III Franchise Value of Banks and Resolution of Banking Crises: 1982–90
  • 1 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund
  • | 2 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund


It is well documented that the challenges faced by policymakers in Latin America following the outbreak of the debt crisis included not only the correction of the countries’ macroeconomic imbalances but also the restoration of their domestic banking systems.20 It is now fully recognized that the serious problems faced by the banking systems in a number of countries in the region placed additional constraints on the effectiveness and sustainability of the stabilization programs implemented in the years immediately after the onset of the debt crisis.21

It is well documented that the challenges faced by policymakers in Latin America following the outbreak of the debt crisis included not only the correction of the countries’ macroeconomic imbalances but also the restoration of their domestic banking systems.20 It is now fully recognized that the serious problems faced by the banking systems in a number of countries in the region placed additional constraints on the effectiveness and sustainability of the stabilization programs implemented in the years immediately after the onset of the debt crisis.21

This section draws on the characterization of the role of banks in developing countries presented in Section II to analyze how the authorities and the banking sectors in Argentina, Chile, Colombia, Mexico, and Peru responded to the financial difficulties during the early and mid–1980s.22 It shows that the state of the franchise value of banks—as defined in Section II—at the inception of the debt crisis was a central element in determining whether the authorities in each of the countries followed a disciplined set of policies in managing the banking problems.

The main conclusions derived from this section are obtained by grouping the sample countries according to the strength of their banking franchise at the inception of the debt crisis and by making relative comparisons among those countries. In summary, the analysis will show that, because the banking systems in Chile and Colombia had relatively strong franchises, bank supervisors and bankers were able to respond to the crisis with a credible program to restore confidence in the banking system. Incentives were put into place to enable bankers and their shareholders to gain from salvaging value from bad credits. The programs in both these countries required a substantial increase in credit, but because credit creation was associated with a program to restore stability, it was noninflationary.

In contrast, banking regulators in Argentina, Mexico, and Peru, in their attempts to solve the crisis, removed authority from bankers and substituted the credit judgment of the central bank or the government directly. These policies also eventually led to credit expansion, which proved to be highly inflationary because investors did not believe the credit created would be repaid in real terms.

Evaluating Banks’ Strength at the Onset of the Debt Crisis

Following a period that started in the late 1970s characterized by large inflows of foreign capital,23 by the end of 1982 and continuing during 1983–84, all five countries under consideration experienced large outflows of capital. These outflows reflected residents’ and foreigners’ deteriorated perceptions regarding the creditworthiness of borrowers in these economies.24 The turnaround of voluntary capital in-flows experienced by each country since 1982 was accompanied by a negative overall balance of payments (Chart 1). The loss of international creditworthiness experienced by these economies called for a domestic policy response—each country had to either put into place policies that restored the confidence of the international financial community or generate sufficient cash flow on its trade account to compensate for the outflow of capital.25

Chart 1.
Chart 1.

Balance of Payments: Current Account and Overall Balance

(Percent of GDP)

Source: IMF, World Economic Outlook.

The lack of confidence in borrowers’ ability to repay their loans had an adverse impact on the banking systems in these five countries—albeit in different proportions. In accordance with the discussion in Section II, banking systems in which the loan-to-asset ratio is relatively high and the cash-to-deposit ratio is relatively low—that is, banking systems where the franchise value is high—have the greatest experience in establishing credible loan workout programs in periods of systemic bank crises. In banking systems where the franchise is low, the tendency in a crisis is to provide new credit to borrowers in arrears on their payments, without establishing adequate controls, in the expectation that these borrowers will be able to salvage a bad business with the new funds. Such credit expansion has often led to greater credit problems in the near future.

At the end of 1982, the banking systems of the five countries fell into two distinct groups. The first group, consisting of Argentina, Mexico, and Peru, had comparatively weak franchises, and the second group, consisting of Chile and Colombia, had comparatively strong franchises as measured by the ratios described above. The first group had cash-to-deposit ratios ranging from 55 percent in Peru and 65 percent in Mexico to over 75 percent in Argentina. In contrast, in Chile and Colombia, the ratio was about 21 percent. Although confirming the classification of countries described above, the differences in the loan-to-asset ratios between the two groups were not quite as extreme. In the first group of countries, the ratio was about 45 percent. In Chile, it was 63 percent and in Colombia about 59 percent (Table 6).

Table 6.

Indicators of Bank Franchise Value, 1982


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Sources: Central Bank of Argentina; Chile, Superintendencia de Bancose Instituciones Financieras, Información Financiera; Colombia, Banco de la Republica; Mexico, Comisión Nacional Bancaria; Peru, Superintendencia de Banca y Seguros; and IMF staff estimates.

Data correspond to 1981.

Incentives to monitor the liquidity of bank borrowers—as measured by the above ratios—determine the quality of bank supervision as well. In banking systems where borrower liquidity determines the liquidity of the banking system, the central bank must monitor bank lending decisions because it may often be called upon for liquidity assistance. To provide this assistance without undermining the franchise value of the banking system, it must be familiar with how its member banks make their lending decisions and how they monitor their borrowers.

A well-known example of how the behavior of a lender of last resort can contribute to the undermining of a bank franchise is the U.S. savings and loan crisis. U.S. savings and loans offer government-insured deposits, mostly to consumers, similar to those offered by banks. In contrast to commercial banks, which hold a portfolio of short-term loans, savings and loans hold mostly long-term home mortgages, which, until the late 1980s, were illiquid securities.

In the 1970s, the deposits offered by savings and loans were short term and subject to interest rate ceilings. When market interest rates rose substantially above the ceilings in an inflationary environment, consumers began to withdraw their deposits. Savings and loans could not sell their mortgage assets, which were fixed-interest-rate securities, because the market was limited. Even if they had been able to sell, however, the losses sustained from the increase in interest rates would have wiped out the capital of many institutions.

During this phase of the savings and loan crisis, policymakers tried to nurse failing savings and loans along with marginal extensions of credit through the Federal Home Loan Bank Board, a kind of central bank for savings and loans, and through regulatory forbearance on accounting issues. Deposit interest rates were deregulated, which stopped the outflow of deposits but did not improve the profit situation as interest expenses exceeded interest income. The asset powers of savings and loans were also liberalized. For example, federally chartered savings and loans were permitted to make direct investments in real estate as well as to hold mortgages. Giving the savings and loans the right to bid for insured deposits paying market interest rates and liberalized powers resulted in increased risk taking, and, with the decline in the property market in the late 1980s, the savings and loan industry was in critical condition.

