Anatomy of Mexico's banking system during the peso crisis

I C 2 5o Latin America and the Caribbean Technical Department Regional Studies Program Report No. 45 Anatomy of Mexico's Banking System During the Peso Crisis by Sri-Ram Aiyer December 1996 Papers in this series are not formal publications of the World Bank. They present preliminary and unpolished results of country analysis or research that is circulated to encourage discussion and conment; any citation and the use of this paper should take account of its provisional character. The findings, interpretations, and conclusions expressed in this paper are entirely those of the author(s) and should not be attributed in any manner to the World Bank, its affiliated organizations, members of its Board of Executive Directors or the countries they represent. ANATOMY OF MEXICO'S BANKING SYSTEM DURING THE PESO CRISIS December, 1996 Sri-Ram Aiyer Technical Department Director LAC Region TABLE OF CONTENTS Page No.: A . M EX IC O 'S B A N K IN G SY STEM ...................................................................................................... 1 1 . B a c k g ro u n d ........................................................................................................................... * Nationalization, Consolidation and Privatization............................................................... * L egal and Institutional R eforms........................................................................................ 2 * Macroeconomic Context of the Banking Crisis................................................................. 3 B. BANKING SYSTEM PERFORMANCE PRIOR To DEVALUATION...................................................... 5 1. A sset an d L o an G row th ...................................................................................................... 5 2. Deterioration in Loan Portfolio Performance........................................................................ 5 3. W eak B anking Supervision 5.................................................................................................. 5 C. EFFECTS OF DEVALUATION ON THE BANKING SYSTEM AND SECURITIES ................................. 6 1. F o reign E x chang e L o sses...................................................................................................... 6 2 . L iq u id ity S h o rtfalls ...........................................ol................................................................... 6 3 . L o an D eterio ration................................................................................................. .......... 6 4 . S e cu ritie s M a rk et ...................................................................................................................6 D. BANKING SYSTEM INTERVENTIONS ............................................................................................ 7 1 . L iq u id ity inje ctio n s .................................................................e.t..................... ....................... 7 2 . B olstering the B anking System............................................................................................. 7 * Temporary Capitalization Program (PROCAPTE).......................................................... 7 * Bank Restructuring 8 * Reform of Foreign Investment Regulation ..................................................................... 10 * E nhancing B anking Supervision ...................................................................................... 10 * A ddressing B orrow er N eeds.......................................................................................... 10 * R evising A ccounting Standards...................................................................................... 11 E. CURRENT STATUS OF MEXICO'S COMMERCIAL BANKING SYSTEM ........................................ 12 F. THE ROLE OF THE W ORLD BANK ............................................................................................... 14 G. CONCLUSIONS & RECOMMENDATIONS .................................................................................... 17 B IB L IO G R A P H Y ..... ............................................................................................................................B 2 0 This paper benefited from valuable comments and suggestions from J. P. Singh. Gerard Caprio, Roy Karaoglan, Mike Lubrano. David Scott, Tu Nogc Dinh., Ross Levine, Sarath Rajapatirana, Suman Bery, Valeriano Garcia, Robert hindle, Carl Dahlman. Evan McCordick and Laura Mecagni provided assistance with the tables. Jorge A. Serraino carefully and patiently prepared several drafts of this paper. ANATOMY OF MEXICO'S BANKING SYSTEM DURING THE PESO CRISIS A. MExIco's BANKING SYSTEM The purpose of this paper is to dissect the key features of Mexico's banking system prior to and during the peso crisis in December 1994. The crisis occurred when the banking system was already weak. The peso devaluation and the economic recession that accompanied it led to spiraling interest rates, liquidity shortfalls, foreign exchange losses, erosion of equity capital, and an immediate deterioration in bank loan portfolios which continued during 1995 and 1996. Positive steps have been taken to respond to these events, but the commercial banking system remains fragile owing to the economic recession from which Mexico is only beginning to recover and its continuing negative impact on loan portfolios. The restoration of soundness to the banking system will need sustained improvement in the macroeconomic situation, and especially in domestic demand. Meanwhile, Mexican banking authorities are encouraging restructuring the commercial banking system which has incurred sizeable losses. Some relatively well managed banks, though, are likely to be poised to take the lead in the banking sector. There are several key points: (i) pre-existing weaknesses in Mexico's banking system exacerbated the effects of the crisis; this suggests the need for continuing vigilance in establishing a sound regulatory framework and supervisory structure and enforcement procedures; important steps toward these ends have already been taken; (ii) deficiencies in banking system performance were only one factor in the banking crisis; political and macroeconomic stability and confidence are essential for stable banking; (iii) the large capital inflows into Mexico through 1994 were regarded as a sign of success illustrating confidence in Mexico's economy among foreign investors; they led to exchange rate appreciation, increases in the price of non-tradeables, the response to which lies in increased productivity and competitive engagement in export markets; and (iv) weaknesses in the banking system coupled with large capital inflows enhance vulnerability which can be mitigated by creating a prudent incentive and institutional framework for the financial system. 1. Background Since the 1980s. policies governing Mexico's banking system have undergone significant change. From nationalization in 1982, to consolidation immediately thereafter, followed by reprivatization, the system has been operating in a changing environment. In 1990, the Mexican Congress enacted legislation that changed the legal and regulatory framework governing the banking and financial system which paved the way for conglomerate banking. Nationalization, Consolidation and Privatization At the beginning of the debt crisis in 1982, Mexico nationalized 58 of its 60 private commercial banks giving the government a monopoly on banking and credit services. Following nationalization was a period of consolidation. By the end of 1983, 20 regional banking institutions had been consolidated with other banks. By 1986, with these and other changes, and a second round of Page 2 ANATOMY OF THE B.NKING CRisis IN MEXIco consolidation, only 18 commercial banks remained -- 6 national banks, 7 multi-regional banks and 5 regional banks. Yet almost 100 percent of credit was directly or indirectly allocated by the Government. Government control in the banking system resulted in crowding out credit to the private sector as bank investments were primarily made in government securities and loans to state enterprises rather than the private sector. In 1986 the private sector accounted for only 25 percent of total commercial bank credit. Major liberalization began in 1990 with support from a World Bank Financial Sector Adjustment Loan (FSAL). Among the many steps taken were the liberalization of deposit and lending rates, elimination of the mandatory requirement for commercial banks to hold long-term government paper to maturity, and the elimination of reserve requirements and the liquidity coefficient. In June 1990, rules for privatization became public. In 1991-1992, 18 banks were reprivatized. Following Mexico's entry into NAFTA, the sector was opened to foreign investment. In February 1995, in the aftermath of the peso crisis, the banking law was amended to permit majority foreign ownership by banks operating in NAFTA countries of all except the three largest banks. Presently there are 52 institutions in the commercial banking sector. Since 1993, 32 new banks have been chartered. Nonetheless, the sector is characterized by high concentration (3 banks account for 46 percent of total system assets) and modest foreign participation. The pent up demand for credit in the private sector resulted in a significant expansion in loan portfolios after liberalization immediately following reprivatization. Banks offered new products such as credit cards and expanded their