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Number 92-40, November 13, 1992


u.s. Banking

On August 12, 1992, the U.s., Mexico, and Canada
completed negotiation of the North American
Free Trade Agreement (NAFTA). Assuming it is
eventually approved by the legislative bodies of
all three countries, NAFTA will progressively
eliminate barriers to trade in goods and services,
remove investment restrictions, and protect intellectual property rights (patents and copyrights)
from the Yukon to the Yucatan.
While the implications of liberalizing trade in
goods (manufacturing and agriculture), and of
easing investment restrictions in Mexico have
been widely discussed, somewhat less attention
has been given in the media to how NAFTA will
liberalize access to Mexico's financial sector and
what the potential opportunities may be for u.s.
banks, This Weekly Letter attempts to shed some
light on this question by reviewing NAFTA's provisions for u.s. bank access as well as factors
affecting the attractiveness of the Mexican

Financial reform
The adoption of NAFTA by Mexico is part of
wide-ranging Mexican financial reform seeking
to limit government intervention in the financial
sector and stimulate market forces. As part of this
process, all of the 18 banks which had been nationalized in 1982 have now been reprivatized,
resulting in the creation of large financial conglomerates that offer universal or multiservice
banking. Onerous regulations that had placed the
Mexican banking sector at a severe competitive
disadvantage also have been lifted. In 1989, controls on interest rates and the allocation of credit
were abolished. Marginal reserve requirements,
which exceeded 90 percent until 1986, were
replaced by a 30 percent liquidity ratio, which
itself was suspended in late 1991. Foreign exchange controls also were abolished at that time,
so Mexican banks may now engage more freely
in external transactions.

tablish wholly owned banking, insurance, and
securities operations in Mexico and to compete
on the same terms as Mexican financial institutions. From the standpoint of foreign investors,
this isa significant improvement over the current
law, which limits individual foreign ownership of
Mexican banks to a minority share of no more
than 10 percent of the paid-up capital of an individual banking institution. (Currently, Citicorp,
which entered Mexico in 1929, is the only foreign banking organizations allowed to do business on its own in Mexico.)
Beginning in 1994, NAFTA would allow u.s.
banks to acquire or establish Mexican banking
subsidiaries, as long as the combined holdings of
u.s. and Canadian banks do not exceed 8 percent of the Mexican banking industry's total capital. This ceiling is to be raised gradually to 15
percent by the year 2000, and then eliminated
completely soon thereafter. During the transition
period, from 1994 to 2000, individual foreign
banks' market shares will be limited to a maximum of 1.5 percent of the industry's capital.
Although the ceiling on the total market share of
foreign banks will be abolished after 2000, bank
acquisitions will be subject to "reasonable prudential considerations" and a 4 percent market
share limit for an individual institution. If the
United States adopts interstate branch banking,
NAFTA may eventually allow u.s. banks to establish branches as well as separately capitalized
subsidiaries south of the border.
The extent to which NAFTA will lead to significant increases in U.s. banking operations in
Mexico will depend on the attractiveness of the
Mexican market, which in turn is likely to depend
on three factors: (i) the prospects for economic
. stability in Mexico; (ii) U.s. direct investment
by nonfinancial corporations in Mexico; and
(iii) banking opportunities in Mexico's domestic

NAFTA and banking

Economic stability

NAFTA reverses a 50-year policy of prohibiting
foreign bank ownership of Mexican banking institutions. It will allow U.s. and Canadian banks
or other financial institutions to acquire or to es-

A potentially very important factor in determining the attractiveness of a foreign market for any
bank is the degree to which the government is
able to achieve economic stability. For example,