At the end of the 1980s, marginal aid policies were abandoned, and large sums of public money were committed. The commitment of public money came with a new policy that made shareholders partners with a government agency to rescue the industry. The government agency, the Resolution Trust Company, took over the assets of failing savings and loans. It then sold the assets through a bidding process. Thus, prospective buyers bid on the assets based on their calculations about future movements in the market as well as on their ability to manage defaulted loans back to profitability. The previous policy of providing distressed savings and loans access to lender-of-last-resort funding on a continuous basis often committed regulators to lend money to institutions that had no capital. Thus, owners had no incentive to use the new money wisely because they had nothing at risk. In contrast, the new policy committed government money immediately and then turned the assets over to new owners, who were required to supply new capital to the project. The new capital commitment was large enough to give the new owners an incentive to manage the assets back to profitability.

Successful bailout programs of banking systems in Latin America paralleled the second phase of the U.S. savings and loans crisis, while unsuccessful bailouts paralleled events in the first stage. That is, bailout programs of banking systems in Latin America were successful only when the supply of central bank credit to distressed institutions was made conditional on a realistic appraisal of the loan portfolio. Under such programs, only borrowers with a reasonable possibility of returning to solvency could be eligible for additional loans.

Macroeconomic Environment and the Franchise Value of Banking Systems

Closely related to the ability of the central bank to promote discipline in financial markets is the state of the overall macroeconomic environment. It is there-fore natural to question whether the ordering of the five countries according to the strength of their banking franchise matched the relative soundness of their macroeconomic systems in the period immediate before the debt crisis.

Based on the fiscal policy stance and the level of inflation, Chile had the strongest macroeconomic environment among the countries under consideration in the early 1980s (Table 7). Consistent with having the strongest fiscal stance, Chile’s average rate of inflation was the lowest among the countries in the sample. Colombia followed Chile in the ordering of countries. With this criterion in mind, Argentina had the weakest macroeconomic condition among the countries in the group: even two years before the outbreak of the debt crisis, the average inflation rate was running at more than 100 percent. Although the rate of inflation in Mexico did not accelerate until 1982—and was similar to that experienced in Colombia in 1980–81—the fiscal deficits (as ratios of GDP) in Mexico during the early 1980s resembled those in Argentina. Finally, Peru’s fiscal deficit and inflation, although less severe than in Argentina, deteriorated during the early 1980s. Indeed, by 1981, the Peruvian inflation rate was closer to Argentina’s inflation rate than to that of any of the other countries in the sample.

Table 7.

Fiscal Balance and Inflation

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Sources: Argentina, Ministry of Economy, and Central Bank of Argentina; Central Bank of Chile; Colombia, Banco de la Republica; Bank of Mexico; Central Reserve Bank of Peru; and International Monetary Fund, International Financial Statistics, various issues.Note: Fiscal balance (overall surplus (+) or deficit (-) of the nonfinancial public sector) data are expressed as a percentage of GDP; inflation figures are shown in percentages. Inflation is calculated using the following formula: ((P[t]–P[t–1])/P[t–1]) 100, where P is the consumer price index (CPI) (IFS line item 64). The CPI is calculated based on the average price prevailing in the economy during the year.

Includes quasi-fiscal operations of the central bank.

Refers to the overall surplus (+) or deficit (-) of the consolidated public sector.

From 1984 onward, the data represent the economic balance; that is, financial intermediation is not included.

Thus, the ordering of countries in terms of their fiscal stances and inflation performances during the early 1980s matched closely the ordering of the franchise value in these countries. Moreover, in Argentina, Mexico, and Peru, ex post real interest rates on bank deposits were mostly negative in the early 1980s, reflecting interest rate ceilings imposed by the authorities26 (Chart 2). To a large extent, these controls, which weakened the franchise value of banks, were not present in Chile and Colombia, and, as a result, ex post real interest rates remained positive throughout the 1980s.27

Chart 2.
Chart 2.

Real Interest Rates

(Annual average, in percent)

Sources: Argentina, Ministry of Economy, and Central Bank of Argentina; Central Bank of Chile; Colombia, Banco de la Republica; Bank of Mexico; Central Reserve Bank of Peru; and IMF staff estimates.

It is not surprising to find out that, using the two alternative criteria, the ordering of countries matches. After all, a stable macroeconomic environment and a stable financial system are complementary.

How the Systems Responded to Immediate Crisis: 1982–85

This subsection considers whether the banking systems in the countries classified as having the highest franchise value among the countries in the sample coped with banking crises in a more disciplined manner than those countries classified as having the lowest franchise value. At the beginning of the international debt crisis in 1982, the banking systems in Argentina and Mexico were already deeply mired in a credit crisis. In Chile and Colombia, the banking systems were about to face the consequences of lender concerns that borrowers could not make good on their debts. In Peru, the crisis was delayed until the middle of the decade, but when it arrived, it was a crisis of major proportions.

In Argentina, the banking system, which had been subject to interest rate ceilings, high reserve requirements, and prescribed lending policies, was rapidly deregulated in 1978. Without appropriate supervision of credit and with bankers lacking the experience to price risks properly, the banking system expanded excessively and, by the early 1980s, suffered from severe credit problems. The central bank responded to the crisis by reimposing stiff reserve requirements and interest rate ceilings on deposits. Real interest rates on deposits became negative (see Chart 2), and reserves in the central bank increased to over 70 percent of deposits in 1982, compared with 12 percent in 1981.

The central bank followed two basic policies: it subjected deposit interest rates to a ceiling that permitted banks to reduce interest rates to borrowers to a manageable level, and it increased reserve requirements, which, in turn, provided the central bank with resources to lend to the most troubled institutions. In 1982, central bank credit to the financial system equaled over 21 percent of GDP (see Table A1).

The central bank response can be said to have solved the crisis by placing as little strain as possible on defaulting borrowers and the most troubled banks. Banks with relatively clean loan portfolios were forced to aid in the bailout of troubled banks by holding high reserves so that the central bank could obtain resources to lend. Depositors were forced to accept a depreciation of their deposits in real terms. Because responsibility was not placed on the shoulders of the parties responsible for the crisis, crisis resolution weakened the franchise value of the banking system.

