Whither the Mexican Banking System? by Donald R. Fraser

Commercial banks in Mexico are currently experiencing significant financial difficulties. The Wall Street Journal recently observed that the five largest Mexican banks reported (after adjustments to show the full effects of loan losses) a staggerin g loss of 4.5 billion pesos for the first quarter of 1995. Past-due loans as a percentage of total loans averaged over 7 percent in December 1994, and the percentage has undoubtedly increased substantially since then (this compares with an average for U.S . banks of under 2 percent.) These difficulties reflect the December 1994 devaluation of the Mexican peso and the subsequent explosion of interest rates, coupled with a sharp contraction in the domestic economy. Some institutions have already failed and others have received financial aid from the Mexican government. It seems likely that more banks will fail and others will require rescue from either the public or the private sector. But where is the Mexican banking system headed? What will be the structure of Mexican banking at the turn of the century? While there are no easy answers to these questions, a review of the recent evolution of Mexican banking provides some useful insights .   Recent Changes in the Mexican Banking System The last twenty years have witnessed great turmoil in Mexican banking (see table 1). The 1974 Law on Credit Institutions established a framework for commercial bank activities similar to the "universal banking" model. In the la tter, banking organizations have broad powers, including investment banking, other finance related functions, and even limited ability to hold equity interests in nonfinancial firms (this is also sometimes referred to as the "supermarket" model). The univ ersal banking model is dramatically different from the U.S. model, in which commercial banks are separated from investment banks and have restricted powers to engage in other finance-related activities. However, the banking structure of Mexico was changed dramatically in 1982 when commercial banks were nationalized. The Mexican banking system has been highly concentrated, with a small number of relatively large banks. The number of banks in Mexico totaled less than 150 when the Law on Credit Institutions was enacted. (Compare this to the more than 10,000 banks in th e United States). Mexico's total shrank to 60 at the time of the 1982 nationalization, and to 20 in 1990, when privatization began. While the number of banks may increase with the NAFTA reforms, it is likely that the Mexican banking system will remain hig hly concentrated.   Banking in Mexico after Nationalization Following the 1982 nationalization, the Mexican banking system was tightly controlled and regulated. Commercial banks were government owned and competition was limited. Foreign banks were excluded from the Mexican marketplace, except for Citibank, which w as grandfathered in the banking nationalization. This situation changed dramatically under the Salinas administration. Commercial banks were privatized and, shortly thereafter, Mexico signed the North American Free Trade Agreement (NAFTA) under which foreign banks gained limited ability to enter the Mex ican market. These two events, even without the peso devaluation, would have placed considerable strain on the banking system by contributing to shrinking profit margins and greater risk of banking instability.   Privatization The privatization procedures adopted by the Mexican government by themselves created the potential for distress in Mexican banking. The major banks were sold to the country's wealthy families at extraordinarily high premiums (2 to 4 times book value compa red with a U.S. average for bank mergers of about 1.5 times). Such a rich purchase price premium required rapid revenue growth from ballooning loan portfolios to provide an acceptable return. At the same time, loan loss reserves were kept low in order to generate higher profits. Even before the peso crisis, Mexican banks were experiencing loan loss problems and they were relatively ill-equipped to deal with those problems. The peso crisis merely intensified an already serious problem.   NAFTA NAFTA also provides the potential for significant change in Mexican banking. NAFTA originally provided for a six-year transition period during which U.S. or Canadian financial institutions could acquire an existing Mexican bank or enter the Mexican market through a de novo subsidiary. (It is interesting and important to note that NAFTA did not allow for U.S. or Canadian banks to establish branches in Mexico.) However, a U.S. or Canadian bank could not acquire a Mexican bank if this left the foreign entity with control of more than 1.5 percent of the total capital of all Mexican banks. Effectively, this provision limited acquisitions to only two banks. Even after the end of the six-year transition period, foreign entities were not to be permi tted to control more than 4 percent of the total capital of all Mexican banks, a limitation that would leave off-limits the six largest Mexican banks, which control 70 percent of the assets of the entire Mexican banking system. Under NAFTA, Mexico granted formal permission to fifty-two foreign banks, brokerage houses, and other financial firms to enter Mexico.   