Experiments in Financial Liberalization

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F E D ER A L R E S E R V E B A N K O F S T. L O U I S REVIEW S E P T E M B E R/O C T O B E R 2007 415

Experiments in Financial Liberalization:

The Mexican Banking SectorRubn Hernndez-Murillo

Since the liberalization of its trade in the mid-1980s, Mexico has pursued an aggressive globaliza-tion strategy, which today makes it the country with the most free trade agreements in the world.This liberalization strategy has also included the banking sector, particularly since 1997, when allrestrictions to the entry of foreign banks were removed. The history of the banking sector in Mexicoincludes episodes of nationalization in 1982, privatization in 1992, and near-complete failure in1995. Since then, however, the Mexican government has undertaken a series of bold reforms thathave contributed to the modernization of its financial system. This paper documents the evolutionof Mexicos banking sector starting from its nationalization in 1982 and culminating with the

increased entry of foreign banks in recent years that has driven the recovery of bank credit to theprivate sector. (JEL G18, G21, G28, P11, D23)

Federal Reserve Bank of St. Louis Review, September/October 2007, 89(5), pp. 415-32.

development of its banking sector and limited thegrowth of financial credit to the private sector,which is necessary for economic development.

Second, given the nature of some of theexperiments that have been followed, Mexicos

experience can also provide lessons about theeffectiveness of aggressive openness reforms tar-geted at improving competition in the bankingindustry and at increasing credit to the privatesectornamely, the elimination of all restrictionson foreign ownership of banking assets in 1997,which allowed foreign banks to dominate the sec-tor. One of the most recent developments in thisregard is the approval in 2006 of Wal-Marts bidto create a commercial bank in Mexico.

In this paper I describe the evolution ofMexicos banking sector by reviewing (roughly

in chronological order) the reforms that havebeen implemented since 1982, when Mexicosfinancial system was nationalized. Continuingproblems with Mexicos institutional and legalframework persisted even after the banking sector

In the mid-1980s Mexico started to liberal-ize its trade; and, since the signing of theNorth American Free Trade Agreement(NAFTA) in early 1994, Mexico has fol-

lowed an aggressive globalization strategy, plac-

ing about 90 percent of its trade flows under freetrade agreements with over 40 countries. Thesepolices have made Mexico the country withthe most free trade agreements in the world.1

Mexicos liberalization strategy has also includedits financial sector and, in particular, the bankingindustry.

Mexicos experience with financial liberaliza-tion provides an interesting case study for at leasttwo reasons. First, economic theory suggests thatfinancial liberalization bolsters economic growth.Mexicos path toward financial liberalization has

been an arduous one and includes several failedattempts, which, until recently, prevented the

1 At the time of this writing, Mexico was negotiating a free tradeagreement with Mercosurto join this bloc as an associate member.

Rubn Hernndez-Murillo is a senior economist at the Federal Reserve Bank of St. Louis. The author thanks Gabriel Cuadra at Banco deMexico for help in obtaining the data used for the figures. Marcela Williams and Christopher Martinek provided research assistance.

2007, The Federal Reserve Bank of St. Louis. Articles may be reprinted, reproduced, published, distributed, displayed, and transmitted intheir entirety if copyright notice, author name(s), and full citation are included. Abstracts, synopses, and other derivative works may be madeonly with prior written permission of the Federal Reserve Bank of St. Louis.


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was re-privatized in 1992 and generated distortedincentives among lenders who engaged in riskylending practices. These practices ultimately ledto a banking crisis by 1995, forcing the Mexicangovernment to implement a massive rescue pro-gram to prevent generalized failure in the sector.

Since 1997, however, the Mexican govern-ment has undertaken a series of bold reforms: forexample, extensive reforms to banks accountingstandards, elimination of all barriers to the entry

of foreign banks, reforms to personal and businessbankruptcy laws, improvements in credit ratingtechnology and regulatory changes to promotethe use of credit bureaus, reforms to capitalizationand risk management standards that conform withthe recommendations of the Basel II accords, and,more recently, reforms that promote the securiti-zation of mortgage loans. By the end of 2006,banks in Mexico were owned almost entirely byforeign financial institutions, with subsidiaries of

foreign banks representing more than 80 percentof total banking assets in the system.

These reforms have started to produce posi-tive results and promise even more favorablechanges in the years ahead. The most positiveresult thus far is that the credit crunch that fol-lowed the banking crisis of 1995 appears tohave subsided; and bank credit to the privatesector has been growing rapidly since 2004. (SeeFigure 1.)

NATIONALIZATION OF THEBANKING SYSTEM, 1982

At the end of the administration of PresidentLpez Portillo, in 1982, Mexico experienced itsmost severe crisis since 1932, with real grossdomestic product (GDP) declining by 4.7 percentin the fourth quarter of 1982. (See Figure 2.) Thecrisis was triggered by adverse shocks to oil prices

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Figure 1

Credit by Commercial Banks

SOURCE: Banco de Mxico.


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and world interest rates, but was ultimately causedby a disorderly expansionary fiscal policy largelysupported by borrowing from international capitalmarkets and by borrowing from the central bank(i.e., simply printing money to finance the deficit),which the government had followed since the1970s. The government devalued the currencyand defaulted on foreign debt payments, whichcaused Mexico to lose access to international

credit markets.In September 1982, the government also

announced a decree to amend the constitutionand nationalize 58 of the 60 banks in the sector.The exceptions were Citibank, which has had apresence in Mexico since 1929, and Banco Obrero,which was owned by a labor union.2

During the new administration of PresidentMiguel de la Madrid Hurtado, the banking systemwas consolidated into a smaller number of banks,

but remained heavily regulated otherwise. Thenumber of commercial banks was reduced to 29in 1983, to 20 in 1985, and finally to 18 in 1988.