consumer lending. Aggressive lending led to suboptimal credit standards with poor collateral and rising exposure to risk. These trends made it difficult for the banking sector to withstand the impact of the devaluation. * Legal and Institutional Reforms Reprivatization was accompanied by changes in the legal framework governing the financial sector. The intent was to allow gradually increasing competition in financial services from foreign institutions while allowing domestically controlled financial institutions time to "get up to speed" in adopting new technologies and internal infrastructure and services. Conglomerate Banking. The Financial Groups Law enacted in 1990 allowed conglomerate banking whereby a single holding company could carry out separate commercial banking, brokerage, and other financial services activities. Conglomerate banking while offering many opportunities, also posed new challenges from a regulatory perspective. At the time the legislation was enacted, regulatory and supervisoy practices needed for conglomerate banking were absent; this shortcoming remains. For instance, conglomerates as a group were neither required to abide by prudential regulations, nor were they required to produce consolidated financial statements. Credit exposure rules likewise were not applied on a conglomerate-wide basis. Practices that expose a conglomerate to the potential insolvency of any single or related group of borrowers can pose undue risk. Regulatory changes in this area needed to be complemented by the ability and will to enforce restrictions on such lending practices. Conglomerate banking led to concentration in financial services. Investor groups already involved in brokerage and insurance were the principal purchasers of banks auctioned for privatization. Mexico sought to alleviate the negative effects of concentration by encouraging credit bureaus for information sharing on individuals and corporations. In practice, however, credit information services were set up to serve only individual affiliates, rather than collective information requirements across the banking system. ANATOMY OF THE BANKING CRISIS IN MEXICO Page 3 Credit Institutions Law. In July 1990, the Credit Institutions Law was enacted which allowed majority private sector ownership of commercial banks. Its aim was to provide a legal framework for the capital structure and operations of a commercial banking system subsequent to reprivatization. The Credit Institutions Law also governed development banks. The law established the Bank Fund for Savings Support (FOBAPROA) which provides support to troubled banks; it is a trust whose day-to-day activities are administered by the Central Bank. Policy decisions are made by a Technical Committee whose members are appointed by the Ministry of Finance, the Central Bank, and the National Banking and Securities Commission (CNBV). Its funding comes from annual and special contributions from commercial banks as well as special allocations from the Central Bank. The Credit Institutions Law also set the maximum levels of foreign investment in Mexico's domestically controlled financial institutions as well as the capital structure and operations of foreign controlled commercial banks. The law established that no person can control more than 5 percent of a bank's capital stock, but this amount can be increased to a maximum of 10 percent under certain conditions. The Credit Institutions Law was amended to accommodate NAFTA provisions regarding the operations of commercial bank subsidiaries of foreign financial institutions. Capital Markets Law. The purpose of the Capital Markets Law was to encourage sound practices and build confidence in the domestic securities market. The Law originally established the National Securities Commission (CNV) which was subsequently merged in May 1995 with the National Banking Commission (CNB). The Capital Markets Law provides for preventive support to troubled brokerage firms by the Fund for Support to the Securities Market (FAMV). This preventive support may be secured by a pledge of brokerage firm shares. The law also sets maximum levels of foreign investment in Mexican controlled brokerage firms and limits on the operations of foreign controlled brokerage firms. Establishment of New Regulatory Structures. The Central Bank was given more authority in the conduct of specific functions, namely the foreign exchange system, bank regulation and supervision, and monetary policy. Both the Central Bank and the CNB were responsible for bank supervision and enforcement of banking regulations. In 1995 the merger of the National Banking Commission and the National Securities Commission consolidated supervision for virtually all financial holding companies as well as banks and brokerage firms. These regulatory structures were more consonant with the new realities of the financial system brought about by the emergence of conglomerate banking. But Mexico did not yet have the requisite bank supervisory capacity when the peso crisis occurred in December 1994. Although an implementation plan was under development, there was insufficient time to translate those plans into actual enhancement of capacity in the supervisory system. In fact, capacity building is ongoing in this arena, even in some industrial countries that have had more experience, so such enhancement of capacity will take time. *k Macroeconomic Context of the Banking Crisis In addition to the significant changes occurring in the banking system, the macroeconomic environment in Mexico was in flux. In the early 1990s, a large current account deficit was financed by very large capital inflows. During the period 1990-1993, Mexico's net capital inflows totaled US$91 billion which was more than half of the flows into all of Latin America. These inflows were, in part, the result of the almost complete elimination of capital controls in 1989. They are also reflective of the trend in increased private capital flows to developing countries which are laying the groundwork for global financial integration. Along with the benefits of financial integration come the consequences of possible reversals of large capital inflows which are typically Page 4 ANATOMY OF THE BANKIN G CRISIS IN MEXCO triggered by a lack of confidence in domestic macroeconomic policies. The capital inflows made Mexico vulnerable to exchange rate appreciation. This was especially so since the capital inflows were largely short-term funds invested in government securities, the stock market, and private sector instruments. The large flows led to overvaluation of the peso and fueled the current account deficit. Increases in consumption and a reduction in savings ensued. This decline in savings contrasts with the increase in savings and investment in East Asian countries when capital inflows increased in the early 1990s. Real GDP growth in Mexico was modest --averaging 2.8 percent a year-- less than many of its neighbors in the region. In contrast, at the same time Chile had 7.1 percent annual GDP growth while Colombia had 4.1 percent annual growth in GDP. The trends in Mexico were perceived as manageable since the system had sufficient flexibility in interest rates and the exchange rate band to manage disequilibria. Increases in productivity were anticipated that would generate significant export expansion which, in turn, would reduce the current account deficit. Yet the sustainability of the rate of capital inflows was uncertain. If they were to stop or slow down, the peso would be overvalued which would necessitate a very large adjustment. In early 1994, foreign funds continued to flow into Mexico in the aftermath of NAFTA. The assassination of a presidential candidate generated a negative reaction among foreign investors who reduced their demand for Mexican securities. The authorities shored up the peso and peso denominated interest rates increased. Additional devaluation was not possible within the prevailing exchange rate regime since the peso was already at the top of the band. It was difficult for Mexican authorities to roll over their maturing peso denominated debt. Higher interest rates might have made this task easier, but a recession which was an unacceptable alternative on the eve of a presidential election. Furthermore, there was the concern that higher interest rates would negatively impact the banking system which had already been weakened by a growing volume of past due loans. In November 1994, foreign investors began reducing their exposure in Mexico and reserves declined by approximately US$5 billion. By December 1994, reserves reached precipitously low levels, and on December 20th the exchange rate band was widened to allow for a 15 percent depreciation. In the absence of a parallel policy to manage possible large withdrawals, investors reduced their exposure and a few days later, the peso was floated. These events pushed the already weak banking system towards insolvency. The Mexican Government initiated a series of economic measures with the support of the IMF and the U.S. Treasury. They included fiscal discipline and tight monetary policy, a floating exchange rate, and structural reforms. Mexico adopted PARAUSEE (alliance for economic recovery) which had several purposes: (i) to reduce the current account deficit to levels consistent with external financing available; (ii) limit the inflation effects arising from the devaluation; (iii) maintain social programs; and (iv) promote macroeconomic stability and growth and restore investor confidence. To these ends, the VAT was raised by 50 percent from a rate of 10 percent to 15 percent. The price of goods and services produced by the public sector was increased but generally at a rate lower than inflation. Public spending was reduced by 10 percent in real terms while essential social spending was kept intact. Limits were imposed on the availability of domestic credit from the Central Bank, and a limit of two percent of GDP was set on loans to the private sector from development banks, a decline of about half from the prior year. The policy of floating exchange rates was maintained. ANATOMY OF THE BANKING CISIS IN MEXICO Page 5 B. BANKING SYSTEM PERFORMANCE PRIOR TO DEVALUATION In the period prior to the banking crisis, Mexico's banking system was characterized by asset and loan growth and subsequent deterioration in the loan portfolio, and insufficient loan loss reserves. These weaknesses suggest gaps in reporting and in the enforcement of banking regulations. 