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January l, 1997

Federal Reserve Bank of Cleveland

The Hidden Costs of
Mexican Banking Reform
by William P. Osterberg

Analyses of the Mexican financial
system in the wake of the 1994- 95 peso
crisis have generally focused on the fiscal costs ofrecapitalizing the nation's
banks and of satisfying bank claimants.
Seemingly missing from these reports
are the possible costs of the incentives
provided by banking reform. Such costs
might be reflected in the prices at which
Mexican banks attract funding or the
likelihood that taxpayers will have to
provide additional assistance.
Mexico's current economic conditions
imply an important role for banking policy in the recovery. Since the implementation of the February 1995 assistance
package, the U.S. government has been
paid back and Mexico has been able to
borrow again. However, as indicated in
figure 1, banks continue to face a heavy
burden of past-due loans. 1 While Mexican banking reforms and commitments
to overhaul the financial system have
been praised by analysts, the eventual
cost of these efforts could easily exceed
recent estimates. 2
Although the financial press has acknowledged that higher interest rates
increase total costs (by affecting debtors'
ability to roll over debts), specific banking reform packages may have additional costs if they create expectations of
future government aid. Furthermore, if
monetary policy becomes oriented
toward providing short-run assistance to
the banking sector by lowering interest
rates, it may jeopardize the enhancement
ISSN 0428-1 276

of banking skills and thus increase the
possibility of dependence on future government aid.
This Economic Commentary emphasizes
how incentive effects can drive up the
cost of banking reform and ultimately
boost the cost ofresolving Mexico's
debt problem. The first part of the article
reviews the recent peso devaluation and
crisis and discusses how monetary policy may become distorted to protect the
banking system,.3 The remaining sections highlight aspects of Mexico's previous banking reforms to show how
incentives are affected, and examine the
costs associated with several features of
the reform efforts.

• Exchange Rate Policy and
the Mexican Banking System
The likely costs of Mexican banking
reform cannot be assessed without discussing exchange rate policy. On the one
hand, exchange rate policy constrains
the resources available to Mexican
authorities. On the other hand, the international value of the peso reflects the
fiscal consequences of banking reforms.
For example, ifthe peso were perceived
to be overvalued, pressure might build
for a tighter monetary policy or a reduction in fiscal expenditures. Either way,
the banking system could be affected. In
the former case, interest rate changes
could influence bank profitability. In the
latter case, expenditures on programs to
modernize the banking sector or to support bank creditors might be included in
the budget cuts.


Observers acknowledge that improvements in Mexico's economic
conditions hinge on the latest banking reforms being successful but not
too costly. However, the ultimate cost
of the reform efforts will depend on
monetary policy restraint and behavioral responses to the reforms. If interest rates are lowered to help the
banks, or if banks expect continued
government assistance, the final cost
could easily exceed recent estimates.

Conversely, the credibility of any banking reform plan is relevant to assessing
its likely cost. If reforms are not perceived as extensive enough, observers
might anticipate an easing of monetary
policy. Thus, a lack of credibility in the
reform effort could negatively impact
the peso.
In 1994, a combination of higher U.S.
interest rates and Mexican political turmoil highlighted this connection.4 Because the Banco de Mexico (BOM) was
committed to maintaining the announced
value of the peso, when investors began
liquidating their peso-denominated
investments and demanding currencies
such as the U.S. dollar, the BOM had to
use its dollar reserves to buy the pesos.
In this case, maintaining a policy of sterilization (preventing the currency transaction from changing the Mexican
money supply) would keep interest rates
from rising and the money supply from
falling. Higher interest rates, however,
might have stemmed the outflow of
funds from Mexico, and lowering the
money supply might have reassured
investors of the monetary authorities'
resolve to fight inflation. Here, the
fragility of the Mexican banking system
may have played a crucial role by
increasing the likely cost of boosting
interest rates. Figure 2 confirms that
interest rates did not rise until reserves
had been depleted and the exchange rate
regime had been abandoned. 5
Although the BOM does not currently
fix the value of the peso, any efforts to
moderate exchange rate movements by
intervening in the foreign exchange market bring up the same dilemma (see
box). Sterilizing an intervention to maintain the money supply affects interest
rates. 6 Thus, the current fragility of the
Mexican banking system could create
another problem for monetary policy.
Lowering interest rates might temporarily help commercial banks burdened
with past-due loans by making their customers more willing to roll over debts.
Increasing the money supply to lower
interest rates might temporarily make it
easier for loans to be paid back. However, this would weaken the credibility
of the BOM's resolve to control infla-