In the early 1980s, the banking sector was thedominant financial intermediary and, along withthe stock market, it constituted the core of thefinancial system. However, its role was diminishedthroughout the nationalization episode as thegovernment restricted universal banking activities,

prohibiting banks from forming integrated finan-cial groups to offer other financial services beyondbanking; consequently, other types of financialintermediaries began to take on more importantroles.3 Private investors turned to alternativesources of financing, such as commercial paper,

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Figure 2

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2 See Bubel and Skelton (2002).

3 With the re-privatization of the banking sector in 1992, bankswould again operate under a universal banking structure.


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further reducing the role of banks as financialintermediaries.

From 1982 to 1984, for example, brokerage

firms essentially controlled the sale and purchaseof financial instruments, which included com-mercial paper and bonds.4 Although short-termMexican Treasury bills had been introduced since1978, the interest rate on these instruments wasset exogenously. This policy limited the extentof their use to finance the public deficit. In 1982,however, a new auction mechanism was devel-oped for their exchange, allowing the market todetermine the rate of return.5

In 1984, the new administration began to selloff bank operations that did not take deposits andmake loans. The goal was to separate differentfinancial intermediation roles among independenttypes of operations to allow private investors(often former bank owners) to form and operatestock brokerage firms, insurance and re-insurancefirms, and currency exchange firms.6

After being excluded from internationalcredit markets, from 1982 to 1988, the Mexicangovernment turned to domestic credit to financeits fiscal deficits, imposing heavy reserve require-ments on the newly nationalized banks. As a

result, bank lending to the private sector declineddramatically.7 The government also imposedmany other constraints on the banking sector,which induced lending inefficiencies, includinginterest rate ceilings on bank deposits and loans,as well as mandated lending quotas on high-priority economic sectors.8

Commercial banks could freely allocate onlyup to 25 percent of their credit, for which theycould charge market lending rates; but they wererequired to allocate all other loans to the federalgovernment or to targeted sectors of the economy.

Furthermore, until 1989, the government alsocontrolled banks operational procedures, suchas deciding on the location and number of bank

branches that could be created and the numberof employees that were hired and approving thebanks annual budgets for income and expenses.

FINANCIAL LIBERALIZATIONREFORMS, 1988-89

Starting in 1988, a new series of reforms wereinitiated to make the financial system more com-petitive. Among these reforms was the elimina-tion in April 1989 of controls on interest rates andthe sectoral quotas imposed by the governmenton commercial lending. The reserve requirementson private deposits were eliminated in 1991.

These reforms culminated with the re-privatiza-tion of the banking sector in 1991 and 1992 underthe administration of President Carlos Salinas deGortari.

By this time, the Mexican money market hadbecome more liquid and the government increasedthe issuance of short-term Treasury bills so thatit no longer relied on commercial bank financing.9

Mexico had also regained entry to internationalcapital markets by 1989 after the implementationof the Brady Plan and enactment of a stabilization

plan (begun in 1987).10

Bank credit to the privatesector began to increase dramatically after 1989.11

Development banks, that is, state-controlledbanks charged with providing credit to privateand state-owned enterprises in targeted sectorsin the economy, also changed significantly. Theshare of loans allocated to state-owned firmsdecreased and loans were increasingly allocatedto private enterprises. At the same time, however,total development bank credit to nonfinancialfirms in the private sector decreased as the regu-lations on commercial banking were removed.12

During this period, the regulatory frameworkof the financial system was updated and new laws

4 See Trigueros (1995).

5 See Katz (1990).

6 See Gruben and McComb (1997).


8 See Gelos and Werner (2002).

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10 The Brady Plan, named after U.S. Treasury Secretary NicholasBrady, was the mechanism used to restructure bonds issued bymany Latin American countries that defaulted on their debt in the1980s. Mexico was the first country to repay its Brady debt, in 2003.

11 See Gelos and Werner (2002).

12 See Gonzalez-Anaya and Marrufo (2001).


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were drafted to regulate commercial banks andinsurance and bonding companies, as well as thestock market and investment banks. In 1990, the

Salinas administration created a new depositinsurance authority, FOBAPROA (Banking Fundfor the Protection of Savings).

In July 1990, the government passed lawsallowing for the formation of integrated financialgroups that could consolidate different types offinancial intermediation under a scheme of univer-sal banking. The law allowed for the integration ofbanks with leasing, factoring, currency exchange,mutual fund management, and asset-based ware-housing firms; and, separately, it allowed for the

integration of brokerage firms with leasing, factor-ing, currency exchange, mutual fund management,and asset-based warehousing firms.13 The finalgroup allowed was holding companies.14 Initially,however, restrictions remained for the integrationof commercial banks with brokerage firms andinsurance and bonding firms.15

THE PRIVATIZATION OF THEBANKING SECTOR, 1990-92

The privatization of commercial banks waspart of a broad program of privatization of state-run enterprises under a general stabilization pro-gram that included increased fiscal disciplineand cuts in government spending, as well asinflation-reduction measures initiated by the dela Madrid administration. The constitutionalamendment allowing for the re-privatization ofthe banking sector was announced in May 1990.In August of that year, the finance ministryannounced the principles that would inspire the

privatization process. Two of the goals of the pro-gram were to increase competition and efficiencyin the financial system and to improve bankcapitalization.

The government took great efforts to guaran-tee transparency of the process; they indicatedthat the sale price of the banks would be consis-

tent with valuations based on objective criteria.But the results of these valuations, however, werenot made public, and the overvaluation of somebanks became obvious after the purchase wascompleted.

