Mexico - Bank Restructuring Facility Adjustment Loan Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. P7347 ME REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED BANK RESTRUCTURING FACILITY ADJUSTMENT LOAN IN THE AMOUNT OF US$505.06 MILLION FOR NACIONAL FINANCIERA, S.N.C. WITH THE GUARANTEE OF THE UNITED MEXICAN STATES November 29, 1999 Mexico Country Management Unit Latin America and the Caribbean Region This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its content may not otherwise be disclosed without World Bank authorization  MEXICO FISCAL YEAR January 1- December 31 CURRENCY EQUIVALENTS (as of November 1999) 9.53 Pesos = US$1.00 ABBREVIATIONS AND ACRONISMS BOM = Bank of Mexico (Mexico's Central Bank) CAR Capital assets ratio CAS = Country Assistance Strategy CLPP = Capitalization and Loan Purchase Program CETES Treasury Certificates (Certificados de Tesoreria de la Federacion) CNBV = National Banking and Securities Commission FOBAPROA = Trust Fund for the Protection of Bank Savings FSRL = Financial Sector Restructuring Loan GAAP = Generally Accepted Accounting Practices GDP = Gross Domestic Product IDB Inter-American Development Bank IPAB Bank Sa-vings Protection Institute IMF = International Monetary Fund MERCOSUR = Common Market of the Southern Cone NAFIN Nacional Financiera S. N. C. NPLs = Non Performing Loans NYSE New York Stock Exchange PDL = Past Due Loans PROCAPTE = Temporary Capitalization Program RTC = Resolution Trust Corporation TIIE = Interbank equilibrium interest rate UDI Investment Units (Indexed) SDR = Special Drawing Rights IBRD Vice President David de Ferranti Country Director Olivier Lafourcade Lead Specialist Augusto de la Torre Sector Manager Danny Leipziger Task Manager Mariluz Cortes This operation was prepared by a World Bank team composed of: Messrs/Mmes. Augusto de la Torre, Fernando Montes-Negret,(Sector Leader LCSFP- Mexico); Juan Ortiz, Yira Mascar6 (LCSFP); Vincent Polizatto (BFI); Teresa Genta-Fons (LEGLA); and James Lacey (consultant). The team was led by Mariluz Cortes (Task Manager) and worked under the general guidance of Augusto de la Torre (Lead Specialist LCSFP) and Fernando Montes-Negret (LCSFP- Mexico).  FOR OFFICIAL USE ONLY UNITED MEXICAN STATES PROPOSED BANK RESTRUCTURING FACILITY LOAN TABLE OF CONTENTS Page No. LOAN AND PROGRAM SUMMARY ........................................................I I. THE SETTING. . A. Economic Context .1 B. Recent Performance .1 II. THE BANKING CRISIS CONTAINMENT POLICIES OF 1995-1998 3 A. Banking Sector Structural Weaknesses Prior to the 1994-1995 Crisis. 3 B. The Government's Response to the 1994-1995 Crisis .5 C. Evaluation of the Crisis Contention Program of 1995-1998 .10 III. THE NEW GOVERNMENT STRATEGY FOR BANK RESTRUCTURING AND RESOLUTION .12 A. Legal Framework to Improve Incentives in the Financial Sector .13 B. Regulatory Reforms to Improve Bank's Capitalization and Soundness . 14 C. IPAB's Bank Capitalization and Resolution Program .17 D. IPAB's Integrated Program for Residual Asset DisposaL .20 E. IPAB's Finances: Cash Flow Projections and Liabilities Management . 21 IV. BANK ASSISTANCE STRATEGY IN THE BANKING SECTOR . 25 A. Bank Assistance Strategy in the Banking Sector .25 B. Bank Experience with, Policy Based Lending in Mexico .26 C. Coordination with Multilateral Institutions .28 V. THE PROPOSED LOAN .28 A. Loan Objectives and Description .28 B. Bank Resolution Transactions to be Supported by the Loan .29 C. Commitments under the Loan .31 D. Disbursements, Reporting and Auditing .33 E. Impact, Benefits and Risks .34 VI RECOMMENDATIONS .37 ANNEX I Matrix of Policy Actions for Tranche Release ANNEX II Banking Statistics ANNEX HII Regulatory Reform ANNEX IV Letter of Sector Development Policy ANNEX V IPAB's Asset Disposal Program ANNEX VI Economic Indicators ANNEX VII Status of Bank Group Operations 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.  