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FINANCIAL INDUSTRY
October 1993

Federal Reserve Bank of Dallas

A Brief Modern History
of the Mexican Financial System
John H. Welch
Senior Economist
William C. Gruben
Senior Economist and Policy Advisor

U.S. Banks, Competition,
and the Mexican Banking System:
How Much Will NAFTA

Matter?

William C. Gruben
Senior Economist and Policy Advisor
John H. Welch
Senior Economist
Jeffery W. Gunther
Economic Advisor

The Government Budget Deficit
and the Banking System:
The Case of Mexico
Robert R. Moore
Senior Economist

1990
1991

J8
1992

This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library (FedHistory@dal.frb.org)
1991

Financial Industry Studies
Federal Reserve B a n k o f Dallas
October 1993

President and Chief Executive Officer
Robert D. McTeer, Jr.
First Vice President and Chief Operating Officer
Tony J. Salvaggio
Senior Vice President
Robert D. Hankins
Vice President
Genie D. Short

Industry Studies is published by the Federal Reserve Bank
of Dallas. The views expressed are those of the authors and
do not necessarily reflect the positions of the Federal Reserve Bank
of Dallas or the Federal Reserve System.

Financial

Subscriptions are available free of charge. Please send requests for
single-copy and multiple-copy subscriptions, back issues, and address changes
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a copy of the publication containing the reprinted material.

A Brief Modern
History of the Mexican
Financial System
John H. Welch
Senior Economist
William C. Gruben
Senior Economist and Policy Advisor
Research Department
Federal Reserve Bank of Dallas

T

he financial services component of the
North American Free Trade Agreement
(NAFTA) represents a new stage in the
financial liberalization that has been occurring
to varying degrees in Canada, Mexico, and
the United States. All three countries have
eliminated interest rate controls, reduced
reserve requirements, and lowered barriers
to entry for new domestic and international
banks. Mexico's financial opening, however, has been much more extensive than
Canada's or the United States'.
Ten years ago, few would have expected
that Mexico would move to integrate its
financial system with those of the United
States and Canada. Following the financial
turmoil of the early 1980s, many Mexicans
concluded that isolating their financial
markets would help avoid financial trauma
and that international capital controls and
bank nationalization were useful policy
tools. However, such policies exacerbated
financial instability. Global and domestic
financial market participants had acquired
the power to override such controls. Recognizing this phenomenon, Mexico has moved
to create one of the more modern and
open financial systems in this hemisphere.
The road to liberalization for Mexico has
not been an easy one. It was interrupted
by a reversal of financial opening when the
government nationalized the banks in the
early 1980s. But the main lesson of the

following history is quite clear: the Mexican
government could only temporarily halt
financial opening, growth, and innovation.
The recent liberalization effort reflects, to a
large extent, the huge growth in the nonbank
sectors of the Mexican financial system and
the recent reduction of barriers to trade in
goods. This history of the Mexican banking
system begins shortly after World War II,
when Mexico deliberately followed highly
protectionist trade policies.

The Financing of Import Substituting
Industrialization: 1 9 4 0 - 7 4
Until the 1970s, the Mexican financial
system was highly regulated, at least by
North American standards. The old regime
included quantitative restrictions on interest
rates, an array of forced lending programs,1
large barriers to entry, and high required
reserve ratios. The financial system reflected
import substituting industrialization, the
trade and growth strategy that Mexico and
other Latin American countries were pursuing at the time.2 In the same spirit, the banking sector was effectively protected from
direct foreign competition, as Citibank was
the only foreign bank since the 1940s to
operate in Mexico. 3
Countries following import substituting
industrialization (ISI) tried to diversify their
productive bases by protecting domestic
producers of formerly imported goods.
Protection involved tariffs, quotas, and direct
subsidies. The imports had typically been
consumer goods, including durables such

1 Banks were required to lend a certain portion of
their deposits to firms in priority sectors.

A succinct analysis of import substituting industrialization can be found in Baer (1992). For a detailed
analysis of the Mexican banking system during this
period, see Brothers and Solis M. (1966). For a similar
analysis of another country, Brazil, which also pursued import substitution, see Welch (1993).
2

An important point is that Citibank's office was a
branch, not a subsidiary.
3

1

as automobiles and nondurable luxuries
such as clothing and scotch. ISI motivated
local financial systems to specialize in underwriting the purchase of the domestic products that replaced these imports. Because
such financing was inherently short term
and lenders faced significant inflation and
exchange rate risk, the financial system's
lending horizons were much shorter than
those found in the United States, Canada,
and Europe.
The private financial sector did not supply
long-tenn financing of industrial activity, and
the trade protection given industry bolstered
retained earnings. Accordingly, most fixed
investment was internally financed. For
industries that required investments too
large to base on retained earnings and for
exporting industries weakened by protectionism (such as agriculture), the government provided long-term funding through
a menu of trust funds and state-controlled
credit institutions, the most notable being
Nacional Financiera. These institutions not
only channeled private and public resources
into "priority sectors" but also intermediated
(as they still do) resources from foreign
lenders and investors.

In a perfectly competitive banking system in which
profits are zero, the relationship between lending
rates, iL, and deposit rates, iD, is
4

where k is equal to the required reserve ratio.
The spread or the difference between iL and iD is
therefore

If k increases, the spread increases. Notice also that
if interest rates rise, so does the spread. For further
details of this relationship, see McKinnon and
Mathieson (1981).
The term "nonbank intermediary" simply refers to a
financial entity that is not a bank but still accumulates
funds (by taking issuing bonds, notes, bills, or acceptances) from some sources and then lends or otherwise distributes them to another party.
5

2

Banks represented the major private
sector institutions in the Mexican financial
system, but their behavior was tightly regulated. Most importantly, interest rates on
loans and deposits were controlled by Banco
de Mexico. Additionally, Banco de Mexico
controlled the money supply through the
use of flexible marginal reserve requirements. If Banco de Mexico wanted to tighten
money, it increased the reserve requirement
on new deposits.
Reserve requirement adjustments were
a particularly important source of policy
flexibility because Banco de Mexico could
not undertake open market operations.
Open market operations require a welldeveloped market for government debt,
and that did not exist. But the policy that
was flexible for Banco de Mexico was
cumbersome and costly for the commercial
banks (Brothers and Solis M. 1966, 59-64).
The bank's frequently changing and complex requirements resulted in costly efforts
on the part of commercial banks to maintain adequate reserves. Further, to the extent
that these reserves did not earn interest,
increases in reserve requirements increased
the spread between borrowing and lending
rates.4 Cash reserve requirements against
demand and savings deposits ranged from
50 percent to 100 percent from the 1940s
through the 1960s.
Cash reserves were not the only assets
held in required reserves. Banks were forced
to maintain a certain percentage of deposits
in the form of government securities,
creating a captive market for government
debt. Banks sometimes had to hold government securities in proportions that ranged
from 0 percent to 75 percent from the
1940s through the 1960s. Also, regulations
required commercial banks to hold a certain
percentage of deposits in the form of
credits to the private sector and private
sector securities. These directed credits
were channeled to what the government
deemed priority sectors.
This level of regulation put commercial
banks at an increasing disadvantage relative
to nonbank intermediaries,5 especially the

financieras.''
Financieras
became the
principle vehicles for financial innovation
during this period; they offered highyielding liquid paper with few of the restrictions that were imposed on commercial
banks. Using resources obtained from
promissory notes issued to corporations and
individuals, financieras
funded the acquisition of fixed-term obligations, financed
working capital and equipment loans, and
extended consumer loans.
Financieras
were not the only successful financial institutions. Mortgage banks 7
played a significant, but unchanging, role
in financial markets during this period.
These banks issued special mortgage bonds
Ccedulas hipotecarias)
to fund their mortgage lending. Other private financial institutions, such as savings and loan associations
and capitalization banks, 8 lost ground because they could not effectively compete for
funds (Brothers and Solis M. 1966, 2 6 - 3 9 ) .
With the growth of nonbank financial
intermediation, securities markets became
increasingly important, but government
regulations impeded the development of
markets for long-term debt. Although the
Mexican government implicitly maintained
the liquidity of all fixed-income securities
through most of this period, it required
them to trade at par. The value was maintained through the loan windows at Banco
de Mexico and Nacional Financiera. Because
the government proscribed discounting,
expected inflation could not be reflected in
discount rates, a problem that inhibited the
development of a long-term securities market.
While the Mexican financial system—
including the nonbank portion—did develop
significantly from the 1940s through the
1960S, markets remained very thin by
developed-country standards. The trading of
fixed-interest instruments on the stock and
securities exchange was limited because
market makers were banks,
financieras,
mortgage banks, capitalization banks, and,
ultimately, Banco de Mexico and Nacional
Financiera. Moreover, for the regulatory
reasons noted above, the market for longterm obligations was particularly thin.

Market thinness and market-inhibiting
financial regulations had resulted in costly
intermediation during the 1940S, 1950S, and
1960S. These high credit costs and the
scarcity of long-term credit, in turn, inhibited
the development of Mexican industry.
Financial system problems worsened in
the 1970s with the acceleration of inflation
during the presidential administration of
Luis Echeverria (1970-76). For the banks,
the principal problem during this period
was disintermediation. 9 Although disintermediation had occurred throughout the
postwar period, during the Echeverria
administration the acceleration of inflation
exacerbated the adverse effects of the
interest rate controls and high reserve
requirements on banks. The relatively low
level of regulatory constraints placed upon

Financieras
were financial institutions that resembled
banks but with a narrower scope of operation. A
financiera
could be seen as a sort of development
bank, which is to say that it focused on making longterm loans to industry. To secure funds,
financieras
accepted time deposits whose minimum duration was
one year. Financieras
also issued their own ten-year
(or longer) certificates of obligation called financial
bonds ( b o n o s financieros).
It was not unusual for a
private financiera
to be part of a collection of financial institutions held by a holding company. As such,
they were often recipients of large amounts of funds
that were able to be employed in the purchase of
claims on industrial and consumer borrowers not
suitable for direct holding by the financial intermediaries—other types of institutions within the holding
company, for example—that made the funds available.
6

Mortgage banks specialized in home mortgagebased lending and collected funds through the issuance of special mortgage bonds, as noted.
7

Capitalization banks focused on long-term lending
for capital goods.

8

Disintermediation occurs when funds shift out of
one type of financial intermediary (in the case under
discussion, banks) and either into another type (here,
financieras)
or out of the financial system altogether.
In the United States before the financial deregulations
of the late 1970s and early 1980s, restrictions on bank
and savings and loan deposit rates caused deposits to
flow out of these institutions and into less regulated
assets when rates went up.
9

3

the financieras
permitted them to adjust to
the resurgence of inflation by paying more
to attract deposits. Many of die new deposits
were diverted from the increasingly uncompetitive banking system. In response, new
reforms were instituted in 1974 and 1975.
The structure of Mexico's current financial
system has its origins in these reforms.