In contrast to this view, the central bank reaction to reregulate suggests that the authorities believed that the banking crisis was caused by deregulation in the late 1970s—that is, by the reduction of reserve requirements and the resulting increase in bank loans. Although it is probably true that the rapid deregulation of a banking system run by inexperienced bankers invited the banking crisis, the resolution of the crisis did nothing to educate bankers in how to deal with credit crises, which was the real problem facing the Argentine banking system. As such, reregulation was a step backward that was to lead to much greater trouble later on than that caused by deregulation.

An additional problem confronting the Argentine banking system was the explosion of credit to the central government in the early 1980s, most of which was lent through the central bank and, again, financed by high reserve requirements on the banks. This expansion of credit had two debilitating effects on the banking system. First, it ensured that high reserve requirements would persist beyond the immediate banking crisis and, second, it placed the central bank in the role of direct lender to the government. As a direct lender and a supervisor, the central bank was faced with a conflict of interest that undermined sound bank supervision.

In Mexico, the banking crisis in 1982 occurred in an environment of sharply deteriorating economic conditions (see Table 7). The crisis could not be blamed on rapid credit expansion following a decline in reserve requirements, because the ratio of cash assets to deposits was extremely high in Mexico before the onset of the crisis. However, because the central bank had used the high reserve requirements to lend to the government, it had few resources to lend to troubled banks (see Table A2).

The lack of resources could have led to a disciplined approach to resolving the banking crisis. Instead, the central bank and the government engaged in a policy of reducing the real burden of borrower debt and forcing depositors to absorb some of these losses through a reduction in the real value of deposits. The latter action was achieved through a combination of policies: forced conversion of foreign-currency-denominated deposits at unfavorable exchange rates and negative real interest rates on peso-denominated deposits. The real value of loans was reduced through the conversion of foreign currency loans to pesos at an exchange rate that overstated the value of the peso relative to the dollar. Thus, as in Argentina, one of the parties responsible for the crisis, the borrower, was given a subsidy, and the party with less responsibility, the depositor, was forced to accept a loss.

In addition, the banks were nationalized, which, if properly managed, could have had a beneficial effect on franchise value because stockholders were forced to absorb losses. Such a policy, however, would have been beneficial to the franchise only if the new owners, whether the government or private entities, had purchased the banks after the assets had been properly evaluated. In addition, new owners should have been required to place substantial new equity into the system with a clear statement of policy that the equity would be lost if the new managers could not successfully manage the assets after reevaluation. That this was not done is suggested by the fact that the capital-to-asset ratio of Mexican banks remained very low until the late 1980s (see Chart 3).

Chart 3.
Chart 3.

Capital to Assets


Sources: Central Bank of Argentina; Chile, Superintendencia de Bancos e Instituciones Financieras, Información Financiera; Colombia, Banco de la Republica; Mexico, Comisión Nacional Bancaria; Peru, Superintendencia de Banca y Seguros; and IMF staff estimates.

The methods used by the Mexican banking authorities to resolve the banking crisis required fewer uses of public funds than in Argentina. These methods, however, were philosophically similar: they were designed to spread the losses in an acceptable manner rather than to improve the franchise. Thus, the responses of the authorities in these two countries parallel those of the U.S. authorities in the first phase of the savings and loan crisis.

In contrast to Argentina and Mexico, Peru did not experience a major banking crisis in the early 1980s.28 Peru had an extremely high ratio of cash to deposits in 1982 and, in contrast to Argentina, had not experimented with reserve requirement reductions in the 1970s. As a result, bank loans to the private sector were small relative to GDP (Table A3), and, in 1982, that ratio was the lowest among the five countries under consideration.

Not extending bank loans may appear to be a very attractive way to prevent a banking crisis; if bank lending is limited, few loans can become nonperforming. Banks that were extending only a few loans, however, lost their credit evaluation skills, and, in the late 1980s, when the central bank expanded credit to finance compounding fiscal deficits, they were unable to respond in a disciplined manner. This generated a crisis of major proportions that will be discussed in the next subsection.

In 1982, the banking authorities eliminated marginal reserve requirements on domestic currency deposits, although average reserve requirements remained extraordinarily high—at more than 50 percent of total deposits. They also simplified the interest ceilings imposed on domestic currency deposits. One of the primary motivations of the authorities in reducing reserve requirements was to expand domestic bank lending activity. A central bank policy of paying attractive interest rates on reserves, however, encouraged banks to continue to hold high ratios of cash to deposits despite the reduction in reserve requirements. Moreover, banks were further encouraged to hold high reserves at the central bank because the uncertain macroeconomic environment increased the risk of lending.

The reforms, however, did not lead to a substantial increase in domestic currency deposits. In fact, as real interest rates on domestic currency deposits were substantially negative in the early 1980s (see Chart 2), foreign currency deposits increased from 46 percent of bank deposits in 1982 to 61 percent by 1984. Because these deposits had high reserve requirements, an increasing share of resources ended up in the hands of the central bank. The central bank lent some of these funds to the government-owned development banks but, in 1984, invested them primarily in foreign reserve assets (see Table A3). The large amount of liquid assets in the banking system and the central bank precluded a major banking crisis in the early 1980s, but crisis loomed on the horizon as a government came to power that was willing to spend these resources. In fact, the unwillingness of the authorities to encourage banks to create domestic credit may have contributed to the support of a new government willing to spend resources domestically. The problem was that this spending was funneled through a financial system without a franchise value, generating a crisis. This crisis is discussed in the next subsection.

Chile and Colombia also experienced banking crises in 1982, but, in contrast to Argentina and Mexico, the central bank authorities attempted to focus responsibility for problems on the shareholders of the most distressed banks rather than on the system as a whole.

In Chile, the rescue effort got off to a somewhat unpromising start. The central bank made extensive credit available to the banking system and to de-faulted borrowers without putting proper controls in place. Net domestic credit of the financial system increased from 54 percent of GDP in 1982 to more than 73 percent of GDP in 1983 (Table A4). Much of this increase was due to central bank lending to financial intermediaries, which rose from less than 7 percent of GDP in 1982 to more than 16 percent of GDP in 1983. In addition, the central bank purchased nonper-forming loans outright from the banks.29

In rescheduling nonperforming foreign currency loans, the central bank offered borrowers favorable exchange rates, which created severe losses at the central bank. Borrowers presented pesos to the central bank to repay their loans, and the central bank exchanged these at a dollar exchange rate that was lower than that prevailing in the open market. In fact, the losses became so severe that the government had to recapitalize the central bank.