Several countries have experienced a repeated pattern of banking and
balance-of-payments difficulties, and the perception that Mexico might have
been following the same path could have concerned investors when the crisis developed in 1994.a If evidence indicates that a similar cycle is in fact
emerging in Mexico, policymakers' task will become more difficult.
A familiar pattern is that a persistent current-account deficit, financed by
capital inflows (borrowing from the rest of the world), pushes up currency
values. These higher values, when combined with slowly falling domestic
inflation, threaten export growth. The capital inflows fuel a boom in bank
lending for consumption, but may not boost investment enough to improve
productivity significantly.
Ultimately, the current account deficit may be perceived as unsustainable, or
the real exchange rate may be perceived as too high. In this situation, a variety of events could precipitate a crisis. In 1994, Mexican political uncertainty
arising from the assassinations of three prominent leaders may have precipitated a crisis by weakening confidence in the BOM's ability to maintain economic progress.
In Mexico and some other countries where balance-of-payments and banking
crises have gone hand in hand, maintenance of announced exchange rate targets required government purchases of the foreign currency that was pouring
in. Then, neutralizing the impact of such purchases on the domestic money
supply through sterilization would increase interest rates and possibly damage
the banking system.
a. These similarities are discussed in Graciela Kaminsky and Carmen Reinhart, "The Twin Crises: The
Causes of Banking and Balance-of-Payments Problems," Board of Governors of tbe Federal Reserve System,
unpublished manuscript, February JO, 1996. The authors find that in 18 of 25 financial crises, financial
liberalization preceded each episod~ by five years or less.

tion, and the pattern oflate 1994 and
early 1995 might be repeated, leading to
interest rate changes and damaging the
nation's banks. On the other hand, it
might be hard to buy credibility for a
monetary policy which keeps rates so
high that costly problems persist in the
banking system.
Using monetary policy to assist banks
facing high levels of problem loans
might also ultimately impede the development ofbanking skills. If the central
bank lends to commercial banks to fund
projects that are not profitable enough,
inflation will result when the creation of
credit is not matched by an increase in
output. 7 Such lending weakens banks'
incentives to enhance their ability to distinguish between good projects and bad
ones. To avoid the temptation to make
problem loans, commercial banks can be
encouraged and aided in developing the

skills necessary to evaluate the riskiness
of borrowers and of outstanding loans.
This may involve training bank personnel or improving data collection and
reporting. 8

• Some Legacies of
Mexican Banking Reforms
Certain aspects of previous Mexican
banking reforms are relevant to assessing
the ultimate cost of the current efforts.9
First, to the extent that current reforms
are viewed as repeating past patterns of
government involvement in banking,
they may strengthen bankers' (or borrowers ') expectations that the government will save them from bankruptcy.
The perverse incentives that this would
create could ultimately increase costs. 1O
A relevant precedent might be the Mexican government's response to the debt
crisis and peso devaluation in the early



Billions of pesos



Past-due loans


Past-due loans/total loans


Total loans





















March June
1996 1996



SOURCE: Comision Nacional Bancaria y de Valores.

Billions of pesos

Billions of U.S. dol lars









o .__~~--''--~~__.~~~........~~~-'-~~~........~~~........~~.....









SOURCE: Banco de Mexico.

1980s. In September 1982, banks were
nationalized and an array of exchange
controls were enacted. In combination
with relatively high reserve requirements, interest rate controls, and forced
lending from the banks to the government, these policies had the effect of
substituting the credit judgments of the
central bank and the government for
those of co=ercial banks. 11
The second reason to consider the history of Mexican banking reforms is that,

Recent Initiatives

Skyrocketing interest rates in late 1994
and early 1995 worsened the already
weak condition of Mexican banks by
making it more difficult for them to fund
existing portfolios and for borrowers to
make loan payments. After the initial
rescue package was announced in March
1995, the Mexican government initiated
a series of programs to help both banks
and debtors. Although some aspects of
the reforms might reward banks for
improved risk management, bank
debtors or investors might also expect
the government to further absorb risk.