Some studies underscore several problemswith the financing schemes that buyers adoptedto purchase these banks from the government,which in some cases included borrowing from thesame banks they were buying.16 These studiesseem to agree that the privatization auctions were

designed to maximize the purchase price of thebanks.The auctions were conducted from June 1991

through July 1992. Interested parties were allowedto acquire the controlling shares of only one bank,and the privatization was open only to Mexicannationals. There were six rounds of bidding.Packages of three or four banks were sold in eachround. The sequencing of the sale was designedto increase competition in subsequent stages ofthe bidding process. The largest banks were soldin the first rounds. Interestingly, the government

provided no minimum bid or reserve priceinformation.17 At the end of the process, bankswere sold at an average price-tobook value ratioof 3.04, producing about $12.4 billion for thegovernment.18

Some studies suggest that buyers paid thoseprices anticipating a concentrated market structurewith oligopolistic profits. In fact, of the existing18 banks, the 4 largest banks controlled 70 per-cent of total bank assets, and Mexican banks didnot face competition from the entry of foreign

banks, as they were not allowed to participate inthe privatization auctions.19

The lack of a competitive market structure inthe newly privatized banks was not the only prob-

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16 See Unal and Navarro (1999) and Haber (2005b).

17 See Avalos and Hernndez Trillo (2006).

18 The calculation of the average is weighted by assets. See Murillo(2002) and Unal and Navarro (1999).

19 See Haber (2005b,c).

13 Asset-based warehousing firms, or almacenes generales dedepsito, stored goods in exchange for certificates of deposit,which could be sold to other credit institutions. See Katz (1990).

14 See Unal and Navarro (1999).

15 See Katz (1990).


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lem. More fundamental problems plagued theinstitutional framework under which the bankswere to operate. From the outset of the new pri-

vatization era, bankers faced incentives that wouldencourage inefficient, risky lending.

Haber (2005b,c), for example, argues that atthe time of the privatization, Mexico had weakproperty rights institutions to assess the creditworthiness of borrowers and to enforce the con-tract rights of bankers. Furthermore, he also arguesthat out of the privatization process emerged aset of institutions that reduced the incentives ofbank directors, bank depositors, and bank regu-lators to enforce the prudent behavior of the newlyprivatized banks. Some of these institutions

would not be reformed until after the 1995 col-lapse. This view is shared by Unal and Navarro(1999), who argue that, despite the recent reforms,the new banks operated under an outdated regu-latory environment and that the supervisoryagencies were often unable to implement newlyadopted regulations or to enforce existing rules.

Efficient monitoring both internally and bythe government was also lacking. No regulatorybody required the banking sector to adhere tothe generally accepted accounting principles in

international markets. Accounting standardswere very lax and, in particular, did not requirebanks to report the entire value of past-due loansas nonperforming, but only the past-due interestpayments; banks were allowed to roll over theprincipal of those loans. Banks were not requiredto provide consolidated financial reports until1995, even though at this time they were operatingunder a universal banking structure.20 This lackof regulation made it difficult to establish limitson lending within financial groups. In addition,the Mexican central bank implicitly guaranteed

unlimited deposit insurance through FOBAPROA.There were no credit bureaus, and legal institu-tions in Mexico did not provide an adequateenforcement of lending contracts.

In contrast with the expectations of an oligop-olistic market structure, banks soon were compet-ing for market share.21 Credit was growing very

rapidly, and nonperforming loans soon became aproblem.

THE BANKING BAILOUT

Risky Lending Practices

The December 1994 devaluation and macro-economic crisis that ensued was not the origin ofthe banking crisis; it was merely the trigger.22

Induced by the lack of an appropriate legal andregulatory environment, banks had been engagedin risky lending practices almost immediatelyafter the privatization process was concludedand past-due loans had been rising dramaticallyprior to the devaluation.

Several factorsincluding low inflation,improvements in the fiscal surplus of the govern-ment, an exchange rate under a controlled rate ofdepreciation, and low real interest ratescon-tributed to an expansion of both bank credit andfinancial intermediation in general. The size ofthe financial sector, given by M4 as a share ofGDP, reached 47 percent at its peak in 1994.23

(See Figure 3.)From December 1988 to November 1994,

credit from local commercial banks to the privatesector rose in real terms by 277 percent, or 25 per-cent per year.24 Nonperforming loans, however,grew even faster. Between December 1991 andDecember 1993 alone, gross past-due loans morethan tripled in absolute terms, while the share ofreportednonperforming loans to total loans rosefrom 4.13 to 7.26 percent.25 This situation per-

20 See Gonzalez and Marrufo (2001).


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22 After a failed attempt of a controlled devaluation on December 20,1994, a run against the peso led to the collapse of the semi-fixedexchange rate regime and the peso was allowed to float onDecember 22, 1994. For a detailed account of the events and an

analysis of the factors contributing to the vulnerability of Mexicosfinancial sector, see Calvo and Mendoza (1996) and Gil-Daz (1998),and also Gruben and McComb (1997).

23 M4 is a broad monetary aggregate defined as M3 + deposits inbranches of domestic banks abroad, where M3 = M2 + domesticfinancial assets held by non-residents, M2 = M1 + domestic finan-cial assets held by residents, and M1 = currency outside of banks,domestic and foreign currency checking accounts in resident banks,domestic and foreign currency current account deposits in residentbanks, and sight deposits in savings and loan associations.

24 See Gil-Daz (1998).



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sisted into the bailout episode that followed.Haber (2005b) estimates that, as of December 1991,the ratio of nonperforming loans to total loans(including principal rollovers and the value ofloans transferred to FOBAPROA) was 13.5 per-cent; it increased to 17.1 percent by December1994, to 36.3 percent by December 1995, and to52.6 percent by December of 1996.