Chart 1

Mexico: Total Number of Banks, 1975-90

The 1974 and 1975 Reforms
The new Mexican policies of the 1970s
supported the consolidation of existing
banks and gave them market opportunities
formerly restricted to nonbank financial
intermediaries. The objective was to allow
banks to exploit economies of scale and
scope. The means to this objective included
a regulatory turn away from a U.S.-style
system of strict division between types of
financial institutions and toward a Germanic
system, in which "supermarket banks," or
multiple banks, could offer a wide variety
of services.
To this end, financial groups, or conglomerates, were constructed of different
types of financial institutions—banks,
brokerage houses, insurance companies,
and so on—connected through a holding
company. In 1974, the new Law on Credit
Institutions, in part the result of Finance
Minister Jose Lopez Portillo's efforts, went
one step further; it created multiple banks
through the merger of these different types
of institutions (Banco de Mexico 1992, 81).
Reflecting their origins, the new multiple
banks could not only perform traditional
banking functions but could also provide
insurance, brokerage services, and custodial
and trust services. Banks were also allowed
to take stock positions in industrial companies, a privilege that would become controversial (Tello 1984).
The immediate results of the 1974 Law on
Credit Institutions included an increasingly
concentrated banking system. As Chart 1
shows, the number of banks in Mexico
decreased from 139 in 1975 to only sixty
by 1982, when the bank nationalization
occurred. This consolidation would con-

4

1975

1979

1982

1983

1986

1990

SOURCE: Banco de Mexico.

tinue even after nationalization.
With the inflation of the 1970s, disintermediation made bank adherence to mandated interest rate ceilings and directed
credit programs impracticable. In the mid1970s, the government reacted by dramatically increasing legal deposit rates, but it
did not free them to reach their market
levels. The absence of full liberalization
gave added impetus to the nonbank sectors
of the financial markets, an impetus that
was accelerated by the Securities Market
Law of 1975.
The Securities Market Law of 1975 created
brokerage houses and reorganized securities exchanges under the oversight of the
newly revamped National Securities Commission (Comision Nacional de Valores, or
CNV), which was originally created in 1946.
Not only did these reforms improve oversight and dissemination of information on
traded securities, but they also created incentives for individual brokers and financial
conglomerates to create brokerage houses.
This sector began to grow rapidly, and expansion accelerated when the government
created new financial instruments that could
be traded in it (Heyman 1989, 13-17).
Perhaps the most important development
in the Mexican securities markets of the
1970s and '80s was the introduction of

government treasury notes, or cetes, in
1978. Until then, Petrobonds (created in
1977) had been the major innovation in
these markets. Petrobonds represented a
share in a trust at Nacional Financiera with
rights to certain quantities of governmentowned oil, and bond values were accordingly linked to the price of oil (Heyman
1989 and Mansell Carstens 1993). Other
innovations of the period included authorization of commercial paper in 1980 and of
bankers acceptances in 1981.

Devaluations and the Debt Crisis: 1 9 7 6 - 8 2
Mexican banks had a long tradition of
offering dollar-denominated deposits and
of extending dollar-denominated loans
(Ortiz 1983). Dollarization had decreased
during the 1960s and remained low until the
mid-1970s, but a burst of inflation during
the Echeverria administration provoked
fears of an imminent devaluation and a
flight back to dollars. The devaluation came
in 1976, when the Mexican government
elevated the peso price of the U.S. dollar
from 12.5 pesos to around 21 pesos. Capital
flight and increased dollarization soon
followed. The devaluation also precipitated
a substantial increase in financial activity,
as well as certain financial refomis.
But instead of liberalizing trade to avert
future balance of payments problems, the
incoming Lopez Portillo administration
resolved to uphold the increasingly threadbare import substitution/industrialization
policies of the prior two decades. New oil
deposits had been discovered, and this
administration projected that it could finance
further import substitution schemes with
rising oil export revenues. The rush to
develop these exports touched off large
fiscal deficits and an unsustainable increase
in foreign debt. Many of the resources that
flowed to Mexico during this period were
ultimately wasted (Gavin 199D- A surge in
world interest rates in 1979 and a plunge in
oil prices in 1980 and 1981 pressed on
Mexico's debt-servicing ability from both
directions. In August 1982, Mexico confessed

that it could not service its foreign debt.
Accompanying this collapse were massive
capital flight, a severe peso devaluation, the
imposition of exchange controls, and the
nationalization of the commercial banks.10

Bank Nationalization
and its Aftermath: 1 9 8 2 - 8 9
In 1982, Mexico went through two major
devaluation episodes—one in February and
March, the other in August and September.
Many inside and outside government contended that more drastic measures were in
order (Maxfield 1992 and Tello 1984).
Candidates included foreign exchange
controls, the effective elimination of Mexdollar accounts, and the nationalization of
the banking system.11
All were implemented by the Lopez
Portillo administration in late August and
early September 1982. On August 18, the
government suspended the transfer of
Mexdollar accounts abroad and converted
these dollar-denominated accounts to pesos
at an exchange rate of 70 to the dollar.
Since market rates were around 100 pesos
per dollar, this act would—for years to
come—create suspicions about what else
the government might impose upon the
Mexican banking system. On September 1,
the government ordained a full array of
exchange controls and also nationalized
the banking system.12 To mitigate the

Two commercial banks escaped nationalization—
Banco Obrero, which was owned by the unions, and
Citibank Mexico.
10

11 See Moore (1993) for additional analysis of the pervasive effects of Mexico's high government deficit on
the Mexican financial system.

12 Fifty-eight of the existing sixty banks were nationalized. As noted above, only Banco Obrero, a bank
owned by the unions, and Citibank Mexico were
spared. When nationalization was implemented,
articles 28 and 123 were amended to exclude the
private sector from holding a controlling interest in a
bank (Bazdresch Parada 1985 and Tello 1984).

5

damage devaluation had inflicted upon
borrowers, a special and highly favorable
exchange rate of 40 pesos per dollar was
applied to their dollar-denominated loans.
Although most of the Lopez Portillo
administration's tactics were conceived to
staunch capital flight, they aggravated it.
Mexicans forsook Mexdollar deposits for
cash dollars and foreign accounts. Banks
suffered severe losses in liquidity and contractions in earnings on dollar-denominated
loans.
The government's administration of the
nationalized banks reflected its concerns
about the stability and solvency of the
financial system. Mexico implemented bank
recapitalization policies and promoted
further consolidation. By 1990, of the fiftyeight banks originally nationalized, eighteen remained (Banco de Mexico 1992, 84).
Nationalization, however, did not signify
wholesale changes in management. Only
the bank directors were removed. The de
la Madrid administration, which replaced
that of Lopez Portillo only a few months
after the nationalization, was less sanguine
than its predecessor about the virtues of
government ownership. Banks were largely
left on their own.
Nevertheless, nationalization did reverse
some past trends. Chief among these was
the reerection of firewalls between the
bank and nonbank sectors of the financial
system. For example, the de la Madrid
administration reprivatized the nonbank
assets of multiple banks but retained control
of the banks themselves. In many cases,
these nonbank assets were purchased by the
prior owners through brokerage houses,
using "indemnification bonds" as payment.13
The growth in the nonbank financial
sector in the 1980s, especially in the money
market, was enormous and helps to explain
why financial innovation was not stymied

13 The prior bank owners were indemnified with these
bonds, which had a maturity of ten years and an
interest rate tied to the CD rate (Heyman 1989, 138).

6

by the bank nationalization. Between 1982
and 1988, nonbank financial institutions'
assets rose from 9-1 percent to 32.1 percent
of total financial system assets.
Recall that the government had begun
to issue treasury bonds (cetes) in 1978.
During the de la Madrid administration, the
trading of cetes in the securities market
(Bolsa de Valores) permitted the government an alternative to forced securities sales,
expressed as noncash reserve requirements,
to the banks. The growth of this alternative
outlet for government finance was a particularly important salve for fiscal imbalances
at this time. Restrictive rules and regulations were continuing to inhibit the expansion of the banking sector, so that even
forced bank financing threatened to be an
insufficient source of funds.
Although much of the initial growth in
the securities market can be explained by
the increased issuance of cetes, these were
followed in 1985 by Bank Development
Bonds, in 1986 by Mexican (U.S.) dollardenominated bonds ( p a g a f e s ) and fixedinterest Urban Development Bonds (BORES),
and in 1987 by fixed-interest Development
Bonds (bondes). The bond market and,
especially, the money market became
increasingly liquid throughout the 1980s
(Heyman 1989, 49-102 and 123-60).
However, with the new surge of the
nonbank sector, the banking system again
required innovation and deregulation to
improve its competitiveness in attracting
funds. The government responded in 1989
by removing its restrictions on interest rates
and permitting a return to universal banking
via the Financial Groups Law of 1990. In
1991, the Salinas de Gortari administration
began to sell the banks back to the private
sector.
At the same time these moves toward
deregulation were occurring, new financial
instruments were also being developed so
that the banks could compete effectively
for funds. Money market accounts ( c u e n t a s
maestras) appeared in 1986. In 1987, as
part of the effort to recapitalize the banks,
the government developed Certificates of

Claim on Net Worth (CAPS).14 In what was
effectively a first step toward privatization
of the banks, the government used these
CAPS as a vehicle for trading 34 percent
of its bank holdings to the private sector.
Banks did not pay dividends on these issues
but the retained earnings represented a
capitalized addition to the net worth (capital)
of the banks. The CAPs were issued during
a general stock market boom and sold at
significant premiums.
Between 1982 and 1987, a combination
of high inflation, interest rate controls,
and high reserve (liquidity) requirements
prompted the growth of a black market for
credit.15 Much of the liberalization that
followed could not have taken place in
the absence of a major fiscal effort by the
Mexican authorities. Public-sector borrowing
requirements dropped from around 17 percent of GDP in 1982 to around - 1 percent
in 1992, a financial surplus (Chart 2).
Accordingly, the government began to
refrain from exacting forced loans from the
banks, especially after 1987. Lowering the
liquidity ratio (a broader term for required
reserve ratio) and liberalizing interest rates
improved the banking system's ability to
compete for funds.
The first step toward hill liberalization
and lower reserve requirements was the
1988 liberalization of the issuance of bankers
acceptances. Under the new rules, interest
rates on these instruments were no longer
controlled. Moreover, bankers acceptances
were now subject to a relatively low 30 percent liquidity requirement.16 These conditions gave bankers acceptances an advantage
over deposits and CDs in attracting funds.
Deposits and CDs were still subject to regulated interest rates and to liquidity coefficients
of close to 60 percent.
Additional liberalizations occurred in early
1989. The government removed interest
rate ceilings on all deposits and securities
and dropped the liquidity coefficient to 30
percent on bank liabilities. Finally, in June
1989, interest payments on checking accounts
were allowed (Banco de Mexico 1992,
90-91).

Chart 2

Mexico: Public-Sector Borrowing Requirements
as Percentage of GDP, 1981-92
Percent
20

-5 H

'81

1

'82

1

'83

1

'84

1

'85

1

'86

1

'87

1

'88

1

'89

1

'90

1

'91

1

'92

1

SOURCE: Banco de Mexico.

The Privatization of the Banks: 1 9 9 0 - 1 9 9 2
These liberalizations set the stage for a
complete privatization of Mexico's eighteen
remaining commercial banks, an act initiated
by legislation in 1990. In June, the Mexican
Congress amended the constitution to allow
private sector control of commercial banks.
In July, Congress approved the Credit Insti-

14

These were issued in the form o f "B" shares that can

only b e held by Mexicans; consortiums cannot form a
controlling interest.
15 The term "liquidity coefficient" refers to required
reserves that can be held in liquid interest bearing
assets such as CETES. This is different from "required
reserve coefficient," which typically refers to the
percentage of liabilities diat must be held in cash
reserves or noninterest Cor low interest) bearing
deposits at the central bank.

16 Bankers acceptances in Mexico are short-term
(maturity not exceeding 180 days) promissory notes
issued on a discount basis by banks. Unlike their
counterpart in the United States, bankers acceptances
in Mexico are not linked to goods traded internationally (Heyman 1989, 138,
144-146).

7

tutions Law, which restored the multiple
bank system (Mansell Carstens 1993, 18).
The return to universal banking did not
completely dismantle the segmentation
imposed with nationalization. The new
legislation allows the formation of three
types of financial groups:
(a) a bank with leasing, factoring,17 foreign
exchange, mutual fund management
and origination, and warehousing
activities,
(b) a brokerage firm with leasing, factoring,
foreign exchange, mutual fund management and origination, and warehousing
activities, and
(c) a holding company.
The holding company must have at least
three of the following institutions, with no
more than one of each type:
(a)
(b)
(c)
(d)
(e)
(0

bank,
insurance company,
brokerage house,
leasing company,
factoring company,
bonding company,

17 A factoring company buys a firm's accounts receivable for less than their face value, does its best to
collect the payments on the accounts at face value,
and profits on the difference.

18 There is one relaxation of this provision. A bank
can hold up to a maximum of 15 percent of a firm's
paid-in capital as long as possession does not continue for more than three years. Moreover, even three
years' possession is permissible only after approval by
two-thirds of the bank's board members and authorization by Mexico's Ministry of Finance (Banco de
Mexico, 1992, 97).

19 These loans must be approved by two-thirds of the
directors (Natella et al. 1991, 45).
20 CAPS issued in 1987 were subsequently turned into
shares.