ANNEX VIII Status of IFC Investments ANNEX IX Mexico at a Glance  MEXICO BANK RESTRUCTURING FACILITY LOAN LOAN AND PROGRAM SUMMARY Borrower: Nacional Financiera, S. N. C. (NAFIN) Guarantor: The United Mexican States Amount and Terms: US$505.06 million. Fixed-spread Libor based rate, with 10 years of grace period and bullet repayment on December 1, 2009. A 0.85% commitment fee for the first four years and 0.75% thereafter (without waivers), and a 1% capitalized front-end fee. Description: The operation will support the first stage of the Government's bank restructuring program which includes: Legal reforms to improve incentives in the banking sector. Measures already taken by the authorities include: (i) approval in December 1998 of the IPAB Law establishing a gradual phase-out of the universal deposit insurance scheme, replacing it with one with limited coverage; (ii) presentation to Congress in April 1999 of the Secured Transactions Law; and presentation to Congress of a new Bankruptcy Law in November 1999; and (iii) the adoption of a final debtor relief program ("Punto Final"). Regulatory reforms to improve Banks' capitalization and soundness. Measures already taken by the authorities include the announcement, in September 1999, of a series of regulatory reforms to change the definition of regulatory capital and require the disclosure of its composition; improve the definition of risk weighted assets; establish classification and new provisioning rules based on repayment capacity; improve accounting practices and standards; and improve disclosure IPAB's bank capitalization and resolution program. This operation will support the restructuring, sale, merger or liquidation of five banks that are under IPAB's restructuring program. Bank funds would help finance part of IPAB's debt-servicing needs arising from the implementation of its bank resolution program, complementing other sources of funds available to IPAB, such as: fiscal transfers, proceeds from asset disposal/recovery; and fees from deposit insurance premia.  Risks and Benefits The proposed loan would contribute to ensure banking soundness by the time when the full deposit guarantee disappears in Mexico, particularly in 2003 (when interbank liabilities are excluded) and 2005 (when the maximum amount of individual insured deposits is reduced to US$100,000 equivalent. Strong and well capitalized banks would be in better position to resume prudent lending to the private sector, which has collapsed in real terms since the 1994-95 crisis, with the attendant beneficial effects on growth, wider access, and employment. By contributing to finance IPAB's program, the loan would help the Government to make explicit the cost of solving the bank problems and avoid a more costly delay. There are several risks in this operation. One is that if IPAB were not able to refinance its debt, it could face increasing limitations in its capacity to capitalize and sell or unwind and liquidate the banks. To prevent this from happening, the executive has introduced in the Budget Proposal for 2000, fiscal transfers to IPAB for about 0.8% of GDP and an increase in IPAB's debt ceiling. Another risk is that if banks cannot increase their capital in response to the new capital regulations, the authorities could postpone the schedule of implementation of the regulatory reform. This is unlikely, because the CNBV has already explored the capability of the banks to raise the required capital and it is confident that they will be able to do so. Another risk is that the large debt issues associated with IPAB's program could imply higher and more volatile interest rates. This is also mitigated because the bulk of the bank resolutions consists in the allocation of historical losses to the Government's balance sheet, an accounting exercise of little economic significance. A greater risk is if the unresolved banking problems aenerate new losses, which is what the proposed operation is designed to prevent. Schedule of Disbursements: The full amount of the loan is expected to be disbursed in calendar year 2000 in three tranches: one tranche upon effectiveness and two floating tranches linked to agreed bank resolution transactions. Closing Date: June 30, 2001 Project ID Number: MXPE-P067491  MEXICO MEMORANDUM OF THE PRESIDENT PROPOSED BANK RESTRUCTURING FACILITY ADJUSTMENT LOAN I. THE SETTING A. Economic Context 1. Following the Tequila episode of 1994-95, the Mexican economy experienced two years of strong export-led recovery during 1996 and 1997, with annual GDP growth averaging 6%. Inflation went down from 52% in 1995 to 16% in 1997, and open unemployment decreased from 8% in 1995 to 3% at the end of 1997. This improving scenario started to falter in 1998, following a tightening of international capital markets generated by the Russian and Brazilian crises, and the sharp decline in oil prices, which was reflected in a widening of the external current account deficit from 1.8% of GDP in 1997 to 3.8% of GDP in 1998. The Government responded to the deterioration in external conditions by cutting expenditures and managing to keep the fiscal deficit at its targeted level of 1.25% of GDP in 1998. At the same