An example of risky lending behavior was

related lending, a topic studied by La Porta, Lpezde Silanes, and Zamarripa (2003). Related lendingrefers to the practice of lending to separate firmsin which bank officials have interests eitherbecause they own these other firms or their associ-ates or family members do. In their study, theauthors tracked a sample of loans outstanding atMexican banks from the end of 1995 through 1999.They found that about 20 percent of loans wereto related parties. They also found that these

parties were more likely to borrow at lower rates,were less likely to post collateral, and were morelikely to default than unrelated parties. Theauthors examined the regulations set forth afterthe 1990 privatization and noted that very fewrules addressed conflicts of interest arising fromlending to related parties. The authors identifiedother key factors, beyond regulation of conflict ofinterests, that provided incentives to engage in

risky lending policies: the universal guaranteesprovided by FOBAPROA (which guaranteed alldeposits up to 100 percent, regardless of thecreditworthiness of the bank and the total amountof deposits) and the minimal capitalizationrequirements imposed on the banks (which wereunrelated to the riskiness of the banks loan port-folio). So, because of the presence of deposit insur-ance, the lower a banks capital, the greater itsincentive was to take on additional risk because

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less of their own wealth was at stake.26 La Porta,Lpez de Silanes, and Zamarripa (2003) arguedthat banks engaged in excessive related lendingbecause of moral hazard: Legally, bank assetswere considered separate from the related firmsassets and regulatory authorities were insuringthese loans, too.27

The Rescue Program

The devaluation of December 1994 gener-

ated capital outflows and high inflation. RealGDP declined by 6.2 percent in 1995, while theannualized inflation rate reached 46.9 percentin December 1995. (See Figures 2 and 4, respec-tively.) The central bank imposed restrictive credit

and monetary policies in February 1995, andinterest rates skyrocketed. Many borrowers wereunable to repay their loans. The rising level ofpast-due loans had put the banking system at thebrink of total collapse.28

Three regulatory authorities intervened inthe design and implementation of the rescuepackage that started in 1995 and continuedthrough December 1998. The first was Mexicoscentral bank, Banco de Mxico. The second author-

ity was Mexicos finance ministry, Secretara deHacienda y Crdito Pblico, which is the mainfinancial authority in Mexico ultimately respon-sible for regulating and supervising the entirefinancial system. These tasks, however, are dele-gated to the third regulatory authority, the nationalbanking and securities commission, ComisinNacional Bancaria y de Valores, which regulates

26 See Furlong and Keeley (1989) and Keeley (1990).

27 For additional literature on the moral hazard problems generatedby deposit insurance institutions, see Demirg-Kunt andDetragiache (2002), Cull, Senbet, and Sorge (2005), and also Martin(2006), as well as references therein.

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28 See Gruben and McComb (1997) and McQuerry (1999).


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and supervises all financial intermediaries inMexico.29

The Mexican government adopted several

measures to prevent the collapse of the bankingsystem, including efforts to improve banksimmediate liquidity requirements following theDecember 1994 devaluation, measures to improvecapitalization, various debtor relief efforts, andultimately the transfer of nonperforming loansinto public debt, approved by the MexicanCongress in December 1998. The funding of theseprograms was channeled through the nationsbank deposits insurance institution, whose liabili-ties amounted to about $60 billion in February

1998 near the end of the rescue program and rep-resented almost five times the amount receivedby the government when banks were privatized.30

I now review some of the specific programsincluded in the rescue package that followed the1995 crisis.

Liquidity Window. After the December 1994devaluation, several banks were unable to rollover their dollar-denominated liabilities. During1995, the central bank offered short-term dollar-denominated credit through FOBAPROA so thatbanks could meet immediate dollar liabilities.The terms of these loans were designed so bankscould soon find alternative funding sources. Theprogram served its purpose, and all banks thatreceived these loans repayed them.

Initial Capitalization Program. In February1995, the government created a special short-termrecapitalization program that would allow banksto raise capital by selling 5-year convertiblebonds to FOBAPROA. The goal was to helpbanks increase their capital-to-assets ratio above8 percent while they tried to raise additional

capital on their own.31 The program includedreforms that removed restrictions on the waysbanks could increase capital. Banks were chargedhigher interbank interest rates and were prohib-

ited from issuing other subordinated debt untilthey exited the program. The program was notentirely successful, as many banks avoided par-

ticipation, motivated in part because the marketseemed to interpret participation as a sign ofweakness and imminent regulatory interventionby the authorities.32 Many banks tried to raisecapital on their own and failed to attain thecapitalization requirements.

Loans for Bonds Swaps. The core programin the rescue package had the goal of preventinggeneralized failure in the banking system. Withthis program, FOBAPROA initially acquired onlya portion of past-due loans from commercialbanks and acquired the rights to any paymentsthat could be recovered by the banks.33 Inexchange, banks had to purchase FOBAPROA-issued special 10-year non-negotiable bondsbacked by Mexicos central bank. Banks werealso required to raise new capital at the rate ofone peso for each two pesos of loans transferredto FOBAPROA. Additionally, FOBAPROA bondswere indexed in a new unit of account (referredto as UDI or Unidad de Inversin) created in1995, which was indexed to the inflation rate toguarantee the real value of funds. When the

maturities of these bonds were reached, bankswould be allowed to either roll over the debt orsell it. Mortgage loans were also included in therescue package.

Participating banks agreed to surrender theirinstitutions to banking authorities if they wereunable to convert their debt with FOBAPROAinto equity capital.34 Some banks were unable toraise additional capital, and FOBAPROA under-took further capitalization efforts to help thesebanks. These efforts allowed banks to continueto operate. When FOBAPROA determined that a

bank was no longer viable, the bank would beliquidated and its assets would be sold. Banksacquiring these assets would also take over thebanks liabilities, which were backed by matchingloans from FOBAPROA.

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29 Prior to 1995, the banking and securities commissions were twoseparate agencies.