1. Asset and Loan Growth Asset Growth. During the period of nationalization, Mexico's banking system can be characterized as "underbanked." After reprivatization of the banks in 1991/92, assets grew sustantially during the three year period from 1991-1994, reaching a record level at the end of 1994. But the peso devaluation in December 1994 resulted in a decline of bank assets by 25 percent in U.S. dollar terms. Loan Portfolio Growth. From 1991-1994, aggregate gross loans increased even more than assets. This expansion in loans paralleled Central Bank policy which, in 1993 and 1994, resulted in credit expansion to the banking system at an increasing rate. Interbank borrowing through lines of credit from foreign banks to the larger domestic banks was funding the loan portfolio growth. This meant that much of the interbank borrowing was denominated in foreign currency. The growth in domestic credit to the banking system led to a loss of international reserves. The loss of reserves accelerated with the reversal of capital inflows which in turn, accentuated the decline in international reserves. The Central Bank did not rein in domestic credit and pressures on the currency mounted, resulting in a major devaluation. The expansion in credit to the banking system from development banks during 1993 and 1994 was also pronounced, and in effect, uncontrolled. This was another policy flaw. 2. Deterioration in Loan Portfolio Performance Growth in lending to the private sector at multiples of overall GDP growth increased exposure to risk and a decline in the quality of loan portfolios. The growth in consumer loans, credit cards and car loans was explosive beginning in late 1992/1993. The huge expansion of credit occurred while banks had inadequate capacity for credit analysis. There was a steady increase in aggregate past due loans. By another measure, the ratio of loan exposure to stockholder equity for the commercial banking system increased from 23 percent to 50 percent from the end of 1991 to 1994. Capital adequacy ratios showed positive signs during this period as an increase in the minimum required ratio of net capital to risk-weighted assets was phased in from 2 percent to 4 percent in 1992. Meanwhile, although Mexico's banks increased loan loss provisions to cover actual and potential losses from N$5 billion to more than N$13 billion from the end of 1991 to the end of 1993, this was still not enough; the ratio of provisions to past due loans declined during the same period from 51 percent to 42 percent. 3. Weak Banking Supervision Banking supervision could not keep pace with the fast pace of privatization, and it became clear that as loan portfolios were growing weaker, monitoring guidelines and procedures were inadequate. In April 1994, following the appointment of its new President, the CNBV increased the rigor of banking supervision even while it lacked adequate capacity. The CNBV took the opportunity to discuss with bank regulators from the U.S. and Canada issues related to organizational structure, management and strengthening banking supervision. Early on, it flexed its regulatory muscle and addressed operational and financial irregularities in two financial conglomerates. But even as loan portfolio quality was deteriorating, the financial authorities had already allowed the expansion of weak institutions which should have been under more strict supervision. Page 6 ANAToMY OF THE BANKING CRisis IN MEXICO C. EFFECTS OF DEVALUATION ON THE BANKING SYSTEM AND SECLRITIES The peso crisis had two immediate deleterious effects on the banking system: (i) banks incurred foreign exchange losses; and (ii) banks' investments in fixed income securities declined in value owing to the increase in interest rates resulting from the devaluation. Deterioration of loan portfolios coupled with the costs of recapitalization further weakened banks' finances. 1. Foreign Exchange Losses Regulations limit foreign currency liabilities of commercial banks to 20 percent of total liabilities. Also, their net open short or long foreign currency cannot exceed 15 percent of net capital. Nonetheless, the banking system as a whole sustained foreign currency losses totaling more than 10 percent of equity (NP$4.6 billion) in the system. Some banks tried to recoup their losses immediately following the peso devaluation by converting net short positions into net long positions. To mitigate the loss of confidence in foreign financial markets, the Central Bank lent foreign exchange to commercial banks. Although the banks did suffer exchange losses, the regulatory limits proved prudent. 2. Liquidity Shortfalls Banks lacked sufficient liquidity and could not roll over certificates of deposit that were coming due, which led to interest rate increases. The value of assets was diminished by high interest rates. In the first quarter of 1995, total foreign currency denominated deposits declined by almost 25 percent, equivalent to about US$3.5 billion. FOBAPROA provided important dollar liquidity support to commercial banks which improved banks' liquidity. 3. Loan Deterioration Banks' foreign exchange losses were compounded by high interest rates in the period following devaluation which only exacerbated weaknesses in loan portfolios. In the first quarter following the devaluation, interest rates on home mortgages, consumer credit, and commercial credit rose to over 80 percent per annum. Debtors were unable to make their debt service payments. In the second quarter after devaluation, interest rate growth subsided and nominal rates declined to approximately 35 percent. In February 1995, CNBV required banks to increase their provisions to the greater of 60 percent of past due loans, the amount of provisions required from quarterly loan classifications made under prevailing procedures, or 4 percent of the loan portfolio. In practice, the 60 percent rule proved to be the required level. Banks increased their loan loss provisions and the ratio of provisions to past due loans was about 55 percent system wide. Meanwhile, a large number of firms had borrowed abroad in sizeable amounts, bypassing the domestic financial system, and had incurred substantial foreign exchange exposures. When the devaluation took place they first had to meet their external obligations before repaying local creditors. Corporations with export earnings were less affected than the others that were catering to the domestic economy. The restructuring of these firms is lagging, which accounts in part for the continued delay in the recovery of bank portfolios. Meanwhile, because of the inadequate legal framework, these firms are not declaring bankruptcy. 4. Securities Market Before the devaluation in 1994, the stock market in Mexico achieved international recognition as an important exchange in developing countries. The devaluation, though, highlighted a number of weaknesses in the legal and regulatory framework. Although the stock market has traditionally not ANATOMY OF THE BANKING CRIsIs IN MEX-Co Page 7 been a critical source of new equity capital, the number of company listings declined from more than 200 to 184 at present. D. BANKING SYSTEM INTERVENTIONS 1. Liquidity Injections The Central Bank responded to the crisis by providing short-term peso credit through credit auctions. In some cases this credit was provided without collateral simply because banks lacked viable collateral. Banks were using pesos to buy dollars to pay off maturing dollar dominated certificates of deposit. After the immediate crisis had lifted, banks were able to secure peso liquidity from the private money markets and no longer needed recourse to the Central Bank facility. Meanwhile, FOBAPROA provided short-term 28-day dollar liquidity at 25 percent annual interest rates. This was a crucial intervention since banks had difficulty meeting maturing obligations denominated in dollars. The commercial banks relied on this vehicle quite heavily, with up to US$4 billion outstanding at times, but dependence declined after May 1995 as other sources of funding emerged more quickly than anticipated. The very high interest rate for these FOBAPROA funds was an incentive to find alternative funding sources. By the end of August 1995, all dollar donunated advances had been repaid. 