. Issue, by September 30, 1995, revised, uniforn accointing principles for banks, and require banks to debt) and repurchase agreements, valuation of fixed use new accounting stamdards (including consolidation of financial statements) beginninig January 1, 1996, assets, disclosure requirements and the definition of non- for completion no later than for year end-1996 accounts. performing assets. Mexican banks generally prepare their financial statements according to CNBV guidelines 3. Formulate, by September 30, 1995, uniform accounting principles, consistent with internationally reporting in accordance with the forn of general ledger accepted principles (U.S. GAAP) and consistent across all transactions and activities, for financial and rules published in CNBV circulars. statements and regulatory rcports for non-bank financial institutions that are affiliates of financial grotips with bank affiliates (first draft). 2. Draft regulations reconcilinig tlhe U.S. and Mexican GAAP are under preparation. FTAL will provide TA as 4. Issue, by December 1, 1995, revised accounting standards (iticluding consolidationi of financial needed. statemiienits) for noni-banik finanicial itislitutions that are affiliates of finanicial groups withi bank affiliates. 3. Action Program: 5. Continue strengthening disclosure by banks to supervisory atitlorities requiring banks to submit new regulatory reports and special reports. (a) Formulate uniform, accounting stanidards consistent with intemationally accepted principles (U.S. GAAP) and 6. Continue ongoing efforts to itnprove disclosure by CNBV to the public9. acceptable to the Bank, and require their use. (b) Strengthening of disclosure requirements. *7. All credit bureaus required to provide services to all providers of credit (financial and non-financial (c) Enforce audit guidelines. institutions). (d) Strenglhen appraisal standards for real estate inclisive of meitodology for determiniing derived investment value. 8. Improvements in quality of financial information: (a) CNBV to require auditors to strictly follow audit guidelines for audlits of banks and brokerage firms, and monitor auditors' performance, begininig with audils of 1994 accounts'