The Peso Devaluation The evolution in Mexican banking associated with privatization and NAFTA became a revolution with the peso devaluation in December 1994. Indeed, the financial viability of the entire Mexican banking system was put at risk. Those Mexican banks that had dol lar-denominated liabilities found that the principal amounts had increased with the decline in the value of the peso. But even for those banks in which exchange rate risk was relatively minor, other effects of the peso devaluation were felt: Interest rates skyrocketed, which caused the costs of funding their asset portfolios to jump dramatically. This was a particular problem for banks with very short-term liabilities. The already low credit quality of the loan portfolio deteriorated further following the devaluation. The combination of high interest rates (borrowing rates between 40 and 50 percent) and the deteriorating economy contributed to rising numbers of bad loans. Many banks were forced to reschedule significant numbers of their loans, lengthening maturitie s and thereby lowering payment pressures on borrowers. In many instances, these actions postpone rather than solve basic problems. Facing this eventuality, Mexican banks began to recognize their bad loans. For example, Grupo Financiero Serfin established a one billion peso reserve against bad loans. The Mexican government moved aggressively to contain these banking problems. It created a "good bank" bailout fund, the Program for Temporary Capitalization (Procapte), which can be used to recapitalize those banks judged to be salvageable, and a "bad ban k" fund (Fobaproa), which is used to take over banks that appear to be beyond help. The "bad bank" fund has already been used to take over one of the largest banks in the nation.   Recent Changes in the Mexican Banking System The financial distress in the Mexican banking system has forced a significant change in the regulations governing foreign financial firms' entry into Mexico. A revision to Mexican banking law, effective February 16, 1995, reduced market share limitations on foreign banks from the U.S. and Canada. Those banks may expand their Mexican operations up to 6 percent of the total capital of all Mexican banks, and NAFTA banks may control, in total, up to 25 percent of Mexican bank capital. Under these new rules, o nly the three largest Mexican banks would be off-limits. Despite current financial problems, these changes make entry by foreign institutions more likely. For example, G.E. Capital Corporation, a subsidiary of the General Electric Company, has acquired a 13 percent interest in Grupo Financiero Serfin. Perhaps m ore significantly, Banco Bilbao Vizcaya, a Spanish bank, became the first foreign financial institution to control a Mexican bank under these new regulations when it acquired in late May a 70 percent stake in Grupo Financiero Probursa. Changes in banking systems are prompted by economic crisis. The depth and duration of the current Mexican economic crisis will determine the extent of the changes in Mexican banking. It is not impossible to visualize a total collapse of the Mexican bankin g system, which would force massive government intervention and reorganization of the financial system. A more likely scenario is a serious but manageable economic problem, one that leads to financial distress and failure, but is containable. In that envi ronment, consolidation of the Mexican banking system would occur through forced mergers (often under government supervision) and foreign entry would become more significant. Acquisitions of weaker banks by those still in reasonably good financial health a lso would be likely under this scenario.   The Lessons of the Texas Banking Crisis of the 1980s The recent experience of Texas banking is perhaps relevant in understanding the outlook for Mexican banking. The Texas economy deteriorated significantly in the mid-1980s as a result of the "oil bust." This economic decline produced a collapse of the bank ing system. The Texas legislature responded to the banking crisis by, for the first time, allowing out-of-state banking organizations to acquire Texas banks. All of the largest Texas banks either failed or were acquired by out-of-state organizations. The net result was a smaller number of banks, a more consolidated banking system, and greater participation by "foreign" banks. In this process, government played a major role and offered significant subsidies to new investors to induce them to enter the industry. Among the lessons that come out of the Texas banking crisis of the 1980s, two in particular seem relevant: 1) Government played a major role in restructuring the banking system. It protected buyers of failed banks from inherited loan losses and potential future litigation and, in many cases, provided significant tax benefits to those willing to in ject capital into the banking system. In some cases, agencies of the U.S. government even provided a guaranteed return on the "bad" assets taken over from the failed institutions. The Texas experience provides evidence that even strong banks are unwilling to take the risk of bailing out floundering institutions without some assistance from government and some assurances that their maximum risk is contained. 2) Conservatively managed banks survived and were able to increase their market shares. These banks frequently found it easier to attract both deposit and loan customers in this turbulent economic environment. While the parallels with Mexico are only partial, this recent Texas experience does appear to provide some useful insights. Dr. Donald R. Fraser is the Hugh Roy Collen Professor of Business Administration and Aston/Republic Bank Professor of Finance at Texas A&M University.