time, the flexible exchange rate in effect since 1995 helped absorb the impact of the external shocks without unduly sacrificing economic activity. In effect, while the currency depreciated by 11.2% percent in the last half of 1998 (22.7% in the year), GDP decelerated in that year to 4.8%, still a strong growth rate relative to the region's average. Banco de Mexico (BOM) tightened monetary policy, with short-term interest rates increasing from 20% by end July 1998 to 31.2% by end December of the same year, but this did not avert a rapid pass-through to the price level of the nominal exchange rate depreciation. In effect, consumer prices increased by 18.6% in 1998, compared to the original target of 12%. B. Recent Performance 2. During the first quarter of 1999, external conditions improved with the increase in oil prices and the improvement in the maturity profile of part of the public sector's outstanding liabilities (stemming form the drawings on external contingency credit lines with international banks), as well as the new IMF Stand by Agreement of US$4.2 billion. Inflation and inflationary expectations, which increased significantly in the second half of 1998, regained their downward trend in 1999. Expected inflation for the year stands at close to the official 13% target. The balance of payments current account deficit is now estimated to be US$13 billion, or 2.8% of GDP, largely financed with foreign direct investment. Nevertheless, international capital markets continue to view Mexico with caution. As a result, international yield spreads on Mexican bonds remain well above their level before the Asian crisis, constraining credit to the private sector. Partly due to the reduced access to international credit markets, but also due to the impact on aggregate domestic demand of the fiscal and monetary tightening mentioned earlier, a further 1  slowdown in economic activity was registered in the first half of 1999, with a 3.4% GDP growth rate anticipated for 1999 as a whole. Nevertheless, in the second half of 1999, Mexico financial markets have calmed down, as the exchange rate has strengthened, appreciating from 10.6 pesos per dollar in January to a range of 9.2 - 9.5 pesos per dollar recently. Short term interest rates have decreased from 32% at the beginning of the year to 20% in April and around 18% in October, and the stock exchange index has risen by 48% in the year. This, together with an improved external liquidity situation, a sharp rebound in oil prices, and higher demand for non-oil exports (reflecting the strength of the US economy), has led to a recovery in domestic demand and output. 3. The financial sector, hit hard by the 1994-95 crisis, has stabilized, but remains undercapitalized, with non-performing and restructured loans still high. Credit growth to the private sector in real terms has remained negative since 19951 (see Figure 1), posing a threat to the sustainability of Mexico's economic recovery and contributing to the increasing duality of the economy. Real Credit to the Private Sector 200,000_ I 90,000 - . _ 180,000 o 170,000 . _ .__ 1 60,000 - 150,000 140,000 2r c-.2 CO- C-- V-- C--- C: 0 5 5 05 5 0 ! I I f ' l l l l l l ] l II x 5, . 5 -~ C; G -n - 5, - _C 0 5, Cl U- - 05 0r5 ST 05 - ,n -5 05 0 5 0 D ate 4. The lingering problems of the banking sector date back to the unresolved problems of the peso crisis of 1994-95. The support measures implemented by the Government to help the banks were successful in averting a systemic crisis and a run on the banks. However, lack of an adequate legal framework limited, to certain extent, the ability of the Government to address the needed structural reforms and the effective resolution of the problem banks. Between June 1998 and June 1999, outstanding credit to the private sector dropped by 18.55% in real terms, bringing the level of lending to that of a decade before. 2  5. The approval, in December 1998, of a law establishing the Banks Savings Protection Institute (IPAB), puts into effect a gradual phase-out of the universal deposit insurance and provides the framework and the incentives for a more effective resolution of the problem banks, in a way that was not possible before. As the authorities embark into a more effective bank restructuring program, they are also launching a major program of regulatory reforms to bring prudential norms and accounting and disclosure standards much closer to international best practice. The Government has also prepared for Congressional consideration legal reforns on secured lending and bankruptcy processes which, if approved, should have a major positive impact on contract enforcement and willingness to pay in Mexico. 