The authorities quickly put in place policies that attempted to provide incentives for banks to work with defaulting borrowers to improve loan quality. In 1984, the central bank bought the banks’ nonperforming foreign currency assets with cash. The banks had to use this cash to repay the central bank for credit drawn on the lines made available in 1982. As a result of this transaction, central bank loans to the banking system declined (Table A4).

Under the initial agreement of 1984, the banks were forced to buy back the bad loan portfolio over a ten-year period at the original face value of the loan plus accumulated unpaid interest, rather than at a value determined by how the loan was performing. The repayment would be made through a provision item in the income statement that flowed into an ac-count on the liability side of the balance sheet, referred to as “a subordinated obligation to the central bank.” The banks, however, were not paying market interest rates on their obligations to repay the central bank.30

As an important component of the original agreement, the banks were placed in charge of administering the loan portfolio they had sold to the central bank, which meant that they had responsibility for collecting loan payments and encouraging borrowers to remain current on their payments. Banks had an incentive to perform this task well, because, under the original terms of their agreement with the central bank, they had to buy loans back at the original face value. With this policy, the central bank at-tempted to play the role of supervisor of banks rather than of manager of nonperforming loans to the private sector.

The authorities encouraged banks to index the principal of domestic currency loans to inflation to reduce the cash-flow burden on borrowers during the relatively high inflation experienced in the mid–1980s. During high inflation, the real principal of nonindexed debt contracts declines. The high nominal interest rate compensates the lender for this loss, but it also forces the borrower to pay off real principal more rapidly than in a noninflationary environment. To offer an indexed loan contract, banks had to find liability holders who were willing to hold deposits with indexed principal. During the first few years of the program, private liability holders were reluctant to supply such a contract. Hence, the authorities provided banks with a line of credit with indexed principal.

Not all banks could be rescued by the above mechanisms, however. The portfolio condition of some banks had deteriorated so much that they had to be recapitalized before they could sell loans to the central bank. The government took over the distressed banks, writing down the value of stockholder equity by marking assets to market, as manifested in the sharp drop in equity-to-asset ratios in 1984 (see Chart 3).31 But, unlike in Mexico, the central bank offered the distressed banks for sale to the private sector.32 Deals were structured so that the new owners contributed sufficient capital to give them an incentive to manage the assets prudently. With new ownership in place, the resolved banks were permitted to participate in the central bank’s distressed loan program. The new stockholders together with the central bank became de facto preferred shareholders: dividends had to be paid to them before dividends could accrue to the original stockholders. This policy had two beneficial effects: it demonstrated to an identified group of shareholders that if banks fail, equity holders lose money. It also put a new management in place with capital to lose, giving them the appropriate incentives to manage loan portfolios.

Despite the merits of the initial rescue plan, a number of banks were unable to maintain their scheduled repayments to the central bank. Therefore, in 1989, the ten-year payback period was extended indefinitely. Under the new agreement, banks are required to repurchase the subordinated debt with their flow of profits (if any) minus the dividends paid out to preferred private stockholders until their debt obligations are fulfilled.33 For some banks, which have not been able to cover even accrued interest, this has resulted in negative amortization of their debts to the central bank. By the end of 1993, the banking system’s obligation to the central bank is estimated to have reached about US$4 billion, or 10 percent of GDP.

During the 1970s and early 1980s, economic conditions in Colombia remained heavily dependent on coffee exports. To a large extent, the banking crisis of the early 1980s was triggered by the sudden end of the coffee boom of the late 1970s and the related deterioration of the fiscal position. As the coffee boom ended, Colombia experienced capital flight as economic agents adjusted their portfolios to the ad-verse external shock. The capital flight resulted in only a mild banking crisis because much of the foreign borrowing was concentrated directly on the balance sheet of the government rather than on the balance sheets of financial institutions. The government was able to cover the flight by borrowing foreign reserves from the central bank, as net central bank credit to public authorities increased from 4.2 percent of GDP in 1982 to over 9 percent of GDP in 1984, causing central bank foreign reserves to decline to 3.4 percent of GDP (see Table A5).

Because of the accumulation of foreign exchange reserves during the coffee boom, the Colombian central bank had a larger amount of funds available to aid troubled banks in the early 1980s than was available in Chile. In 1982, its net international reserves equaled more than 10 percent of GDP compared with about 5.5 percent at the Chilean central bank (see Tables A4 and A5). The impact of capital flight on the banking system is evident from the increased central bank lending to banks, which increased from—3.3 percent of GDP in 1982 to–1 percent of GDP in 1984.34 A few small banks failed, and banks’ capital-to-asset ratios dropped sharply, indicating that shareholders were forced to sustain losses from nonperforming credits. The full severity of the crisis was not felt until the mid–1980s, and its resolution will be discussed in the next subsection. Nonetheless, unlike in Argentina, Mexico, and Peru, real interest rates in Colombia remained positive in the early 1980s, indicating that losses were focused on the stockholders of failed institutions.

Crisis Resolution: 1985–90

By the middle of the decade, Chilean banks were recovering, whereas Colombian banks were experiencing a more severe crisis in 1985 and 1986 than in the early 1980s. Nevertheless, the second Colombian banking crisis was quickly resolved. By the end of the decade, capital-to-asset ratios at the banks in both countries had recovered to their precrisis level, and the central banks’ role as lender to the banking system was declining.

In contrast, the banks in Argentina and Peru faced severe competition from the central bank as direct lender and from government-related development banks. In Mexico, by the middle of the decade, banks were lending most of their funds to the government and government-related enterprises. In all three countries, the banks were not able to exercise their monitoring function over borrower liquidity, and the central bank could not function as an arm’s-length regulator. This lack of independence of central banks from expansionary fiscal policies led to high inflation by the end of the decade.

Chile and Colombia

In Chile, by 1989, the central bank’s medium-and long-term foreign liabilities had declined from al-most 28 percent of GDP in 1985 to 10.5 percent of GDP, and central bank net domestic credit had fallen from 32 percent of GDP to 3.5 percent. Net international reserves were growing strongly relative to GDP (see Table A4).