See Chart 2 in Gruben, Welch, and Gunther in this
issue.
21

8

(g) mutual funds management company,
(h) currency exchange broker, and
(i) warehousing company (Natella et al.
1991, 2 3 - 2 5 and Mansell Carstens
1993, 18-19).
Moreover, while banks can now take equity
positions in nonbank enterprises, holdings
are limited to 5 percent of a firm's paid-in
capital.18 Loans to principal bank shareholders, managers, or directors—or to firms
they own—are limited to 20 percent of a
bank's loan portfolio.19 Additionally, the
extension of any such loans now legally
requires the express approval of the bank's
board of directors.
The Credit Institutions Law defined the
terms of the subsequent privatization.
Ownership structure was (and remains)
apportioned according to three types of
shares.20 "A" shares are common stock held
by the controlling interest and can represent
up to 51 percent of total shares outstanding
of any one bank. These may only be held
by Mexican individuals, excluding institutional and corporate investors. "B" shares
may be held by Mexican individuals, firms,
and institutional investors and may represent
19 percent-49 percent of the total shares
outstanding. Finally, "C" shares may be
held by all Mexicans and foreigners and
may represent no more than 30 percent of
the shares outstanding (Natella et al. 1991,
22-23, Banco de Mexico 1992, 96-97, and
Mansell Carstens 1993, 18-19). The Mexican
government also restricted the share of
total bank capital possessed by any individual. Without special approval from the
Ministry of Finance, no one may own more
than 5 percent of outstanding shares; with
approval, an individual may derive title to
up to 10 percent.
The eighteen banks sold in fourteen
months (June 1991-July 1992) at an extraordinarily high average price-to-book ratio
of 3.49 (Trigueros 1992 and Carstens 1993).21
Meanwhile, the government continued to
initiate regulatory reforms. Mexico eliminated its remaining liquidity coefficient of
30 percent in September 1991 and abolished

Chart 3

Growth in Real Financial Assets (M4), 1980-92

'80

'81

'82

'83

'84

'85

'86

'87

i

88

i

'89

'90

'91

'92

Concluding Remarks
What has the recent liberalization accomplished? The most striking benefit of the
liberalization and the inflation stabilization
has been an increase in financial stability,
a dramatic fall in interest rates, and robust
growth in financial assets. Additionally, a
recovery in lending to the private sector for
investment is under way. Growth in the
broad money aggregate M4 recovered to
high and sustainable rates starting in 1988
{Chart 3). Continued liberalization with the
implementation of NAFTA should increase
further the efficiency of the banking system
and help lower the cost of financial intermediation in Mexico.

SOURCE: Banco de Mexico.

exchange controls in December 1991
(Carstens 1993). The authorities also imposed
new capital standards that turned out to be
stricter than those contained in the Basle
agreement.

9

References
Baer, Werner (1992), "U.S.-Latin American
Trade Relations: Past, Present, and Future,"
in Free Trade within North America: Expanding Trade for Prosperity, Gerald P.
O'Driscoll, Jr., ed. (Norwell, Mass.: Kluwer
Academic Publishers), 53-71.
Banco de Mexico (1992), The Mexican
Economy 1992. (Mexico City: Banco de
Mexico).
Bazdresch Parada, Carlos (1985), "La
Nacionalizacion Bancaria," Nexos (January):
49-55.
Brothers, Dwight S., and Leopoldo Solis M.
(1966), Mexican Financial
Development
(Austin: University of Texas Press).
Carstens, Agustin G. C. (1993), "The Mexican Financial System" (Lectures presented
at the Federal Reserve Bank of Dallas,
January).
Gavin, Michael (1991), "The Mexican Oil
Boom," Discussion Paper no. 548, Columbia University, Department of Economics,
(New York, May).
Gruben, William C., John H. Welch, and
Jeffrey W. Gunther (1993): "U.S. Banks,
Competition, and the Mexican Banking
System," Federal Reserve Bank of Dallas
Financial Industry Studies, this issue.
Heyman, Timothy (1989), Investing in
Mexico. (Mexico City: Editorial Milenio).
Mansell Carstens, Catherine (1993), "The
Social and Economic Impact of the Mexican Bank Reprivatization" (Paper presented
at Institute of the Americas, La Jolla, January).

10

Maxfield, Sylvia (1992), "The International
Political Economy of Bank Nationalization: Mexico in Comparative Perspective,"
Latin American Research Review 27, no. 1,
75-103.
McKinnon, Ronald I., and Donald J. Mathieson (1981), "How to Manage a Repressed
Economy," Princeton Essays in International Finance, no. 145, December.
Moore, Robert R. (1993), "The Government
Budget Deficit and the Banking System:
The Case of Mexico," Federal Reserve
Bank of Dallas Financial Industry Studies,
October.
Natella, Stefano, et al. (1992), The Mexican
Banking System II (New York: CS First
Boston).
, et al. (1991), The Mexican
Banking
System (New York: CS First Boston).
Ortiz, Guillermo (1983), "Dollarization in
Mexico: Causes and Consequences," in
Financial Policies and the World Capital
Market: The Problem of latin
American
Countries, Pedro Aspe Armella, Rudiger
Dornbusch, and Maurice Obstfeld, eds.
(Chicago: University of Chicago Press),
71-106.
Tello, Carlos (1984), La Nacionalizacion
de
la Banca en Mexico (Mexico City: Siglo XXI
Editores).
Trigueros, Ignacio (1992), "El Sistema Financiero Mexicano" (mimeo, ITAM, December).
Welch, John H. (1993), Capital Markets in
the Development Process: The Case of Brazil
(Pittsburgh: University of Pittsburgh Press).

U.S. Banks, Competition,
and the Mexican
Banking System:
How Much Will NAFTA Matter?
William C. Gruben
Senior Economist and Policy Advisor
John H. Welch
Senior Economist
Research Department
Federal Reserve Bank of Dallas
Jeffery W. Gunther
Senior Economist and Policy Advisor
Financial Industry Studies Department
Federal Reserve Bank of Dallas

F

or Mexico, the details of the financial
services portion of the North American
Free Trade Agreement (NAFTA) are an
important part of a broader program of
financial liberalization that has been under
development for close to a decade. 1 Not
only do NAFTA's details represent a major
step in Mexico's recent financial liberalization efforts, but the general framework of
the agreement also is important.
NAFTA's financial-sector portion commences with an explication of general
principles and subsequently focuses on the
expression of these principles through the
industry-by-industry details of the agreement. In this regard, NAFTA reflects an
attempt to apply trade policy concepts to
the financial services sector, an innovation
stemming from prior efforts to develop the
General Agreement on Trade in Services.
Sauve and Gonzalez-Hermosillo (1993, 4)
note that this approach derives from the
recognition that the joint pursuit of "business globalization and trade liberalization
requires agreement among countries on a
guiding set of rules and disciplines relating

to matters of establishment, market access,
standard of treatment, transparency of
regulations and dispute settlement." By
establishing both a general framework for
greater foreign participation in Mexico's
financial markets and particular rules governing that participation, the agreement
represents a palpable reduction in the
payoff to protectionist lobbying and an
increase in the long-term sustainability of
financial reform.2
This article provides an overview of the
financial portion of NAFTA and includes
analysis of its potential impact on the
Mexican banking system. NAFTA's general
framework, combined with the details of
the important financial liberalization that
NAFTA sets forth, indicates that the agreement will further Mexico's goal of increasing
competition and efficiency in the provision
of financial services. Differences in the
agreement's treatment of various financial
services, together with certain characteristics of financial markets in Mexico, suggest
that most entries into the Mexican financial

We would like to thank Agustin Carstens and Moises
Schwartz of the Banco de Mexico and Yves Maroni of
the Board of Governors of the Federal Reserve System
for their comments. Of course, all remaining errors are
our own and the usual caveats apply.
1 See Welch and Gruben (1993) for an analysis of the
financial liberalizations that occurred in Mexico both
over the past ten years and in previous periods of
Mexico's modern history.

Also, by increasing the credibility of policy permanence, NAFTA can reduce response time to a policy
change. An important reason for having free trade
agreements like NAFTA, as Gould clarifies, is that
"unlike most legal contracts, enforcement of these
agreements is entirely voluntary, and their credibility
does not depend on the objectives and interests of
only two parties, but on the relative power of competing interests within two or more subscribing countries"
(Gould 1992, 20). Incredible policy changes may have
neutral or even perverse effects. In the early 1980s,
Peru's attempt at trade liberalization lacked credibility.
Suspecting that tariffs would rise again, investors
imported large quantities of foreign goods and reduced
domestic investment (Gould 1992).
2

11

sector under NAFTA likely will occur in
nonbank areas, especially brokerage. As
competition in the provision of nonbank
financial services continues to grow, arid
as more banks—both foreign and domestic—commence operations in the Mexican
market, Mexico's banks will be challenged
to make strong gains in efficiency.

NAFTA also represents much effort to ensure procedural transparency; in fact, transparency is one of the
general principles on which diis principles-based
agreement is founded. In processing applications for
entry into its financial services markets, each NAFTA
country has committed itself to clarifying its requirements for completing applications, to providing information on the status of an application on request, to
making an administrative determination on a completed application within 120 days, to publishing
measures of general application no later than their
effective date, to allowing interested persons the
opportunity to comment on proposed measures, and
to establishing inquiry points to answer questions
about its financial services measures.
3

NAFTA countries generally have agreed not to increase
current impediments to cross-border trade. However,
the United States has declined to make such a commitment with regard to cross-border trade in securities
with Canada, even though such an agreement does
exist between the United States and Mexico. Likewise,
Canada has not committed to such a "standstill" agreement with the United States. While NAFTA countries
generally have agreed to permit their residents to purchase financial services provided from the territory of
another party to the agreement, the transaction must
originate at the request of the purchaser. Active solicitation of business from a seller in one NAFTA country
to a purchaser in another is not part of the agreement.
4

5 The financial services chapter of NAFTA focuses
more on institutions than on products. NAFTA's focus
is a departure from that of other agreements, such as
the General Agreement on Trade in Services, in that
NAFTA treats financial services as institution-specific,
so that the rules for one type of lending or depositaccepting institution are different from those of another.
Under NAFTA, the same category of service may face
different regulations or restrictions in accordance with
the category of institution providing the services.

The term "comparable" is important. Sauve and
Gonzalez-Hermosillo (1993) note that NAFTA borrows
from the General Agreement on Trade in Services in
defining national treatment in a de facto rather than
dejure sense. A de jure national treatment means that
the very same laws apply to foreign firms as domestic.
6

12

The Financial Services Portion of NAFTA
One way to facilitate the process of business globalization and trade liberalization,
and accelerate the speed of adjustment to
a policy change, is to assure that the new
policy is easily understood.3 Accordingly, the
two most important doctrines in the financial services portion of NAFTA are relatively
simple: each country allows its residents to
buy financial services in other NAFTA countries4, and foreign subsidiary institutions
receive national treatment. The first clause
implies a promise that Mexico's capital flight
restrictions of late 1982, which inhibited
foreign financial services' availability to
Mexicans, will not reappear. In the second
clause, national treatment means that foreign
financial institutions5 are subject to laws, rules,
and regulations comparable 6 to those governing domestic institutions in a given host
country.7 The country for which this doctrine
signifies the biggest change is Mexico, where
NAFTA allows U.S. and Canadian financial
services firms to set up wholly owned
subsidiaries for the first time in fifty years.
Although the principal tenets of NAFTA's
clauses on financial institutions are relatively
simple, several complications arise from the
past histories of each country's individual
financial service industries, such as banking
or securities, and from the connections
that different countries permit among such
industries. Unlike the United States, Mexico
permits the same holding company to
own banks, insurance companies, stock
brokerage houses, funds management firms,
bonding institutions, factoring operations,
exchange houses, leasing firms, and warehousing firms.8 As will be seen, these variations in what NAFTA signatories permit
invest the agreement with some peculiar
clauses. Moreover, under NAFTA, the structure of Mexican financial services firms
owned by U.S. or Canadian firms is important. The Mexican firms must be subsidiaries
rather than branches of their foreign owners.
This rule means that a Mexican bank will
have its own board of directors, even if it
is owned by a U.S. or Canadian firm. More

importantly, these subsidiaries can fail, even
when the foreign parent bank does not.
NAFTA phases in liberalization. Mexico
will allow U.S. and Canadian commercial
banks, insurance companies, brokerage
firms, and finance companies their fullest
access only after a six-year transition period
(beginning in 1994), during which the
market will be limited. For example, the
capital of foreign insurance affiliates may not
exceed 6 percent of the aggregate capital of
all insurance companies in Mexico during
the first year of the transition period, but
that share goes to 12 percent on January 1,
1999, and to 100 percent a year later.9
Similarly, during 1994, bank capital under
the control of foreign investors in Mexico
may not exceed 8 percent of the value of
all bank capital in the country. In the last
year of the six-year transition period, this
limit goes to 15 percent.
But even after the phase-in period,
NAFTA's characterization of national treatment is limited. Mexico will still be able to
treat potential U.S. and Canadian-owned
subsidiaries somewhat differently than it
treats domestic firms. As an example, consider Mexico's banking system. Each of
Mexico's two largest banking institutions,
Banamex and Bancomer, accounts for more
than 20 percent of total bank capital in the
country. Together, they account for about 50
percent of total bank capital. After NAFTA's
phase-in period for banks, neither Canadian
nor U.S. groups may acquire an institution
that accounts for more than a 4-percent
share of the aggregate capital of all commercial banks in Mexico. In addition, once
the six-year transition period is over, the
Mexican government has the one-time
option of freezing temporarily the total
level of capital of Canadian and U.S. banks
if that capital reaches 25 percent of total
bank capital in Mexico. 10
The United States, likewise, explicitly
restricts what foreign financial institutions
of NAFTA signatory countries may do, and
some of these restrictions reflect differences
between Mexican and U.S. financial institutions. The United States will permit a Mexi-

can financial group that before NAFTA's
enactment had acquired both a Mexican
bank with U.S. operations and a Mexican