2. Bolstering the Banking System There were two main objectives for the banking system in the post-devaluation period (i) staving off a further contraction in the real economy emanating from a collapse of the banking system; and (ii) creating a solid foundation to help the banking system absorb future shocks in the domestic and external economies and markets. A number of steps were taken toward these ends. * Temporary Capitalization Program (PROCAPTE) For banks that could not meet the increased provisions without becoming insolvent, a transitional umbrella, PROCAPTE, was created as a first mechanism designed to increase confidence in banks' financial condition and avoid runs on deposits and a collapse of the system, a shock that the economy probably could not have withstood. Its purpose was to recapitalize banks whose capital adequacy ratio fell below the regulatory requirement of 8 percent of risk-weighted assets. The intent was to provide core capital to undercapitalized banks to keep them in operation until new sources of capital could be found. Banks with a ratio below 8 percent that opted for PROCAPTE were recapitalized by FOBAPROA; the alternative was suspension or revocation of their operating charter. FOBAPROA's capital injection took the form of subordinated convertible debentures that raised the net capital of each participating bank to 9 percent of its risk-weighted assets. The equivalent of the proceeds from the debentures were deposited in a designated account at the Central Bank thus avoiding net liquidity creation. Banks operating under PROCAPTE were under strict supervision from CNBV. Dividend payments were discontinued and new loans were limited. FOBAPROA would make every effort not to exercise its right to conversion of debentures, but if it needed to, its ownership of corresponding shares would be sold to the public as soon as feasible. In keeping with its market oriented strategy, the Government was eager to demonstrate to the markets that it did not wish to renationalize banks, however weak. Six banks whose equity before devaluation was equivalent to about 23 percent of the commercial banking system's total capital participated in the PROCAPTE scheme. Their capital had Page 8 ANATOMY OF THE BANKING CRisis IN MExico declined by almost one-third in the first few weeks of 1995. Through the program, the banks were able to increase their average capitalization to more than 9 percent. Participating banks were anxious to leave the scheme as soon as possible owing to the stigma that the market attached to these banks, in the form of higher interbank rates for funds, for example. The program had a positive effect on depositor confidence. All participating banks except one exited the PROCAPTE scheme by June 1995 by injecting new capital in return for a purchase of non- performing assets by FOBAPROA. The effect on future profitability, however, was not so positive because of the high level of subordinated debt in the composition of the capital. Six of the healthy banks had subordinated debt totaling more than 7 million new pesos or about 38 percent of capital stock, or 13 percent of their total capital. * Bank Restructuring The restructuring of vulnerable banks was initiated with diagnostic studies conducted by independent auditors of the financial status of the commercial banks under PROCAPTE. The restructuring plan had to simultaneously address both the financial and management needs of the banks at least cost to the Government. The restructuring process also focused on creating a desirable environment for investors to recapitalize the banks. The role of the public sector in bank recapitalization was to be kept to a minimum, and where possible, mergers and liquidations were to be used to consolidate the banking system. The long-term sustainability of bank restructuring depended critically on the incentive framework. Several principles were to govern bank restructuring. In the first instance, shareholders should bear the losses incurred and management had to be changed. The immediate objective was to remove some or all non-performing assets from insolvent banks' balance sheets, with the intent of making insolvent banks more attractive to prospective buyers. Performing assets would remain on the balance sheets of the restructured bank. FOBAPROA purchased poorly performing portfolios from insolvent banks (see Table 1). The funding for the purchase of poorly performing assets was in the form of 10-year bonds carrying the lowest interest rate possible, CETES, with all interest being capitalized. Thus, the dual needs of minimizing the cash outlay by the Government in the short term and meeting the balance sheet requirements of restructured banks to meet minimum capital requirements were met. FOBAPROA has been involved to varying degrees in individual banking institutions. In collaboration with CNBV, it has organized sales and mergers of banks while monitoring asset recovery and liquidation. These tasks necessitate strong management teams with experience in the marketplace, particularly banking operations, legal affairs, mergers and acquisitions, and administration for which CNBV has been the main source. Some banks are improving many of their internal systems including origination, monitoring of loans and risk management. FOBAPROA has helped to improve banks' asset quality through loan purchases, yet the disposal of banks and the restructuring of individual institutions has proceeded slower than desired, in part because of a shortage of capital from "fit and proper" sources. How has bank restructuring been financed? Funding for FOBAPROA comes from contributions which have normally been at 0.3% of annual deposits from the banks rather than the maximum of 0.5%. This funding source was clearly insufficient to address ongoing bank restructuring needs. To meet the shortfall, the Central Bank provides repayable advances to FOBAPROA, but this was still not enough. While the entire role of FOBAPROA needs review, additional funding measures are needed in the short term and could include bonds issued by FOBAPROA, increases in the current ANATOMY OF THE BANKING CRisis IN MEXcco Page 9 contributions of banks, advances from banks against future contributions, or increased lending by the Central Bank. These advances will need to be reimbursed over time to the Central Bank from the proceeds of asset liquidation and future contributions from banks. The use of bonds minimizes the adverse monetary impact from restructuring. While bonds improve banks' stock of assets, they do not provide any liquidity to banks, which were unable to extend credit during a period of economic contraction. What has been the impact of FOBAPROA? The incentives created by the near universal liability protection are a major concern. In purchasing non-performing portfolios in lieu of a capital infusion --in the ratio of 2:1 in this case, FOBAPROA and CNBV would have done better to do this as a one-time operation, taking into account the need of each bank for positive cash flows rather than just for the stock of capital required to meet the ratio of risk weighted assets. In practice the first round of restructurings focused on restoration of capital to meet regulatory requirements. Several banks which still faced a liquidity squeeze --because of the large volume of loans that did not produce cash flows-- had to return for a second round of clean up and sought a further purchase of non-performing portfolios by FOBAPROA in return for an injection of additional capital. The incentives created by an open-ended clean up scheme are clearly undesirable The incentives for collection of non-performing loans were preserved since the formula required banks to administer non-performing loans purchased by FOBAPROA and bear 25% of any losses. Table 1: Increase in Capital and Purchase of Portfolio by FOBAPROA ($NP, Billions1) Capital Purchase of Portfolio Bank Increase Net* Gross PROBURSA I and II 3.4 6.8 8.4 SERFIN I and II 12.8 24.9 28.7 ATLANTICO I and II 3.1 5.7 6.3 PROMEX 1.7 3.0 3.4 BITAL I and II 3.7 7.4 8.7 BANCRECER/BANORO I and II 7.4 14.0 15.3 BANORTE I and II 2.1 3.6 4.1 BANAMEX 8.5 15.0 16.2 MEXICANO 3.9 6.9 8.4 BANCOMER 8.7 15.6 17.8 CONFIA I and 11 3.2 6.5 7.4 TOTAL 58.5 109.4 124.7. (*) Net of Provisions Source: CNBV FOBAPROA needs to dispose of the assets of liquidated intervened banks, along with the assets of intervened banks that are to be sold. To this end, a new subsidiary of FOBAPROA has been established, Valuaci6n y Venta de Activos (VVA). Its purpose is to assist in the transfer to the private sector of the portfolios purchased by FOBAPROA and the assets that remain from intervened banks. Presently VVA is focusing on understanding the nature of the assets in the FOBAPROA trusts and developing approaches to asset disposition. The task of selling up to US$40 billion in risky bank loans is quite monumental and it is highly likely that the market value of the assets will be much less than face 1US$ = NP$7.90 as of December. 