economic instability in Latin America in the
1980s resulted in heavy losses to u.s. banks and
prompted them to shift their operations to more
stable economies, such as Europe and the AsiaPacific region, or, in many cases, to curtail their
international banking operations.
Mexico has made great strides in achieving a
more stable business environment as a result of
policy reforms adopted since the 1980s that have
reduced the government's claim on economic resources and given freer rein to market forces. As
part of these reforms, monetary poiicy was tightened and the government budget deficit (the
borrowing requirement) was cut sharply, from a
recent peak of 16 percent of GOP in 1987 to 3.5
percent in 1990. Deficit reduction efforts were
facilitated by the privatization of public enterprises, which generated revenues from asset sales
and also ended government subsidies to unprofitable enterprises. Over 85 percent of about 1600
public enterprises existing in 1982 have been privatized. Revenues were further enhanced by imorovements in economic efficiency following the
~Iimination of burdensome regulations and of
barriers to trade and foreign investment, and by
more effective tax collection.
As a result of these economic reforms, inflation
fell from a recent peak of 160 percent in 1987 to
around 7 percent in the first half of 1992. The
resulting decline in inflationary expectations appears to have contributed to falling interest rates
and greater stability of the Mexican peso. The
Mexican treasury bill rate feU from 103 percent in
1987 to under 15 percent in the first half of 1992,
while the annual rate of depreciation of the Mexican peso slowed from around 56 percent to less
than 7 percent over the same period.
Mexico's standing among external creditors and
private investors also has improved. The bulk of
Mexico's debt to foreign commercial banks has
been restructured, significantly cutting Mexico's
external debt burden. Interest payments as a pro"
portion of exports of goods and services fell from
38 percent in 1986 to 23 percent last year. The
burden of servicing the external debt has been
further reduced by private capital inflows into
Mexico, which increased nearly sixfold between
1989 and 1991, to $22 billion.

u.s. direct investment
Although economic stability in Mexico encourages expanded u.s. banking operations in that

country, it is not by itself sufficient to spur entry.
Traditional commercial banking requires the development of long-terrn relationships between
bankers and their corporate clients. Such relationships give bankers information on borrowers
and the deep knowledge of credit markets that
is required to make sound and profitable credit
decisions. In the absence of such close relationships with clients in Mexico, U.S. banks initially
may be reluctant to incur the costs of setting up
subsidiaries in Mexico, even if NAFTA allows
them to do so.
One factor that may help banks to overcome this
hurdle is the rapid growth in direct investment
by U.S. nonfinancial firms in Mexico, which may
encourage u.s. banks to follow in order to serve
the financing needs of their U.S. corporate customers. In response to efforts by the Mexican
government to attract foreign investors, U.s.
direct investment in Mexico increased at a 24
percent annual rate between 1987 and 1992, to
nearly $12 billion last year. NAFTA is expected to
encourage continued rapid growth in U.s. investment for two reasons. First, U.s. producers are
expected to invest in Mexico in order to exploit
the opportunities for increased exports to the U.S.
and Canadian markets offered by NAFTA. Second, with some exceptions (such as the petroleum sector, which is reserved for the Mexican
state), NAFTA would remove discriminatory restrictions on foreign investors that had discouraged U.S. investment in Mexico in the past.

Mexican demand for banking
U.S. banks may find it profitable to serve not only
their U.S. clients in Mexico, but alsothe domestic market, as rapid increases are expected in the
demand for banking services. Mexico has a relatively large population, totaling 86 million in
1990, compared to 250 million in the u.s. and
27 million in Canada. And, though total Mexican
output in 1990 was only about 4 percent the size
of U.S. output and 40 percent the size of Canadian output, due to lower output per worker, it
is likely that the Mexican economy will grow
rapidly in coming years. Mexico's real output
grew at a respectable 4 percent average annual
rate in 1990 and 1991, compared to 1 percent annually in 1985~1989, and the approval of NAFTA
is likely to accelerate growth further.
Rising incomes and greater economic stability
are expected to increase the demand for banking
services by Mexicans, most of whom live outside
the major cities and currently have no banking
relationship at all. Institutional changes that will
provide many Mexicans access to bank services
will further stimulate demand. For example,
under a new government pension fund system,

many companies will for the fist time pay a percentage of each employee's salary into a bank
account. Workers will receive pension account
statements at home, and can choose how they
want their money invested.
As rising incomes are expected to give the main
impetus to bank growth, Mexican bankers see
the largest growth potential in retail banking
and consumer credit. Bank lending grew by over
15 percent last year and is likely to grow by as
much or more in 1992, with most of the growth
comprised of consumer loans for durable goods,
including automobiles, and for mortgages and
credit cards.
Rapid growth in demand for bank services is
expected to continue for some time. tVlexico's
central bank estimates that the flow of funds into
the Mexican banking system will double over the
next eight years, and the number of bank accounts is expected to double by the year 2014.