30 See Hernndez Trillo and Lpez Escarpulli (2001).

31 This was the minimum capitalization ratio recommended by theBasel I accords.

32 See Mackey (1999).

33 Later, as past-due loans continued to rise, more loans were alsoincluded in the rescue package.

34 See McQuerry (1999).


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The national banking commission had theright to formally intervene in cases of irregularpractices, which ranged from failure to meet

reserve and capitalization requirements to illicitoperations and fraud: The authorities would takecontrol of the banks management and suspendstockholder privileges while the investigationswere ongoing. Meanwhile, FOBAPROA continuedto support these banks in their capitalizationefforts. By June 1998, the authorities had inter-vened in the operations of 12 banks. Two of these,Banca Cremi and Banco Unin, were under theauthorities control prior to the peso devaluation.Additionally, several banks, including BancaSerfn, Mexicos third largest bank, underwent

de facto intervention and were subjected to a morestrict supervisory process, which included manyof the controls used in a formal intervention.35

NAFTA and Foreign Banks. As part of therescue program, early in 1995, the governmentalso allowed foreign investors to purchase atroubled bank, if that bank accounted for no morethan 6 percent of total Mexican bank capital; butthese foreign entities were not allowed to startnew banks yet. This reform legalized the purchaseof all but the three largest banks.36 The new law

also raised the maximum amount of bankingcapital that could be controlled by foreign banksto 25 percent, compared with the previous limitof 9 percent initially allowed by NAFTA in 1994.

Debt Relief Programs. Throughout the 1995-98 banking bailout episode, there were severaldebt relief programs designed to provide supportto small borrowers (individually or in specificindustry sectors) and help them repay their bankloans. Some programs were financed by thegovernment and others involved negotiationsamong the banks and their borrowers. All these

programs were supervised by the national bank-ing commission.These programs included features such as

reduced interest rates, payment discounts, anddebt restructuring into the newly created inflation-indexed accounting unit with a fixed real interestrate. Debtors were responsible for repaying the

real interest rate, while the government coveredthe difference between the nominal and realinterest rates.

Mackey (1999) found that these debt reliefprograms succeeded in helping a large numberof small debtors repay their loans. The overallimpact on these programs on total past-due loanswas most probably minimal. However, Mackey(1999) argues that in designing these programs,the authorities were more interested in prevent-ing generalized runs against the banking systemcaused by lack of depositors trust.

POST-CRISIS FINANCIAL REFORMSSince 1995 the national banking commissionhas sought the advice of U.S. government agencies,such as the Federal Reserve and the Office of theComptroller of the Currency, as well as interna-tional organizations, such as the World Bank andthe International Monetary Fund, to improve itsregulatory practices (Mackey, 1999). The Mexicangovernment has also striven since 1997 to alignthese practices with international standards,particularly with regard to banking accountingstandards, capitalization requirements, and creditrisk qualifications; it has also enacted reformssince then to improve bankers incentives, includ-ing changes to FOBAPROA and reforms to bank-ruptcy and mortgage laws, as well as the promotionof private credit bureaus.

Bank Accounting Standards andSupervision Practices

New bank accounting standards in Mexicowere approved by the banking regulatory author-ity in December of 1995 and were adopted inJanuary 1997.37 The new criteria imposed greaterdisclosure on banks and made their balancesheets more directly comparable with those inother countries, particularly with regard to thedisclosure of nonperforming loans. The new rulesalso required consolidated balance sheets andincome statements for financial groups.



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37 See Mackey (1999), McQuerry and Espinosa (1998), and Delngel, Haber, and Musacchio (2006).


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As related earlier, one of the problems thatled to the banking crisis of 1995 was the lack ofstrict disclosure rules regarding nonperforming

loans. Banks calculated nonperforming loanswith a due payments criteria; that is, only loanpayments 90-days past due were recorded asnonperforming, as opposed to classifying as non-performing the value of the entire loan itself. Allthe while, the outstanding balance could stillaccrue interest. In addition, if loans were restruc-tured or renegotiated, the loan was reclassifiedas a new loan. As a result of these practices, abanks income statement and its capital adequacyratios did not reflect accurate information aboutthe banks financial health.38

Under the new laws, the value reported aspast due was now the total unpaid balance of theloan, and loans were listed as nonperformingafter a set number of payments went unpaid. Thenew criteria also required more strict provisionsfor loan losses, and interest could no longer beaccumulated.

The new laws also set stricter standards todeal with related lending. In particular, a bankwas required to inform the banking regulatoryauthority of all the details of a related loan, after

the loan was approved by a majority of the banksdirectors. Limits were also set on the total amountof loans made to related parties.39

In 1999, the banking authorities also estab-lished new rules for the assessment and measure-ment of risks; these rules were strengthened in2003 to conform with recommendations on capitaladequacy and contingency reserve requirementsfrom the Basel II accords.

Reforms to FOBAPROA

In December 1998, Mexicos deposit insuranceinstitution, FOBAPROA, was replaced by a newentity, the Institute for the Protection of BankSavings, or IPAB. This institution is now respon-sible for insuring bank deposits and managingbank support programs. It differs from FOBAPROAin several aspects and is more similar in design

to other international deposits insurance institu-tions, such as the Federal Deposit InsuranceCorporation in the United States. This new insti-

tution is designed to offer more protection tosmall depositors and allows larger depositors toface more risk. In particular, whereas FOBAPROAoffered implicitly unlimited guarantees ondeposits, IPAB offers limited guarantees explicitly.IPAB also has the authority to formally interveneif it detects irregularities in a member bank,although the authority of the national bankingcommission supersedes that of the IPAB.