1996 Page 10 ANATOMY OF THE BANKING CRISIS IN MlEXICO value. VVA is hobbled by a legal context that could reduce sale prices significantly, as investors will offer lower prices to compensate them for the risk of inadequate laws. Some observers estimate potential losses in revenue to the government of US$3 - 6 billion2, and Mexican banks will bear some burden of reduced sales prices as well. * Reform of Foreign Investment Regulation The government's response to the devaluation included reforms in Mexican financial sector legislation. The government sought to encourage more capital into Mexico's financial system by modifying laws governing the shareholding structure of financial holding companies, commercial banks and brokerage firms. These changes were aimed at attracting more investment in the equity of financial institutions by Mexican firms and foreign financial institutions. Limits on overall and individual shareholders' investments in financial institutions were made less restrictive. The intent of this change was to encourage joint ventures between foreign and domestic financial institutions. For domestically owned financial institutions, a single individual or company can now hold 10 percent of the share capital of a financial holding company or commercial bank, as compared to 5 percent prior to the amendments. Also, under prior law, no more than 30 percent of the voting capital of domestic financial holding companies, commercial banks, and brokerage firms could be owned by non-Mexicans. This provision reflected Mexico's wariness of foreign ownership in the financial sector. Now, foreign individuals and companies as a group can have as much as 49 percent of the voting capital of a Mexican controlled entity. In February 1995 an important change was made in Mexican law that allows the Ministry of Finance to waive the limits on market share in NAFTA on a case by case basis in certain circumstances. To encourage well capitalized foreign financial institutions to merge with or take over existing Mexican banks, the legislation allowed foreign financial institutions to buy a controlling stake in existing Mexican commercial banks as long as the resulting foreign controlled bank had no more than 6 percent market share. But foreign controlled banks can account for no more than 25 percent of total capital in the banking system. This provision therefore would allow mergers or takeovers of smaller banks, while the largest Mexican commercial banks remain off limits. Almost 90 new financial institutions have been allowed to operate in Mexico since NAFTA was approved, including 18 commercial banks and 10 financial groups. * Enhancing Banking Supervision In 1995, CNBV received technical assistance from U.S. bank inspectors. It also launched a series of CAMEL inspections of every commercial bank in early 1995, which found virtually across the board deficiencies in internal controls, insufficient credit analysis, and unsatisfactory management of liquidity and risk. Auditors were used to conduct diagnostic studies of banks that had benefited from a loan purchase by FOBAPROA to better assess the banks' financial condition, but more importantly focusing on management and systems and make recommendations in areas in need of strengthening. These diagnostic audits were useful to CNBV in conducting its own evaluation of its strengths and weaknesses in bank supervision. Meanwhile improved reporting of bank portfolios, begun by CNBV in 1994, continues. * Addressing Borrower Needs In April 1995, the government introduced the unidad de inversion, (UDI), a program to restructure mortgage and commercial loans. These loans are restructured into UDIs which are an inflation indexed peso-denominated unit of account for financial transactions. The intent of UDI was - Wall Street Journal, December 13. 1996. ANATOMY OF THE BANKING CRISIS IN MEx[co Page 11 to allow financial arrangements to be based on a real unit of account for predictability, to shield debtors from volatility in nominal interest rates while at the same time allowing lenders a rate of return higher than the inflation rate. UDI sought to help viable borrowers by initially reducing their payments and, over time, reducing interest rates by reducing the premium on interest rates experienced in economies with high inflation. The program allows banks to renegotiate eligible loans and increase their maturity to up to 12 years. These loans are placed in a trust which is funded by loan loss reserves of the banks. The Government is the main source of funding and provides finance to banks in UDIs which the Government , in turn, finances by borrowing from the banks at the CETES rate. Banks are required to keep the trusts adequately provisioned and assume the bottom line risk for the UDI portfolio. In addition, the Government initiated a program in June 1995 to provide direct interest subsidies to assist consumers and small debtors. The program is in part a response to pressure from borrowers seeking relief The Agreement of Immediate Support of Bank Debtors (ADE) was available for personal consumer debt, mortgage loans, credit card balances, and business enterprises' commercial loans. Interest payments by borrowers were capped during a one year period and loan restructuring was allowed to take place before action could be taken by the banks against borrowers. The program enabled more than 75 percent of borrowers from Mexican banks to completely refinance their debts. An estimated 25 percent of outstanding loans were incorporated in ADE. Borrowers obtained interest rate relief and collection procedures were forestalled. The cost of the interest rate subsidy was approximately evenly split between the banks and the government. The UDI and ADE initiatives helped to maintain banks' liquidity and preclude a spate of borrower defaults. But more was needed, particularly with regard to large debtors. The existing bankruptcy laws and procedures were totally inadequate to enable a "work out" between insolvent shareholders and their creditors. A Coordinating Unit for Bank-Enterprise Agreements (UCABE) was established in December 1995 to lay the foundation for the financial restructuring of the largest debtors. The effectiveness of this new vehicle has been somewhat circumscribed, however. The banks' largest debtors with loans totaling US$150 million to US$500 million equivalent, together account for about 8-10% of total bank lending. As of December 1996, 13 such financial restructurings had taken place. Additional debt relief was made available in May 1996 with a mortgage subsidy program. This program added UDI 43 billion in Government financing for homeowners and residential real estate developers. Defaults occurred even with mortgage loans restructured under the UDI initiative, and the imminent introduction of new accounting and classification rules prompted this program. It allows individuals unable to pay their mortgage to transfer title to the bank but remain in their homes for up to six years and pay rent which will accrue and allow the home to be repurchased at the end of the six years. Also, borrowers can obtain a discount, with the cost of the subsidy borne by the government. In July 1996, Mexico initiated a program to provide debt relief to the agricultural sector. Farmers, fishermen and ranchers can be eligible for debt relief up to 30% of their loans, or NP$800,000, whichever is less, based on loan size and whether the lending bank forgives part of the loan. Revising Accounting Standards The financial statements of banks in Mexico are very different from those prepared using international accounting standards. The areas of divergence include the valuation of fixed assets, the definition of non-performing assets, and the treatment of interest income on loans. What are the differences between Mexican banks' accounting practices and those in the United States? In the U.S., an allowance for potential loan losses is to be provided for based on estimates of Page 12 ANATOMY OF THE BANKING CRISIS IN MEXICO loan losses as determined by bank management. Provisions are generally charged to current operations. In some cases, specific reserves are provided. General reserves are provided after taking into account prevailing economic conditions, past experience, and delinquency statistics. In contrast, general loan loss provisions are required based on a classification of individual loans of at least 80 percent of the loan portfolio. The loan portfolio has to be classified quarterly. Provisions are adjusted by applying selected percentages to the various credit risk classifications. Other differences pertain to interest income on loans. In the U.S., interest on loans is credited to income based on the outstanding principal. Interest accrued is discontinued when it appears likely that the borrower will not be able to make payments. All unpaid interest accrued is reversed. In Mexico, CNBV guidelines allow interest to continue to accrue on loans except in cases where the entire balance of the underlying loan principal is past due. Unpaid interest is included in the loan classification system for determining the amount of loan loss provisions. CNBV does not require reversal of past due interest income accrued. In December 1995, as part of improving the quality of information provided to markets by banks and transparency, CNBV issued regulations requiring banks to comply with new accounting standards effective January 1, 1997. These new rules are broadly consistent with internationally accepted standards in most respects and are a considerable improvement over existing standards. One of the limitations of the new standards is that restructured loans can be treated as current --even though the performance of the loan could still be doubtful. On the other hand, in some areas the new standards are somewhat more conservative than U.S. standards, and perhaps justifiably so. E. CURRENT STATUS OF MEXICO'S COMMERCIAL BANKING SYSTEM The Mexican Government estimates the cost of the banking crisis as equivalent to 8.5 percent of GDP. Some observers estimate higher losses. In 1995, GDP declined by as much as 6.9 percent and formal sector unemployment doubled. Exports are growing strongly, however, and based on these trends, coupled with some revival of domestic demand, GDP growth for 1996 is estimated at 3.5 percent. If economic recovery is lackluster, though, the cost of the banking crisis will likely rise further. Mexico's commercial banks have witnessed severe strains on their capital resources owing to the continued deterioration in portfolio