like the liberalization efforts of the early
1990s (which were designed to increase
market discipline), current reform efforts
could place new strains on bank supervision. The relaxation of interest rate controls (1988 - 89) and the privatization of
banks (1990) were intended to promote
the development of banking skills. However, as the chief of Mexico's national
banking commission has noted, "Supervision was not precise enough to be able
to accurately assess the new risks [of
changed markets] ." 12

The Mexican deposit insurance fund,
Fonda Bancario de Proteccion al Ahorro
(FOBAPROA), was bolstered by the
Mexican government and international
financial institutions in order to provide
funding to clean up troubled banks. One
of its major roles has been to provide
funds to buy bad loans from banks in
amounts equal to twice the new equity
injected by owners. FOBAPROA has
also funded a foreign exchange window
to help Mexican banks meet their obligations denominated in foreign currencies
without the market being alerted. 13
The Programa de Capacitacion Temporal (PROCAPTE) was a temporary program administered by FOBAPROA to
recapitalize banks. Banks with capital
ratios below the 8 percent threshold
were required to issue subordinated debt
to FOBAPROA in exchange for bad
loans. The debt converts into equity
after five years, and banks cannot take
on more debt until FOBAPROA has
been repaid. If the bonds are not paid off
in five years, the government then owns
the bank, which would presumably be
sold. The bank remains in charge of
managing the loans. However, payments
by FOBAPROA remain outside the
bank while the loans are being resolved,
so that only in an accounting sense does
the capital position irnprove. 14 Both
viewed as having initially stabilized conditions in the Mexican banking system.
A third program was conceived to help
banks reduce their inflation risk. Eligible bank loans are placed in a trust, their
maturity is lengthened to as much as




Change in
the CPlb

Treasury rate

o L..~~.L.~~-L~~-L~~-:L~~-:-:1:::-~-:::';:::'---'
a. The real Treasury rate equals the nominal rate minus the change in the Consumer Price Index (CPI).
b. Annualized rate of change based on six-month moving average.
SOURCE: Banco de Mexico.

12 years, and their denomination is
changed to Unidades de Inversion
(UDis), which are peso-denominated but
linked to Mexican consumer prices. 15
The program was slow to be accepted,
and was extended from consumer and
commercial Joans to mortgages and
local government problems. The Mexican Banking and Securities Commission (Comision Nacional Bancaria y de
Valores, or CNBV) also announced that
$5.57 billion would be made available
for restructuring real estate debt, with
banks asked to reduce interest rates and
to extend payment periods.
In August 1995, a fourth program was
announced. The Acuerdo de Apoyo
Inmediato a Deudores de la Banca
(ADE) was designed to help borrowers
and banks agree on debt restructuring.
Under its terms, individual loans would
be renegotiated, with rate reductions
subsidized by the federal government,
and banks would agree to suspend all
repossession and collection efforts.
Debtors' organizations have opposed
the effort and have pushed for debt
moratoriums. 16
Several other efforts have also been
unveiled. The Mexican accounting system is being replaced by one consistent
with Generally Accepted Accounting

Principles (GAAP), and consumer databases will be established to help banks
better track and evaluate consumer
credit risk. Training programs for bankers and supervisory and regulatory personnel are also planned. All of these
efforts will ultimately make Mexican
banks more attractive to purchasers, and
regulatory changes have smoothed the
way for foreign banks to participate in
such transactions.

• What Determines the
Total Cost of Rescuing Banks?
A July 1996 estimate by the CNBV
placed the fiscal cost of bailing out the
banking sector at 135 billion pesos,
excluding the ADE program, which was
paid for from the 1995 fiscal surplus. 17
Bad debt remaining on banks' books
was estimated at 152 billion pesos as of
March 1996, or roughly 18 percent of
banks' total portfolios. An October
1996 estimate by Standard & Poor's put
the cost of the total effort at 12 percent
ofl996 GDP. 18
Although the growth rate of bad-debt
portfolios has slowed and bank capital
ratios have risen, serious problems
remain. Particular concerns have been
voiced about consumer credit card debt
and the burden on banks to make provisions for problem loans.