Competitiveness of Mexican banks
Aside from its growth potential, the Mexican
banking market may prove attractive to U.s.
banks because it has so far been relatively sheltered from competition. This has contributed to
inefficiency as well as unusually large profits.
Under these conditions,U.s. banks may profit
by producing bank services in Mexico at a lower
cost, while also charging lower prices.
One reason for the relatively weak competitive
environment is the years of government ownership and constraints on pricing and credit allocation, which appear to have reduced Mexican
banks' incentive to compete. Another reason is
that the domestic banking sector is characterized
by an apparently very high degree of concentration. As of mid-1992, the top three banks in
Mexico held 58.7 percent of total Mexican bank
assets, while the top three in the u.s. held only
12.4 percent of total U.S. bank assets. This relatively high concentration was encouraged by
the sharp decline in the number of banks over
the years, as a result of abandoning specialized
banks in favor of "full service" banks in the
1970s and a deliberate government policy to
promote mergers in the 1980s. Currently, there
are 20 banks in Mexico (including Citicorp),
compared to 109 in 1974 and 59 in 1982.
The lack of effective competition in Mexican
banking is reflected in two ways. First, Mexican

banks appear to be relatively inefficient and have
not kept pace with innovations in the u.s. and
Canadian financial sectors. In 1990, the ratio of
noninterest operating costs to assets in Mexican
banks was 6.3 percent, compared to 3.4 percent
for u.s. banks. Including interest expenses, the
1990 ratio rises to 22.9 percent for Mexican banks,
but increases to only 9.5 percent for u.s. banks.
In particular, Mexican banks appear to lag in the
efficiency of their technology and in the efficient
provision of corporate banking services, including services that take advantage of relatively new
financial technology, such as interest rate swaps.
Second, Mexico's banking sector appears to be
highly profitable. As of June 30, 1992, the average
return on equity for all U.s. banks was 12.7 percent, while the return on assets averaged 0.9
percent. In comparison, the average return on
equity of the 12 largest banks in Mexico as of
the same date was a relatively high 27.2 percent,
while the average return on assets for these banks
was also relatively high, at 1.7 percent. (Average
figures for all Mexican banks were unavailable.
However, because of Mexico's highly concentrated banking market, average statistics for the
12 largest banks can be considered representative of the Mexican banking market as a whole.)
Consistent with this, Mexican banks appear to
enjoy relatively large interest rate margins. For
example, while the average cost of funds for the
banking sector was about 24 percent in the first
half of 1991, the average rate for bank loans to
private sector borrowers was around 40 percent.
Such a large spread does not appear to reflect
unusually high risk, as the nonperforming loan
ratios of Mexican banks are reportedly relatively
low, and the financial condition of Mexican firms
is currently fairly strong.

For decades, the door to Mexico's financial
sector has been closed. However, Mexico has
undergone d change in attitude over the past
decade towards free markets and foreign entry,
of which NAFTA is the most recent expression.
As U.s. firms take advantage of the improved
investment opportunities resulting from this
change, U.S. banks likely will follow them to
Mexico and eventually find profitable opportunities in serving Mexicans themselves.

Elizabeth Laderman

Ramon Moreno

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor or to the author..•. Free copies of Federal Reserve publications can be
obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120.
Phone (415) 974-2246, Fax (415) 974-3341.

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Index to Recent Issues of FRBSF Weekly Letter



10/2 92-34
10/9 92-35
10116 92-36
10/23 92-37
10/30 92-38
11 /6

Sch midtlDean
Cromwell/Schm idt


California Banks' Problems Continue
Is a Bad Bank Always Bad?
An Unprecedented Slowdown?
Agricultural Production's Share of the Western Economy
Can Paradise Be Affordable?
The Silicon Valley Economy
EMU and the ECB
Perspective on California
Commercial Aerospace: Risks and Prospects
Low Inflation and Central Bank Independence
First Quarter Results: Good News, Bad News
Are Big U.s. Banks Big Enough?
What's Happening to Southern California?
Money, Credit, and M2
Pegging, Floating, and Price Stability: Lessons from Taiwan
Budget Rules and Monetary Union in Europe
The Slow Recovery
Ejido Reform and the NAFTA
The Dollar: Short-Run Volatility and Long-Run Adjustment
The European Currerlcy Crisis
Southern California Banking Blues
Would a New Monetary Aggregate Improve Policy?
Interest Rate Risk and Bank Capital Standards

The FRBSF Weekly Letter appears on an abbreviated schedule in June, July, August, and December.