In 2005, regulations established an upperbound on the total amount of insured depositsof 400,000 UDIs (about $100,000 at the then-prevailing exchange rate) per individual or busi-ness by bank.40 In general, the reason to limitdeposit-insurance coverage is to encourage deposi-tors with large balances to monitor bank behaviorand thereby establish a better link betweendeposit interest rates and balances and a banksrisk taking.

Bankruptcy Laws

Before the re-privatization, Mexican laws onbankruptcy and debt moratory dated back to 1943.A reform in 1988 created special bankruptcycourts to deal with business bankruptcies, whichfell within the purview of federal legislation;personal bankruptcies, in contrast, were legislatedat the state level and dealt with in state civilcourts. In spite of these reforms, bankruptcy casesin Mexico continued to be notoriously lengthyand complex, as the laws generally provided littleincentives for the repayment of debts. As a con-sequence, lenders often faced difficulties recover-ing assets from insolvent borrowers. In addition,

there were not enough such bankruptcy courts.Banks often settled negotiations with debtorsoutside of the courts, with great advantages tothe latter.41

On April 25, 2000, a new law was approvedby the lower house of the Mexican Congress thatwould replace existing bankruptcy laws for per-

Hernndez-Murillo




40 See Haber (2005a).



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sons and businesses. It seems, however, that thisnew law still falls short in terms of providingbanks with adequate repayment guarantees.42

Mortgage Markets

After the 1995 crisis, mortgage lending bycommercial banks plummeted along with totalprivate lending, and banks all but exited the hous-ing lending market. (See Figure 5.) New financialassociations with limited functions (known inMexico as SOFOLES) had been created in 1993to foster competition in the financial system; afterthe 1995 crisis, these non-bank financial inter-mediaries became important players in the low-income mortgage market.

These non-bank banks borrowed funds fromgovernment development banks as well as from

private commercial banks; in turn they gave loansto consumers to purchase homes and autos butwere initially prohibited from accepting depositsor investing in securities or derivatives.43

In recent years, the role of non-bank banks inproviding financing services to the private sectorhas increased remarkably. From 2000 to 2006 theshare of total loans to the private sector providedby non-bank banks increased from 6.3 percent to9.1 percent. In real terms, total loans by these

intermediaries grew by about 130 percent.44 ByDecember 2006, there were 56 non-bank banks.The largest share of total loans granted by theseinstitutions has been for private housing, reachingabout 42 percent by December 2006. The next-largest categories are loans to private industry

42 See Hernndez Trillo and Lpez Escarpulli (2001) and Avalos andHernndez (2006).

Hernndez-Murillo


0.0000.005

0.0100.015

0.020

0.0250.0300.035

0.0400.0450.050

0.055

0.0600.0650.070

0.075

0.0800.085

0.0900.0950.100

0.105

0.1100.1150.120

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006


Share of GDP

0.000

0.005

0.010

0.015

0.020

0.025

0.030

0.035

0.040

0.045

Share of GDP

Private Industry (left scale)

Private Housing (left scale)

Private Consumption (right scale)

Figure 5

Bank Credit to Private Sector


43 See Haber and Musacchio (2005).

44 Data through September 2006. Source: Secretara de Hacienda yCrdito Pblico.


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(37 percent) and for private consumption (18percent).45

Mortgage markets in Mexico are currently

undergoing a very remarkable transformation.From 2001 to 2006, the average compound annualgrowth rate of housing loans was 27.3 percent;in 2006, these loans amounted to about $79.6billion.46 Bank lending for private housing beganto increase in 2004. (See Figure 5.)

From 1995 to 2002, two government institu-tions provided most of the funding to non-bankbanks; since about 2003, however, mortgageorigination by non-bank banks and commercialbanks has been funded largely by other sources.47

Non-bank banks, investment banks, and the

Federal Mortgage Association had been pushingforward the securitization of mortgage-backedbonds to develop a secondary market, whichstarted in 2003, when the first mortgage-backedsecurity was issued for $178 million.48

In 2006, the first commercial bank enteredthis market. Also in 2006, a new unified propertyregistry began operations in Mexico. Its objectivehas been to concentrate records for all the existinghousing supply as well as new starts that can bepurchased with funding by private and publicmortgages lenders. By maintaining updated infor-

mation, which can be used by developers, lenders,and consumers, the registry is expected to helpimprove efficiency and boost the developmentof housing and mortgage markets.

In 2007, Mexicos Federal Mortgage Associa-tion, in association with the Netherlands Develop-ment Finance Company, created a new companycalled HiTo to provide a bridge between mortgagelending and the bond market by standardizingmortgage-backed securities into large pools, withthe goal of increasing liquidity and efficiency inthe market.49

Credit Bureaus

A credit bureau operated by the central bank

has existed in Mexico since 1964, but it was onlyfor business loans and was rarely used.50 From1993 to 1998, Mexican regulatory authorities laidthe framework for the existence of private creditbureaus, which was designed to improve the wayindividuals credit history information was col-lected.51 Additional laws to regulate the creditbureaus were passed in 2002 and 2004.

The goal of credit bureaus is to improve creditscreening and assessment of repayment capabili-ties of individuals and firms. Starting in 1998,the banking commission has required banks toestablish reserves for 100 percent of those loansin which borrowers are found to have poor or nocredit history.52

Since 1995, three firms have entered themarket; but today only one, Bur de Crdito,remains, and it now tracks the credit histories ofboth consumers and businesses.

Increased Participation of ForeignBanks

Some of the most remarkable developmentsthat followed the 1995 crisis were the reformsthat allowed for increased foreign ownership ofcommercial banks. Today, foreign participationhas essentially rebuilt the sector, improving capi-talization and the quality of bank assets and con-tributing to the accelerated decline of bad loans.Since 2004, foreign participation has helped toincrease bank credit in the economy. (See Figures1 and 5.)