After 1985, bank capital ratios also recovered—rising from 4 percent of assets to about 6 percent of assets by 1989, implying that bank earnings were growing (see Chart 3). Further indication that the franchise value of banks was improving was the increase in the loan-to-asset ratio, which had fallen when the central bank removed bad loans from the banks’ balance sheets. In assessing the effectiveness of the Chilean solution to the banking crisis of the early 1980s, it is necessary to take into account both the costs and the benefits of the procedures chosen. On the negative side, because the interest rate on banks’ debt has remained below that paid on central bank paper, the central bank has sustained losses throughout the mid–1980s and early 1990s. On the positive side, however, the problem was managed in an orderly way and did not result in a sustained deterioration of the fiscal stance or a rapid and sustained acceleration of inflation.35 In addition, only depositors in the failed institutions were forced to absorb some of the losses of those institutions. In contrast, depositors of both good and bad banks in Argentina and Mexico were forced to absorb losses under policies encouraging negative real interest rates. In Chile, real interest rates remained positive, and there was a relatively clear policy that only those connected with a failed institution would bear the burden of the failure (see Chart 2).

Indeed, to a large extent, the management of the banking crisis in Chile resembles that in several industrial countries. Even in countries where a banking crisis came to an end relatively quickly, such as in Sweden in the early 1990s, the resolution of the financial difficulties involved large costs to the tax-payers.36 In the United States, with the resolution of the savings and loan crisis, the accumulated loss suffered by U.S. taxpayers has, to date, amounted to about 3 percent of GDP.

In 1992, banks with debt outstanding to the central bank had net income before dividends and payments to the central bank of about CH$110 billion, which, discounted at the cost of banks’ liabilities, equaled about CH$800 billion.37 With total subordinated debt outstanding amounting to about CH$1.5 trillion, this simple approximation suggests that, using 1992 data, about 45 percent of the subordinated debt is uncollectible. This portion represented about 5 percent of 1992 GDP.38 This figure suggests that the cost of the Chilean banking crisis relative to GDP is higher than the cost to GDP of the U.S. savings and loan crisis; however, it is lower than the cost incurred in resolving the banking crisis in Sweden.

Although the cost of resolving the banking crisis in Chile is a substantial burden, it must be noted that, relative to the original magnitude of the banking crisis, during which central bank net domestic credit swelled to 30 percent of GDP, the debt hangover is moderate. Thus, despite the costs currently borne by the central bank, the resolution of the banking crisis in Chile minimized economic dislocations relative to those suffered by other countries in the sample considered in this paper. In addition, as a result of the experiences during the crisis, the Chilean bank supervisory framework is now among the best in Latin America.

In Colombia, in 1985, the central bank began reducing net domestic credit and accumulating net international reserves. In the same year, its net credit position toward banks declined, indicating that it had reduced lending to the banks. This event did not, however, signal the resolution of the banking crisis as it did in Chile; in fact, nonperforming loans at commercial banks equaled 500 percent of capital and 268 percent of capital at all financial institutions in 1985.39 Capital-to-asset ratios at commercial banks and finance companies fell sharply (see Chart 3). Rather, the reduction in central bank lending to banks signaled a new method for dealing with distressed banks.

The Colombian authorities established a deposit insurance fund to lend to banks with distressed loan portfolios and to resolve banks that had failed. The insurance system received its funding largely from the government and from extraordinary revenues made available by a sharp rise in coffee prices in the mid–1980s. The insurance fund ultimately purchased the largest banks in the banking system but originally had problems selling them, because it could not find buyers that met the legal criteria established to prevent industrial or financial conglomerates from developing.40 The purpose of the legislation was to prevent concentration of credit to single borrowers and to en-sure arm’s-length credit decisions. Many of the bank failures in the 1980s were blamed on such abuses.

In early 1994, the insurance fund successfully sold the largest bank—Banco de Colombia—to an industrial conglomerate. This sale raises the question of the abuses that the legislation was designed to curb. Strong supervision (such as restrictions on loans to related companies and limits on credit exposure to single borrowers), however, can alleviate many of these potential problems. If the Colombian authorities successfully complete the sale of the remaining resolved major bank—the Banco Cafetero—and effectively strengthen the supervisory process to avoid abuses, the Colombian rescue efforts will have rein-forced the franchise value of the banking system.41

Argentina, Mexico, and Peru

The banking systems in the three countries with relatively weak franchises all experienced an expansion of credit to government-related institutions relative to credit provided to the private sector through private financial institutions in the mid-to late 1980s. Although the details of how this credit was directed to the public sector differed by country, the outcome was the same in all countries. The projects financed through money creation did not generate a corresponding expansion in economic activity. As a result, severe inflation followed, and holders of assets denominated in domestic currency experienced a loss in their real wealth. In all three countries, the central bank failed to act as a bank supervisor because it had a conflict of interest as a direct lender, and the banks lent funds to government institutions that were too powerful to be monitored by normal bank credit policies. Thus, the checks and balances that restrain risk taking in well-supervised banking systems did not exist.

In Argentina, starting in 1986, central bank credit to the central government expanded faster than commercial bank credit to the private sector (see Chart 4). The credit expansion was caused primarily by a lack of confidence in the government’s ability to repay the central bank, which forced up interest rates, requiring further borrowing to service the debt. At the same time, central bank funding to the banks also expanded more rapidly than commercial bank credit to the private sector. In 1989, the net domestic assets of the financial system relative to GDP exploded, in-creasing from less than 40 percent of GDP in 1988 to more than 50 percent.

The credit explosion resulted in hyperinflation and a deterioration in the exchange rate (Chart 5). The rapid depreciation of the currency reflected investors’ perceptions that the credit created by the central bank, both directly and through the banks, could not be paid off in real terms.

Extreme negative real interest rates on domestic currency deposits accompanied hyperinflation (see Chart 2). In addition, the central bank effectively confiscated domestic currency time deposits by forcing depositors to exchange their deposits for dollar bonds worth about half the market exchange rate value of the original deposits. The reduction in interest expenses on bank liabilities permitted banks to renegotiate credit terms to lenders and provided funds to pay off loans from the central bank. As indicated in Chart 3, the central bank’s policy caused banks’ capital-to-asset ratios to increase because, by confiscating deposits, the central bank effectively wrote down the value of liabilities to solve banks’ credit problems. In well-functioning accounting systems, the improvement in capital-to-asset ratios signals an increase in the market value of assets relative to liabilities. Because this was not the case in Argentina, investors could not use the capital-to-asset ratio as a reliable guide to bank soundness.