11. THE BANKING CRISIS CONTAINMENT POLICIES OF 1995-19982. 6. Between mid-December 1994 and the end of the first quarter of 1995, Mexico's banking system suffered a major systemic, solvency and liquidity crisis, triggered by the massive (100%) devaluation of the peso. To contain the crisis, the Government implemented a number of support measures aimed at helping banks, as well as bank debtors and depositors. A. Banking Sector Structural Weaknesses Prior to the 1994-95 Crisis 7. Many of the root causes of the 1994-95 banking crisis can be traced to policy mistakes of the 1980s and early 1990s. In 1982, Mexico nationalized 58 of the 60 commercial banks then in operation, initiating a process of consolidation into fewer banks (see the current banking sector structure in Annex II). The newly transformed public banks increasingly became a source of financing for the rising public sector deficit, while the share of bank credit to the private sector in total bank credit declined from about 40% of GDP in 1980-81 to 25% of GDP in 1986. Misguided policies (exchange controls, interest rate controls, high reserve requirements and forced lending to the government) had the effect of substituting the credit judgments of the government for that of commercial banks. Starting in 1988, and coinciding with the improvement in Government finances, the authorities initiated a process of financial liberalization, freeing interest rates, reducing drastically legal reserve requirements3, and, starting in 1991, re- privatizing the banks. The process of bank re-privatization ended in mid-1992. Banks were sold to the domestic private sector (no foreign entry was allowed), at (ex-post) very high prices, 2.2 to 3.1 times book value, generating about US$12.5 billion for the Government. It can be argued that the way the banks were re-privatized planted the seeds of the 1994-95 crisis. 2 This section is based on several financial sector reports prepared by Fernando Montes-Negret, Sector Leader, FPSI, Mexico Department. 3 The speed of financial sector liberalization was one of the major proximate causes explaining the fall of the savings rate of the Mexican private sector (see 1997 CEM). 3  8. Poorly managed and weak banks. During the ten years that commercial banks were in public hands, they progressively lost their lending and risk-assessment skills and a large number of their most qualified personnel. Banks systematically under-invested in modernizing their information technology, in training staff, and in developing measurement and risk control systems, making them ill-prepared for the liberalization and privatization that followed. The re-privatization process was carried out without due diligence to identify the already poor quality of the banks' loan portfolios, and lack of control over the origin of funds amassed by the buyers. Equally damaging was the fact that during the re-privatization of the banks, the regulatory and supervisory functions were weak and the accounting system was opaque. Lack of transparency and disclosure meant that directors did not have the right incentives to take the ultimate responsibility for the management of risks, and blunted market discipline. 9. In spite of being ill prepared to understand and control their risks, starting in 1992 the re-privatized banks went into a lending-spree, which previously credit-rationed borrowers were eager to take. The banks' loan portfolios grew during those years (1992- 94) at an average annual rate close to 24% in real terms, or more than eight times the rate of growth of the Mexican economy. Many banks funded their expanding lending with expensive and volatile inter-bank deposits, and through short-term lines of credit from foreign banks. The outcome was that in 1994 total average bank assets had risen to close to 60% of GDP from 42% only a few years earlier (1991). Consumers and corporations over-borrowed to finance consumption and investment, reaching gearing ratios and exposures to interest and foreign exchange risks that made them very vulnerable to the contraction that followed, amplifying and exacerbating the crisis. 