While the overall thrust of the reform
efforts has been praised by many observers, the eventual cost of the programs may be higher than estimated.
Analysts have generally focused on two
reasons for this: 1) Higher interest rates
or abrupt exchange rate changes could
burden debtors further, and 2) the condition of Mexican banks is obscured
by differences between their current
accounting principles and GAAP, a
standard more familiar to Western investors. I 9 However, as I emphasize
below, the total cost will also be influenced by moral hazard and by any efforts to use monetary policy to protect
banks from higher interest rates.
Moral hazard arises if creditors, anticipating that the government will absorb
future banking losses, undertake riskier
investments, which then lead to further
government assistance. Some aspects
of the current reforms are clearly designed to control moral hazard. For
example, under PROCAPTE, banks
must learn to manage bad debts or risk
being taken over by the government.
Also, the conversion to GAAP will
make it easier for foreign investors to
identify well-run banks.
Other aspects of the reforms, however,
could induce moral hazard. For instance, the general extension of debtor
aid programs throughout the economy
might encourage some debtors to hold
out for government assistance. Or, if
investors interpret the government's
willingness to absorb some ofbanks '
foreign exchange risk as signaling it
will do so again in the future, banks
might not be penalized by the market
for taking on such risk.
Finally, any efforts by the central bank
to ease monetary policy and thus
smooth the road for banking reform
may also prove costly. Keeping interest
rates low may appear to reduce the
costs of reform. However, such a policy
could risk more than a repetition of the
previous crisis. Any inflation created
may mask the true state of banking
skills. At some point after sufficient
progress has been made against inflation and banking conditions have begun
to rebound, it could be tempting to ease




monetary conditions. 2 Figure 3 shows
the recent history of the Mexican real
one-month Treasury bill (CETES).
Skyrocketing real rates in early 1995
precipitated a banking crisis. Negative
real rates might imply that inflation is
temporarily benefiting banks. For example, loans being used simply to
finance inventory accumulation could
be profitable even without any value
being added to the inventories.21




The fragility of the Mexican banking
system may have played a crucial role in
the peso crisis of 1994-95. Under the
previous exchange rate regime, monetary policy was oriented toward controlling the exchange rate. Sterilizing an
intervention influences interest rates for
the sake of neutralizing the impact on
the money supply. Although the
exchange rate is no longer fixed, there
may be a continuing temptation to modify monetary policy for the sake of propping up banks. Such a policy not only
risks a further loss of confidence in the
peso, but in the long run it may also
inhibit banks from utilizing or developing banking skills.
Analysts have praised most of the
reform packages designed to address the
burden of bad debt, although the total
cost of these packages may exceed
recent estimates. In this article, I have
stressed that the ultimate cost will
depend not only on the uncertain course
of interest rates, but also on monetary
policy and the behavioral responses to
these programs.
The health of the Mexican banking system ultimately hinges on banks no
longer expecting or relying on government assistance. Some aspects of the
current reform efforts help in this regard.
Other features, however, have only
short-run benefits and might be viewed
by some as repeating previous government intervention in banking, which
could increase costs in the long term.



1. See Stephen Fidler, "Concern over Credit
Health of Mexican Banks," Financial Times,
August 2, 1996, p. 5. At first glance, the
past-due loan ratios in figure 1 do not seem
dramatically higher than U.S. rates (approximately 5 percent in the third quarter of 1996).
However, accounting differences greatly
complicate the comparison. (This point is
discussed in more detail later in the paper.)

2. Estimates vary from 6 to 12 percent of
1996 GDP.

3. The Banco de Mexico administers the
nation 's deposit insurance system.
4. A variety of factors have been cited as
contributing causes of the crisis. A good survey of the literature is provided in Marco
Espinosa and Steven Russell, "The Mexican
Economic Crisis: Alternative Views," Federal Reserve Bank of Atlanta, unpublished
manuscript, February 1996. See also Jeffrey
Sachs, Aaron Tomell , and Andres Velasco,
"The Mexican Peso Crisis: Sudden Death or
Death Foretold?" Columbia University,
working paper, Apri I 1996.
S. One recent study argues that Mexican
monetary policy preceding the crisis was not
different from past policy, and that increases
in money demand (and the unforeseeable role
ofTesobonos) complicated the BO M 's job.
See Steven Kamin and John Rogers, "Monetary Policy in the End Game to ExchangeRate-Based Stabilizations: The Case of Mexico," Board of Governors of the Federal
Reserve System, International Financa Discussion Paper No. 540, February 1996.
6. In a previous Economic Commentary, I
discussed the choices facing the BOM during
the period of capital inflows and upward
pressure on the peso. See "How Important
Are U .S. Capital Flows into Mexico?"
December 1, 1994.
7. This point is emphasized in Liliana RojasSurez and Steven Weisbrod, "Financial
Fragilities in Latin America: The 1980s and
1990s," International Monetary Fund Occasional Paper No. 132, October 1995.