quality and the increases in loan provisions despite the many debt relief programs that the Government introduced. Yet several of the banks improved their capital position by managing to increase their equity quite significantly. The profitability of Mexico's banks in 1995 is likely to have been overstated though since past due interest income continued to be accrued. Past due interest is significant, and the overstatement of net interest income in 1995 is estimated in the range ofNP$5 billion. The combined losses of the banking system during 1995 totaled NP$36.5 billion. These losses are largely the result of additional non-performing assets that were determined by CNBV, but are also the consequence of continuing economic conditions. The loan loss provisions of the banks covered only about one half of their past due loans. These figures will increase with the application of internationally accepted accounting standards which are more stringent than Mexican accounting standards in portfolio classification. Banks that are not under FOBAPROA control reported a net profit of NPS3. I billion in aggregate during 1995. But these profits are overstated, again owing to differences in accounting. Only 60 percent of past due interest is provisioned for. The cumulative overstatement of net profit is ANATOMY OF THE BANKING CRISIS IN MEXIco Page 13 significant. The newer banks have less exposure to non-performing loans simply by virtue of their shorter-term existence. Of the banks that have been in operation for some time, there are some that are carrying a respectably healthy margin. The economic recession of 1995 continuing into 1996 has jeopardized the quality of banks' loan portfolios. Interest rates need to decline before realistic loan repayment scenarios can be projected, and in 1996 interest rates were declining. The intervened banks which incurred large losses will require sizeable additional capital infusions before they are sold, with fiscal implications for the government. This points to the need to restructure and expeditiously sell those especially vulnerable banks as a means to reduce the overall cost to the public sector of bank restructuring. At the end of the third quarter of 1996, working estimates of the net equity of Mexico's banking system were NP$51.5 billion (see Table 2). This modest level reflects the NP$23.7 billion of negative equity in the intervened banks. Overall profits were negative --NP$36.9 billion -- reflecting the negative profit status not only on the intervened banks for also for many of the non-intervened banks. Since the new local banks and new subsidiaries of foreign banks have yet to gain a significant foothold in the market, their situation did not influence the banking system's overall profitability. Table 2: Structure of the Mexican Commercial Banking System (millions of NP$, as of end September 1996) Number Gross Direct Net profit Group of banks Assets lansI fundinj2 Equity or losses. Intervened banks 10 154,242 143,240 109,475 -23,703 -34,308 Privatized banks 12 971,631 645,548 557,256 62,588 -4,531 New local banks 14 44,109 20,428 15,632 6,606 1,077 Subsidiaries of foreign banks 17 60,891 8,930 11,458 6,061 903 Banking system 53 1,230,873 818,146 693,821 51,552 -36,859 1 Including Discount Loans. 2 Including deposits, bankers acceptances, and money market repo agreements. 3 Group does not include privatized foreign owned banks, i.e. Inverlat and Probursa. Source: CNBV The continual increase in the ratio of past due loans which grew from 9 percent in December 1994 to 21.7 percent in September 1996 (see Table 3 for preliminary figures) merits attention. FOBAPROA continues to expand its role and as of March 1996 it accounted for more than 30 percent of the banking system's total loan portfolio, as compared to 20 percent in June 1995. Projections of the ratio of past due loans through the end of 1996 suggest an increase to 24 percent by December 1996. Moreover, if the more stringent U.S. generally accepted accounting principles are applied, the ratio of past due loans jumps to 35.6 percent at the end of the year under the best case scenario, and higher to more than 40 percent under less optimistic assumptions. It is unclear whether the past due loan situation is a function of borrower inability to pay and/or whether the incentives in the system, e.g. expectations of further relief in the future and the associated moral hazard, are encouraging borrowers who are able to service their debts but are unwilling to do so. The ratio of past due loans for the 12 non-intervened banks also points to continuing fragility. Even after accounting for FOBAPROA purchasing loans from the non-intervened banks, the ratio of past due loans grew from 7.5 percent in December 1994 to 10 percent in September 1996. The loan purchases by FOBAPROA coupled with increased shareholder capitalization helped to increase the capitalization ratio for the group of 12 non-intervened banks. Nonetheless, their capitalization remains inadequate and they have poor cash flows because a large share of the loans on their books have been Page 14 ANATOMY OF THE BANKING CRISIS IN MEXICO recently restructured. Overall, the financial condition of the banks will not improve unless and until loan portfolio losses are stemmed and ultimately reversed. The problem is exacerbated by firms operating in the domestic market which were severely hit by the foreign exchange losses from pre- December 1994 borrowings abroad. Workouts of these firms and their recovery will take time even with a reasonable upturn in economic growth. F. THE ROLE OF THE WORLD BANK The Bank assisted in Mexico's adjustment during the latter part of the 1980s. Included in this adjustment effort, the Financial Sector Adjustment Loan (FSAL) lent support for policy reforms that liberalized the financial sector. Among the areas of deregulation were interest rates and reserve requirements on deposits denominated in pesos. Following an active dialogue and analyses during late 1993 and 1994, the Bank approved a Financial Sector Technical Assistance Loan (FTAL) to bolster the financial system with more effective regulation and supervision using incentives for participants in the system to regulate their own activities. In the aftermath of the devaluation, the technical assistance under the loan focused on immediate necessities, namely support in the form of bank inspectors from the US, in-depth diagnostic audits of banks that benefited from public support and consultancy services in bank restructuring. The devaluation necessitated deeper involvement by the Bank to help the Mexican government with a strategy and targeted actions to restructure the financial sector. In June 1995, a two tranche Financial Sector Restructuring Loan in an amount of US$1,000 million equivalent was approved. The second US$500 million tranche was released in July 1996 upon completion of several agreed measures by the Government covering bank restructuring, prudential regulation and supervision. The loan had several objectives. First, Bank funds supported the cost of restructuring the financial sector, recognizing that the success of such restructuring depends crucially on adequate system oversight, strengthening institutional capacity, and enhancing the workings of the marketplace. Bank support served to improve accounting standards, prudential regulation, and the quality and transparency of information in the commercial banking system. Other activities included improving the ability of the Central Bank to manage liquidity in periods of instability. The IMF worked in tandem with the Government on macroeconomic stabilization efforts, exchange rate policy, and liability management issues. The implementation to date of the financial sector restructuring program is consistent with the commitments the government made, although progress has been somewhat slower than originally anticipated in restoring systemic strength. There is now increasing evidence of foreign investor interest in participating in the capitalization of existing banks. Merger of some weak banks with healthier ones to inject new capital and management is underway. Following the recapitalization, over half the assets in the banking system should be in banks that are considered solvent. Intensive bank inspections have been conducted on all banks in 1995, with assistance from a team of inspectors from U.S. regulatory agencies,, financed under the Financial Sector Technical Assistance Loan. The focus of the inspections is now on banks that are especially vulnerable. Banks that benefited from the FOBAPROA purchase of non-performing assets were also subject to diagnostic audits conducted by independent auditors. These auditors covered not only portfolio quality but more importantly internal management systems. The findings led to Memoranda of Understandings between CNBV and the banks on improvements to be made. Table 3: Statistics on the Commercial Banking System & Projected Scenario for its Evolution (in millions of NP$, as of end month) Actual Data Projected Under U.S. GAAP Scenario Dec-94 Mar-95 Jun-95 Sep-95 Dec-95 Mar-96 % ch % ch % ch Jun-96 % ch Sep-96 % ch Dec-96 Dec-96 O March Mar-March June Sep Dec 50% worse 80% worse Intervened Banks qtr qtly averg qtr qtr qtr Gross Loans 118,621 126,792 126,226 128,218 141,951 142,318 0.3 3.1 00 142,318 O0 142,318 0.0 142,318 142,318 142,318 Past Due Loans 19,348 28,694 38,642 46,863 52,172 56,432 8.2 24.2 8.0 60,947 8.0 65,822 80 71,088 106,632 127,959 Ratio: Past due/Gross loans 16.3% 22.6% 30.6% 36.5% 36.8% 39.7% 42.8% 46.3% 50.0% 74.9% 89.9% 