10. The relative overvaluation of the exchange rate of the Mexican peso during the years preceding the banking crisis led to a rapid increase in the relative prices of non- tradable goods and to significant asset price inflation, particularly in real state4 and traded securities. By the end of 1994, housing loans had reached 16.5% of the banks' total outstanding loans, and an important share of commercial credits had real state as collateral. During 1994, real estate prices dropped and past due loans increased considerably. As early as September of that year, the Government had to intervene two banks and three more were under a special program of close supervision. 11. Weak regulatory and supervisory environment. Before 1995, poor organization and management of the banks--particularly of the credit function, combined with deficient prudential norms, and the limited enforcement capabilities of the then Comisi6n Nacional Bancaria (CNB, before its merger with the Securities Commission) compounded the problem. Accounting guidelines for financial institutions varied not only from Mexican GAAP rules for other Mexican corporations, but had major 4 Real estate prices in Mexico City grew by a factor of 17 between the fourth quarter of 1987 and the fourth quarter of 1994, or at a rate of 50.6% per year. 4  differences with US-GAAP, making it very difficult to know the true financial condition of the Mexican banks. 12. Government Deposit Guarantee. Banking system unsoundness prior to the crisis was also exacerbated by the implicit guarantee provided by the Mexican Government to all bank liabilities, including inter-bank deposits. For decades, the Federal Government had, in practice, granted full protection to bank depositors and most creditors (excluding only those holding subordinated debt). In case of bank insolvency, the Federal Government had traditionally allocated public funds either to take control of the institution or to pay all the liabilities of the bank. In 1986, the Government created the Fondo de Apoyo Preventivo a las Instituciones de Banca Mtdtiple, which operated during the time the commercial baking system was government-owned. In 1990, the Fondo Bancario de Proteccion al Ahorro (FOBAPROA) was created to carry out preventive operations aimed at avoiding financial problems in banking institutions. 13. This universal, implicit deposit guarantee contributed to moral hazard by bank shareholders, managers and depositors, who acted as if they would be fully protected. Excessive risk taking by the newly privatized banks resulted in rapid and imprudent growth in lending. When the crisis began in late-1994, banks were ill equipped to confront the impact that the rapid depreciation of the peso, high interest rates, and economic downturn had on their loan portfolios. The new conditions made it difficult for banks to fund existing portfolios, and for borrowers to honor loan payments. 14. Weak judicialframework. At the end of 1994 and in 1995, when debtors started defaulting on their loans, banks had little protection, since in Mexico there are few consequences if debtors refuse to pay. Mexican bankruptcy legislation, which dates to 1943, is imprecise, cumbersome, and subject to long delays, while leading to inconsistent interpretations by the judges. The system for pledging movable assets does not function, because the laws governing enforcement and collection are unclear and offer excessive protection to debtors. Lack of legal clarity allows the courts frequently to decide on the side of the debtor, particularly in cases of residential evictions. Since judicial cases to repossess collateral may take from three to seven years5, and the outcome is uncertain, many banks opt for out of court settlements, and in many cases only collect on a fraction of their loans plus interests after expenses. B. The Government's Response to the 1994-95 Crisis 15. When the crisis stroke at the end of 1994, banks, households, and corporations were extremely vulnerable, since all had been betting on fast, continuous growth, lower real interest rates and a stable currency. However a current account deficit of 8% of GDP in 1993 and in 1994, heavily funded with short-term capital inflows (portfolio 5A recent survey among large commercial banks indicates that it takes about 5 years for a bank to repossess and sell a house mortgaged as collateral for a housing loan. The bank recovers, on average, about one third of the value of the original loan (after expenses). 5  investments), combined with rapid monetary expansion and a relatively over-valued exchange rate (a policy tool to reduce inflation), proved not to be sustainable. Foreign exchange reserves rapidly dwindled, falling by US$ 10 billion prior to the widening of the foreign exchange band in December 1994. The announcement in mid-December 1994 of a 15% devaluation of the Mexican peso precipitated massive capital flight6 that forced the floating of the peso, which depreciated by almost 100% in the first quarter of 1995. 