8. Policymakers may want to consider both
enhancing banking skills and giving bankers
the necessary incentives to utilize their skills.

9. A more thorough review of previous
Mexican banking reforms is provided in John
H. Welch and William C. Gruben, "A Brief
Modem History of the Mexican Financial
System," Federal Reserve Bank of Dallas,
Financial Industry Studies, October 1993,
pp. 1- 10.
10. A relevant concept here is moral hazard,
which might be defined as actions taken by
economic agents to maximize their own utility to the detriment of others in situations
where the agents do not bear the full consequences of their actions. See Th e New Pa/grave: A Dictionary ofEconomics, New
York: Stockton Press, 1987, pp. 549 - 51.
11. A large government budget deficit may
have strengthened the government's incentive to reduce its borrowing costs through
various interferences in the banking industry.
For details, see Robert R Moore, "The Government Budget Deficit and the Banking
System: The Case of Mexico," Federal
Reserve Bank of Dallas, Financial Industry
Studies, October 1993, pp. 27 - 36.
12. Eduardo Fernandez, quoted in Michael
Tangeman, "The Once, and Future, Banking
Crisis?" Institutional Investor, vol. 29, no. 11
(November 1995), pp. 119-25.

13. Such uses of FOBAPROA are reflected
in monthly movements of Mexico's foreign
exchange reserves. As of mid-1996,
FOBAPROA's portfolio ofloans amounted
to $13.8 billion, 92 percent of which was
commercial loans.
14. Several banks have succeeded in repurchasing the subordinated debt and then instituting their own recovery programs. Often,
PROCAPTE has been utilized by banks that
were subsequently sold to foreign interests.

15. The trust is funded by banks ' contributions of 15 percent of the eligible loans and
by government bonds. Banks receive nonnegotiable, nonindexed, zero-coupon government bonds, which are redeemed as the loans
are repaid.

J6. The original enrollment deadline was
October 31 , 1995, and the original renegotiation deadline was January 31, 1996. However, by October 31, 1995, only 60 percent of
the eligible debtors had signed up, so enrollment was extended to January 31 and renegotiation to April 30.
J7. As reported in "Crisis Was Bigger than
Portrayed: CNBV Figures Out Banks' Pastdue Portfolio at US$ 20BN," Latin American
Weekly Report, July 25, 1996, p. 333.
18. See "Mexico: More Time and Money
Needed," Financial Times, October 28, 1996,
p. 3. By way of comparison, another study
estimates that the present value cost of U.S.
savings and loans closed between 1980 and
1992 was $130 billion. This would equal 2.5
percent of 1992 U.S. GDP. See James Barth,
Carl Hudson, and Jobn Jahera, " S&L Closures and Survivors: Are There Systematic
Differences in Behavior?" in The Causes and
Costs ofDepository Institution Failures, Norwell, Mass.: Kluwer, 1995, pp. 9-27.

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101
Address Correction Requested:
Please send corrected mailing label to
the above address.
Material may be reprinted provided that
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of reprinted materials to the editor.

19. These differences are discussed in
"Recovery Predicted for Mexican Banking at
Cost to Government of up to $8 Billion,"
BNA Banking Daily, July 3, 1995.


William P Osterberg is an economist at the

Federal Reserve Bank of Cleveland. For

helpful comments on earlier drafts, the author
20. A future test of this possibility may arise
as a result of the UDI program, which combines lengthening maturities and long grace
periods in order to push the largest interest
and principal payments into the future.

than.ks Jagadeesh Gokha/e, Joseph Haubrich,
Owen Humpage, Mark Sniderman, James
Thomson, and Walker Todd.
The views stated herein are those of the
author and not necessarily those of the Fed-

21. See Guillermo A. Calvo, "Financial
Aspects of Socialist Economies: From lnflation to Reform," in Vittorio Corbo, Fabrizio
Coricelli, and Jan Bossak, eds. , Reforming
Central and Eastern European. Economies:
Initial Results and Challenges, Washington,
D .C.: World Bank, 1991 , pp. 197- 205.

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Board of Governors of the Federal Reserve
Economic Commentary is available

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