A de facto standard takes account of the potential
inequality of effects that regulatory requirements might
have if they were applied identically to domestic and
foreign institutions. Accordingly, defacto treatment may
allow somewhat different laws and regulations to apply
to foreigners than apply to locals, "so long as their
effect is equivalent and does not place the former at a
competitive disadvantage in the host country market"
(Sauve and Gonzalez-Hermosillo 1993, 13). Of course,
not all parties will agree in every future case on what
equal effects are. There is a dispute settlement mechanism to address these potential differences.
The host country provision contrasts with that of
the European Economic Community, which allows
country A's subsidiary financial institutions operating
in country B to behave in accordance with country A's
regulations instead of country B's.

7

See Welch and Gruben (1993) for a description of
Mexico's regulations pertaining to financial structure.
We should note that NAFTA prohibits U.S. and Canadian banks from investing in credit unions, development banks, and foreign exchange firms
8

NAFTA also allows foreign insurance providers to
enter Mexico through a partial equity interest in a new
or existing Mexican insurance company. Under this
alternative entry mechanism, the share of a Mexican
insurance company's voting common stock owned by
foreign insurance providers is subject to limits that are
relaxed during the transition period.
9

10 The freeze is permitted to last only three years and
can only be implemented during the period 2 0 0 0 2004. NAFTA provides a similar option for Mexico
with regard to securities firms, but there the aggregate
capital percentage that triggers the option is 30 percent,
although the same three-year maximum freeze period
holds. Note that Canada exempts Mexican firms and
individuals from its prohibition against nonresidents'
collective acquisition of more than 25 percent of the
shares of a federally regulated Canadian financial
institution. Canada had already extended this exemption to the United States as part of the Canada-U.S.
Free Trade Agreement. Mexican banks are also exempted from the combined 12-percent asset ceiling
that applies to non-NAFTA banks, and also need not
seek the approval of the minister of finance as a
condition of opening multiple branches in Canada.
Financial services commitments of Canada and the
United States under the Canada-U.S. Free Trade
Agreement will be incorporated into NAFTA.

13

securities firm with U.S. operations to
operate both for five years after the acquisitions. The U.S. securities affiliate, however,
will not be permitted to expand through
acquisition. Moreover, the United States
requires that the majority of directors of a
foreign subsidiary bank be U.S. citizens.
With regard to start-up operations in
Mexico, one of NAFTA's attractions for
Canadian and U.S. firms is the opportunity to
carry out operations denominated in pesos
rather than dollars, which will enable firms
to accumulate peso liabilities to offset their
peso-denominated assets.11
The breadth of opportunities offered by
NAFTA is important. For example, NAFTA
signifies that finance companies may ultimately establish subsidiaries to provide consumer lending, commercial lending, mortgage
lending, or credit card services. During the
transition period, such operations are subject to the restriction that they may not
collectively exceed 3 percent of the sum of
the aggregate assets of all banks in Mexico
plus the aggregate of all types of limitedscope financial institutions in Mexico, a
phrase that refers to companies that provide
consumer lending or commercial lending
or mortgage lending, or credit card services.
After the transition period, such firms
receive purely national treatment, which is
to say they will not be subject to the caps
that banks will face after the phase-in.
Even during the transition period, some
types of auto-related financing are not subject
to the caps that other financial operations
will face during the phase-in. Accordingly, it
should not be surprising to note reports that
at least one U.S. nonbank firm is already
planning the introduction of auto financing
and leasing operations, and that U.S. brokerage firms, meanwhile, are planning cross-

11 In general, to gain peso exposure, U.S. and Canadian financial institutions must locate operations in
Mexico, as offshore peso trading is strictly prohibited.
However, certain operations between U.S. and Mexican markets also provide vehicles for peso exposure.

14

border mergers and acquisition activity and
the introduction of swaps and options into
the Mexican market.

Attractiveness of Mexico for Entry
by U.S. Financial Institutions
Are U.S.-based financial instiaitions likely
to be interested in establishing operations
in Mexico under NAFTA? A look at the
Mexican banking system, as an example,
offers an indication of what may make
NAFTA attractive to U.S. financial institutions.
Mexico's banking system is highly profitable, highly concentrated, not very competitive, fairly inefficient, and somewhat
less aggressively oriented toward marketing
than some developed-country systems.
Mexican banks are more profitable than
U.S. banks and most European banks. In
1992, the net return on assets for Mexican
banks was approximately 1.45 percent,
versus 0.96 percent for U.S. banks. The
return on average assets in 1991 was 1.09
percent in Mexico, compared with 0.53
percent for the United States, 0.41 percent
for all of Western Europe, 0.19 percent for
Japan, and 1.11 percent for Spain (Chart 1).
When the Mexican government began to

Chart 1
Bank Return on Assets, 1991
Percent

Mexico

United States

SOURCE: Natella et al.

Europe

Japan

Spain

Chart 2

Banco Obrero)—held about three-fifths of
all Mexican commercial bank assets. In
contrast, as of year-end 1992, the three
largest U.S. banking organizations held
roughly one-seventh of total U.S. bank
assets.13 The level of competition that such
concentration implies for Mexico, which
lacks a deep nonbank financial market for
private debt, may explain why large interest
rate spreads persist.14

Mexico: Commercial Bank Privatizations
Two-Year
Average 3.49

Date sold
July 6__
June 28~
June 14
April 12~
April 5
March 29"
March 5
Feb. 9~
Jan. 26"
Nov. 10"
Oct. 28
Aug. 26_
Aug.18
Aug. 1 f
Aug. 4
June 23
June 17
June 10

1992
B H B H H 9 H I

•••••••••••

1

1

1991

•"

1

1

1—1

1

In addition, some indicators suggest that
Mexican banks may not have begun to
operate very efficiently, at least by commonly applied standards. In 1991, the ratio
of noninterest operating costs to assets in
Mexican banks was 5.9 percent, versus 3-7

Ratio of price to book value
SOURCE: Banco de Mexico.

privatize the formerly state-owned banking
system in 1991, some U.S. observers were
surprised to see the selling prices of these
banks range from 2.6 times book value to
5.4 times book (Chart 2). Expectations of
future profitability helps explain these prices.
Moreover, some observers suspected that
privatization would make Mexican banks
compete more intensely with one another,
paying higher rates on deposits and charging lower interest rates. But instead of
narrowing, spreads between interest rates
on loans and bank deposits have widened.
During the second half of 1990, interest
rate spreads averaged about 5 percentage
points. During 1992, when inflation rates
had declined considerably compared with
rates in the 1980s, spreads fluctuated
between 7.57 percent and 10.69 percent
0Chart 3).u
The Mexican banking system is currently
highly concentrated, especially when compared with the U.S. banking system (Chart
4). As of mid-1992, the three largest commercial banks in Mexico—from a total of
twenty (counting First National City Bank, or
Citibank, and the union-owned institution,

12 In a discussion of this point, Mansell Carstens notes
that spreads have remained high and are likely to stay
high over the next two years, not only because of the
oligopoly power in the provision of commercial bank
services, but because "commercial banks have b e e n
moving into high yield consumer lending" (Mansell
Carstens 1993, 29). She notes that consumers had not
had access to credit since the early 1980s; that banks
have enjoyed a seller's market in satisfying the backlog of credit demand; that banks will probably expand
their credit card, consumer durable, and mortgage
lending programs to middle and lower-income groups;
and that such operations typically involve large spreads.

The bank assets of individual U.S. banking organizations are approximated by the sum of the assets of
their bank affiliates. U.S. concentration measures
based on deposits are similar to the asset concentration figures reported here. Note that the national
concentration measures used here do not necessarily
reflect the degree of concentration within local market
areas in either Mexico or the United States.
13

14 Concentration, in and of itself, need not preclude
competitive provision of banking services. Shaffer
(1992) finds that the Canadian banking system, which
is comparable to Mexico's in terms of market concentration, still behaves competitively. The historical
difference has b e e n the contestability of Canadian
markets for the types of financial services that Canadian
banks offer. That is, market entry has traditionally
been more viable in Canada, and securities markets
for private debt are broader and deeper than those in
Mexico. Later in this article, w e more fully address
problems of Mexico's nonbank private-debt markets
in providing competition for the banks.

15

Chart 3
Mexico: Net Interest Margin, 1990-92
Percentage points

NOTE: Difference between average lending rate and
average cost of funds for multibanks.
SOURCE: Banco de Mexico.

percent for U.S. banks. 15 It should be noted
that Mexico's 5.9 percent in 1991 represents
a decline from 6.3 percent in 1990 and
that, for reasons discussed below, this ratio
will probably continue to fall.
Other evidence suggests Mexican banks
may devote less attention to marketing
than is common in the United States and
Europe. In 1991, Mexico had one bank
branch for about every 18,000 people. In
the United States, the number was about

15 International comparisons of financial ratios probably offer a general picture of differences between the
Mexican banking system and its counterparts in other
countries, but care must be exercised and tenths of a
percentage point ought not to be taken seriously. For
a more extensive clarification of international comparisons of financial ratios in the context of NAFTA
countries, see Gavito Mohar, Sanchez Garcia and
Trigueros Legarreta (1992). Despite their cautions,
those authors still draw conclusions about the essential differences between Mexican and U.S. financial
performance, and the conclusions are very similar to
those w e draw in this article.