In 1994, NAFTA allowed foreign-owned banksto operate in Mexico, although there remainedsevere restrictions on the market share that for-eign banks were allowed to control. NAFTA alsorestricted the equity share controlled by foreignnationals on Mexican banks. By 1994 there were35 banks in the system, and only 2 banks, which

Hernndez-Murillo


45 Source: Comisin Nacional Bancaria y de Valores.

46 See www.shf.gob.mx/files/pdf/Estrategia%202007-2013.pdf.

47 The first government mortgage institution is a trust for lower-income housing whose liabilities are funded by Mexicos centralbank, the World Bank, and other sources (see Pickering, 2000). Thesecond institution is the Federal Mortgage Association created in2001 to promote the development of a secondary mortgage market.

48 See Skelton (2006).

49 See The Economist(2007).


51 See Negrin (2001).



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Hernndez-Murillo


Table 1

Commercial Bank Assets as of December 2006

Bank name Assets (million pesos) Share of total Foreign control

All banks total 2,564,279.8 100.0

BBVA Bancomer 600,836.3 23.4 Yes

Banamex 538,881.1 21.0 Yes

Santander 402,075.2 15.7 Yes

HSBC 284,045.4 11.1 Yes

Mercantil del Norte 209,031.9 8.2 No

Scotiabank Inverlat 127,150.0 5.0 Yes

Inbursa 80,800.3 3.2 No

I.N.G. Bank 57,980.6 2.3 Yes

Del Bajo 46,131.4 1.8 No

Banco Azteca 44,088.5 1.7 No

J.P. Morgan 31,911.9 1.2 Yes

Bank of America 16,609.3 0.7 Yes

IXE 15,226.0 0.6 No

Interacciones 12,881.2 0.5 No

Afirme 11,438.6 0.5 No

American Express 10,707.5 0.4 Yes

Invex 10,345.7 0.4 No

Banregio 9,720.7 0.4 No

G.E. Capital 9,598.3 0.4 Yes

Mifel 7,581.5 0.3 No

BBVA Bancomer Servicios 5,982.1 0.2 Yes

Deutsche Bank 5,880.9 0.2 Yes

Ve por ms 4,890.2 0.2 No

Bans 4,264.5 0.2 No

Credit Suisse 3,614.5 0.1 Yes

Compartamos 3,283.8 0.1 No

A.B.N. Amro Bank 3,269.9 0.1 Yes

Barclays Bank 2,728.5 0.1 Yes

Tokio-Mitsubishi UFJ 2,402.4 0.1 Yes

Monex 569.7 0.0 NoAutofn 352.0 0.0 No

SOURCE: Assets are from Boletn Estadstico de Banca Mltiple, Comisin Nacional Bancaria y de Valores, December 2006,www.cnbv.gob.mx.


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provided retail lending, were controlled by foreignownership.53

By December 1996, only 7 percent of total

bank assets were controlled by foreign banks, butthis share increased to 11 percent by December1997 after all the restrictions were removed. ByDecember 1999, 20 percent of bank assets werecontrolled by foreign banks; by December 2004,83 percent of bank assets in Mexico were con-trolled by foreign banks.54 As of December 2006,foreign banks still controlled about 82 percent oftotal bank assets. (See Table 1.)

Haber and Musacchio (2005) argue that theentry of foreign banks has increased competitive

pressures, which have improved efficiency in thesector, even among those banks not controlled byforeign banks. They find that, while foreign entrybetween 1997 and 2004 improved the profitabilityof the sector, foreign banks were not more prof-itable, on average, than domestic banks, althoughforeign banks may have been initially better atscreening borrowers. Schulz (2004) has also foundthat increased entry of foreign banks has helpedimprove various measures of productivity in thesector.

The entry of foreign banks in the sector has

been instrumental to the recovery of bank credit,which had plunged after the 1994 devaluation.Total credit by commercial banks declined fromabout 40 percent of GDP in the fourth quarter of1994 to about 13 percent in the first quarter of2004. Similarly, bank credit to the private sectordeclined from about 37 percent of GDP in thefourth quarter of 1994 to about 9 percent in thefirst quarter of 2004. (See Figure 1.)

In contrast to total bank credit, credit for pri-vate consumption started recovering soon after

the bank rescue program was completed in 1999,reflecting in part an increase in the use of creditcards. Other types of bank credit to the privatesectorin particular, housing loanswould notbegin to recover until 2004. Bank credit to theprivate industry, however, still remains stagnantat about 2 percent of GDP. (See Figure 5.)

The recovery in private bank credit, driven byentry of foreign banks, has produced significantwelfare gains (in the form of lower net interest

margins) among Mexican consumers.55 The entryof foreign banks has also generated positiveeffects on banks productivity and capitalizationderived from the increase in foreign capital, andthe improvement in bank asset quality has helpedaccelerate the reduction of bad loans in the bank-ing system.56

FOBAPROA/IPAB bonds had begun to matureby the end of 2005 and are now being rolled overinto negotiable bonds, which will provide bankswith additional liquidity to lend to the privatesector. The cumulative effects of Mexicos reformsin the financial system, including the widespreadpresence of foreign banks in the sector, suggest thatthe recent reversal in bank credit will continue.57

WAL-MARTS BANK IN MEXICO

In November 2006, Wal-Marts subsidiary inMexico received approval to open a bank andbecame the second retail chain in Mexico to oper-ate a bank. The first, Grupo Elektra, has beenoperating a full-service bank, Banco Azteca, since