12 Privatized Banks' Gross Loans 496,307 546,964 551,482 532,733 565,222 552,388 -2.3 0.2 2.0 563,436 2.0 574,704 2 0 586,199 586,199 586,199 E Past Due Loans 37,226 53,672 56,974 56,034 45,805 49,294 7.6 -2.0 8.0 53,238 0 0 57,497 8.0 62,096 93,144 111,773 5 Ratio: Past due/Gross loans 7.5% 9.8% 10.3% 10.5% 8.1% 8.9% 9.4% 10.0% 10.6% 15.9% 19.1% 2 Loans sold to FOBAPROA by 12 privatized banks (2) (3) (4) (5) Gross Loans - - 12,472 31,535 75,573 102,972 36.3 0.0 102,972 0.0 102,972 00 102,972 102,972 102,972 Past Due Loans - - 6,328 16,852 37,355 43,810 17.3 17.0 51,258 17.0 59,972 17.0 70,167 105,250 126,300 0 Ratio: Past due/Gross loans 50.7% 53.4% 49.4% 42.5% 49.8% 58.2% 68.1% 102.2% 122.7% Total for 12 banks (incl. loans sold to FOBAPROA) Gross Loans 496,307 546,964 563,954 564,268 640,795 655,360 2.3 5.0 1 .7 666,408 1.7 677,676 1.7 689,171 689,171 689,171 Past Due Loans 37,226 53,672 63,302 72,886 83,160 93,104 12.0 18.4 12 .2 104,495 12.4 117,468 12.6 132,263 198,394 238,073 Ratio: Past due/Gross loans 7.5% 9.8% 11.2% 12.9% 13.0% 14.2% 15.7% 17.3% 19.2% 28.8% 34.5% New Mexican Banks and Foreign Subsidiaries Gross Loans 12,966 16,810 18,301 20,232 24,110 25,723 6.7 13.3 7.0 27,524 7 0 29,450 7.0 31,512 31,512 31,512 Past Due Loans 28 379 697 693 713 868 21 7 32.3 22.0 1,059 22.0 1,292 22.0 1,576 2,364 2,837 Ratio: Past due/Gross loans 0 2% 2.3% 3.8% 3.4% 3.0% 3.4% 3.8% 4.4% 5.0% 7.5% 9.0% Total System (excl. loans sold to FOBAPROA) Gross Loans 627,894 690,566 696,008 681,184 731,283 720,429 -1.5 1.1 1.8 733,277 1.8 746,473 1.8 760,028 760,028 760,028 Past Due Loans 56,602 82,745 96,313 103,590 98,690 106,594 8.0 7.2 8.1 115,243 8.1 124,611 8.1 134,760 202,141 242,569 Ratio: Past due/Gross loans 9.0% 12.0% 13.8% 15.2% 13.5% 14.8% 15.7% 16.7% 17.7% 26.6% 31.9% Total System (incl. loans sold to FOBAPROA) Gross Loans 627,894 690,566 708,480 712,719 806,856 823,401 21 4.8 1.6 836,249 1 6 849,445 1 6 863,000 863,000 863,000 Past Due Loans 56,602 82,745 102,641 120,442 136,045 150,404 10 6 20 4 10.7 166,501 10.9 184,582 11.0 204,927 307,391 368,869 Ratio: Past due/Gross loans 9.0% 12.0% 14.5% 16.9% 16.9% 18.3% 19.9% 21.7% 23.7% 35.6% 42.7% Quarterly % change in past due loans 46.2% 24.0% 17.3% 13.0% 10.6% 107% 10.9% 11.0% MEMO: Restructured UDI Loansb - - 1,903 36,833 97,955 131,314 34 1 No tes8: 1. This data includes discounted loans but excludes loans sold to FOBAPROA 2. As of June 1995 loans had been sold to FOBAPROA by Probursa and Serfin 3. By September 1995, additional loans had been sold to FOBAPROA by Atlantico, Bancrecer/Banoro, Bital and Promex 4. By December 1995, additional loans had been sold to FOBAPROA by Banorte, Banamex, Mexicano and Bancomer 5. And by March 1995, additional loans had been sold to FOBAPROA by Confia, Probursa (1l) and Serfin (ll) 6. From Indicadores Economicos, December 1996. Page 16 ANATOMY OF THE BANKING CRisis IN MEXIco Acquisitions of Mexican banks by foreign banks have contributed to the increase in the share of foreign capital in the system. Table 4 highlights selected major Mexican bank acquisitions by international banks. Table 4: Selected Acquisition of Mexican Banks by Foreign Banks Banks Acquired Year of Purchase % Stake Price US$ million CREMI 1996 100 20 PROBURSA 1991-1995 90 495 BANCO MEXICANO 1996 75 425 BITAL 1996 10 50 INVERLAT 1996 55 193 BANCOMER 1996 16-20 435 SERFIN* (*) Acquisition of SERFIN by Hong Kong and Shanghai Banking Corporation likely, per Wall Street Journal. December 23 1996. Source: CNBV. Also, some initial positive signs are beginning to emerge in bank credit to the private sector. While bank credit fell 35 percent in real terms in 1995, it began to increase 3.5 percent in real terms in the first few months of 1996. With the projected decline in interest rates coupled with a rise in domestic demand which collapsed in 1995, some signs of an upturn are possible. Different scenarios can be projected as illustrated in Table 5 which are based on preliminary estimates. Table 5: Banking Sector Strategy: Alternative Macroeconomic Scenarios Scenario A 199-5 1996 1997 1998 1999 Real GDP growth (%) -6.9 2.5 3.5 4.0 5.0 Inflation (%; CPI-eop) 51.3 25.0 12.5 9.0 7.0 Interest Rate (28-day cetes, ave) 48.0 28.0 24.5 18.4 15.3 Fiscal Balance (% of GDP) 0.5 -0.3 -0.5 -0.1 0.0 Curr. Acc. Bal. (% of GDP) -0.3 -0.5 -1.8 -1.8 -1.7 Scenario B 1995 1996 1997 1998 1999 Real GDP growth (%) -6.9 2.2 2.5 2.0 2.5 Inflation (%; CPI-eop) 51.3 27.0 22.0 30.0 29.0 Interest Rate (28-day cetes, ave) 48.0 30.0 38.0 40.0 39.0 Fiscal Balance (% of GDP) 0.5 -0.3 -1.0 -1.1 -1.0 Curr. Acc. Bal. (% of GDP) -0.3 -0.5 -0.5 -0.5 -1.0 Fiscal Costs of Banking System Restructuring Scenario A Scenario B Costs already committed (in present value terms) 8% of GDP 8% of GDP Additional Fiscal Costs (in present value terms) 2% of GDP 6% of GDP Total 10% of GDP 14% of GDP Annual Budgetary Costs: (average 1997-1999) 1.25% of GDP 2.2% of GDP ANATOMY OF THE BANKING CRISIS IN MEXICO Page 17 Scenario A depicts the effects of a concerted effort of banking system reform. This would entail one time portfolio clean out exercises for weak banks in return for capital infusion taking into account not only restoration of capital to the minimum regulation requirement but also the projected liquidity and cash flows to enable the bank to lend and earn income. It would envisage more aggressive action on resolution of weak banks, likely through mergers with stronger ones so as to stem the continuing losses given the inadequate incentive environment for weak banks to perform. It would also envisage a review of the present comprehensive liability protection scheme with a view to a gradual phase down to eventually protect only small depositors -- as is customary on grounds of information asymmetries -- and again reduce incentives for high risk behavior. Scenario B represents a projected outcome from a more incremental and gradual approach. The fiscal implications of these two scenarios are quite different, ranging from 1.2 percent of GDP annually during the period 1997- 1999 under Scenario A, to 2 percent of GDP during the same period under Scenario B. In summary, banking system rejuvenation and economic growth go hand in hand. Banks will find it difficult to recover if they cannot lend, and in the present environment, substantial lending will be difficult because of the lingering slack in domestic demand, even as exporters prosper. At the same time, economic growth will be difficult without firms having access to financing. With an economic upturn, the fiscal costs of the banking crisis will be less than if the recession in the domestic economy continues into 1997. Under a pessimistic scenario, the fragility of the banking system and the economy generally could lead to significant social disruption. Hence, an important challenge facing Mexico and other similarly situated countries is managing the impact of global financial integration and domestic financial sector reform in the context of unsettled macroeconomic conditions. G. CONCLUSIONS & RECOMMENDATIONS A number of factors precipitated the banking crisis in Mexico -- which necessitates multiple solutions to addressing the crisis and preventing them in the future. The magnitude and rapidity of capital inflows intermediated by the banking system led to lending that did not always meet acceptable lending criteria. Moreover, the rapid growth in bank liabilities occurred in the context of the short-term nature of the capital inflows, reliance on foreign currency-denominated debt, and the variability of exchange rates and interest rates. Also, more attention was paid to the prices offered for banks that were privatized in 1991/92 than to the "fit and proper" criteria that should have been applied to the bidders, resulting in groups with little experience in banking per se acquiring the privatized banks. Furthermore, the regulatory and supervision framework and its implementation were inadequate in the context of financial liberalization. Market discipline failed to "kick in" because of the inadequacies of the accounting and legal framework, while the incentive structure gave risk-takers little incentive to avoid excessive risks. On a positive note, many of the causes of Mexico's banking crisis are manageable. In a study examining 29 banking crises in countries around the world, deficient bank management, inadequate supervision and regulation characterized one-half to two-thirds of them -- causes which are manageable. For example, in Mexico market discipline can take root if there is transparency in financial transactions. Financial conglomerates need to provide consolidated financial statements that reflect the position of the entire group. The release of such information could help bring transparency to intragroup transactions that might distort the actual financial situation of one or more of the affiliated institutions. More open, reliable and transparent information systems will allow for more market based discipline, which, in turn, can serve as an important adjunct to formal supervision. Page 18 ANATOMY OF THE BANKING CRISIS IN MEXICO Regulatory agencies need to continue to develop the capacity to conduct on and off-site surveillance of conglomerates. Approaches to supervision of conglomerates are still developing even in industrial countries, so the exchange of experience in such supervision among countries working to build capacity would be useful. Banking supervision staff need to determine whether the actual practices of financial institutions -- and not just their reporting -- are in conformity with regulations