See Mansell Carstens (1993) for further discussion of
this issue.
16

16

one branch per 4,000 inhabitants and, in
Europe, about one for every 2,000. 16 Nevertheless, as in the case of other bank characteristics, time may not have permitted
recent bank behavior to reflect fully the
impact of privatization.
Although these factors suggest that under
NAFTA Mexico may attract U.S. banks, it
is important to emphasize that the Mexican
financial system is anything but static. The
circumstances implied by the financial
statistics and ratios cited earlier will probably
not persist.
The first reprivatization of a Mexican bank
did not occur until June 1991 and the last,
that of Banco del Centro, took place in July
1992. There is much reason to suspect that
insufficient time has elapsed for any bank
to complete its transition from a public to
private entity. In a study of bank acquisitions
by holding companies in the United States,
Johnson and Meinster (1973) show that an
acquired bank's income and balance sheet
ratios do not begin to display statistically
significant differences from those of prior
management until two years of new ownership. Moreover, the hill impact of a change
in management appears not to be felt until
four years after the acquisition (Johnson
and Meinster 1975). As of this writing, only
two years have passed since any Mexican
banks were privatized.
Tenure of ownership is not the only factor
contributing to the state of flux in Mexican
banking. As of September 1993, applications
had been made for the establishment of at
least six new (rather than acquired) banks,
and five had been approved. Whether or
not competition has intensified since bank
privatization, the opportunities for intensification are clearly increasing. NAFTA's six-year
phase-in to the point at which Canadian
and U.S. banks receive their full opportunities for establishment in the Mexican market
is likely to offer profound changes in the
Mexican financial system, even without any
foreign entrants.
In addition to the rapidly changing nature
of financial institutions and markets, other
factors in Mexico raise questions about the

Chart 4

Asset Concentration in Top Five Banks
(Share of Total Assets)
Percent
80

Top 1

Top 2

Top 3

Top 4

Top 5

SOURCE: Comision Nacional Bancaria-Mexico; Reports of
Condition and Income.

intensity and rapidity with which Canadian
and U.S. banks may choose to enter the
Mexican market. While Mexico may be
underbranched, and while "rising incomes...
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"
(Laderman and Moreno, 1992, 3), Mexican
banks have well-established positions in
the retail market, which U.S.-owned institutions may have difficulty achieving.17
With regard to wholesale banking, Mansell Carstens (1993) notes that Mexican
banks have faced competition from foreign
finrts in this sector for years. While foreign
banks have not been permitted to establish
themselves as banks per se in Mexico, they
have had representative offices. Moreover,
Mexican banks, private and public corporations, and the government have relied for
decades on these institutions. Mansell
Carstens remarks that "for the wholesale
banking sector, NAFTA may be a nonevent"
(Mansell Carstens 1993, 37).
A related detail may offer a useful perspective on the extent of competition that
Canadian and U.S. financial institutions

could face from Mexican entities. Although
the Mexican bank nationalization that
occurred in 1982 formally removed only
bank directors and left other employees at
their desks, many of these employees
departed for securities firms, which took
on a rising share of financial activity.18
Later, Mexican securities fimis turned out to
be the major purchasers of privatized Mexican banks. Since many securities industry
executives were bankers before the nationalization, the recent financial deregulation
has meant a reunification of financial products and personnel. Does this mean that
Mexican banks have an information advantage that would make a U.S. bank's entry
into the Mexican market a highly competitive event? It seems to suggest that, because
of personnel movement out of banking and
into the securities business and then back,
human capital appropriate to the joint provision of securities services and traditional
banking products may be particularly abundant in the Mexican financial system.19
Perhaps the main barriers to entry by U.S.
banks are the minimum capital requirements
and the global and individual maximum
market share restrictions on U.S. bank holdings. The initial minimum capital requirement for a new entrant into the banking
system is 0.5 percent of total paid-up capital
plus reserves in the banking system, while

17 In a discussion o f this point, Mansell Carstens (1993)
notes that the smallest of Mexico's three largest banking institutions (Banca Serfin) has 596 branches and
that both B a n a m e x and Bancomer have more.

18 See Welch and Gruben ( 1 9 9 3 ) for a description of
the Mexican bank nationalization.

19 The stock of financial experience in Mexico's banks
contrasts sharply with that of many U.S. financial
institutions in die 1980s. The partial erosion of barriers
to competition at that time in the United States led
many U.S. thrifts to enter into areas in which they had
little or no previous experience. Similarly, the financial deregulation of the 1980s broadened the types of
financial controls that U.S. banks and thrifts were
required to maintain on their own, leading to substantial financial difficulties at some institutions.

17

the maximum allowed is 1.5 percent of the
sum of total paid-up capital, reserves, and
current gross profits.20 As of December
1992, these requirements convert to about
$20 million for the minimum and $90 million
for the maximum. Given recent trends in
capital growth, these limits easily could rise
to $26 million for the minimum and $126
million for the maximum. The minimum
capital requirements exclude a number of
would-be entrants into the Mexican market
(see the box entitled "NAFTA's Implications
for U.S. Border Banks"). But the maximum
capital requirements are small compared
with the rest of the banks in the banking
system. If a U.S. firm wanted to buy a
Mexican bank, only two of the twenty
could be purchased because the remainder
have capital larger than the maximum.
The maximum capital allowed for any
individual entrant grows to 4 percent by
the year 2000. If 4 percent were the maximum today, all but the largest five banks
could be bought by an interested U.S. bank.
But these five banks command a huge
proportion of Mexico's banking system.
Hence, the strategy in NAFTA allows U.S.
banks to enter in the phase-in period only
in a very limited part of the market, mainly
in regional retail operations. U.S. banks
will essentially have to "grow their own"
Mexican subsidiaries because the restrictions on banks that develop a large market
share are considerably less stringent.

Current Issues in Mexican Banking
A broader issue involving the development of the Mexican financial system is the
connection of this process to other compo-

Note that the measure of capital used in determining
the maximum is different from that used in determining the minimum. This difference results from the fact
that the minimum capital requirement was determined
by the Law on Credit Institutions of 1990, whereas the
maximum is specified by NAFTA. Also, the Mexican
authorities have much discretion in determining minimum capital requirements.
20

18

nents of Mexico's liberalization programs,
which have attracted large influxes of
foreign capital into the country. While very
little of these international flows have taken
place in the form of loans from foreign
banks, their implications for banking have
been important.
These inflows of foreign capital, and
their translation into pesos, have bolstered
both the demand for the peso and its rate
of exchange against other currencies. Partly
as a result of the strong peso (or the weak
U.S. dollar), and partly because Mexico has
dramatically lowered its barriers to foreign
trade in recent years, the United States
increasingly has become a low-cost supplier
for Mexican buyers. In fact, U.S. producers
have begun to out-compete Mexican producers in so many Mexican markets that
Mexico's imports from the United States
have quadrupled since 1987. As a result of
rising U.S. and other foreign competition,
Mexican tradeable goods producers have
begun to default on their debt to Mexican
banks at a more rapid rate than in past
years (Chart 5 ) . Also, loans with a moderate
or higher risk of default rose from 5 percent of total loan volume in September
1991 to 9 percent in September 1992.
Does this mean that increased U.S. sales
to Mexico under NAFTA will mean more
defaults? In fact, it is hard to separate the
various factors that have caused increases
in the ratio of past-due loans to overall
loans. While foreign competition plays a
role, other issues are important as well. A
significant portion of the recent rise in
troubled assets may be linked to loans
booked under the directed credit programs
maintained by the Mexican authorities
before privatization. The Mexican government created a compensation mechanism,
within the privatization program, to reimburse the purchasers of the banks for any
initially unreported problem loans. The
problem loans associated with these past
programs would, in any case, not be expected to reflect accurately any new trends
in financial performance generated by the
restructured financial system. Nor should

Chart 5

Mexico: Ratio of Past-Due Loans
to Total Loans, 1 9 7 9 - 9 2
Percent

'79

80

'81

'82 '83 '84 '85

'86 '87 '88

'89 '90 '91

'92

SOURCE: Comision Nacional Bancaria-Mexico.

on riskier portfolios (Keeley 1990).
Perhaps similar forces are at work in
Mexico. But despite problems of disintermediation qualitatively similar to those in
the United States, Mexico's financial reforms
occurred in an atmosphere somewhat less
hostile to banks. The relatively illiquid
nature of Mexico's financial markets continued to offer banks there a central role
in supplying liquidity and monitoring the
financial condition of borrowers. Moreover,
as Mexico's financial markets continue to
broaden and deepen, Mexico's relatively
unrestrictive regulations pertaining to financial structure offer broader avenues for
avoiding the erosion of market share than
those afforded U.S. banks in the 1980s.21
These conditions may help curb the recent
rise in problem loans.

Other Mexican Financial Markets
they call to question the solvency or profitability of these banks.
The rise in problem loans also reflects
greater risk-taking at Mexican banks. However, some (Garber and Weisbrod 1991)
have argued that the important role of banks
in Mexico's financial system imparts a substantial franchise value to Mexican banks, particularly those with high market shares and
strong reputations. The incentive to protect
this franchise value from loss due to failure
may partially offset banks' propensities to
extend large volumes of high risk loans.
A comparison with recent events in the
U.S. financial system helps illustrate the
incentive Mexican banks may have to maintain a moderate risk profile. During the
1970s and 1980s, advances in information
technology, together with the regulatory
restrictions imposed on banks and thrifts,
meant savings were more remunerative
and borrowing cheaper at other sorts of
institutions (Kaufman 1991)- The partial
financial deregulation that occurred during
the 1980s materialized largely in reaction
to these forces. In response to the lower
charter values brought on by increased
competition, U.S. financial institutions took

We have suggested that bank concentration need not inhibit competitive provision
of banking services but that, up to now, it
seems to have done so in Mexico. One
reason Mexico's banking system seems to
lack competition appears to involve a shortage of contestable markets. That is, the
viability of entry by new banking firms or
the existence of deep and broad markets
for nonbank funding of private enterprise
seem not to have been sufficient to discipline banks toward competitive behavior.
While stock and securities markets exist in
Mexico, and while factoring and leasing
operations and other nonbank sources of
de facto finance for private borrowers have
also existed for years, many of these institutions have had problems of their own that
have impaired their competitive strength.
Consider the stock market in Mexico. In
general, stock markets transfer capital from

21 See Gunther and Moore (1992) for a discussion of
the relatively unrestrictive product and geographic
expansion laws that distinguish Mexico's banking
system from that of the United States.

19

savers to investors (the primary market),
provide liquidity to owners of fixed capital
(the secondary market), and improve the
efficiency and performance of firms through
the market for corporate control (the secondary market). However, the performance
of the stock market depends not only on
market access but also on the market's
ability to discipline its corporate participants.
The Mexican stock market is small compared with those of developed countries.
An important reason involves contestable
markets, but of a somewhat different sort
than those stressed in our previous discussions. Here, the contest involves the threat
of takeover when a company's managers
behave in their own interests rather than
the stockholders'. McConnell and Servaes
(1990) provide evidence that self-serving
managerial behavior increases with the
percentage of insider ownership and that
increases in insider ownership accordingly
lower the value of stock.
High insider ownership rates are common in Mexico, and the result has been an
illiquid market. Under the current Mexican
regime of comparatively loose regulation
of company perfonnance reportage, in a
milieu of heavy insider stock holdings,
participants in the Mexican market are
suspicious of managers and discount stock
values accordingly.
Moreover, the market suspicions that
have been inspired by Mexico's longtime
corporate issuers naturally contaminate
efforts of new firm entrants to fund themselves efficiently in the equity market.
Accordingly, Mexico's stock market is less
liquid than that of developed countries
and offers even less competition with the
banking system than do stock markets in
developed countries.22
Other forms of private-firm securities
likewise play a smaller role in Mexico than
in developed countries. As an example,

22

For further development of these issues, see Welch

(1993).

20

consider commercial paper, an open market
substitute for bank loans. The ratio of commercial paper holdings to bank lending is
less than one-fourth as high as in the United
States. And the banks themselves behave
as if they are money market mutual funds.
They place their own funds and those of
the trusts they operate into commercial
paper that they themselves market (Garber
and Weisbrod 1991).
More generally, until now the overwhelming share of securities traded in the
Mexican Bolsa de Valores has been of government issue. Because of the thinness of
nonbank financial markets for nongovernmental borrowers, firms that could go abroad
for funding have. It has been common for
Mexico's great conglomerates to issue fixedincome securities in U.S. or European
markets, and it is not unusual for the government to do the same.
Over time, however, the role of government issues in the Mexican securities market
has diminished and will probably continue
to decline. Recent innovations, expected
developments (such as a Mexican options
market), as well as a broadening and
deepening of existing markets, suggest a
diminishing role for traditional lending
services in Mexican financial markets, much
as has been the case in the developed
world. The worldwide revolution in information processing that has increased the
abilities of nonbank financial institutions to
tailor securitized debt to the special needs
of particular borrowers will likely continue
to affect Mexican domestic financial markets
(Walter 1992). That is, Mexican firms may
be increasingly able to offer services at a
level of particularity that up to now has been
restricted to bank lending.
However, the same is true for Canadian
and U.S. brokerage firms that could enter
Mexican markets under NAFTA. Moreover,
Canadian and U.S. firms already have
experience and technology of the types
that Mexican institutions are just now gaining. Accordingly, this is the area of the
Mexican financial market that may see the
greatest foreign penetration. Growth in such

securities and trading by both Mexican and
foreign institutions may prevent the fall in
the liquidity of the Mexican financial system
Garber and Weisbrod (1991) expected to
result from reductions in the number of
Mexican treasury instruments outstanding.
Private issues may offset those of the
government.
Another reason most entries under NAFTA
will be in securities brokerage is the agreement's relatively favorable treatment of this
industry. As mentioned earlier, during the
agreement's transition period, the maximum
level of start-up capital for a new entrant
into Mexico's banking system is 1.5 percent
of the sum of systemwide, paid-up capital,
reserves, and current gross profits. That
limit increases to 4 percent by the year
2000.23 The comparable restricted maximum
for securities firms is more liberal, starting
at 4 percent during the transition period
before being removed entirely in the year
2000. Similarly, restrictions on the aggregate capital under the control of foreign
investors in Mexico also treat securities
brokerage relatively favorably. For bank
capital, the aggregate restriction increases
from 8 percent in 1994 to 15 percent in
1999, as mentioned earlier. In contrast, the
comparable restriction for securities firms is
10 percent in the first year of the six-year
transition period and 20 percent in the last.
The relatively quick opening of brokerage
services should facilitate early foreign penetration into that area.
Another possible role in the Mexican
financial system for foreign financial firms is
that of an offshore banking center. In July
1990, for example, the Law on Credit Institutions changed to allow Mexican banks to
create dollar-denominated deposits for nonresident depositors. Currently, however,
several factors discourage foreign institutions from establishing offshore operations
in Mexico. First, the Mexican income tax for
such institutions is 35 percent, a relatively
high level compared with those obtaining
in traditional offshore banking centers. In
addition, Mexican labor laws require any
company in Mexico to share 10 percent of

its profits with its workers. Inasmuch as
financial institutions in general, and offshore banks in particular, realize relatively
high profits per employee, these laws may
also dissuade potential offshore bankers
from establishing operations in Mexico
(Mansell Carstens 1992).