16. The immediate impact of the crisis on the banking system took the form of a severe dollar liquidity squeeze, particularly in January 1995, as banks were unable to roll over foreign currency denominated certificates of deposit and short-term lines of credit. In addition, banks suffered immediate losses on their uncovered exposures in foreign exchange. Interest rates increased by a factor of more than five between mid-December, 1994 and March 1995 (jumping from 20% to 110% in the inter-bank market), leading to large bank losses in the fixed interest instruments they held. Banks' financial positions were badly damaged, as they were exposed to large term transformation (liquidity) and interest rate risks on account of the wide gaps between the maturity of their loans and the short-term funding, and the rapidly increasing cost of funding. 17. These shocks made most bank borrowers insolvent, unable to service and repay their debts which, together with high contagion risk fostered by a general fall in confidence, threatened a systemic crisis in the Mexican banking system. From mid-1995 non-performing loans (NPLs) increased dramatically -even with the deficient accounting and loan classification standards being followed- forcing significant increases in loan loss provisions (partly explained by new provisioning requirements)7. The latter was reflected in bank losses and reductions in the capital to risk weighted asset ratio. 18. To avoid a financial meltdown, the Government responded with a number of measures that included an adjustment program with US$50 billion in financial support from multilateral institutions (mainly the IMF with US$17.8 billion and the World Bank with a US$1.0 billion loans), and the US Treasury. The banking sector-related measures implemente.d by the Government included: (a) reform of banking regulation; (b) support programs for the banks and their borrowers; and (c) the reaffirmation of the universal guarantee on bank liabilities (including inter-bank deposits, but excluding subordinated debts). The remainder of this section discusses the first two groups of measures in greater detail. Reform of Banking Regulation and Supervision 19. Towards the end of 1994, significant regulatory changes started to take place. The supervision methodology and processes were importantly improved by the adoption 6 Foreign exchange reserves losses amounted to US$4 billion in two days: December 20-21 7NPLs (Mexican definition) doubled from 4% to 8% of total loans from 1991 to 1994. 6  of the MACROS system, which is similar to the US CAMEL'. In 1995, the financial market's regulatory authorities were consolidated in a single entity, the National Banking and Securities Commission (CNBV)9. The CNBV issued regulations establishing higher requirements for provisions, equal to the highest total between 60% of past-due loans (PDL) and 4% of the bank's total loan portfolio. Compliance with these new rules implied building up M$16.6 billion of additional provisions, an increase of 27% of the banks' net equity and 50% of existing loan-loss reserves. 20. In January 1997, the CNBV issued a new set of accounting and prudential rules affecting the valuation of the banks' investment portfolios, the treatment of non- performing loans, interest accrual rules, and the treatment of inflation for accounting purposes. These changes represented a major improvement towards international standards. Under the new standards, banks were required to prepare and present consolidated financial statements to the CNBV (after January 1, 1998). Restructured loans had to remain in non-performing status until at least three payments had been made and they were deemed current (restructured loans under Mexican Government support programs are considered performing loans). In addition, deferred taxes were included in the financial statements according to US GAAP. 21. TheI995-97 regulatory reforms did not address a number of aspects that are important for the level and quality of bank capital aspects that are being only dealt with recently, in the context of a new phase of regulatory reforms (see below). These aspects include: * Asset Classification and Provisioning. There was a tendency to emphasize collateral as the main criteria to classify loans regardless of the debtor's capacity to repay, while required provisioning percentages were set at levels below international standards'