2002. In 2006, other retailers also applied for andreceived licenses to operate banks. The statedgoal of both Wal-Marts and Elektras banks is toprovide banking services to Mexicos low-incomeindividuals, who have traditionally faced barriersto loans from commercial banks or have chosennot to maintain checking or savings accountsbecause of steep maintenance fees. Elektra, whoseretail operations include mostly consumer elec-tronics and home appliances, for example, pro-vided consumer loans for about five decades

before creating a commercial bank.Wal-Mart entered the retail chain market inMexico in 1991 when the first Sams Club openedin December. In 1992, Wal-Mart started an alliancewith Grupo Cifra, which controlled a successfulchain of retail stores. In 1993, Wal-Marts first

Hernndez-Murillo


53 See Bubel and Skelton (2005) and also Haber (2005b).

54 See Haber (2005c) and also Haber and Musacchio (2005).

55 See Haber and Musacchio (2005).

56 See Schulz (2004).

57 See Bubel and Skelton (2005).


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Supercenter opened, and more companies (achain of restaurants and a chain of clothing stores)joined the alliance with Cifra. Wal-Mart quickly

gained market share and in 1997 bought a con-trolling stake in Grupo Cifra. By 2001, Wal-Martde Mxico controlled about half of all supermar-ket sales in the country. In 2006 alone, 120 storeswere opened and total sales reached about $18.3billion, an inflation-adjusted increase of 15.9percent over 2005 sales.58 Today, Wal-Mart isMexicos largest private employer, with 149,584employees; it owns 917 stores in 147 cities, whichinclude supermarkets, restaurants, and clothingstores.

Wal-Marts banking experiment is interesting

because of the regulatory environment it will facein Mexico. Gelpern (2007) notes that all otherforeign banks in Mexico, although established bylaw as wholly owned and separately capitalizedsubsidiaries, have parent institutions that arethemselves regulated and subject to supervision bytheir home country authorities. Given Wal-Martsfailed attempts to enter the banking sector in theUnited States, Wal-Marts bank in Mexico remainsits only banking venture in the world, and there-fore the Mexican authorities will have sole respon-sibility over its regulation and supervision, whileWal-Marts headquarters in the United States willremain outside of Mexican authorities regulatoryscope. Gelpern warns, however, that althoughthe banking license establishes limits to the tiesbetween Wal-Marts banking and retail businesses,Mexicos limited leverage over Wal-Mart activitiesoutside of Mexico puts Wal-Mart in a unique posi-tion to demand support from Mexican authorities.This, Gelpern argues, is because of Wal-Martsstrength in the retail sector, because no other for-eign bank has retail stores, and because other

retail chains with banks are currently owned byMexican nationals and therefore subject entirelyto Mexican laws.

Thus far, Wal-Marts strategy in entering thebanking sector appears to be similar to Elektras:first, approach customers who have traditionallyavoided the banking sector; afterwards, expand

to middle-income consumers. The effects ofWal-Marts entry on banking competition are yetto be seen. However, Wal-Marts entry into the

banking sector should provide for an interestingenvironment in the very immediate future: Despitethe improved conditions in the sector, Mexicanconsumers still face high fees for banking serv-ices, and Wal-Mart may extend its traditionallyaggressive low-pricing strategy to its bankingbusiness.

WHAT NEXT?

Apart from recent favorable developments in

Mexicos bank credit, at its core, the country stillfaces fundamental problems with its legal infra-structure. Property rights in Mexico were untilvery recently not well defined and in many casescontinue to be poorly enforced.59 Even today, itis difficult even to ascertain who owns a particu-lar asset (recall that a unified property registrywas not put in place until 2006); and, as a conse-quence, it is still difficult for banks to repossessassets given as collateral in a loan. Haber (2005c)argues that, as long as these institutional problemsare not resolved, they will continue to limit the

type of contracts that bankers can enforce. Habersview reflects the notion that the protection ofproperty rights has positive effects on long-runeconomic performance, a notion that is widelyrecognized by economists. (See, for example,Acemoglu and Robinson, 2000; Acemoglu,Johnson, and Robinson, 2002; and, more recently,Gradstein, 2007, among others.) It would seem,then, that Mexico stands to gain from continuingto foster the development of its banking sectorand, as a long-run goal for its overall develop-ment, modernize its legal infrastructure, espe-

cially contract enforcement and the definitionand defense of private property rights.

REFERENCES

Acemoglu, Daron; Johnson, Simon and Robinson,James A. Reversal of Fortune: Geography and

58 Source: sales and store counts from www.walmartmexico.com.mx;United StatesMexico exchange rate as of December 2006 fromresearch.stlouisfed.org/fred2/data/EXMXUS.txt.

Hernndez-Murillo


59 For an analysis of property rights in the Mexican Constitution,see also Katz (1998).


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Institutions in the Making of the Modern WorldDistribution. Quarterly Journal of Economics,November 2002, 117(4), pp. 1231-94.

Acemoglu, Daron and Robinson, James A. Why Didthe West Extend the Franchise? Democracy,Inequality, and Growth in Historical Perspective.Quarterly Journal of Economics, November 2000,115(4), pp. 1167-99.

Avalos, Marcos and Hernndez Trillo, Fausto.Competencia Bancaria en Mxico. NacionesUnidas. Comisin Econmica para Amrica Latina(CEPAL), November 2006, Serie Estudios yPerspectivas 62. Mxico.

Bubel, Robert V. and Skelton, Edward C. FinancialGlobalization: Manna or Menace? The Case ofMexican Banking. Federal Reserve Bank of DallasSouthwest Economy, January/February 2002, 9(1),pp. 17-19.

Bubel, Robert V. and Skelton, Edward C. MexicoEmerges from 10-Year Credit Slump. FederalReserve Bank of Dallas Southwest Economy,May/June 2005, 12(3), pp. 14-18.

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the Masses and the Home-Host Hole. ConnecticutLaw Review, May 2007, 39(4), pp. 1513-38.

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Hernndez-Murillo

Documents

Experiments in Financial Liberalization