Conclusion
Despite much discussion of Canadian
and U.S. banks entering the Mexican market,
and despite the likelihood that some will,
there is reason to suspect that the Mexican
banking market may constitute one of
NAFTA's least inviting financial market
apertures. The Mexicans have taken special
care to protect their banks from foreign
competition during the long phase-in period.
Because of the capital ceilings, the areas
open to U.S. banks are the smaller regional
banks, which mainly deal in retail banking
and consumer financing. Although these
areas are extremely profitable, most U.S.
banks are not familiar enough with the
Mexican market to compete effectively in
the retail area. On the other hand, the
more liberal treatment given to brokerage,
bonding, leasing, factoring, insurance, and
warehousing suggests that equity and bond
markets will almost surely prove more
attractive.
The complexion of the Mexican banking
system indicates that in the next ten years
most entry will be in these nonbank areas,
especially brokerage. Mexico already imports
a large amount of brokerage services from
the New York Stock Exchange through the
floatation of American Depository Receipts
(ADRs) and from world bond markets
through the large flotations from PEMEX,
some large banks, and also some smaller
firms. Hence, brokerage operations with
strong links to U.S. investment banks will
enjoy a strong position not only for arbi-

This 4-percent limit applies only to acquisitions and
not to new banks.

23

21

trage between the Mexican and New York
markets but also to tailor asset and liability
products to the needs of firms that conduct
business internationally.
Certainly, increasing competition in the
nonbank sectors from foreign participation
in combination with a number of new
Mexican banks will put pressure on banks
to improve their efficiency. As we have
described, this process is already well under
way. The Mexican financial system, although
not competitive at present, shows signs
that very soon the institutions and markets
will offer better financial services at significantly lower cost.
But a number of questions remain. One
concerns the role that banks will play relative to securities markets. The remaining
statutory barriers to entry in Mexican banking and the problems with the Mexican
market for corporate control indicate that
banks will maintain a privileged position
in the Mexican financial system for many

22

years to come. But the decline of banking
in the United States and Europe cannot be
explained solely by overregulation, implying
that perhaps the importance of Mexican
banks may also erode over time. Technological advance in information processing
and financial instruments has given securities
markets an edge, as witnessed by the major
increase in securitization (Kaufman 1991).
If U.S. and Mexican specialist institutions
can offer nonbank services more efficiently
than banks, then one would expect the
importance of banks to wane. The favorable
treatment of securities brokerage by NAFTA
would be expected to promote such a
competitive process. These considerations
make projections of the future structure of
the Mexican banking system extremely
difficult. But no matter what the ultimate
outcome, the evolution of the Mexican
banking system should prove a fertile experiment in financial market liberalization.

NAFTA's Implications for U.S. Border Banks
The greatest opportunities that
NAFTA's financial provisions present
U.S. firms, at least initially, are outside
traditional retail banking. One of the
factors that suggests this conclusion
is the information advantage Mexican
financial institutions have over most U.S.
banks in assessing risks and opportunities among Mexico's bank customers.
However, because of their proximity to
Mexico and familiarity with its markets,
U.S. banks along the Mexican border
may face a relatively low information
hurdle in competing with Mexican financial institutions. Regulatory barriers, not
information costs, will limit the capacity
of most border banks to enter Mexico
under NAFTA.
Border banks' specific knowledge
and skills favor their penetration into
Mexican retail markets. U.S. banks along
the Mexican border generally are familiar with retail banking opportunities in
Mexico. The banks' proximity to Mexico
enables them to provide deposit services to Mexican citizens, and they
extend credit to Mexican businesses.
Moreover, the local banking markets on
the U.S. side of the border are, in many
respects, similar to the banking environment in Mexico.
The familiarity of border banks with
Mexican markets should help these
banks assess the credit quality of small
and mid-size businesses in Mexico. As
a result, any information advantage
that established business relationships
impart to Mexican banks should be reduced. In this regard, the border banks
are particularly well-suited for entry into
Mexico's growing retail banking market.

Although the proximity of border banks
to Mexico enhances their position as
potential entrants, other factors suggest
that the entry of border banks into Mexico
under NAFTA will be limited. Mexican
financial companies provide commercial banking, brokerage, and insurance
services jointly through an extensive
network of branch offices. The established retail market position of Mexican
banks increases the difficulty entering
U.S. banks will face in attracting a broad
base of retail customers. And this barrier to entry may be particularly formidable for border banks, most of which
are relatively small.
Perhaps the greatest obstacle constraining the ability of border banks to
take advantage of NAFTA's entry provisions is the minimum capital requirement
established by the Mexican authorities
for new banks. The required minimum
level of capital that would apply to new
banks established by U.S. financial services providers under NAFTA is, as of
this writing, approximately $20 million.
Moreover, each of the new Mexican
banks recently approved by the Mexican authorities has been established
with more than $40 million in capital,
suggesting that investments well above
the published minimum are encouraged.
While this level of capital would not be
expected to pose a serious barrier to
entry by large U.S. banking organizations, it could represent a problem for
smaller institutions along the border that
otherwise would be interested in establishing a bank in Mexico.
(Continued on the next page)

23

NAFTA's Implications for U.S. Border Banks— Continued
The capital levels of Texas banking
organizations near the Mexican border
illustrate how the minimum capital requirement may constrain the entry of
smaller U.S. banks into Mexico. As of
year-end 1992, forty-eight banking organizations operated at least one bank
in Texas counties along the Mexican
border. As shown in the accompanying
chart, the minimum capital requirement
of $20 million was more than five times
greater than existing bank capital at 32
percent of these banking firms. 1 And the
minimum capital requirement exceeded
100 percent of bank capital at 86 percent of the firms. To meet the minimum
capital requirement for establishing a
bank in Mexico, while maintaining an
adequate level of capitalization among
their domestic banks, these banking
organizations would need to raise large
amounts of external capital. And it generally is difficult for small banks to raise
equity externally. Similar adjustments
would be required of all but the largest
U.S. banking organizations that currently operate a bank along the Mexican
border.
The regulatory constraint posed by
Mexico's minimum capital requirement,
coupled with the extensive market resources of Mexican banks, suggests
that most U.S. border banks will be

24

Distribution of Texas Border Banks
by Minimum Required Capital Relative
to Existing Capital

SOURCE: Reports of Condition and Income.

unlikely to exploit their familiarity with
Mexican markets by establishing banks
in Mexico. Rather, the factors considered here indicate that NAFTA represents the greatest opportunity for
relatively large U.S. banking organizations. The primary benefit of NAFTA for
most of the border banks will be an
indirect one resulting from an increase
in trade and economic activity in the
border region.
1 Total bank capital is approximated by the s u m of
the year-end 1992 capital levels of an organization's individual banks.

References
Garber, Peter M., and Steven R. Weisbrod
(1991), "Opening the Financial Services
Market in Mexico," (Paper presented at the
Conference on the Mexico-U.S. Free Trade
Agreement, Brown University, October
18-19).
Gavito Mohar, Javier, Sergio Sanchez Garcia,
and Ignacio Trigueros Legarreta (1992),
"Los Servicios Financieras y el Acuerdo de
Libre Comercio: Bancos y Casas de Bolsa,"
in Eduardo Andere and Georgina Kessel,
eds. Mexico y el Tratado Trilateral de Libre
Comercio: Impacto Sectorial (Mexico City:
ITAM and McGraw-Hill).
Gould, David M. (1992), "Free Trade Agreements and the Credibility of Trade Reforms,"
Federal Reserve Bank of Dallas Economic
Review, first quarter, 17-41.
Gunther, Jeffery W., and Robert R. Moore
(1992), "Mexico Offers Banking Opportunities," Federal Reserve Bank of Dallas
Financial Industry Issues, fourth quarter.
Johnson, R.D., and D.C. Meinster (1975),
"The Performance of Bank Holding Company Acquisitions: A Multivariate Analysis,"
The Journal of Business 48, 204-12.
, and
(1973), "The Analysis
of Bank Holding Companies' Acquisitions:
Some Methodological Issues," Journal of
Bank Research 4.
Kaufman, George G. (1991), "The Diminishing Role of Commercial Banking in the U.S.
Economy," Federal Reserve Bank of Chicago
Working Paper no. WP-1991-11, May.
Keeley, Michael C. (1990), "Deposit Insurance, Risk, and Market Power in Banking,"
American Economic Review 80, (December): 1183-1200.
Laderman, Elizabeth, and Ramon Moreno
(1992), "NAFTA and U.S. Banking," FRBSF
Weekly Letter no. 92-40, 1 - 3 .

Mansell Carstens, Catherine (1993), "The
Social and Economic Impact of the Mexican Bank Reprivatization" (Paper presented
at Institute of the Americas, La Jolla, January).
(1992), Las Nuevas Finanzas en
Mexico (Mexico City: Editorial Milenio).
McConnell, John J., and Henri Servaes (1990),
"Additional Evidence on Equity Ownership
and Corporate Value," Journal of Financial
Economics 27-2, October, 595-612.
Natella, Stefano, Thomas H. Hanley, Justin
Manson, Suhas L. Ketkar, Veronica Dias
(1992), The Mexican Banking System II
(New York: CS First Boston).
Sauve, Pierre, and Brenda Gonzalez—
Hermosillo (1993), "Financial Services and
the North American Free Trade Agreement:
Implications for Canadian Financial Institutions," unpublished paper, External Affairs
and International Trade Canada and Bank
of Canada, Ottawa.
Shaffer, Sherrill (1993), "A Test of Competition in Canadian Banking," Journal of
Money, Credit, and Banking 25, February,
49-61.
Walter, Ingo (1992), "A Framework for the
Optimum Structure of Financial Systems,"
New York University Salomon Center
Working Paper Series no. S-92-47.
Welch, John H. (1993), "The New Face of
Latin America: Financial Flows, Markets,
and Institutions," Journal of Latin American
Studies, forthcoming.
, and William C. Gruben (1993),
"A Brief Modern History of the Mexican
Financial System," Federal Reserve Bank
of Dallas Financial Industry Studies, this
issue.

25

The Government
Budget Deficit and
the Banking System:
The Case of Mexico
Robert R. Moore
Senior Economist
Financial Industry Studies Department
Federal Reserve Bank of Dallas

T

he change in fiscal and bank regulatory
policy in Mexico over the past decade
is striking. At its peak in the mid-1980s, the
government deficit was equal to roughly
one-sixth of the Mexican economy's output.
During this same period, the banking system
was subjected to numerous restrictions that
contributed to a lack of growth in bank
lending to the private sector. Reforms initiated in 1987 eliminated the deficit, with
Mexico achieving a budget surplus by 1991The elimination of the deficit was accompanied by changes in bank regulatory policy
that contributed to a more than threefold
increase in inflation-adjusted bank lending
to the private sector between the beginning
of 1988 and the third quarter of 1992.
Although difficult to quantify, there were
linkages between the deficit and bank
lending to the private sector that operated
through the deficit's effect on bank regulatory and monetary policies. Part of the
government's need to fund the deficit was
satisfied through the banking system. When
the deficit in Mexico was approaching its
peak, the banking system was subject to
restrictions that were ostensibly aimed at
reducing the government's cost of financing
the deficit but that were also likely to have
had the unintended effect of contributing
to the stagnation of bank lending to the
private sector.