The Argentine experience indicates that the financial system lost its ability to enforce discipline on borrowers in the mid–1980s. This was a direct result of the loss of an arm’s-length relationship between the central bank and the ultimate borrowers in the economy, which resulted from the inability to deal with the banking crisis in the early 1980s in a manner that would restore the credibility of the banks.

In Mexico, as in Argentina by the mid–1980s, the government had taken an increasing share of total credit. In contrast to Argentina, however, the increased flow of credit to the government occurred on the balance sheets of the nationalized commercial banks (see Table A2). By 1986, over 60 percent of net domestic bank credit flowed to the government, compared with 35 percent in 1982.

Net domestic credit of the financial system expanded rapidly beginning in 1986, when it increased to over 70 percent of GDP from 52 percent the previous year (see Chart 4). As in Argentina, much of the increase in financial system credit relative to GDP during 1986–87 was accompanied by a deterioration in the exchange rate and high inflation rates, which peaked in 1987 and 1988 (Chart 5). Real interest rates on bank deposits became negative in 1987, reducing the government’s real burden in paying off its bank loans, which declined substantially relative to GDP in 1988 (see Table A2).

In Peru, net domestic credit of commercial banks relative to GDP remained low in the early part of the decade because of very high reserve requirements. This policy, however, was abandoned in the mid–1980s when the central bank expanded credit sharply—partly financed with bank reserves held at the central bank. Net credit of the central bank expanded from–4.7 percent of GDP in 1985 to 1.4 percent of GDP in 1986, and a large amount of foreign exchange reserves was lost. The central bank continued to expand credit in 1987 and 1988, primarily financed from arrears on foreign debt and increased liabilities to the private sector (Table A3). In 1988, central bank credit equaled over 40 percent of net domestic credit, compared with less than 10 percent in 1986. Most of the credit went to the public sector, especially the agricultural banks.

The impact of the credit expansion followed a familiar pattern. In 1988, inflation turned into hyperinflation, which was accompanied by extremely negative real interest rates on domestic currency bank deposits (see Chart 2). In addition, there was large disintermediation in domestic currency deposits.42

Unlike Argentina and Mexico, Peru experienced only one major crisis because the high reserves at commercial banks precluded an earlier one. When the crisis erupted, however, it was the sole result of central bank mismanagement. The high reserves placed considerable resources in the hands of the central bank, which lent them without regard to sound lending practices. Thus, the Peruvian financial crisis is a classic example of a central bank abandoning its traditional role of examiner of bank credit decisions for a role of undisciplined primary lender.

Chart 4.
Chart 4.

Selected Financial Indicators

(Percent of GDP)

Sources: Argentina, Ministry of Economy, and Central Bank of Argentina; Central Bank of Chile; Colombia, Banco de la Republica; Bank of Mexico; Central Reserve Bank of Peru; and IMF staff estimates.Note: The shaded areas in Argentina, Mexico, and Peru, correspond to the high-inflation periods.1 Net domestic assets of the consolidated banking system for Peru.
Chart 5.
Chart 5.



Source: IMF, International Financial Statistics, various issues.

State of the Banking Systems at the Beginning of the 1990s

By the early 1990s, the banking crises in the countries under consideration had largely come to an end. How does the strength of the banking franchise in each of the five countries at the beginning of the 1990s compare with their strength in the early 1980s? The early 1990s is an important time to evaluate the strength of the franchise for two reasons: first, both bankers and regulators have absorbed the lessons from the crisis and, second, the banking systems are facing new challenges to their lending skills in the form of renewed capital inflows from overseas.

Chart 6.
Chart 6.

Cash Assets to Deposits


Sources: Argentina, Superintendencia de Entidades Financieras y Cambiarias, Estados Contables de las Entidades Financieras, various issues, and Central Bank of Argentina; Chile, Superintendencia de Bancose Instituciones Financieras, Informatión Financiera; Colombia, Banco de la Republica; Mexico, Comisión Nacional Bancaria; Peru, Superintendencia de Banca, y Seguros; and IMF staff estimates.1 Estimate for the entire banking system (including commercial banks, finance corporations, and savings and loan corporations).

In addition to evaluating the franchise value of banks based on the two ratios considered at the beginning of this section, the discussion that follows examines the franchise value from the perspective of financial investors—that is, the willingness of the public to keep financial funds in the domestic banking sector, as measured by the ratio of deposits to GDP.43

Chart 7.
Chart 7.

Loans to Assets


Sources: Chile, Superintendencia de Bancos e Instituciones Financieras, Informacion Financiera; Colombia, Banco de la Republica, Revista del Banco de la Republica; Mexico, Comision Nacional Bancaria; and Peru, Superintendencia de Banca y Seguros.1 Commercial banks only.2 Data for total assets held by commercial banks are not available for 1982.

The behavior of the franchise ratios—cash to deposits and loans to assets—during the crisis period and the early 1990s is displayed in Charts 6 and 7, respectively. Overall, the ratios indicate an improvement of the franchise value of the banking systems at the beginning of the 1990s relative to the early 1980s. During the crisis, however, the ratios, affected by the policies used to resolve the banking difficulties, fluctuated significantly in most countries.

In Argentina, Chile, and Mexico, the cash-to-deposit ratio declined significantly during most of the 1980s and into the early 1990s (Chart 6). In Mexico, the decline in cash assets resulted from a major decline in the ratio of required reserves to deposits, ultimately falling to zero in the early 1990s. In Argentina, the decline in cash assets to deposits also resulted from a decrease in reserve requirements, which, in 1982, were 100 percent on new deposits.

In Colombia, cash assets fell relative to deposits in the mid–1980s as banks divested themselves of cash assets to cover nonperforming loans. Although by 1991 this ratio had returned to its 1982 level, reductions in reserve requirements in early 1993 suggest that the ratio may have declined again. In Peru, cash assets increased relative to deposits throughout the 1980s. The large increase in 1988 occurred because banks held excess reserves on which they earned interest. By the early 1990s, Peru had reduced reserve requirements on both domestic and foreign currency deposits, but they remained substantially higher than those of any other sample country. Moreover, by early 1994 a portion of reserve requirements on foreign currency deposits still earned interest.

The loan-to-asset ratios in Argentina and Mexico improved substantially during the 1980s (Chart 7). Mexico experienced an interruption in the improvement in this ratio in the late 1980s owing to heavy bank investment in government securities, which was the result of a government program that allocated a significant component of banks’ assets.