and best practices. The enforcement of regulations which is affected by political will need not rely as much on the imposition of penalties as on the exercise of other powers, namely the removal of bank directors and managers. Bank restructuring should be a one-time effort, taking into account not only steps required for capital adequacy but also the financial flows necessary for future profitable operation. In addition, while ease of entry and exit to banking are important, the standards for entry in terms of minimal experience to meet the "fit and proper" criteria are key, especially during privatization or resale. It could be argued that given the greater susceptibility of developing countries to external shocks and poorer quality of information in such countries, minimum capital adequacy requirements should be set higher than the Basle guidelines. The composition of capital should also be given careful consideration in terms of its impact on capital adequacy, cash flow liquidity, and ability to raise funds for lending. Policies governing the protection of deposits in Mexico merit reconsideration. The Credit Institutions Law does not formally obligate government to explicitly guarantee or insure any obligations of any commercial bank. The government, however, has indicated that it will cover all bank and brokerage firm liabilities with the exception of subordinated debt. This sweeping coverage generates moral hazard and reduces the incentive that managers and directors have in assuring the efficient operations of their financial institutions. On the other hand, the protections afforded to bank depositors precluded a run on the banks during the recent crisis. But there are costs to such protection. Depositors and even bond markets have little incentive to select more efficient banks or to monitor banks in general while bank managers have less incentive to manage portfolio risks judiciously. Given the many debt relief schemes that were introduced, it is possible that Mexico's banks and debtors are still operating under the assumption that the government will continue to subsidize future losses. This incentive structure impedes sustainable reform of the sector. Another critical area of reform needed is in Mexico's bankruptcy law. The original provisions of Mexico's bankruptcy law have permitted many debtors to effectively be immune from collection efforts. In 1994 an initial draft of a bankruptcy reform program was proposed which would have lifted the effective immunity of debtors, but this legislation was never enacted. Restructuring of real sector firms is hampered by this and other deficiencies in the legal framework and this, in turn, will delay the restoration of bank portfolios. Laying the conditions necessary for an orderly restructuring of firms is essential. Although important changes have been made in recent years in rationalizing the activities of development banks so that they operate as a second-tier system, more remains to be done. The total financial obligations of development banks are not tracked or monitored in a consistent manner. Clarity of operations of development banks as well as understanding the costs to the government of development bank operations needs to be improved. A broader policy issue is the role and relevance of the alternative functions that they perform such as wholesale external resource mobilization, second tier lending to the domestic banking system and targeted sectoral lending and segmentation of these markets. It is appropriate to reassess the comparative advantage of development banks in lending to low income individuals and households, for example. Development banks may not be necessary if loan guarantees are instead funded through a budgetary line item that provides some degree of guarantee for private commercial bank lending to the poor. ANATOMY OF THE BANKING CRISIS IN MEXICO Page 19 These steps to improve the health of Mexico's banking system are essential for the efficiency in the delivery of financial services. They are also important if Mexico is to reap the benefits from the growth in private capital flows to developing countries and the financial integration that ensues. In fact, financial integration makes it essential to engage in financial sector reforms since a sound infrastructure is needed to sustain the greater exposure to externally induced volatility that could ensue. For example, the rapid pace of globalization enables firms in developing countries to borrow abroad incurring exchange risk, which, in the event of a crisis, becomes the government's burden. The issue of whether requirements can be imposed to limit these risks, and how governments can prepare for the potential liabilities in the event of an exogenous shock merit discussion. These measures are among those that can significantly reduce the incidence of banking crises in Mexico and elsewhere. The lessons learned are instructive for other countries that have likewise experienced difficulties in their banking sectors, and perhaps they will prompt national authorities in countries whose systems are at risk to establish safeguards to prevent future systemic financial distress and its fiscal burden. Page 20 ANATOMY OF THE BANKING CRISIS IN MEXICO BIBLIOGRAPHY Aiyer, Sri-ram, "Capital Inflows in Latin America" (undated). 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Garcia, Valeriano, "Black December: Banking Instability. The Mexican Crisis and its Effects on Argentina" - The World Bank, mimeo, 1996. Giorgio, Luis Alberto, "Banking Distress and Crisis - Lessons from Selected Experiences in Latin America" - The World Bank (undated). Glaessner, Thomas, et. al., "The Technical Process of Bank Privatization in Mexico" (undated). Goldstein, Morris and Turner Philip, "Banking crises in Emerging Economies: Origins and Policy Options," Bank for International Settlements, 1996. "HSBC Close to Purchasing Stake in Big Mexican Bank" The Wall Street Journal, December 23, 1996. Karaoglan, Roy and Lubrano, Mike, "Mexico's Banks After the December 1994 Devaluation: A Chronology of the Government's Response" - Northwestern Journal of International Law & Business, vol. 16, No. 1, 1995. Karaoglan, Roy, Memorandum on Mexican banking system, October 4, 1995. IMF Survey, May 20, 1996. Lubrano, Mike, "Mexico Amends Financial Sector Legislation to Attract Greater Investment and Reinforce Supervision" - North American Corporate Lawyer, Vol. II, No. 4, 1995. Lubrano, Mike, "UCABE Workout Scheme: Practical Difficulties in Mexican Workouts and Bankruptcy" - North American Corporate Lawyer, Vol. III, No.3, 1996. ANATOMY OF THE BANKING CRISIS IN MEXICo Page 21 Mexico Strategy Papers, The World Bank, June 10, 1995. Nicholl, Peter, "Market Based Regulation" - Paper presented at World Bank Conference on Preventing Banking Crises in Latin America, April 15-16, 1996. President's Report, Mexico: Financial Sector Restructuring Program. May 24, 1994. President's Memorandum, Mexico's Financial Sector Restructuring Program, May 24, 1995. President's Report, Mexico: Financial Sector Technical Assistance Project. May 25, 1995. President's Memorandum, Country Assistance Strategy for the United Mexican States, November 25, 1996. "Private Capital Flows to Developing Countries: The Path to Financial Integration" International Economics Department, December 18, 1996 (draft). Rojas-Suarez, Liliana, and Weisbrod, Steven, "Financial Fragilities in Latin America" - IMF, October 1995. Sjaastad, Larry, "Deposit Insurance: Do We Really Need It" - Paper presented at World Bank Conference on Preventing Banking Crises in Latin America, April 15-16, 1996. Standard & Poors CreditWeek, August 7, 1996. Torres, Craig, "Mexico's version of RTC gears UP for 1997" Wall Street Journal, December 13, 1996. Turner, Philip, "The Difficulties of Managing Banking Crises: An Overview" Paper presented at the XXXIII Meeting of the Technicians of Central Banks of the American Continent, November 18-22, 1996. Other Reports in the Regional Studies Program Series: No. 35: The Power Sector in LAC: Current Status and Evolving Issues, LATAD, June 1995. No. 36: Infrastructure and Growth: the Latin American Case, LATEA, January 1996. No. 37: Sustaining Safety and Soundness: Supervision, Regulation, and Financial Reform, LATEA, January 1996. No. 38: Effective Financing of Environmentally Sustainable Development in Latin America and the Caribbean, LATEN, January 1996. No. 39a: Argentina: Mutual Fund Regulation, LATAD, October 1996. No. 39b: Argentina: Mutual Fund Industry, LATAD, October 1996 No. 39c: Brazil: Securities Portfolio and Investment Fund Regulation, LATAD, October 1996. No. 39d: Chile: La Regulacion de los Fondos Mutuos, Fondos de Inversion y Fondos de Inversion Extrajera, LATAD, October 1996 No. 39e: Chile: Los Fondos Mutuos, LATAD, October 1996 No. 39f: Colombia: La Regulacion de los Fondos de Valores, LATAD, October 1996 No. 39g: Mexico: Mutual Fund Regulation, LATAD, October 1996 No. 39h: Peru: Mutual Fund Regulation, LATAD, October 1996 No. 40: Sustainable Agriculture and Poverty Reduction in Latin America's Risk-Prone Areas: Opportunities and Challenges, LATEN, October 1996. No. 41: Infrastructure in LAC: Investing in the Future, LATDR, November 1996. No. 42: Pursuit of Sustainable Energy Development in the Americas: A Look at Recent Progress, LATEN, November 1996. No. 43: Pursuit of Sustainable Forest Policy in the Americas: Current Initiatives and Opportunities for Regional Cooperation, LATEN, November 1996. No. 44: Road Maintenance by Contract: Dissemination of Good Practice in LAC, LATAD, December 1996.