In this article, I examine the deficit,
restrictions on banking, and bank lending
to the private sector. The article begins by
briefly reviewing the recent history of the
deficit and the banking system in Mexico.
Next, it argues that the need to finance the
deficit provided an incentive to the government to adopt policies that may have had
the unintended consequence of inhibiting
bank lending to the private sector. The
elimination of the deficit reduced the
incentive to pursue these policies, and,
consistent with a new policy thrust that
favored a greater role for the private sector,
the government reversed its restrictive
banking policies, which, in turn, contributed to the rapid growth in bank lending
to the private sector.
The striking changes in the deficit and
in the banking industry in Mexico over the
past decade make it an interesting setting
in which to examine the influence of a
government budget deficit on a country's
banking industry.

The Budget Deficit in Mexico
The deficit in Mexico fluctuated dramatically during the period 1983-92. In the
mid-1980s, Mexico's deficit roughly equaled
16 percent of its gross domestic product
(GDP), implying that to balance the budget,
the government would have had to seize
roughly one-sixth of the economy's output
in additional tax revenue, cut its spending
by an amount equal to one-sixth of the
economy's output, or pursue some combination of these two policies.1
The large deficit contributed to the
financial instability that led to the reform
package initiated in 1987. Much of the
financial turmoil that followed the crash of
the Mexican stock market in October 1987
was attributed to the volatility of expectations that prevailed in the high-inflation

1 During the period 1947-92, the U.S. deficit-to-GDP
ratio reached its peak of 6.3 percent in 1983.

27

environment. The high rate of inflation
stemmed from the government's reliance
on printing money to finance a significant
portion of its deficit. Thus, one of the goals
of the reform package was to eliminate the
deficit (Ortiz 199D- The reform eventually
resulted in the elimination of the deficit,
and in 1991, Mexico achieved a government budget surplus of 1.8 percent of GDP.
Chart 1 shows government spending and
tax revenue in Mexico after adjusting for
inflation.2,3 The deficit is equal to the difference between government spending and
tax revenue. As can be seen in Chart 1, the
deficit was large in the mid-1980s and declined sharply in 1988. Continuing improvement has resulted in recent surpluses. The
elimination of the deficit was achieved
predominantly through sharp reductions in
government spending; higher tax revenue
contributed only modestly to the deficit re-

Chart 1
Deficit Reduction in Mexico
Billions of 1978 pesos

NOTE: Centered 12-month moving averages.
SOURCE: SIE, Banco de Mexico.

duction. Mexico's economy grew at roughly
a 3-percent annual rate during the period
when the deficit was being eliminated.
Because of the tremendous rise in prices in Mexico
during the sample period, it is important to adjust
variables measured in pesos for inflation. This adjustment is accomplished by dividing the peso-denominated variables by the price level and multiplying by
100. As an example, a collection of consumer goods
that cost 100 pesos in 1978 cost roughly 27,793 pesos
in 1991. Thus, while the government spent 232,112
billion pesos in 1991, government spending in 1991
would have been roughly 835 billion pesos (835=
(232,112^-27,793)xl00) in 1991 if prices in 1991 had
been the same as in 1978. Thus, government spending
in 1991 was 835 billion pesos in "real" or inflationadjusted terms. Unless noted otherwise, in the rest of
this article all peso-denominated variables are measured in real terms but the word "real" is dropped; for
example, government spending means real government spending. Amounts measured in non-inflationadjusted pesos are called "nominal."
2

The raw data for this study run from January 1983 to
September 1992. Also, rather than plotting the actual
mondily values of government spending and tax
revenues, centered 12-month moving averages of the
variables are shown. The 12-month centered moving
average shows the values of the variables with their
month-to-month variability smoothed out.
3

4

A more comprehensive history of Mexico's financial

system is provided elsewhere in this issue.

28

Mexico's Banking System
The sharp swings in the deficit were
accompanied by substantial changes in the
banking system, including adjustments to
the 1982 bank nationalization and the
reprivatization of the banks in 1991—92.
The history of Mexico's banking system
during 1983-92 can be broken into three
periods: the fully nationalized period,
1983-84; the transition period, 1985-90;
and the privatized period, 1991-present. 4
The fully nationalized period. Mexico's
banks were nationalized in 1982. Following
nationalization, the government replaced
the banks' presidents with its own appointees but retained most of the banks' other
personnel. Although there was consolidation
during the nationalized period, eighteen
separate commercial banks were still in
operation when the banks were auctioned
back to the private sector. The government owned the banks but did not actively
manage them on a day-to-day basis. Instead,

the government exercised control through
regulations, including interest rate controls,
selective portfolio restrictions, and required
reserve ratios. The interest rate controls
limited the interest banks could pay depositors, thereby hindering banks' ability to
attract funds. The selective portfolio restrictions forced banks to extend credit to
selected sectors of the economy, including
the government sector.5 The required reserve
ratio, as in the United States, required
banks to hold some fraction of their deposits
as reserves, but unlike reserves in the
United States, deposits at the Banco de
Mexico earned interest. Reserve requirements reduce banks' flexibility, because
they force banks to hold some minimum
amount of reserves.6
These restrictions on banks may have
reduced the government's borrowing cost,
as discussed below, but they also limited
banks' ability to provide financial services to
the private sector; this drawback strengthened the incentive to reduce some of these
restrictions and to move toward privatization.
In other words, the government may have
perceived the reduction in its cost of financing the deficit provided by the restrictions
as a benefit of the restrictions, but a cost of
the restrictions was the reduction in banks'
ability to provide financial services to the
private sector. As the government cut its
spending and reduced the deficit, it no
longer needed to borrow as much as it had
before reducing the deficit. This reduction
in the need to borrow reduced the government's perceived benefits from the restrictions, and the government reduced the
restrictions.
The transition period. One of the goals
of the transition period was to create an
environment in which banks could better
provide financial services to the private
sector. During the transition, restrictions on
banking were reduced, thus setting the
stage for the full privatization that was to
follow. As a first step toward reprivatization
of the banking system, the government
offered minority shares in the commercial
banks in 1985. While the government

retained a majority interest in the banks,
the minority shareholders did establish a
base to build on when the banks were
later fully privatized.
By 1989, the deficit reduction plan had
sharply cut the deficit, thereby reducing the
government's borrowing needs, which
permitted the government to ease the
restrictions on the banking system. One
part of this easing was the introduction of
liquidity coefficients to replace reserve
requirements in April 1989. The required
reserve ratio required banks to hold some
fraction of their deposits as vault cash or as
deposits at the central bank. The change to
the liquidity coefficient required banks to
hold some fraction of their deposits as
vault cash, deposits at the central bank, or
as selected short-term government securities. Thus, the movement to the liquidity
coefficient gave banks greater flexibility
than the reserve requirement regime.
Because of increased flexibility, it was
less costly for banks to satisfy the liquidity
coefficient than it had been to satisfy the
reserve requirement.7 The reduced burden
allowed banks to provide financial services
more effectively. Because the liquidity
coefficient could be satisfied by holding
assets that offered a market rate of interest,
it allowed banks to generate higher income
on their portfolios than they could under
the reserve requirement, thus allowing
banks to offer more favorable returns to
their depositors. This increased the attractiveness of bank deposits and improved

5 As an example of a portfolio restriction, at the margin, 35 percent of peso-denominated deposits had to
be lent to the government in October 1988.

Reserve requirements are also an important tool of
monetary policy.
6

Although deposits at the central bank did pay some
interest, the interest rate offered on short-term government securities was higher, thereby leading banks to
satisfy their liquidity requirement largely through
holdings of short-term government securities.
7

29

banks' ability to provide financial services.
As a result of continued improvement in
the government's deficit, the liquidity
coefficient was eliminated in September
1991, further improving banks' ability to
compete for funds.
Although replacement of the reserve
requirement with the liquidity coefficient
had a favorable effect on banks' ability to
provide financial services, it also reduced
the subsidy to the government's borrowing
cost. In effect, the reserve requirement had
forced the banks to lend to the government
at below market interest rates. The liquidity
coefficient, however, could be satisfied
through holding government securities that
offered a market rate of interest. Thus, the
government was no longer borrowing at
the subsidized rates enjoyed under the
reserve requirement. The cost to the government of losing the subsidy, however,
was limited by the reduction in the government's need to borrow that had been
achieved by 1989Interest rate restrictions were also relaxed
in April 1989- One effect of the interest rate

This argument only accounts for the direct effect on
the attractiveness of government debt relative to bank
deposits. There is also an indirect effect that operates
through the effect of interest rate restrictions on the
efficiency of the financial system. By making it less
attractive to hold savings within the banking system, it
is likely the restrictions made it less attractive to hold
savings in Mexico as a whole. Thus, the overall effect
of interest rate restrictions on the government's borrowing costs is theoretically undetermined. On the
one hand, the restrictions increase the attractiveness
of government debt relative to bank deposits, which
by itself would reduce the government's borrowing
costs. On the other hand, the restrictions decrease the
overall attractiveness of saving, thus decreasing the
pool of savings, which, by itself, would increase the
government's borrowing costs.
8

In 1991 alone, privatization occurred in a number of
industries, including iron and steel, fertilizer, and telecommunications.

9

10 Gunther and Moore (1992) provide further discussion of the privatization of Mexico's banks.

30

restrictions was that they may have reduced
the government's cost of financing the
deficit. By limiting the interest rates that
banks could pay on deposits, the restrictions
increased the attractiveness of alternative
assets, including government debt, and
may therefore have reduced the government's borrowing cost.8 But the limits on
interest rates decreased the attractiveness
of holding deposits in the Mexican banking
system, leading to a deposit outflow and
weakening banks' ability to compete in the
financial services market. The reduction in
the deficit that had been achieved by April
1989 reduced the government's need to
borrow and thus decreased the perceived
benefit of maintaining the interest rate
restrictions, but the cost the restrictions
imposed on banks' ability to provide financial services remained. This shift in benefits
versus costs may have influenced the
government's decision to relax the interest
rate restrictions.
The privatized period. The elimination of
the deficit by 1991 occurred in an environment in which the role of private ownership was being increasingly emphasized.9
Consistent with this new policy thrust, the
banks were returned to the private sector
through government auctions held between
mid-1991 and mid-1992. The banks sold for
a total of more than $12 billion (U.S.)—
more than three times their book value—
showing the value that the private sector
placed on commercial banking in Mexico.10
Because privatization occurred so recently,
it is difficult to draw empirical conclusions
about its effect on bank behavior. The data
available, however, do show that the trend
toward greater bank credit to the private
sector continued through September 1992,
coinciding with decreases in the deficit.

The Deficit and Bank Lending
The behavior of the deficit and die amount
of bank lending to the private sector, shown
in Chart 2, is consistent with the deficit's
having a negative influence on bank lending to the private sector. From 1984 until

Chart 2
The Government Deficit and Bank Loans
to the Private Sector in Mexico
Billions of 1978 pesos

NOTE: Centered 12-month moving averages.
SOURCE: SIE, Banco de Mexico.