In Chile, the loan-to-asset ratio declined during 1982–86 following the central bank program to rescue banks, which, as discussed above, involved replacing nonperforming loans with central bank liabilities and removing troubled loans and liabili-ties from bank balance sheets. After 1986, as faith was restored in the banking system, the loan-to-asset ratio again began to improve. It remained below its 1982 level, however. In Peru, as in Chile, the loan-to-asset ratio did not materially improve between 1982 and 1992, and it remained the lowest of the five countries. It fell substantially in the mid-to late 1980s as the cash-to-deposit ratio increased. By the early 1990s, the loan-to-asset ratio had deteriorated moderately in Colombia relative to its position in 1982. The temporary increase in the loan-to-asset ratio in the mid–1980s reflected the decline in the ratio of cash to deposits during that period.

In the three countries with weak franchises, as measured by the ratios in 1982, there was considerable financial disintermediation during the crisis. In Argentina, the deposit-to-GDP ratio fell from about 19 percent in the early 1980s to less than 10 percent during the early 1990s. The pattern in Peru was similar. The ratio fell from about 15 percent in the early 1980s to 10 percent in 1992. In Mexico, the ratio fell to less than 10 percent in 1988 from almost 30 percent in the early 1980s (Chart 8).44

Because of the extreme disintermediation in the countries with weak franchises, means of transacting had to be found outside the usual deposit channels. In Argentina and Peru, informal payments markets developed. Trade credit between firms increased dramatically. In contrast, Mexico developed the liquidity of the short-term government bills (CETES) market. Banks purchased these bills from securities firms under repurchase agreements, making them very liquid instruments that could substitute for bank deposits.

The deposit-to-GDP ratio in Mexico recovered in the early 1990s, exceeding its 1982 level by 1991, which is consistent with the finding that the franchise ratios improved. In the early 1990s, banks were privatized and supervision has recently been strengthened. Banks experienced some credit problems after privatization, which they have dealt with by increasing provisions for nonperforming loans and slowing lending growth. In addition, between 1991 and 1992 the capital-to-assets ratio strengthened after a fall during the early years of privatization (Chart 3). Investors are apparently satisfied that the banking system is fairly well managed. Based on this confidence, Mexico, alone among the weak franchise systems in 1982, joined the relatively strong franchise group by the early 1990s.

In contrast, by 1992, investors in Argentina had not yet recovered confidence in the banking system despite the improvement in the ratios. This may have had several causes: the banking crisis in Argentina was much deeper than in Mexico, and, unlike in Mexico, bank ownership is in the same hands as during the crisis. A large segment of the banking system is still in provincial hands, and these banks have, in the past, made loans based more on politics than on sound banking principles.

Chart 8.
Chart 8.

Total Deposits

(Percent of GDP)

Sources: IMF, International Financial Statistics, various issues, and World Economic Outlook, various issues; Central Bank of Argentina; Chile, Superintendencia de Bancos e Instituciones Financieras, Información Financiera; Colombia, Banco de la Republica; Mexico, Comisión Nacional Bancaria; Peru, Superintendencia de Banca y Seguros; and IMF staff estimates.

Appendix Tables

Table A1.

Argentina: Summary Accounts of the Financial System

(Percent of GDP)

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Sources: Central Bank of Argentina; Ministry of Economy; IMF, International Financial Statistics, various issues; and IMF staff estimates.

Preliminary data.

Foreign currency bonds (BONEX, BOTE, BOTESO, and BOCON). The item also encompasses the adjustment for BONEX included in the BCRA’s reserve assets.

The decomposition of central bank credit by financial institutions is not available.

Includes bonds and frozen deposits in the central bank.

Table A2.

Mexico: Summary Accounts of the Financial System

(Percent of GDP)

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Sources: Bank of Mexico: IMF, International Financial Statistics, various issues; and IMF staff estimates.

September 1993 data.

Net credit to federal government plus net credit to other public sector.

Sum of medium-and long-term liabilities plus money and quasi money in foreign currency.

Liabilities to nonbank financial public sector (which excludes liabilities to official trust funds of the Bank of Mexico); it also includes capital and surplus for 1982–84.

For 1982, balance of payments support loan from Bank for International Settlements (BIS) was included as a foreign reserve liability of the monetary authorities and only a portion appears as credit to the federal government.

The sum of the following categories: net credit to official trust funds of Bank of Mexico, net claims on other government-related financial corporations, net credit to commercial banks, and net credit to government development banks.

Sum of net credit to commercial banks plus net credit to government development banks.

Data for 1985–92 are significantly revised in late 1980s, and hence the 1981–83 data are not strictly consistent with the 1985–92 data.

Medium-and long-term liabilities item included in this category also include net disbursements under Commodity Credit Corporation (CCC) loans in 1983, 1984, and 1985.

Liabilities to nonbank financing public sector (which excludes liabilities to official trust funds of the Bank of Mexico) for 1985–92; it also includes liabilities to the rest of the banking system for 1983 and 1984 and capital and surplus for 1982.

Excludes public sector deposits incorrectly classified as private sector deposits.

Table A3.

Peru: Summary Accounts of the Financial System

(Percent of GDP)

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Sources: Central Reserve Bank of Peru; IMF, International Financial Statistics, various issues; and IMF staff estimates.

June 1992 data.

Table A4.

Chile: Summary Accounts of the Financial System

(Percent of GDP)

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Sources: Central Bank of Chile; and IMF staff estimates.

Preliminary data.

Excludes holdings of treasury notes on account of the 1983–86 capitalization of the central bank, which are included in other net domestic assets.

Includes foreign liabilities on account of deposits placed by the corporate sector in the Central Bank in the context of the 1983–85 rescheduling agreements with foreign commercial banks.

Table A5.

Colombia: Summary Accounts of the Financial System

(Percent of GDP)

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Sources: Banco de la Republica; and IMF staff estimates.

Central administration plus rest of public sector.

Banco de la Republica accounts were revised in December 1989 to improve the account sectorization between the private and public sectors. Because of this revision, the series of credit flows to the private and public sectors before and after these dates are not strictly comparable.

The category central administration excludes assumption of debt for Col$5,174 million (capitalization of Banco del Estado) and for Col$9,691 million (capitalization of National Electric Finance (FEN) Company) in 1982.

For commercial banks plus specialized banks.

Includes adjustment for exchange rate valuation account before end 1989. Includes capital of Banco de la Republica and Special Exchange Account.

A new reporting system was introduced for financial system accounts starting in December 1989 and was adjusted in December 1990. Thus, data for end–1989 and end–1990 are not comparable to earlier data.

Comprises development finance corporations, trade finance companies, savings and loan companies, cooperative institutions, and development banks (BANCOLDEX, FINAGRO, FINDETER). A new reporting system for financial system accounts was introduced at end–1990. Data for 1990 are there-fore not strictly comparable to earlier data. Data for 1990 exclude PROEXPRO.


For a review of the issues and experiences in a number of developing countries that faced banking crises in the early 1980s, see Sundararajan and Balino (1991).


This issue is discussed further in Balino (1991).


As the discussion below will show, the diversity of experiences across these countries is enough to guarantee an appropriate representation of the banking difficulties in Latin America.


For a discussion of the factors that explain the evolution of foreign capital flows before and during the debt crisis in several Latin American countries, see Rojas-Suárez (1991). A comparison between the capital inflows problem in the 1970s and early 1990s is presented in Calvo, Leiderman, and Reinhart (1992).


A detailed analysis of the capital flight problem experienced by Latin American countries during this period is contained in Rojas-Suárez (1991).


Confidence of the international community in the financial performance of most Latin American countries was not restored during most of the 1980s. Indeed, the large capital flight that followed the onset of the debt crisis, as well as the deceleration of external loans, was accompanied by a sharp increase in the re-source balance-—defined as net exports of goods and nonfactor services—during 1983—86; that is, for the Latin American countries, net transfers of resources abroad were a direct cost associated with their severely reduced access to external credit. Further discussion of these issues appears in Rojas-Suárez (1991).


Although interest rates were liberalized in Argentina in 1978, controls on bank deposits were reimposed in 1981. See the discussion in the next subsection.


In Chile, during the late 1970s and early 1980s, ex post real interest rates increased drastically and were accompanied by a significant widening of the spread between domestic interest rates (adjusted for exchange rate changes) and comparable foreign interest rates. The review of the Chilean experience suggests that these high domestic rates emerged when the domestic financial system was liberalized in conjunction with the opening of the capital account (see Mathieson and Rojas-Suárez, 1993).


The crisis was confined to the collapse of two banks in early 1983. This made remaining banks very cautious in extending new loans. The impact of bank failures and bank loan loss problems on bank balance sheet quality is difficult to discern from capitalto-asset ratios because the accounting data appear unreliable. Thus, the large fluctuations in the capital-to-asset ratios during 1980–90 shown in Chart 3 largely reflect accounting procedures rather than true changes in real capital.


For a thorough description of the bailout procedures in Chile, see Morris and others (1990) and Velasco (1991).


Because reserve requirements in Chile were so low, the central bank had very few funds with which to aid the banks. Most of its resources came from an expansion of borrowing from over-seas, which increased from less than 2 percent of GDP in 1982 to more than 27 percent by 1985. Much of this increase was due to the depreciation of the Chilean peso; however, in U.S. dollar terms, foreign borrowing by the financial system increased from almost $6 billion in 1982 to almost $10 billion in 1985. The additional funds were made available through rescheduling agreements with foreign lenders.


Marked to market means that assets are valued at current market prices rather than at book values. In contrast, in Argentina capital-to-asset ratios actually increased during the banking crisis, indicating either that shareholders gained from the rescue package or that nonperforming loans were not marked at market values.


The central bank had to provide monetary enhancements to these deals (tax exemptions were also granted). This is similar, however, to the experiences of bank regulators in a number of industrial countries when dealing with resolution of banking crises.


These are the new shareholders, the so-called capitalistas populares, who bought shares when banks were recapitalized in the mid–1980s.


The negative asset position indicates that the banks were net creditors of the central bank.


It needs to be recognized, however, that the sustained losses of the central bank have acted as a constraint to reduce the Chilean inflation rate to industrial country levels.


In Sweden, by the end of 1992, capital injections and government guarantees to support troubled banks amounted to 6.4 percent of GDP.


The assumed discount factor equals 13.5 percent, which is the average nominal cost of liabilities of the national banks in 1992.


Actual payments to the central bank were CH$78 billion in 1992 because only a proportion of banks’ net income was required to be used as payments to the central bank. However, in calculating the amount of debt that is potentially serviceable, it is appropriate to consider the entire cash flow available for debt ser-vice. Using the lower figure would imply that the unserviceable debt equals about 6 percent of GDP.


The Colombian banking system is made up of commercial banks, savings banks, development finance companies, and trade finance companies.


The sale of the Banco de Bogota was criticized as providing a large subsidy to purchasers.


The Banco Central Hipotecario was sold to the Social Security Institute. The state will retain the ownership of the Banco Popular.


Although a large number of transactions were performed using the U.S. dollar, bank deposits denominated in foreign currency—which had been allowed since December 1977—decreased significantly during August 1985-December 1990, when fully convertible foreign currency deposits were prohibited. In particular, foreign currency deposits could be converted into intis (the domestic currency at the time) only at the official exchange rate (measured as the number of intis per U.S. dollar), which fell sharply below the rate in the parallel (black) market. Large disintermediation from the banking system followed, and, rather than declining, U.S. dollar transactions intensified through the development of informal real and financial markets. Indeed, two forms of holding U.S. dollars were clearly identified by Peruvian residents: U.S. currency notes that could be obtained in the well-established domestic black market for U.S. dollars and deposits in foreign banks reflecting capital flight. Fully convertible foreign currency deposits were reestablished at the beginning of 1991.


As discussed in Section II, ratios of nonperforming loans to total loans do not provide a good indicator of bank soundness in developing countries because banks could be rolling over problem loans. In this connection, recent restructurings of the banking system that have forced banks to recognize problem loans as such in the accounting procedures may lead to the misleading conclusion that bank difficulties have increased.


The sharp decline in the deposit-to-GDP ratio in Mexico in 1988 (Chart 8) is somewhat overstated because of a bank liability, called banker’s acceptances, that had many of the characteristics of a bank deposit but was not classified as such. In 1988, banker’s acceptances, unlike bank deposits, were not subject to interest rate ceilings, and, in that year, the rules guiding their issuance were liberalized.