1988, the period when the government
budget deficit was largest, bank loans to
the private sector were essentially constant.
From 1988 through mid-1992, the period
when the government was reducing its
deficit and moving to the recent budget
surplus, bank loans to the private sector
were increasing rapidly.
While it is difficult to establish causality,
the increase in bank lending to the private
sector that accompanied the reduction in
the deficit may have been more than coincidental. My contention is that the deficit
contributed to the adoption of regulatory
and monetary policies that had an adverse
effect on bank lending to the private sector,
and the elimination of the deficit contributed to the reversal of these policies. Thus,
the deficit may have indirectly influenced
bank lending to the private sector through
the deficit's effect on regulatory and monetary policies.11
Regulations on bank portfolios. One
way the deficit may have affected bank
lending to the private sector was through
the deficit's influence on the government's
incentives to impose regulations on bank

portfolios. Because there were many different
reserve requirements, selective portfolio
restrictions, and liquidity coefficients—
depending on the type of deposit—it is
difficult to calculate precisely the total
amount of reserves, government securities,
and direct credit to the government that the
banking system was required to maintain.
Rather than calculate the total requirement
under these restrictions, I instead examine
the total amount of the banking system's
reserves, government securities, and direct
credit to the government. While not all of
the total was required, whatever portion of
the portfolio was held in this form was not
being lent to the private sector and indicates what fraction of banks' portfolios was
directed to the government.
Chart 3 shows the ratio of banks' holdings of government securities, reserves, and
direct credit to the government to total
assets. As the chart shows, the ratio declines
from an initial level in excess of 50 percent
to a final level near 13 percent. The decline
in the ratio during 1988-92 mirrors the
decline in the deficit that was occurring at
roughly the same time. In 1988, Mexico
began to achieve a reduction in the deficit,
thereby reducing the government's borrowing needs, which permitted the government to ease restrictions on the banking
system. In other words, as the deficit
declined, the government's need for funding declined, reducing the government's
incentive to hold down its borrowing cost
by requiring the banking system to hold
government debt. As these restrictions on
bank portfolios were reduced, the fraction
of bank assets devoted to funding the gov-

11 In addition to the channels of influence this article
examines, Garber and Weisbrod (1991) argue that the
decline in the government securities market relative to
the e c o n o m y made liquidity scarcer, thereby increasing the demand for bank deposits, since bank deposits
are a source of liquidity. This is evidence of another
link between the government budget deficit and
banking activity.

31

Chart 3
Banks' Holdings of Reserves, Government
Securities, and Credit to the Government
as a Percentage of Assets
Percent

SOURCE: SIE, Banco de Mexico.

ernment declined, and bank lending to the
private sector increased.
Interest rate restrictions. Restrictions on
interest rates were another regulatory factor
that limited banks' ability to compete in the
financial services market. The competitive
disadvantage interest rate restrictions imposed on the banking system was compounded by the high rate of inflation and
nominal interest rates that stemmed from
the deficit's influence on the money supply
in Mexico. Because the deficit in Mexico
led to rapid growth in the nominal money
supply, it also resulted in a high inflation
rate that peaked near 160 percent in 1987.
The high inflation rate, in turn, pushed the
market value of nominal interest rates to
high levels, with the interest rate on short-

12 Cetes are short-term debt obligations of the Mexican
government, analogous to Treasury bills in the United
States.

13

The unregulated interfirm market is also called the

"informal" market.

32

term government securities peaking near
150 percent at the beginning of 1988.
These high market values of nominal
interest rates were at times accompanied
by deposit interest rate restrictions that
prevented banks from offering rates on
deposits to match the rates available on
Cetes or other alternative assets.12 Chart 4
shows the spread between the interest rate
on one-month Cetes and the interest rate
on short-term bank deposits. As can be
seen in the chart, the spread was quite
volatile, turning slightly negative at times
and at other times running as high as 30
percentage points ( n o t basis points).
Prior to the elimination of interest rate
controls in April 1989, the artificially wide
spread between the interest rate on Cetes
and the interest rate on bank deposits
reduced the attractiveness of bank deposits,
making it difficult for the banks to raise
hinds, which, in turn, weakened their ability
to extend loans. Rather than depositing
their savings in banks, individuals and
firms found it preferable to lend directly to
the government or private sector borrowers.
While interest rate restrictions were in
place, a large, unregulated interfirm credit
market was developed by the investment
banks in Mexico.13 Because this market was
unregulated, it could offer interest rates to
savers above the maximum rate allowable
for commercial banks, enabling the interfirm market to attract funds that would
have otherwise been deposited in commercial banks.
To allow banks to compete with the
unregulated interfirm market, several steps
were taken to relax interest rate restrictions. The government's fall 1988 financial
deregulation package allowed commercial
banks to issue bankers acceptances without interest rate restrictions. Moreover, in
April 1989 interest rate restrictions were
removed on other bank liabilities, with the
exception of checking accounts.
The reduction in the deficit contributed
to the reduction in interest rate restrictions,
because the reduction in the government's
need to borrow reduced the desirability of

Chart 4

Chart 5

Spread Between Cetes
and Short-Term Bank Deposit Rates

The Government Deficit, Monetary Base,
and Inflation in Mexico

Percentage points

Percent
500
400 •
300
200

—
—

'83

'84

'85

'86

'87

'88

'89

'90

'91

'84

'92

SOURCE: SIE, Banco de Mexico.

Inflation*
Monetary Base Growth*
Deficit/Monetary Base**

I

'85

1

'86

1

'87

I

'88

1

'89

1

'90

i

'91

1

'92

I

* Centered 12-month moving averages.
** Centered 12-month moving sum.
SOURCE: SIE, Banco de Mexico.

imposing interest rate restrictions to hold
down its borrowing cost. The reduction of
interest rate restrictions allowed banks to
compete for funds more effectively, which,
in turn, helped facilitate the expansion of
loans to the private sector. Thus, one way
in which the deficit influenced banking
was through policymakers' reliance on
interest rate restrictions to attempt to reduce
the government's borrowing costs.
Inflation. The deficit may have also affected
bank lending to the private sector through
its effect on monetary policy and inflation.
The effect of a deficit on inflation depends
on how the deficit affects the money supply, which, in turn, depends on how a
government finances the deficit.14 Roughly
speaking, a government has the choice of
financing the deficit by issuing bonds or by
printing money.15
If the amount of money printed to finance
the deficit is large enough to cause rapid
growth in the nominal money supply, then
high inflation will result. Thus, the potential inflationary impact of the deficit can be
measured by the ratio of the deficit to the
monetary base.16 When this ratio is large and
the deficit is financed by printing money,

then the nominal monetary base will grow
rapidly, implying rapid growth in the
nominal money supply and high inflation.
Chart 5 shows the ratio of the Mexican
deficit to the monetary base, the growth
rate of the nominal monetary base, and the
rate of inflation. The deficit was near its
peak relative to the monetary base in late
1987 and early 1988, when the annual
deficit was roughly four times as large as
the monetary base. The evidence indicates
that a substantial portion of this deficit was

14

Robinson (1987) provides an analysis of the influ-

e n c e of fiscal policy on monetary policy in the United
States.
15 More precisely, the government may finance the
deficit by either issuing bonds to the public or by
borrowing from the central bank. Borrowing from the
central bank will increase the monetary base; I call
this financing the deficit by "printing money."

16

The monetary base is the sum o f currency held by

the public and in bank reserves.

33

monetized. The high ratio of the deficit to
the monetary base, coupled with reliance
on printing money to finance the deficit,
resulted in an annual rate of growth of the
nominal monetary base near 100 percent at
its peak and a rate of inflation near 160
percent at its peak. The peak in the ratio of
the deficit to the monetary base roughly
coincides with the peaks in the nominal
money growth and inflation rates. The
reduction in the government budget deficit
that began in 1988 was accompanied by
corresponding reductions in the rate of
growth of the monetary base and inflation.
Thus, the ratio of the deficit to the monetary base, nominal money growth, and
inflation tended to move together in Mexico.
When a government prints money to
finance its deficit, it is, in effect, imposing
an inflation tax because the increase in the
price level caused by the expansion of the
nominal money supply reduces the purchasing power of money.17 Thus, the inflation
tax is ultimately a tax on wealth held in the
form of money. Analysts generally expect
the private sector to respond to a tax on an
asset or activity by reducing its holding of
the taxed asset or reducing its participation
in the taxed activity. This analysis applies
to the inflation tax as well. When the government finances the deficit by printing
money and higher inflation results, the cost
of holding assets in the form of money
increases, and the public responds by
reducing its demand for money by substituting away from money to other financial
or physical assets.18
The decline in the real money supply in

17

Bailey ( 1 9 5 6 ) provides further discussion of the

inflation tax.
18 Cagan ( 1 9 5 6 ) provides further discussion of the influe n c e of inflation on money demand. More recently,
Brock ( 1 9 8 9 ) argues that government may use the
required reserve ratio to increase the demand for
currency and therefore to extract a greater amount of
revenue from the inflation tax than would b e possible
in the absence of reserve requirements.

34

Chart 6
Real M2 and Real Total Bank Assets
Trillions of 1978 pesos

SOURCE: SIE, Banco de Mexico.

Mexico, which can be attributed in part to
the inflation tax, can be seen in Chart 6. At
its low point in early 1989, real M2 had
fallen one-third from its value at the beginning of 1983- The downward trend in real
M2 from the beginning of 1985 through the
end of 1987 roughly coincides with the
period when the deficit was growing
relative to the monetary base. The decline
in real M2 is consistent with individuals
behaving as if they perceived the potential
inflationary impact of the growth in the
deficit and decreasing their demand for
money accordingly.
Chart 6 also shows movements in the
value of bank assets. Because banks fund
their assets using liabilities that make up
the money supply, a decline in real money
demand makes it more difficult for banks
to fund their assets, and hence, a decline in
money demand is likely to reduce bank
assets. As Chart 6 shows, there is a close
connection between movements in bank
assets and movements in real M2. Moreover, looking back to Chart 2 reveals that
the trends in bank lending to the private
sector behave similarly to the trends in real
M2. Thus, the deficit may have affected
bank assets (including loans to the private

sector) through the effect of the deficit on
real money demand.

Conclusion
The large government budget deficit in
Mexico had a major impact on the country's
financial system. Because a significant
fraction of the government's budget deficit
was financed through money creation, the
deficit caused a high rate of growth in the
money supply and, hence, produced high
inflation. Even after monetizing part of the
deficit, the government's need for funds
remained massive. Much of this need was
satisfied through the commercial banking
system, resulting in stagnation in bank
lending to the private sector.
The banking system was used to help
finance the government's budget deficit in
many ways. Selective portfolio restrictions,
reserve requirements, and liquidity coefficients created an artificial demand for the
government's debt by the banking system.
Second, interest rate restrictions hampered
banks' ability to compete for funds, and
because these restrictions made government debt more attractive relative to bank
deposits, they also may have helped reduce the government's borrowing cost.
Finally, the reduction in money demand
induced by the inflation tax made it more
difficult for banks to raise funds, further
depressing the growth in banks' assets.
The cut in the deficit reduced the government's need for funding, allowing for
reductions in the rates of money growth
and inflation and for a restructuring of the
banking system. On the regulatory side, the
reduction in interest rate controls and the
near elimination of reserve requirements

and liquidity coefficients improved banks'
ability to compete in the financial markets.
On the fiscal side, the elimination of the
government budget deficit that resulted
from sharp reductions in government
spending and modest increases in tax
revenue helped shift the focus of the banking system from public to private lending.
Moreover, the reduction in the deficit and
the accompanying reduction in the rate of
money growth led to a reduction in the
inflation tax, which contributed to an
improvement in banks' lending capacity.
The close connection between the deficit
and the government's treatment of the
banking system stemmed, at least in part,
from the government's attempts to finance
its deficit through the banking system. As
the deficit was approaching its highest
levels, the banking system was subject to
numerous restrictions that may have been
intended to reduce the government's borrowing cost but that had the unintended
effect of crippling bank lending to the
private sector. In the new policy regime
that followed the 1987 reform, the deficit
was eliminated, the restrictions on the
banking industry were reduced, and lending to the private sector flourished.
The linkage between the deficit and the
banking system in Mexico highlights an
important, but perhaps underappreciated,
effect of deficits. The high deficit may have
contributed to the adoption of bank regulatory policies that had the undesirable side
effect of suppressing bank lending to the
private sector. Eliminating the deficit made
it easier for the government to reform its
bank regulatory policies, thus improving
banks' ability to lend to the private sector.

35

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Economy 64 (April): 93-110.
Banco de Mexico (1992),
Indicadores
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Banco de Mexico).
(1992a), The Mexican
Economy
1992 (Mexico City: Banco de Mexico).
(1992b), Sistema de
Informacion
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Mexico).
Brock, Philip L. (1989), "Reserve Requirements and the Inflation Tax," Journal of
Money, Credit, and Banking 21 (February):
106-21.

Cagan, Phillip (1956), "The Monetary Dynamics of Hyperinflation," in Studies in the
Quantity Theory of Money, Milton Friedman,
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(1991), "Opening the Financial Services

36

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